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Using Corporations To Reduce Or Defer Taxation For Individuals



The war against corporations and the shareholders of those corporations

Corporations as entities that are separate from their shareholder/owners

As every law students knows, a corporation is a legal entity that is separate from its owner. As a legal entity that is separate from its owner, a corporation is capable of holding assets, carrying on a business and investing in a way that results in separation of the shareholder(s) from the business itself. It is a mistake to infer that the corporation’s status as a separate legal entity means that the corporation’s income will not be taxed to its shareholders.

Corporations as legal instruments of tax deferral

When corporate tax rates are lower than individual tax rates, there is incentive for individuals to earn and invest through corporations rather than to earn and invest as individuals. In other words, in certain circumstances, corporations can be used to pay less taxes.

Corporations as instruments of tax evasion

In many jurisdictions is it possible to create a Corporation and NOT disclose the identities of the beneficial owners. Because of this circumstance:

1. Corporations (as was made clear in the “Panama Papers Story”) can be used to hide income and assets for either legitimate or illegitimate reasons; and

2. Corporations can be used to avoid the attribution of income earned by the corporation to the shareholders.

Interestingly, the combination of FATCA (the USA demands information from other countries) and the unwillingness of the USA to join the CRS (meaning that it will NOT exchange information with countries) has made the United States one of the top tax havens in the world.

Corporations and FATCA

As described in “The Little Red FATCA Book,” the United States is forcing other nations to report on any and all corporations owned by “U.S. Persons”.

Corporations as the original “tax shelter”?

This article offers history lesson that includes:

Believe it or not, corporations were the original tax shelter. This statement may sound insane, but it’s true. For a long time, individual income tax rates were substantially higher than corporate income tax rates, and since corporations are viewed as separate and distinct entities for U.S. federal income tax purposes (and taxed accordingly), this disconformity in the tax rates resulted in what is essentially tax arbitrage, whereby taxpayers would use corporations as a tax-planning tool to minimize their tax liabilities.

Most often, this manifested itself in the form of taxpayers contributing assets (e.g., stocks, bonds, real estate, etc.) to corporations that generated various types of passive income, such as interest, dividends, capital gains, rents, royalties, etc. Again, this sounds insane by modern-day standards, because in today’s world any tax advisor worth his salt will tell you that placing assets, appreciated or otherwise, that generate passive income into a corporation is almost never a good idea, specifically because any income or gains realized will be subject to two levels of taxation. As Bittker and Eustice so eloquently put it, “a corporation is like a lobster pot: easy to enter, difficult to live in, and painful to get out of.”

But back in 1934, when the PHC rules were enacted, this is exactly what taxpayers were doing, specifically because the income and gains realized from the contributed assets were taxed at a substantially reduced rate, allowing the income to compound more quickly inside the corporation and greatly increasing the rate of return on such assets. Individual taxpayers were then able to delay the day of reckoning because they would be taxed on the income that had built up inside the corporations only when such corporations either liquidated or paid a dividend, or when they sold their stock, the timing of any of which was very much under the control of such shareholders.

Congress viewed this result as unacceptable because, in its opinion, taxpayers were using corporations to improperly obtain a deferral of tax. It could have easily solved this problem by equalizing the tax rates between individuals and corporations (which it did eventually, sort of, although it took almost a century). But, never being one to take the easy walking trail when the arduous, rockslide-prone mountain pass would just as well suffice, Congress instead chose to enact two complicated mechanisms, the accumulated earnings tax (AET) and the PHC rules, which, while different in their application, had the same ultimate goal: to incentivize corporations to pay dividends to their shareholders on a current basis by penalizing them for not doing so.

(Note that in Canada and many other countries, individual tax rates are far higher than corporate tax rates.)

Government responses to prevent the use of corporations to reduce and defer taxes

Corporations provide the opportunity to pay lower taxes and defer taxes in two distinct ways:

First, assets owned and income earned by the corporation is NOT earned by the individual. In general income earned by the corporation will not be attributed to the individual.

Second, corporate tax rates may be lower than individual rates. Given that income must be taxed, why not arrange for it to be taxed at the lower rate?

Governments typically attack taxpayer attempts to use corporations to minimize taxes in two ways:

1. The Government imposes penalties directly on the corporations (U.S. PHC – Personal Holding Company tax, etc.)

(See for subchapter G of the U.S. Internal Revenue Code.)

26 U.S. Code Subchapter G – Corporations Used to Avoid Income Tax on Shareholders

PART I – CORPORATIONS IMPROPERLY ACCUMULATING SURPLUS (§§ 531 to 537)

PART II – PERSONAL HOLDING COMPANIES (§§ 541 to 547)

PART III – REPEALED] (§ 551..)

PART IV – DEDUCTION FOR DIVIDENDS PAID (§§ 561 to 565)

Note that a Government must have jurisdiction over the corporation in order to regulate the corporation. The Personal Holding Tax “PHC” is a tax imposed directly on the corporation and NOT directly on the shareholders.

2. The U.S. Government imposes penalties directly on the shareholders (U.S. Subpart F, PFIC, etc.)

These penalties can be in the “form” (you know what is coming) of either “tax penalties” or “reporting penalties”.

 

Note that the CFC and PFIC rules are attempts to punish the use of “foreign corporations”. The U.S. does NOT have tax or regulatory jurisdiction over “foreign corporations”. As a result, the CFC and PFIC penalties are levied on the U.S. shareholders of those corporations.

Reporting penalties – Form 5471, Form 926, Form 8621, etc.

As Donald Dewees, a U.S. citizen residing in Canada learned, the United States will impose very strict penalties for failing to disclose ownership in Canadian Controlled Private Corporations. (You can learn more about this here and here.)

CFC rules in other countries

Many countries have rules which prevent their “tax residents” from using foreign corporations to avoid taxation. Interestingly the U.S. CFC rules were enacted at the same time that Britain enacted its equivalent CFC rules. Russia has (in addition to its “citizenship reporting rules“) Canada (a particularly efficient tax collector) also (who could have known?) has it’s CFC rules. Canada’s robust set of CFC rules is described (in part) as follows:

Canada currently has a robust set of CFC rules. The “foreign accrual property income” or “FAPI” rules are a broad set of anti-deferral rules applicable to passive income earned by a “controlled foreign affiliate” of a Canadian taxpayer. Passive income for this purpose very generally includes income from property (such as rents, royalties, interest and non-foreign affiliate dividends) and income from certain businesses that either have a link to Canada or do not meet certain minimum employee and other requirements. FAPI does not include income from an active business carried on by a foreign affiliate. A Canadian shareholder is generally required to include, in its income for a taxation year, its share of any FAPI earned by any of its controlled foreign affiliates in such year, regardless of whether or not any amount is distributed by the controlled foreign affiliate to the shareholder. A deduction is available in respect of any foreign taxes attributable to FAPI. If FAPI in a controlled foreign affiliate is less than C$5,000, it is not required to be included in the shareholder’s income. There is no “low-tax threshold” or “high-tax kick out” – the FAPI rules apply even if the controlled foreign affiliate is resident in a country that imposes tax at a rate that is equal to or exceeds the Canadian rate. Generally speaking, if FAPI, which is computed using the rules in the Income Tax Act (Canada) (the ITA) and in the Canadian taxpayer’s functional currency, is subject to foreign tax of at least 25%, no additional tax should be payable in Canada.

The Reality of U.S. Citizenship Abroad

My name is John Richardson. I am a Toronto based lawyer – member of the Bar of Ontario. This means that, any counselling session you have with me will be governed by the rules of “lawyer client” privilege. This means that:

“What’s said in my office, stays in my office.”

The U.S. imposes complex rules and life restrictions on its citizens wherever they live. These restrictions are becoming more and more difficult for those U.S. citizens who choose to live outside the United States.

FATCA is the mechanism to enforce those “complex rules and life restrictions” on Americans abroad. As a result, many U.S. citizens abroad are renouncing their U.S. citizenship. Although this is very sad. It is also the reality.

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3 thoughts on “Using Corporations To Reduce Or Defer Taxation For Individuals

  1. Ken Owens says:

    You and I and and all of the knowledgeable tax community KNOWS that the US is in no way a tax haven. I laughed out loud at your comment that FATCA helped make the US a tax haven, as the irony exploded before my eyes. Repeating political commentary does not belong here. Shame on you.

    Of course, you must believe that both the US’ double taxation of corporate earnings and the imposition of tax on worldwide income are both penalties, since you deem the acceleration of such taxes as penalties. Both are taxes imposed on income, whenever they occur, but clearly not penalties. Why do you hide the truth this way? Shame again.

    Oh, by the way, even a college student wouldn’t be crazy enough to “fill” a paper with a portion of the index to the IRC, let alone someone claiming to be an experienced professional. Really, John?

  2. Ken, thank you for your response. The first part of your comment addresses (I think) this part of the post:

    “Interestingly, the combination of FATCA (the USA demands information from other countries) and the unwillingness of the USA to join the CRS (meaning that it will NOT exchange information with countries) has made the United States one of the top tax havens in the world.”

    The point is a simple way. There is no reciprocity pursuant to FATCA. FATCA is a one way street that requires other countries to provide information on “entities” with U.S person beneficial ownership. The U.S. is not required to and does not reciprocate under FATCA.

    In addition, the U.S. has not joined the CRS which would require the USA to provide information about beneficial ownership to other countries.

    The result is that the USA is one of the few remaining countries in the world “beneficial ownership” of entities can be hidden.

    Since you don’t like this post, I suggest you google “Peter Cotorceanu Hiding in plain sight: how non-US persons can legally
    avoid reporting under both FATCA and GATCA” which (as well as not being political commentary) explains the interaction between FATCA and the OECD Common Reporting Standard rather well.

  3. Ken, continuing to thank you for your response. I believe that the second part of your comment is directed to:

    2. The U.S. Government imposes penalties directly on the shareholders (U.S. Subpart F, PFIC, etc.)

    These penalties can be in the “form” (you know what is coming) of either “tax penalties” or “reporting penalties”.

    “Note that the CFC and PFIC rules are attempts to punish the use of “foreign corporations”. The U.S. does NOT have tax or regulatory jurisdiction over “foreign corporations”. As a result, the CFC and PFIC penalties are levied on the U.S. shareholders of those corporations.”

    Let’s start with the PFIC rules. As you presumably know, for something to be a PFIC, it must be a “foreign corporation”. Unfortunately non-U.S. mutual funds are understood to be PFICs. The “taxation” (which is actually called an “Interest charge on tax deferral” operates to impose a “tax” that (depending on the length of the holding period) can approach 100% of the gains. Why? Because the mutual fund is a “non-U.S. mutual fund”. Of course U.S
    mutual funds are NOT subject to the same tax regime. Let’s compare the situation of two U.S. taxpayers.

    1. Homeland American buys a mutual fund in the USA. This fund is not taxed according to the PFIC regime.

    2. American abroad buys the same mutual funds with a non-U.S home office that includes exactly the same basket of stocks. This fund is taxed according to the PFIC regime.

    The American abroad will pay (what you would call just a “tax”) but what I would call a “penalty” for investing in the non-U.S. fund.

    The fact that a requirement to pay appears in the Internal Revenue does NOT make it a “tax”. The PFIC rules are clearly designed to punish investors in non-U.S. mutual funds.

    Maybe that’s okay if the the rules are applied to U.S. residents. But, these rules are NOT applied just to U.S. residents. They are applied to Americans abroad who are also subject to the tax regime of another country.

    The point is that the imposition of these rules on Americans living abroad makes the process of normal investing and financial planning very difficult (if not impossible).

    Now on to the CFC rules and Subpart F regime:

    Again, I write from the perspective of Americans abroad trying to live a “normal life” which might include having a small business corporation in a country outside the United States.

    Leaving aside the “reporting requirements”, the Subpart F income issue is extreme because the rules attribute company income to the individual. We can argue all day about whether this is a penalty or a tax or whatever, but I would make the following points:

    – the Subpart F regime attributes income from the corporation directly to the shareholder; and

    – by deeming the Subpart F income to be ordinary income and not allowing the income to flow through retaining its original character as “capital gains” or whatever, a tax is imposed on the “attributed income” at a higher rate. You might call this a “tax”. But, it is actually an enhanced tax because the income was attributed from a “foreign” corporation.

    The PFIC and Subpart F regimes are two ways of penalizing the use of foreign mutual funds and foreign corporations. These are examples of kinds of things that make life for Americans abroad somewhere between difficult and impossible.

    Yes, regardless of what these things are called, they are actually penalties that are imposed on Americans abroad.

    The reporting requirements

    Do you think that an American abroad who doesn’t report his “foreign corporation” to the IRS should be subjected to a $10,000 a year penalty? Or do you think that this is just a “tax” too?

    Finally, re your comment about “worldwide taxation”:

    The problem is NOT “worldwide taxation”. The problem is imposing “worldwide taxation” on people who don’t live in the United States and are “tax residents’ of other countries.

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