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Despite budget cuts that have constrained the workforce at the IRS, enforcement of international tax compliance is at an all-time high. With its recent spate of active campaign announcements, the Large Business and International Tax Center (LB&I) is very busy looking for non-compliant taxpayers. But how?
While traditional audit techniques still reliably raise revenue, the IRS has focused its attention on artificial intelligence and data analytics. Using “big data” and the information it already has – your tax information – the IRS is quickly transitioning to automated auditing techniques. Much of this can be accomplished with a simple algorithm matching data from multiple IRS sources. Using such techniques, the IRS is quickly and easily identifying low-hanging fruit – often, unsuspecting taxpayers who simply fail to fully comprehend their tax filing obligations.
For taxpayers with international tax reporting obligations, these new compliance and enforcement efforts are particularly onerous – the applicable rules and regulations are already overly complex, tax compliance can be very expensive, and in 2017 the rules changed! Nevertheless, non-compliance is no longer an option. With these new tools at its disposal, the IRS is increasingly more effective at identifying non-compliant taxpayers. Notices are issued automatically and without much – if any – review by an actual person.
But while identification of non-compliance is seemingly more and more automated, resolution of non-compliance issues is not. In fact, tax service providers have discovered longer and longer response times on issues as simple as resolving an incorrectly issued notice. Unfortunately, the increased time required to address such notices and non-compliance issues only increases the overall compliance cost for the taxpayer.
|Active campaign||Practice area||Campaign objective|
|1120-F Delinquent Returns||Cross-Border Activities||This campaign encourages foreign entities to timely file Form 1120-F returns and address the compliance risk for delinquent 1120-F returns. This is accomplished by field examinations of compliance risk delinquent returns and external education outreach programs. The campaign addresses delinquent-filed returns, Form 1120-F U.S. Income Tax Return of a Foreign Corporation.|
|Forms 1042/1042-S Compliance||Withholding and International Individual Compliance||This campaign addresses Withholding Agents who make such payments but do not meet all their compliance duties. The Internal Revenue Service will address noncompliance and errors through a variety of treatment streams, including examination.|
|Section 956 Avoidance||Cross-Border Activities||This campaign focuses on situations where a CFC loans funds to a US Parent, but nevertheless does not include a Section 956 amount in income. The goal of this campaign is to determine to what extent taxpayers are utilizing cash pooling arrangements and other strategies to improperly avoid the tax consequences of Section 956. The treatment stream for this campaign is issue-based examinations.|
|Related Party Transactions||Enterprise Activities||This campaign focuses on transactions between commonly controlled entities that provide taxpayers a means to transfer funds from the corporation to related pass through entities or shareholders. LB&I is allocating resources to this issue to determine the level of compliance in related party transactions of taxpayers in the mid-market segment. The treatment stream for this campaign is issue-based examinations.|
|Inbound Distributors||Treaty and Transfer Pricing Operations||U.S. distributors of goods sourced from foreign-related parties have incurred losses or small profits on U.S. returns, which are not commensurate with the functions performed and risks assumed. In many cases, the U.S. taxpayer would be entitled to higher returns in arms-length transactions. LB&I has developed a comprehensive training strategy for this campaign that will aid revenue agents as they examine this IRC Section 482 issue. The treatment stream for this campaign will be issue-based examinations.|
The current LB&I active campaign list is extensive, but international tax reporting has center stage – some examples include:
- Expatriation & Repatriation
- FATCA Filing Accuracy & the Swiss Bank Program Campaign
- Forms 1042/1042-S Compliance
- Form 1120-F Non-Filers and Delinquent Returns
- Section 965 Avoidance
- Inbound Distributors
- Post OVDP Compliance
Calvetti Ferguson has successfully identified and resolved these issues for our clients. For many taxpayers, relief may be possible if non-compliance issues are identified and addressed prior to the taxpayer receiving an IRS notice. All facts and circumstances must be considered, and no two fact patterns are ever the same. One thing is for sure – these issues will not go away on their own. As the IRS continues to increase its enforcement of international tax reporting, now is the time to review and address any potential non-compliance.
International Tax Perspectives: Corporate and Individual Tax Issues of Middle-Market Companies and their Employees
The international expansion of business is inevitable. It used to be that this was reserved for only international oil companies (IOCs), which span the entire oil and gas value chain. This, however, is no longer the case. More and more, middle-market companies are able to sell their products and services internationally. These middle-market firms often start selling into the various markets from their respective countries and eventually end up sending their personnel to those markets to continue to penetrate and grow the business.
Thus, the globalization of business creates more opportunity for companies to go from dipping their toes in market to establish a presence through either a branch or establishing a subsidiary. Ultimately, they send the best and brightest to plant these flags and bring in more business.
These international assignments come with a host of business implications, and taxes is among the top priorities. They may send one or two individuals with their respective families or they may send a team of people depending on the size of their budget.
If you are one of these middle-market companies, you probably want to know in advance how to compensate these people while making sure you and them remain compliant with both home-country and host-country laws. The global mobility of the workforce brings a litany of tax, immigration and accounting issues that must be run to ground to avoid unpleasant surprises, such as missed filings and related penalties and interest and, worst of all, an unhappy employee.
U.S. Payroll Tax Obligations
Generally, a U.S. employer generally must withhold U.S. income taxes plus Social Security and Medicare (i.e. FICA) taxes from wages paid to an employee. Also, the employer must pay FICA and unemployment (FUTA) taxes on such wages. The employer must deposit these taxes timely and, in most cases, file quarterly employment tax returns reporting the wages, income tax and FICA taxes paid and file an annual FUTA return. Additionally, the employer must file and pay for state unemployment taxes. The employer also must provide to the employee and file with the Social Security Administration and the Internal Revenue Service (“IRS”) a Form W-2, Wage and Tax Statement showing the wages paid and taxes withheld from the employee. To do all of this, an employer must obtain an employer identification number or an EIN.
For an international employee, these U.S. tax obligations raise many questions and, depending on how your business is structured, the answer to those questions may differ every time. Thus, it’s important to establish the facts and circumstances while also having a good understanding about what international assignment entails.
For example, a foreign company may be unwilling to obtain a U.S. employer identification number simply to payroll their employee working in the U.S. If the foreign company already has a subsidiary in the U.S., it may be able to utilize the U.S. subsidiary EIN for these purposes.
Typical Scenarios Driving the International Assignment Complexities
In comparison to a well-established multinational accustomed to the exchange of personnel from across the world through an expansive network of affiliates, a growing middle-market company often finds that this process to be a growing pain. Nevertheless, like the large multinational, the middle-market company must comply equally and must involve the various departments or teams in the company, which may include the following:
Executive (CEO and Business Development): Decision to penetrate a foreign market or serve a foreign customer is made.
Legal (Corporate Counsel): Input is needed to understand the contracting with customers.
Finance, Accounting, & Tax (CFO, Accounts Payable, & Tax Director): Create the expansion budget, understand financial reporting implications, and comply with U.S. and local country corporate and payroll tax reporting and withholding requirements, involves tax experts to manage tax risks associated with going global.
Human Resources (HR director, Payroll, Employment and Immigration Attorney): Find and recruits candidates, formulates compensation package and terms and conditions, coordinates with payroll for tax reporting, obtains work permits and visas, tries to gain an understanding of global workforce requirements and establishes related policies and procedures.
Insurance (Risk Management Function): Provides customer with security in terms of being able to deliver products and services.
The typical scenario is a chain reaction that involves internal and external advisors who can provide the guidance for a successful project or simply one without surprises. Also, it is possible that the responsibilities described above often rest in a few number of people that represent entire management of a middle-market firm.
Finance, Accounting, Tax & Human Resources – Collaborate Throughout the Entire Process
It might seem that there must be one single best way to structure the international assignment to help meet the company’s goals. But there is not. Different expat assignments need to be structured in different ways depending on the business circumstances. For example, you may be sending someone to a jurisdiction where you have an up-and-running affiliate but your next expat may be going to a place where you have no on-the-ground infrastructure. As you can see, this can turn into a complicated planning scenario in an instant. Whether you are a U.S. business sending a U.S. citizen to work abroad or a foreign business sending a non-U.S. citizen to work on U.S. soil, the time and effort must be invested to prevent incorrect taxation for the business and the employee, payroll reporting, and noncompliance, which all translate into higher costs to the company in addition to the compensation package negotiated with the employee.
U.S. Employees Working in a Foreign Country
A U.S. citizen or resident alien (green card holder) is subject to worldwide taxation regardless of where the individual earns the income. Thus, if he or she relocates to a foreign country you and they will need to understand the U.S. withholding and reporting requirements. For example, both the company and the employee will need to understand if the foreign earned income exclusion will apply so that U.S. withholding is reduced. Furthermore, taxation in the U.S. and the foreign country may also depend on whether there is a tax treaty between the countries. Often times, the tax treaties may provide additional wiggle room to work with as the operation in defined.
What about social security? As discussed above, U.S. or foreign employers are still responsible to comply with relevant social security systems unless they can avail themselves from a totalization agreement. Thus, the preplanning process will require this consideration as well as understanding what documentation needs to be in place in order to receive benefits under either a double tax treaty or totalization agreements.
Foreign Employees Working in U.S. Soil
It’s not rare for a foreign company that already has a U.S. subsidiary to assign someone to assist the U.S. operations in some form or fashion without truly first addressing how the employees will be taxed. As mentioned above, these requirements still apply to those foreign workers in the U.S. with some few exceptions.
A foreign employer generally must withhold income taxes unless the employee is a non-resident alien who is present in the U.S. only for a short time (90 days or less) during the tax year and earns only a small amount ($3,000 or less), or unless there is evidence that a tax treaty provides some protection.
To make matters more complicated, the audit risk for the foreign employer grows significantly when the employees already in the U.S. try to file in the U.S. to report their wages. This creates a matching issue with the IRS because there is no evidence of a form w-2 (wage reporting statement) properly issued by a U.S. employer.
Payroll Processing and Related Mechanisms to Ensure Tax Compliance
Again, both the employer and the employee must understand specifically how the payroll reporting will take place in each relevant jurisdiction to remain compliant. For example, if an international assignee is paid by a foreign country payroll and is subject to U.S. taxation, the foreign employer may need to use a “shadow” payroll to make sure that the U.S. tax withholding and reporting requirements are met. If there is a U.S. subsidiary in place, the foreign parent and the U.S. subsidiary must determine who will pay the employee as part of this consideration.
Permanent Establishment Risk (Economic Nexus that may Result in Unexpected Taxation)
Another important question is whether you are deemed to be doing business in the country as a result of the activity your employee is engaged in in the foreign country. If so, the employee may have just caused you to have to register your business and file and pay income taxes plus other local taxes such as VAT (which exists in almost all non-U.S. jurisdictions). This concept of permanent establishment risk alone is worthy of executive-level attention and is beyond just how to pay the employee. Again, a treaty may provide protection if there is one between the jurisdictions at play.
In the eagerness to operate “freely” and cross-border throughout multiple jurisdictions, companies and their employees often find the world is filled with countries looking to protect their tax base in addition to ensuring that local immigration and labor laws among other are complied with. International business continues to grow nonetheless.
Great! Now, U.S. taxpayers will enjoy a lower corporate statutory rate of 21% on corporate profits or, if the U.S. business is a flow-through business, a rate of 37% (less the potential Qualified Business Deduction of 20%). We are nearly on par with many other developed countries transitioning from a worldwide taxation system to a territorial taxation system.
Well, not so fast! We hope you stop to think about what this new tax law means for you and your business before you file it under “passed.” If you own an international business or plan to expand your U.S. or foreign business operations to other countries, you must revisit your legal entity structure or plans before you embark on any changes. Depending on your facts and circumstances, you may find that the new tax law has both advantages and disadvantages.
In December 2017, Congress passed the House and Senate Conference Committee Agreement, which the President has signed into law. The enacted version, called the “Tax Cuts and Jobs Act of 2017,” is the most comprehensive piece of tax legislation to be enacted in over 30 years. In addition to the many domestic tax impacts, this legislation will also significantly alter the international tax landscape for all worldwide multi-national corporations with U.S. business operations.
The scope of the legislation is broad, and most tax practitioners currently believe there will be further changes to the legislation as it needs to be reconciled with the protocols and obligation of the United States to the World Trade Organization, the Organization for Economic Co-Operation and Development, and other worldwide political and economic unions like the European Union, ASEAN, etc.
Given the broad scope of this legislative change, this article will discuss the significant provisions that we believe will have the most direct and immediate impact on our clients. As additional guidance is released by the Internal Revenue Service and the Treasury, we will provide updates as they relate to the international tax consequences of the 2017 tax reform.
Dividend Received Deduction
The most significant impact of the 2017 tax reform is the transition away from a worldwide tax system and toward a hybrid territorial tax system. Previously, the U.S. taxed U.S. individuals and corporations on their worldwide income, regardless of where the income was derived. For example, if a U.S. C corporation owned a Mexican subsidiary corporation, the U.S. corporation would be taxed upon receiving a dividend from its Mexican subsidiary corporation. This was frequently criticized, particularly as other major economies moved toward a territorial tax regime. To transition toward a hybrid territorial system, new Section 245A was enacted. This new Section provides a 100-percent dividends received deduction for the foreign-source portion of dividends received by a U.S. C corporation from its foreign subsidiaries. Under the example, the U.S. parent corporation will not be taxed on dividends received after 2017.
A dividends received deduction (“DRD”) is a federal tax deduction applicable to corporations (not individuals) receiving dividends from related entities. In the case of Section 245A, the purpose of the deduction is to eliminate U.S. taxation on dividends resulting from foreign business activity.
The DRD does not come without limitations. First, the DRD specifically applies to the foreign-source portion of a dividend received by such domestic corporation from a “specified 10%-owned foreign corporation” in which such domestic corporation is a “United States shareholder.” For purposes of the DRD, a “specified 10%-owned foreign corporation” is any foreign corporation (1) other than a passive foreign investment company (PFIC) that is (2) not a controlled foreign corporation with respect to which any domestic corporation is a United States shareholder.
Second, the definition of a U.S. shareholder is also updated. Under current law, a U.S. shareholder is defined as any U.S. person that owns 10% of the voting stock of a foreign corporation. Under the expanded definition, a U.S. shareholder also includes any person that owns 10% of the value of the stock of a foreign corporation. Additional changes to the definition of a U.S. shareholder for international tax reporting purposes are discussed below.
Third, the DRD does not apply to a U.S. shareholder receiving a dividend from a CFC if the dividend is a hybrid. A hybrid dividend is an amount received from a CFC for which a deduction would be allowed under Section 245A and for which the specified 10-percent owned foreign corporation received a deduction from taxes imposed by a foreign country. Instead, hybrid dividends are treated as subpart F income to the recipient CFC in the tax year of receipt and, therefore, included in the gross income of the U.S. shareholder to the extent of the shareholder’s pro-rate share of subpart F income.
Fourth, the 2017 tax reform includes a minimum holding period requirement in order to claim the DRD. The U.S. corporate shareholder must meet the ownership requirements for more than 365 days during the 731-day period beginning on the date that is 365 days before the date on which the shares become ex-dividend. Traditionally, the ex-dividend date is the day on which all shares bought and sold no longer come attached with the right to be paid the most recently declared dividend. This may not be an important date for closely held companies, but the date is significantly more important for companies with many shareholders, particularly those that trade on exchanges.
Fifth, no credit or deduction is allowed for any foreign income taxes paid or accrued with respect to any portion of a dividend that qualifies for the deduction. In effect, these foreign tax credits will be eliminated, putting the significant time and money companies have dedicated to monitoring foreign tax credit positions at risk.
Sixth, and finally, the credit is only available to U.S. C-corporations. S-corporations, RICs, and REITs must continue to include income distributions in income.
The other half of the transition to a hybrid territorial tax regime involves the repatriation – deemed or otherwise – of the estimated $2.5 trillion dollars currently held in foreign subsidiaries. This “toll charge” is widely seen as a one-time charge applicable to the foreign earnings currently held offshore by U.S. taxpayers (corporate and non-corporate). Other economies have used similar methods to transition from a worldwide system of taxation to something more akin to a territorial system.
The 2017 tax reform amends Section 965 to require U.S. shareholders of CFCs to include in income the shareholder’s pro rate share of the deemed repatriation amount. The deemed repatriation amount is measured as of the taxable year beginning before January 1, 2018, and certain measures were taken to ensure an accurate portrayal of a CFCs untaxed E&P. For instance, the deemed repatriation amount is the greater of the CFC’s post-1986 E&P as of (1) November 2, 2017, or (2) December 31, 2017, that were not previously subject to U.S. tax.
The toll charge operates as a one-time tax on foreign earnings that would otherwise have been repatriated at the historical U.S. corporate income tax rate of 35%. Under the new regime, the effective rate for the portion of the deemed repatriation equal to the U.S. shareholder’s aggregate foreign and cash and cash-equivalent assets is 15.5 percent. The effective rate for the remainder is 8 percent.
U.S. shareholder’s may elect to pay the net tax liability resulting from the deemed repatriation in eight annual installments. Each installment must be made by the due date for the tax return for the respective tax year, without regard to extensions. No interest is charged on the deferred payments, provided they are timely paid. They payments for each of the first five years equals 8 percent of the net tax liability, the sixth is 15 percent, the seventh is 20 percent, and the remaining 25 percent is payable in the eighth and final year. Under an acceleration rule, certain triggering events accelerate the due date of all remaining installments to the date of the relevant event. Such events include failure to pay an installment payment and liquidation or sale.
Changes to Subpart F Rules
In addition to the expanded definition of a U.S. shareholder, as discussed above, the 2017 tax reform addresses a number of other issues related to the definition of a U.S. shareholder, as well as other functions of the Subpart F rules.
First, related to the definition of a U.S. shareholder, the tax reform modifies the existing stock attribution rules. Currently, Section 958(b)(4) prevents domestic corporations, partnerships, and trusts and estates from being treated as owning stock held directly or indirectly by their foreign shareholders, partners, beneficiaries, or owners. In effect, that provision prevented foreign subsidiaries of foreign-parented groups not held under U.S. entities from being treated as CFCs. The modification to this rule would repeal Section 958(b)(4) so that the foreign subsidiaries of foreign-parented groups with at least one controlled U.S. subsidiary or an interest in at least one U.S. partnership would be treated as a CFC, even if they are not held directly under a U.S. entity.
Second, under current law a U.S. shareholder of a foreign corporation is required to include amounts in income under Subpart F for a tax year only if such foreign corporation has been a CFC for at least 30 consecutive days in that tax year. The modification to this rule eliminates the 30-day requirement. The modifications, including these two and the updated definition of a U.S. shareholder discussed above, significantly increase the number of foreign entities treated as CFCs and the number of U.S. persons treated as U.S. shareholders. Naturally, that means more direct and indirect U.S. shareholders will need to report subpart F income from foreign CFCs, increasing the necessary precautions that must be taken to ensure compliance with U.S. income tax filing obligations.
Base Erosion Provisions
The 2017 tax reform introduces a new type of income called “global intangible low-taxed income,” (“GILTI”) (pronounced guil-ty). The provision requires a U.S. shareholder of a CFC to include in its gross income its GILTI amount. The factors used to determine the GILTI amount are beyond the scope of this article, but fundamentally the GILTI tax is designed to target the excess income foreign subsidiaries have over a 10% rate of routine return on tangible business assets (this rate of return having been determined by Congress).
The taxable GILTI amount is subject to a 50% deduction through 2025 (thereafter, 37.5%) and is subject to tax at a rate of 21 percent. GILTI is grossed-up by 100 percent of the foreign taxes deemed paid or accrued with respect to the income, then the foreign tax credits are available for up to 80% of the foreign taxes. The foreign tax credit allowance creates a unique problem for Section 904, so the new provision limits foreign tax credits in two ways. First, GILTI income is a separate Section 904(d) category, meaning only foreign tax credits deemed paid as a result of a GILTI inclusion can offset a GILTI inclusion. Second, Section 904(c) is amended to prevent the carryforward of GILTI foreign tax credits.
The 2017 tax reform also introduces Section 250, which allows a domestic corporation to claim a deduction for an amount equal to 37.5% of its foreign-derived intangible income (“FDII”). Again, FDII is a new term for the code determined by reference to other newly defined terms for the code, the complexity of which we will not address in this article. Effectively, when combined with the GILTI rules above, the FDII deduction is intended to subject U.S. domestic corporations to a reduced rate of tax on income derived in connection with their intangible assets, including sales to, or services performed for, foreign customers. The tax is applicable without regard to whether the income is earned by U.S. corporation or by its CFCs.
Combined, the GILTI and FDII provisions function to decrease the advantage U.S. corporations currently have exploit intangible property held offshore. As noted above, many tax professionals expect the combined effect of these provisions will be challenged by the WTO. As a result, taxpayers should anticipate future changes to one or both of these provisions.
Finally, the 2017 tax reform expands the definition of “intangible property” under Section 936(h)(3)(B) to include goodwill, going concern value, workforce in place, and any other item the value or potential value of which is not attributable to tangible property or the services of an individual. Effectively, this provision legislatively overturns recent Tax Court cases that held such assets were beyond the scope of the statutory definition of “intangible property.” Additionally, the previous law stated that intangible property under this provision was required to have substantial value independent of the services of an individual. The updated provision has no such requirement, meaning “transfers” of such assets by a U.S. person to a foreign corporation will be subject to Section 367(d) or Section 482.
There are a number of miscellaneous provisions that have received little public attention, but nevertheless may have a significant impact on U.S. multinationals.
First, the 2017 tax reform repeals the active trade or business exception under Section 367(a). Previously, transfers of assets to foreign subsidiaries could be considered tax-free if the subsidiary foreign corporation used the assets in an active trade or business. The updated version of Section 367(a) states that when a U.S. person transfers property to a foreign corporation to be used in the active conduct of a foreign trade or business, the foreign subsidiary corporation will not be treated as a corporation for purposes of determining gain on the transaction. Therefore, gain will need to be determined on each transfer of assets to a foreign subsidiary corporation.
Second, under current law the source of a taxpayer’s income from the sale of inventory property produced in the U.S. and sold outside of the U.S. was generally (subject to many regulations) sourced 50 percent to the place of production and 50 percent to the place of sale. This was based on the longstanding legal principle called the title passage rule. The 2017 tax reform modifies this rule and provides that the source of the income is determined solely based on the location of production.
Finally, U.S. multinationals previously could elect to allocate and apportion interest expense among U.S. source income and foreign source income based on either the adjusted tax basis or fair market value of assets. Under the new law, interest expense must be allocated and apportioned based on the adjusted tax basis of the assets.
This is a brief introduction to some of the changes that can be expected from the newly enacted 2017 tax reform. Tax professionals expect some of these changes to be challenged by the WTO, OETC, and other economic trade unions, but without a doubt this significant piece of tax reform will have a dramatic impact on international tax compliance, reporting, and planning. Because the new tax law continues to be interpreted and understood, now is a good time to work with your tax advisor to form an idea how this will impact you or your business.