Wealthy foreigners who live in the U.S. face the prospect of an unexpected new tax on non-U.S. income.
Drafters of the 2017 tax overhaul repealed a rule that kept some foreign-held assets outside the U.S. tax net, meaning foreigners who become U.S. residents now have to report the worldwide income of their families’ foreign businesses in the U.S. and pay tax on the income of each company and subsidiary.
The repeal of tax code Section 958(b)(4) not only affects multinationals and private equity firms that have foreign subsidiaries but also domestic trusts, partnerships, and estates in ways that leave the U.S. individual with tough options: pay taxes on more income, dispose of foreign shares, or leave the U.S—a move that could bring its own income and estate tax consequences.
“Wealthy individuals and families don’t realize yet that because there is a U.S. entity in the ownership chain, they have tainted the entire family empire,” said Richard LeVine, a wealth adviser at Withersworldwide, a tax and wealth advisory firm.
“Unfortunately, most people don’t come to the U.S. after they’ve figured this out. We have to undo the situation they’re in, and sometimes our best advice is to leave,” said Ian Weinstock, a partner at Kostelanetz & Fink LLP in New York.
The original intent of tax writers was to prevent large multinational companies from stashing profits offshore to avoid paying U.S. taxes. Now, with the repeal of Section 958(b)(4), privately held businesses will find themselves inadvertently caught within the same net.
“This is just a trap for the unwary, because its not what Congress intended to do,” LeVine said.
Tax Planning Trap
Section 958(b)(4) carved out an exception that blocked the shares of foreign trusts, partnerships, and companies from being assigned to a non-U.S. shareholder and then back down to a U.S. company, making those shares taxable in the U.S.
Without the exception, foreign shareholders are subject to Section 318 rules that determine how stock is attributed between shareholders and companies. Those rules now more broadly deem foreign entities as taxable controlled foreign corporations (CFCs).
Such a characterization means that those foreign companies are taxable on some of their foreign source income, known as Subpart F income—to ensure that U.S. taxpayers aren’t keeping undistributed foreign earnings offshore and outside the U.S. taxing jurisdiction, practitioners said. Under Subpart F rules, a CFC is a foreign corporation that is more than 50% owned by U.S. shareholders that own 10% or more of the total stock in the CFC.
Weinstock said the most pertinent point is that the exception no longer exists, and that means the attribution rules are applied broadly when determining which foreign companies are CFCs.
For example, a Chinese family could jointly own a Chinese company and also own U.S. real estate through a U.S. corporation. If one of the family members is a U.S. taxpayer, all the assets of the Chinese company—including its subsidiaries—would be deemed to be owned by the U.S. corporation.
“The attribution rules are not applied to tax a U.S. taxpayer on anything except their income from a CFC, and without the attribution exception there are a lot more of those,” Weinstock said.
It’s common practice for foreigners to own U.S. real estate through U.S. corporations, because foreign sales of U.S. property are subject to a withholding tax.
“If that wealthy family is well advised, the U.S. company shareholder may want to disclaim their inheritance to spare the rest of the family from a huge headache,” LeVine said. “Or they could restructure the ownership of the U.S. real estate and securities portfolio without involving a U.S. entity, but often at the cost of triggering additional U.S. tax withholding.”
“There are going to be a lot of families who have empty apartments in New York City and Miami and so on. Most of those people are not giving thought to the fact that their whole empire might be subject to U.S. reporting,” he said.
Treasury officials said they would correct this issue through regulations to the extent they have the authority to do so, but new guidance on downward attribution addressed only part of the problem impacting multinationals, and didn’t go so far as to address constructive ownership rules.
Taxpayers are now stuck between waiting for the IRS to issue regulations that address the problem and the possibility of a technical corrections bill reversing the repeal of the attribution exception.
A tax package (amendment to H.R. 88) released by House Ways and Means Committee ranking member Kevin Brady (R-Texas) included a fix to the attribution problem, but the bill didn’t pass.
“The IRS is saying they don’t have the ability to fix the root of the problem and that it would have to be through a legislative fix,” said Cory Perry, an international tax senior manager in Grant Thornton LLP’s Washington National Tax Office.
Wealthy foreign families may be spared from audits due to the highly technical and resource intensive nature of this issue, practitioners said. Lack of IRS funding could mean the agency chooses not to enforce a tax that came about by accident.
“This could lead to a lot of rejigging of ownership, but the IRS doesn’t have a lot of resources in this area and some might make a good argument that this was not an intended result,” Weinstock said.
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