Foreign Corporations, Form 5471, and GILTI
Last time here at CPAs For Expats, we gave a quick overview of the taxation of overseas businesses owned by US expats. We discussed how a business can be a sole proprietorship, a partnership, or a corporation, and the different tax implications of each. We then delved into the minutiae of self-employment tax and other tax issues faced by proprietors.
Today, we are going to talk about corporations—specifically, foreign corporations. US expats understandably want to do business in a way that satisfies local laws, and forming a corporate entity according to your adopted country’s local laws is generally a good idea.
However, in the IRS’s eyes, foreign corporations can be seen as problematic. This is not the fault of US expats, but US expats will suffer because of the actions of others, especially in this case. Let’s learn a bit about foreign corporations, some potential pitfalls of owning them, and what the responsibilities are for a US expat owner of a foreign corporation.
Taxation of Corporations
In general, corporations are legal entities separate from their owners in regard to both liability and taxation. Corporate profits are taxed twice: Once at the corporate level, and again when the profits are distributed to the shareholders as dividends. Therefore, the owner of a corporation can delay paying the second half of the tax long as he or she doesn’t take the profits out of the corporation as a dividend.
Why the IRS Dislikes Foreign Corporations
Historically, the IRS has viewed foreign corporations owned by Americans with something ranging from suspicion to outright hostility. The reason for this is because massive multinational corporations were using foreign corporate entities in low-tax jurisdictions to park cash, where they would avoid paying US tax on the money until they really needed it, at which point they would bring some of the money back to the US and pay tax on that portion of their profits.
Types of Foreign Corporations
In the United States, corporations are generally designated by the suffixes “Inc.”, “Co.”, or occasionally “Ltd.” (for “incorporated”, “company”, or “limited”, respectively). Your country of incorporation will determine whether your business counts as a foreign corporate entity for the purposes of US tax. Some examples of a foreign corporation include (but are not limited to):
Australia: Pty. Ltd., Pty., or Ltd.
Brazil: S.A. or Ltda.
Canada: Ltd., Lteé, Inc., Corp., or S.A.R.F.
China: 股份有限公司 (Gǔfèn Yǒuxiàn Gōngsī)
European Union: Many varieties, including SE, SPE, Ltd., S.p.a., and GmbH
Israel: Chevra Ba’am (בע"מ), Ltd., or occasionally B.M.
Japan: 株式会社 (kabushiki geisha), K.K. or Co. Ltd.
Korea: 주식회사 (jusik hoesa) or 유한회사 (yuhan hoesa)
New Zealand: Ltd.
Saudi Arabia: Private Limited Company (شركة ذات مسئولية محدودة, sharikat dhat mas'ouliyya maḥduda) or Joint-Stock company (شركة مساهمة, sharika musahima)
Switzerland: AG, SA, GmbH, Sagl, or Sárl
United Kingdom: Ltd. or plc (Cyf or CCC in Welsh)
The Tax Cut and Jobs Act (TCJA) Changes
With the passage of the TCJA in 2017, US taxation of foreign corporations changed drastically. The TCJA changed many things about corporate tax, but for our purposes today we will focus on the treatment of the earnings of foreign corporations owned by US persons.
Under the TCJA, earnings of a foreign corporation owned by a US person are now immediately taxable in the United States at the shareholder’s rates, whether or not the corporation issued a dividend. This was a huge change from the previous rules and required the IRS to set up a special “transition tax” regime for the tax year 2017, where all of a foreign corporation’s accumulated retained earnings from 1986 through 2017 were suddenly taxed at a special rate and “deemed” distributed to their US owners. US expats who owned corporations were suddenly staring at a potentially massive tax bill, with virtually no warning.
This situation set off panic alarms in US CPA offices around the world, and in the heads of US expat business owners. Fortunately, the IRS issued regulations to tax professionals on how to deal with the transition tax, and the impact for many of the foreign business owners was, if not minimal, smaller than it otherwise could have been.
Foreign Corporate Taxation in 2018 and Beyond
Today, US expats who own foreign corporate entities need to operate under the assumption that all of their corporate earnings could be considered taxable income in the United States, under one of two tax regimes:
Subpart F: Subpart F income is passive income (such as interest, dividends, capital gains, and rent) earned by a foreign corporation with US ownership. Subpart F income has been taxable in the US for years—this is not a new development.
Global Intangible Low-Taxed Income (GILTI): In the running for the last decade’s most idiotic acronym, GILTI has nothing to do with whether your company’s income is “intangible” or “low-taxed”. Corporate earnings that are from normal operations are GILTI, which began to be included in personal tax returns for 2018.
If you pay corporate tax in your home country, then there may be ways to avoid paying tax on GILTI, but that discussion is beyond the scope of this post. Contact CPAs For Expats for a consultation if you think you may be subject to GILTI and you would like to discuss strategies for mitigating your exposure.
Even before the IRS started trying to tax the earnings of foreign corporations, it was trying to gather information on foreign corporations owned by Americans. Therefore, it introduced Form 5471 (“Information Return of US Persons with Respect to Certain Foreign Corporations”) in 1960 to make Americans with foreign corporate interests disclose their holdings.
Form 5471 is an information return—meaning that filing the return does not directly impact the amount of tax owed (although GILTI and Subpart F income are both calculated based on the information presented on Form 5471). As is typical for information returns, failure to file Form 5471 when required carries a penalty of $10,000 per form per year. So, that means if you own multiple foreign corporations, and you haven’t filed returns for a few years…well, let’s just say the penalty calculations can get to very high levels quickly.
Who Needs to File Form 5471—Categories
The IRS lists five types of filers who need to file Form 5471, and the category determines which schedules you must file along with the form.
Category 1: This category includes a “controlled foreign corporation” (see category 4 below) as well as most foreign corporations with one or more 10% domestic corporation shareholders.
Category 2: If a US person is an officer or director of a foreign corporation in which a US person acquired a 10% interest during the year.
Category 3: If a US person acquires a 10% interest in a foreign company during the year (or becomes a US person while owning 10% of stock in a foreign company), or a US person who had owned 10% of the stock of a corporation sells enough of their stock to reduce their interest to below 10%.
Category 4: If a US person has control of a foreign corporation by owning more than 50% of the voting stock, or more than 50% of the total stock of the corporation. Most of these “controlled foreign corporations” (CFCs) are also Category 1 filers.
Category 5: If a US person owns stock in a foreign corporation that is a CFC.
Many (if not most) filers fall into more than one category—in that case, you would fill out the schedules required for the most stringent category. For example, if a person starts a new foreign corporation and keeps 100% of the shares for himself, he is a filer in all five categories:
Category 1: He owns a CFC;
Category 2: He is the director of a corporation in which a US person (himself) acquired more than 10% of the stock of the foreign corporation;
Category 3: He is a US person that acquired more than 10% of the stock in a foreign corporation (by virtue of him organizing the company);
Category 4: He is a US person who has control of a foreign corporation (he owns 100% of the stock, which is more than 50%);
Category 5: He is a US person who owns shares in a CFC.
Incorporation is a strategy that makes sense for many business owners and offers advantages such as protection from personal liability, the ability to obtain capital via the sale of shares, and wealth maximization for the business owner’s family. However, US expats need to make sure that if their businesses are incorporated outside the United States, they should be on top of their US filing obligations when it comes to information returns and potential GILTI tax.
Do you own a foreign corporation and need to get into compliance with the IRS? Need to file Form 5471? Contact CPAs For Expats for a consultation today!