by Monte Silver
reprinted with permission of the author
The U.S. 2017 tax reform has made it very problematic for an American residing in the UK to conduct business through a UK corporation. Operating through a UK corporation exposes the expat to two new taxes: Repatriation and GILTI. This article will discuss the little known 962 election, how it can be used to reduce Repatriation tax liability, and some issues that must be considered before doing so.
A numerical example is helpful. An American living in the UK has been operating a CPA sole practice or family restaurant for 30 years through a wholly owned UK company. After paying UK corporate income tax on profits over the years, the company has $500,000 in retained earnings in its bank account, which the expat is counting on for retirement. Under the Repatriation tax, the expat is now personally liable for $87,700 (17.54% * $500,000) of that amount.
How is this tax paid? In eight annual payments, with the first payment of 8% (or $7,016) being due June 15, 2019 (as a result of the extension achieved from the U.S. Treasury).
Let’s assume that the expat has no personal foreign tax credits to use to offset to the Repatriation tax. In other words, in previous years the expat has already used all personal income tax paid in the UK to offset U.S. income tax.
Section 962 of the U.S. Internal Revenue Code (“IRC”) may help. Section 962 allows the expat to be treated as a corporation for a specific year (say in 2017) solely for purposes of the Repatriation tax (and other Subpart F income which taxpayers rarely have).
Why does this help? Simple. If we assume an average UK corporate tax rate of 20% over the past 10 years, then approximately $100,000 ($500,000*1.20%) of UK corporate tax has been paid. As the UK corporation never owned U.S. taxes, it never utilized these taxes as credits on any U.S. corporate tax return.
And if the expat utilizes the 962 election in 2017, there are two potential benefits: (1) ability to use the corporate taxes paid in the UK to offset the Repatriation tax, and (2) enjoy the lower corporate Repatriation tax rate.
In the real world, situations are rarely black and white – i.e. lots of corporate credits but no personal credits. For example, if the expat has some personal tax credits available, the point at which the 962 election becomes beneficial requires analyzing different numerical scenarios, taking into account many factors, such as gross-up rules under section 78. However, in cases where the UK corporation has a significant pool of unused tax credits and the expat has none, the 962 election may make sense.
The remainder of the article will discuss one significant landmine that may arise when using the election. And it is important to state until now, 962 has rarely been used, so there may be others:
Post-2017 distributions. What happens when the UK corporation finally distributes the $500,000 to the expat? If no 962 election was made, no additional U.S. tax is paid by the expat (IRC 959). UK tax, however, may be due. And if 962 election was made? Bad news: all the distributions out of the accumulated earnings, beyond what was paid on the Repatriation tax, are subject to U.S. tax (IRC 962(d))! Ouch. At what rates? Most likely personal marginal rates. Double ouch.
An example will help illustrate this. In the above example, if no 962 election is used and no personal tax credits are available, the expat would be liable for $87,700 in Repatriation tax, but no more U.S. tax would be due upon distributing the $500,000. But under 962, let’s assume that the $100,000 in corporate tax credits eliminated any Repatriation tax liability. Upon distribution of the $500,000, the expat would pay U.S. taxes at the marginal rate, or as much as $185,000 ($500,000 * 37% – the highest marginal rate). Triple ouch!
Does 962 make sense? It may in the following three situations, but careful analysis is required: (1) When the UK corporate tax credits far outweigh the personal income tax credits available, and/or (2) when the expat has no plans to withdraw the money in the corporation, and/or (3) the UK taxes due at the time of distribution may render any U.S. additional taxes minimal.
In summary, in planning around the Repatriation tax, the 962 election is an option. However, careful analysis is required to achieve the best results under U.S. and UK tax law. A totally different analysis exists for the 962 election with regard to GILTI in 2018 onward.
Nothing herein shall be deemed legal advice
American Tax Solutions
What a nightmare!
Hopefully Monte and those who are fighting the Repatriation Tax in DC will get a legislative fix during or before the lame duck session! What a clusterf*ck this rushed TCJA created.
I don’t think the section 962 election is as useless as Monte seems to imply. Yes, the section 965 inclusion does not become “previously taxed income” (except to the extent of any actual tax liability after FTC), but this is not necessarily fatal, especially if the home country has a high dividend tax. With the section 962 election you’re doing a better job of matching foreign tax credits with US tax. However, you need to do the numbers properly, and the numbers above are misleading.
First, a company paying tax at 20% with $500,000 retained earnings must have earned $625,000 and paid $125,000 in tax, not $100,000. Second, section 965 says that you only get to claim a portion of the tax paid by the company. If the company has $500,000 or more in cash, all of the section 965 inclusion is taxed at a 15.5% rate – but this is done by allowing a deduction of 55.71% of the $500,000, so the $125,000 foreign tax paid must also be reduced by the same proportion.
So, that means we have:
Gross Inclusion $500,000
Deduction (55.71%) $278,550
Net Inclusion $221,450
s78 adjustment $ 55,363 = (1-55.71%)*$125,000
Tax at 35% $ 96,884
FTC $ 55,363 = same as s78 adjustment
Net US tax due $ 41,522
Without the section 962 election, tax due would be $221,450*39.6% = $87,694 (not 37% because the tax is computed in 2017 not 2018). So the section 962 election saves $46,172 on the transition tax (which can be spread over 8 years).
On the other end – the UK will charge tax on the $500,000 dividend. A quick search shows that taxpayers with more than £150,000 will pay 38.1% tax on dividends. Using that rate, the UK dividend tax on $500,000 will be $190,500.
Without the section 962 election, there is no US income tax on the dividend, but there is Net Investment Income tax of 3.8% or $19,000. Total tax paid is $190,500 + 19,000 = $209,500.
With the section 962 election, US income tax is paid on all but $41,522 of the dividend. Since the UK has a tax treaty with the US, the dividend should be a qualified dividend taxed at 20%. But, even if it is not a qualified dividend, the UK dividend tax rate exceeds the 2018 maximum US tax rate of 37%, so there will be no additional US tax due after foreign tax credits (except for the Net Investment Income Tax, which cannot be offset by FTC). So the net tax due is the same as computed above without the section 962 election.
What does this tell us? In a high tax country like the UK, there is likely to be no net US tax on the subsequent dividend, therefore the savings generated under the section 962 election is not offset by higher tax on the dividend.
The other takeaway is that, unless the home country tax rate is above 35%, the deemed FTC will not fully offset the section 965 transition tax due to the haircut/grind down of FTC required by section 965.
Finally, FTC can be carried BACK one year. So it is possible that UK tax generated by a 2018 dividend might be available to carry back to offset the transition tax in 2017. This can reduce the benefit of the section 962 election.
Anyone facing this decision must run the numbers using their own facts, FTC carryover, and local tax rates. Fortunately, you have until 15 October (possibly 15 December) if you want to file and elect the 8 year spread.
The US should have had a section 962 election in 2016, so no one would even be able to figure out who won.
Dear Uncle Sam,
F**k you and your ‘credits’. Please leave the rest of the world in peace.
Well said biscuit.
On July 2, 2018 (a pre “Independence Day” announcement, the IRS announced 5 brand new international compliance campaigns. Interestingly, one initiative is for the purpose of confiscating the retirement assets of Americans abroad. Here it is.
Anyone reading this should ponder the second sentence of the article. Namely:
“An American living in the UK has been operating a … family restaurant for 30 years through a wholly owned UK company.”
Anybody operating a family restaurant in the UK for 30 years should ignore the rest of tell article and tell Uncle Sam to pound sand. Kafka wasn’t writing an instruction manual.
Hopefully we will win without a lawsuit. However, the Treasury has violated a few federal laws in issuing the proposed 965 rules and on of the laws grants us judicial review. So we will wait and see what Treasury does and then decide. Be optimistic.
For a small business owner, this isn’t even a tax – it’s confiscation. It’s a thug pulling a gun and asking you to hand over your available cash for “protection” money. It’s an abomination on a couple of levels:
1) This is a retroactive tax. No way to anticipate or plan for this
2) This money is already taxed twice before going to the IRS. Once by local corporate taxes, and again when I have to withdraw the money as income and pay the local income tax. At a 40% tax rate, a 20000 dollar tax will cost me an additional 8000 dollars in local tax.
And no, we can’t tell the IRS to “pound sand” .. they’ll garnish my retirement income later when the time comes. If we avoid prison, that is.
It outrageous. You might want to look into Monte Silver’s legal action against the Transition Tax and GILTI here: http://www.americansabroadfortaxfairness.org/
He’s also provided a link to his Facebook group there.