International Tax and Planning

On March 13, 2018, the IRS announced that the Offshore Voluntary Disclosure Program (OVDP) will be closing on September 28, 2018. This program has been in place since 2009.

In general, US persons, that is, citizens and residents of the US, must report their worldwide income on their US income tax returns. They also must report their financial accounts held outside the US on an annual FBAR (FinCEN Form 114) if the aggregate balance of their accounts exceeds $10,000.

The OVDP offers a structured program for taxpayers to amend income tax returns to report any unreported foreign income, submit any unfiled international tax filings, and disclose the existence of financial accounts outside the United States.

To participate in the OVDP, taxpayers have had to pay a substantial civil penalty based on the value of the unreported accounts, in addition to paying back taxes with a 20% penalty and interest.

The incentive to participating in the OVDP is that the IRS will not criminally prosecute the taxpayer for the failure to report his or her accounts and that all other potential civil penalties will not be assessed in lieu of the one OVDP penalty.

The OVDP is intended for those taxpayers who knew that the law required reporting of their foreign accounts but who decided to not report such accounts on an FBAR or on other international tax filings. These taxpayers have the most to gain from participating in the OVDP and remain exposed if they choose to not come into compliance.

The OVDP requires eight years of amended return filings, six years of FBAR filings, as well as several other items to be submitted to the IRS. The IRS requires a complete OVDP submission by the September 28 deadline. These submissions require time to compile the necessary documentation and to prepare amended returns. It is important for those not in compliance to decide on participating now – well before the September deadline – or you will not be able to complete the OVDP.

What options do taxpayers have if they didn’t file FBAR’s or report their foreign income but their mistakes were inadvertent? This is referred to as a “non-willful” case and is common for many taxpayers who have accounts from their home country that were opened before moving to the US or for those whose tax return preparer did not advise them as to what the tax law requires. The IRS is continuing a program known as “Streamlined Filing Compliance Procedures,” for non-willful violations. These procedures, which may also require a penalty, will continue past September. There are also other ways to return to compliance.

What will IRS enforcement in this area look like once the OVDP is ended? We believe that examinations in this area will only increase. The IRS has gathered a decade’s worth of material on foreign institutions and bankers through the OVDP. This data, along with the information that the IRS now receives from many foreign countries pursuant to a law known as FATCA, allows the IRS to identify non-compliant taxpayers much more easily today than in the past. These international audits are quite intrusive and can expose taxpayers to substantial penalty. We expect the number of these audits to increase.

Once the OVDP option has ended, taxpayers will still be able to voluntarily come forward to disclose past misdeeds. (The IRS has stated that the precise details how to do so will be forthcoming.) It is clear, though, that as onerous as the OVDP penalty is now, the toll to come into compliance in the future will only be greater.

The recently enacted 2017 tax act (originally called the Tax Cuts and Jobs Act – “Tax Reform Act”) contains sweeping changes to US international tax rules that will affect international  businesses and cross border investments.   A review of how to take advantage of these new rules can reap significant benefits or avoid tax pitfalls, as discussed below.

New Territorial Tax System

The Tax Reform Act adopts a new territorial system of taxation (also known as a participation exemption system), which may eliminate or reduce US income taxes on income earned outside the US by US C corporations (“C corps”).  If a C corp owns 10% or more of a foreign corporation that pays a dividend, then the C corp receives a 100% dividends received deduction (“DRD”) for the foreign source portion of the dividend, which will eliminate or reduce the US tax imposed on the dividend.  This DRD is only available for C corps and not for S corporations or individuals.

A DRD will not apply if the foreign corporation is a passive foreign investment company (“PFIC”) unless the foreign corporation is also a controlled foreign corporation (“CFC”) as discussed below.  A PFIC is a foreign company whose income predominantly comes from passive investments (such as marketable securities).

The new territorial system does not apply to income earned by a C corp from a foreign branch.  Income from a foreign branch is subject to US tax, although if foreign tax is imposed on that income, then a foreign tax credit may reduce or eliminate US tax.  As a result, businesses that operate as C corps may want to incorporate their foreign branches to eliminate US tax on branch income.

This system also can reduce the taxable gain realized when a C corp (but not an S corporation or an individual) sells the stock of a foreign corporation.  If the C corp owns the stock of a foreign corporation for one year or more, pre-2017 law recharacterizes any amount realized by the C corp on the sale as a deemed dividend to the extent of the accumulated earnings and profits of the foreign corporation.  The Tax Reform Act provides that such deemed dividend is eligible for the participation exemption system and thus, is not subject to tax.  As a result, a US C corp can eliminate part or all of the taxable gain on the sale of stock of a foreign subsidiary.

New Global Intangible Low-Taxed Income (“GILTI”) Tax

While labeled a tax on intangible income, the GILTI tax is actually a current tax imposed on US shareholders of CFCs on their share of any income earned by the CFC that exceeds a 10% return on investment.  A CFC is any foreign corporation if US shareholders own more than 50% of its stock; for this purpose, a US shareholder is any US person who owns 10% or more of the voting stock or value of the stock of the foreign corporation.  If a CFC has certain types of passive income known as Subpart F income, then US shareholders must include in their income their share of the Subpart F income even though no dividend is paid to them.

The Tax Reform Act provides that a US shareholder of any CFC must include in gross income, for a taxable year, its GILTI in a manner generally similar to the inclusion of Subpart F income.  GILTI means the excess of the shareholder’s net CFC tested income over the shareholder’s net deemed tangible income return in that CFC.  The shareholder’s net deemed tangible income return is an amount equal to the excess of 10% of the aggregate of the shareholder’s pro rata share of the qualified business asset investment (“QBAI”) in that CFC over certain interest expense of each CFC with respect to which it is a US shareholder.  The QBAI is essentially a book value concept since it is based on the tax basis of the CFC’s assets and not their fair market value.  As a result, the 10% threshold can easily be exceeded.

US shareholders who are C corps are given special tax benefits that can eliminate the GILTI tax.  First, under the new law, a C corp can deduct 50% of the GILTI inclusion amount, which reduces the potential corporate tax from 21% to 10.5%.  Second, for any amount of GILTI included in the gross income of a C corp, the C corp would be deemed to have paid foreign income taxes equal to 80% of the foreign taxes paid by the CFC with respect to such income.  If the CFC pays foreign taxes of 13.125% or more, then this special foreign tax credit will eliminate any GILTI tax.  Individuals and S corporations get no similar treatment and pay full US tax on any GILTI inclusion amount.


US taxpayers should carefully review the structure of their foreign entities with their advisors to determine if the new territorial tax system may apply to them, and whether any foreign corporations may qualify as CFCs, which will subject their US shareholders to the new GILTI tax as well as numerous other rules affecting CFC shareholders.  Since the Tax Reform Act limits the benefits of the new territorial tax system to C corps and also only allows C corps benefits to eliminate the GILTI tax, US taxpayers should consider owning foreign stock in a C corp.  Individuals who own foreign corporate stock may want to transfer such stock to C corps; S corporations owning foreign corporate stock also may want to restructure to take advantage of these new rules.  While this task may not be simple, the tax benefits may significant.

The new tax bill passed by Congress is expected to be signed into law by President Trump in the next few days.  Based on the changes that will take place as of January 1, 2018, there are several items that taxpayers should consider implementing prior to December 31, 2017.

Please note that each taxpayer’s situation is different and each suggestion below should be discussed with the taxpayer’s tax and financial advisors to determine what steps, if any, should be implemented now or deferred until next year or whether it should be implemented at all depending on the taxpayer’s business and tax attributes.

Items to consider:

  • Prepay real estate property taxes if you have amounts due for 2018 (cannot prepay NJ or NY state income taxes)
  • Prepay home equity interest (no deduction after this year)
  • Make charitable contributions this year, especially if not itemizing deductions in 2018
  • Accelerate business deductions
  • Medical expense deduction floor reduction to 7.5% only lasts through 12/31/18, so incur medical expenses if possible before then
  • Delay or accelerate Roth conversion
  • Defer or accelerate income*
  • If you are a US person with foreign businesses, potentially converting to an S corporation before year end could be beneficial due to a “deemed repatriation” of profits in the new bill
  • If you have children in private elementary, junior high or high schools and have not already been funding 529 plans, consider use of 2017 annual exclusions not otherwise exhausted to fund 529 plans


*Deferral of income until 2018 could save taxes for some taxpayers because of the lower marginal rates, while acceleration of income could save taxes for others due to the limitation on deductions of state and local taxes.  Whether or not a taxpayer is subject to AMT also plays a role.  Again, each taxpayer should consult his or her own tax and financial advisors for specific advice.

The US Tax Court recently held that a foreign corporation is not subject to US income tax on the sale of a partnership interest where the partnership conducts a US business.  In so holding, the Tax Court rejected a 26 year old Revenue Ruling (Rev Rul 91-32) that reached the opposite conclusion.  For foreign investors in US businesses (that do not own real estate), this is an important decision.

A foreign investor who owns an interest in a partnership that holds US real estate may be subject to US federal income tax on a sale of that partnership interest under the Foreign Investment in Real Property Tax Act (“FIRPTA”).  For real estate, the IRS has indicated that gain derived by a foreign investor from the disposition of an interest in a partnership is subject to US tax only to the extent it is attributable to US real property interests owned by the partnership.  Regs §1.897-7T(a); Notice 88-72.

In Rev Rul 91-32, the IRS set forth its view that taxation on the sale of a partner’s interest in a partnership can go beyond mere real estate investment and apply to a sale of an interest in a partnership if the partnership is engaged in any US trade or business and has effectively connected income (“ECI”).  In this ruling, the IRS applied the “aggregate” theory of partnership taxation to justify looking through the partnership to its underlying assets in determining the source and character of the partner’s gain.

In July, 2017, the Tax Court issued its decision in Grecian Magnesite, Mining, Industrial & Shipping Co, SA v Comm’r, 149 TC 3The court declined to follow the IRS’s long standing position under Rev Rul 91-32, and held that a non-US person’s gain from the sale of its interest in a partnership engaged in a US trade or business is generally not subject to US federal income tax.

Grecian Magnesite Mining was a privately owned corporation organized under the laws of Greece that sells magnesia and magnesite to customers around the world.  From 2001 through 2008, it was a member of a US LLC that was engaged in the business of extracting, producing, and distributing magnesite in the US.  In 2008, Grecian Mining’s interest in the LLC was completely redeemed, resulting in treating the transaction as a sale or exchange of the membership interest.

The IRS asserted that the capital gain was properly treated as ECI since Grecian Mining was engaged in a trade or business as a result of its investment in the LLC.  Grecian Mining’s position was that the assets of the LLC do not control the character of the gain from a disposition of an interest in the LLC.  The gain should not have been treated as US-source gain and generally cannot be taxed in the US as ECI under the proposition that foreign-source income cannot be ECI except in limited instances that arise from the presence of US real estate under FIRPTA, which only applied to a small part of their gain.

Foreign investors should carefully review their US tax exposure on a sale of a partnership interest before they simply pay tax on their realized gain.  Grecian Magnesite calls into question the validity of Rev Rul 91-32 (though an appeal or non-acquiescence is possible).  A foreign investor should be able to rely on this case to avoid paying tax.  Moreover, foreign investors that have already paid income tax based upon Rev Rul 91-32 may wish to file a refund claim based on this decision.

The Supreme Court has recently struck down state bans on same-sex marriage as unconstitutional in Obergefell v. Hodges, 576 US ___ (2015), after previously striking down the federal exclusion of same-sex couples from marriage-related laws in US v. Windsor, 570 US ___ (2013).  The Internal Revenue Service (IRS) has now followed suit to recognize same-sex marriage for all federal tax purposes, including income, estate, gift, generation-skipping, and employment tax.

On October 23, proposed regulations were published in the Federal Register, which redefine the terms “husband” and “wife” under Section 7701(17).  Both terms will now mean an individual lawfully married to another individual, and the term “husband and wife” will mean two individuals lawfully married to each other. These definitions would apply regardless of sex.  Prop Reg § 301.7701-18(a).  The IRS is accepting comments for a limited time.

However, the proposed regulations redefining marriage will not apply to domestic partnerships, civil unions or other relationships. Prop Reg § 301.7701-18(c).  The couples’ choice to remain unmarried is respected by the IRS as deliberate, for example, for purposes of preserving eligibility for government benefits or avoiding the tax marriage penalty.  Preamble to Prop Reg 10/21/2015.  In addition, a marriage conducted in a foreign jurisdiction will be recognized for federal tax purposes only if the marriage would be recognized in at least one state, possession, or territory of the United States.  Preamble to Prop Reg 10/21/2015.