Tax savings for US investors in pass-throughs with foreign operations
INSIGHT ARTICLE |
Many U.S. individual taxpayers are familiar with the preferential tax rate on qualified dividend income (QDI), received from U.S. domestic corporations. This income is taxable at capital gain rates resulting in a tax rate savings of up to almost 20 percentage points, depending on the individual’s marginal tax bracket. Dividends received directly (or indirectly through an S corporation, partnership or limited liability company (LLC)) from certain foreign corporations may also qualify for the QDI tax rate. To qualify, the foreign corporation must be a resident of a country that is party to a comprehensive income tax treaty with the United States and must qualify for treaty benefits. The U.S. treaty network includes more than 60 countries, including our largest and most important trading partners.
Use of foreign holding companies
Companies with foreign operations in a non-treaty jurisdiction may be able to convert ordinary income to QDI by interposing a treaty-resident holding company between the foreign and U.S. entities. The treaty jurisdiction must be carefully selected to avoid another layer of taxation. Ideally, the treaty country will exempt the dividend received and impose no additional withholding on the dividend paid to the United States. Care must be taken to ensure that the holding company meets the requirements for treaty residency and benefits. Often, this will require hiring one or more resident directors, holding board meetings in the foreign jurisdiction, and having a business purpose for the holding company. The potential tax savings and other benefits of a foreign holding company must be weighed against the cost of forming and maintaining the company.
Foreign tax credit coordination
Companies operating as S corporations, partnerships or LLCs often make “check-the-box elections” to treat foreign subsidiaries as branches or partnerships for U.S. tax purposes. The benefits of such elections include flow-through of start-up losses and entity-level income taxes, which generally are not available as foreign tax credits for individual taxpayers absent such election. (Foreign withholding taxes on dividends and other payments are available as foreign tax credits in any case.) Because the foreign entity must be respected as a corporation for QDI purposes, such elections should not be made or must be revoked for QDI purposes. The potential QDI tax savings must be weighed against the cost of foregoing foreign tax credits for entity-level income taxes. Ideal candidates for a QDI strategy are companies with foreign operations in low-tax jurisdictions or subject to tax holidays.
The key to this planning is careful structuring to ensure proper compliance with the requirements of current law (specifically section 1(h)(11)(c)(j) and Notice 2011-64). In a nutshell, to obtain preferential taxation on foreign dividends, the paying foreign corporation must be eligible to obtain benefits of a comprehensive income tax treaty with the United States that includes an exchange of information program and that is listed on the aforementioned IRS Notice (the “Treaty Test”). Common treaty partner jurisdictions for QDI planning include Australia, Barbados, Cyprus, Ireland, Luxembourg, Malta, the Netherlands and Switzerland.
Eligibility for benefits under the Treaty Test also requires careful navigation of a treaty’s “residence” and “limitation on benefits” (LOB) provisions. In general terms, in order to enjoy the benefits of a U.S. income tax treaty, a person must qualify as a resident in one of the treaty countries. Residence alone, however, is not sufficient.
The United States is very concerned about “treaty shopping” (the manipulation of existing income tax treaties between jurisdictions to manipulate tax efficiencies). Thus, most U.S. income tax treaties, including all modern U.S. income tax treaties, include an LOB.
LOB articles test whether a resident of a treaty country has a sufficient connection with that country to justify entitlement to treaty benefits. Navigating these challenging provisions is feasible provided a client’s facts and circumstances can align with his or her qualified foreign corporation jurisdiction choice.
U.S. taxpayers who have not structured their international investments and operations to obtain qualified foreign dividends may do so by undertaking certain steps to restructure how they hold such interests. Restructuring in this context consists of taking a myriad of steps to interpose a qualified treaty jurisdiction holding company between the U.S. investor and its non-treaty foreign holding or operational company. A restructuring may qualify as a non-taxable reorganization. The essence of a proper restructuring involves migrating or transferring a current non-treaty holding company or operating company to a qualified treaty jurisdiction or creating a new holding company in an appropriate jurisdiction.
Obviously, the benefits of a QDI restructuring should outweigh the legal and tax advisor costs of implementation before the taxpayer pursues a QDI planning strategy. A word of caution is that a pre- and post-transaction analysis of the U.S. Subpart F rules, which require current taxation of passive income and related party income, should be performed.