A foreign national may structure business and investment activities through a non-US (that is, foreign) corporation to effectively mitigate home country tax. If such an individual later accepts an assignment in the US, he/she may be caught unaware of the US tax implications of a US resident owning stock in a foreign corporation. Specifically, a foreign national on US assignment may become liable for US federal income tax on certain earnings of a foreign corporation, regardless of whether those earnings are distributed. In addition, the assignee may be subject to reporting requirements in the US with respect to these corporate interests. Furthermore, if an employer is responsible for any host country tax (that is, US tax), the overall assignment costs may be increased. With proper US income tax planning before the US assignment commences, a foreign national's US federal income tax liabilities and reporting obligations may be reduced, as well as the employer's overall assignment costs.

This article provides an overview of the potential US federal income tax consequences and reporting obligations of a foreign national who owns stock in a foreign corporation after establishing US tax residency. Any foreign national who owns shares in a foreign corporation and is considering a US assignment should consult with a US tax adviser about the application of these rules with regard to his/her particular circumstance before becoming a US resident.

Generally, a US shareholder in a foreign corporation may defer US tax on earnings derived through the foreign corporation until such earnings are actually distributed. Thus, US tax residents may be inclined to earn income through a foreign corporation specifically to capitalize on the inherent tax deferral benefit.

The ability of US taxpayers to defer and potentially avoid US tax on passive income (either business or portfolio) by earning the income through US controlled foreign corporations (CFC) or foreign controlled investment funds raised policy concerns. In particular, there was a concern that deferral would encourage taxpayers to invest or do business outside, rather than in, the US.

In response to this tax policy concern, the US adopted anti-deferral provisions designed to place US and foreign business and investment options on equal footing from an income tax perspective. The two most broadly applicable anti-deferral regimes are the CFC rules (also referred to as subpart F provisions by reference their placement in the Internal Revenue Code), and the passive foreign investment company (PFIC) provisions. A third anti-deferral regime, the foreign personal holding company provisions, was likewise enacted to prevent the shifting of assets to offshore tax havens. Like the CFC and PFIC provisions, the foreign personal holding company regime denies US tax deferral on certain income earned by a foreign corporation. However, the foreign personal holding company provisions were repealed effective for tax years of foreign corporations beginning after 2004 and tax years of US shareholders ending with or within such tax years. Thus, a discussion of the foreign personal holding company regime is beyond the scope of this article.

Unfortunately, foreign nationals who have structured their business and investment dealings through foreign corporations to mitigate potential home country tax and legal liabilities may unwittingly find themselves subject to one of the US anti-deferral regimes if they establish US tax residence at some later date.

Controlled foreign corporation

The subpart F provisions operate to deny US tax deferral on earnings in a foreign corporation controlled by US interests. Under the subpart F rules, certain income earned by a CFC is, subject to limitations, includible in a US shareholder's taxable income, whether or not the income is actually distributed.

In addition, where a foreign corporation's earnings are invested in US property, an amount may be included in the US shareholder's taxable income. Theoretically, a US shareholder in a CFC can make effective use of a foreign corporation's funds by directing the foreign corporation's investments. Therefore to the extent a foreign corporation's earnings are invested in the US, amounts may be deemed distributed and the US shareholder required to pay the shareholder level tax.

A foreign corporation is a CFC if, on any day during the foreign corporation's taxable year, US shareholders own more than 50% of the combined voting power of all classes of stock, or more than 50% of the total value, of the foreign corporation.

Generally, a US shareholder is any US person, including a US citizen or resident, owning at least 10% of the total combined voting power of all classes of voting stock of the foreign corporation. Direct, indirect (that is, stock owned through foreign entities), and constructive ownership are considered in applying these ownership tests. Subpart F attribution rules treat stock owned by lineal family members (such as spouse, parents, grandparents, and children, but not brothers and sisters) as stock owned by the taxpayer. However, stock owned by a non-resident alien is not attributable to a US citizen or resident. For example, stock owned by a non-resident is not attributable to his/her US resident spouse. This exception in the attribution rules is significant since US shareholders must own more than 50% of the combined vote and value a foreign corporation for the corporation to be considered a CFC subject to the subpart F rules. Thus, a foreign corporation owned equally by a husband and wife will not meet the definition of a CFC if one spouse is a non-resident.

Generally, subpart F income consists of five components including insurance income, foreign base company income (comprised of five subcomponents) and certain other income.

The category of subpart F income that most commonly affects foreign nationals is foreign personal holding company income, a component of foreign base companies income. Subject to statutory exceptions, foreign personal holding company income includes, in part, dividends, interest, royalties, rents, annuities, gains from the sale or exchange of property, and certain personal services income.

The anti-deferral policy of subpart F primarily targets tax haven situations. If a foreign country taxes the corporation's income at a rate that equals or exceeds the US tax rate, this policy is not violated. Thus, certain income subject to high foreign tax may be excluded from treatment as subpart F income. In general, the exception applies if income that otherwise would be includible under subpart F is subject to an effective rate of income tax imposed by a foreign country of greater than 90% of the maximum US corporate income tax rate (35 %).

If a foreign corporation is a CFC for an uninterrupted period of 30 days or more during any taxable year, every US shareholder of the CFC who owns stock in the corporation on the last day of the CFC's taxable year is required to include in gross income his/her pro rata share of the CFC's subpart F income and earnings invested in US property for the year.

Generally, a pro rata share consists of the amount that the US shareholder would have received if, on the last day of the taxable year, the CFC had actually distributed to the US shareholder a dividend equal to its share of the CFC's subpart F income and earnings invested in US property. This amount is reduced if the foreign corporation was a CFC for only a portion of the year or if the US shareholder acquired the CFC stock during the year. When computing the US shareholder's pro rata share of the deemed dividend, only direct ownership of the CFC stock and indirect ownership through foreign entities is considered, not constructive ownership (In defining a US shareholder, direct, indirect and constructive ownership of the foreign corporation's stock is taken into account. However, in calculating the US shareholder's pro rata share of the CFC's subpart F income and earnings invested in US property, only direct and indirect ownership are considered).

US shareholders are not taxed on amounts in excess of the dividend that would have been received had the CFC's income been distributed. Since earnings and profits are a measure of dividend income, a CFC's subpart F income for any tax year will not exceed the CFC's earnings and profits for the tax year. The CFC's earnings and profits are computed as of the close of the taxable year, without any reduction for current year dividend distributions.

In general, a US individual shareholder cannot claim a foreign tax credit for taxes paid by the CFC on undistributed earnings that are deemed distributed and included in US income for the year. Therefore, a US shareholder may be taxed in the US on a deemed distribution (or the employer may incur the added cost if it has agreed to pay the employee's US taxes) and the CFC taxed in the foreign country where the income is earned. In addition, if the shareholder receives an actual distribution from the foreign corporation after ending a US assignment, the income may be subject to a third tax on the same income in his/her home country. Some pre-assignment tax planning may mitigate this result.

As previously mentioned, a US individual is not entitled to claim a foreign tax credit for taxes paid by a CFC with respect to the CFC's income that is distributed as a dividend or included under subpart F. If the US individual is treated as having paid the foreign taxes imposed on the CFC's income, however, he/she can claim a foreign tax credit. A US individual can obtain this result for US tax purposes by electing to treat an eligible CFC as fiscally transparent for US tax purposes under the check-the-box regulations.

If a check-the box election has been made the CFC will be treated as a branch of the US shareholder rather than as a separate corporation, and Subpart F would no longer apply. As a branch operation, all income of the foreign entity (not just subpart F income) is taxed directly to the owner, but an individual US owner may claim a foreign tax credit for any foreign taxes paid by the foreign entity. Depending on the effective tax rate in the CFC's country of residence, the check-the-box election may reduce or eliminate the US tax that a US resident shareholder would otherwise pay on the CFC's subpart F income.

An analysis of whether the CFC is an eligible foreign corporation, the timing of the check-the-box election, and the estimated foreign tax credit benefits should ideally precede the date the assignee becomes a US tax resident. In some cases a foreign corporation may need to be converted from a per se corporation, which cannot make a check-the-box election, into an entity eligible for a check-the-box election. In addition, proper timing of the check-the-box election is critical to avoiding unnecessary US tax consequences.

Alternatively, an individual US shareholder in a CFC may claim a credit for foreign taxes paid by the CFC with respect to subpart F income by making a section 962 election. This election is designed to place the individual shareholder in the same position as if he/she held the CFC stock through a US holding corporation. If the election is made, the US shareholder is taxed at corporate rates on the subpart F income inclusion, and may claim a foreign tax credit for foreign taxes paid by the CFC on the subpart F income under the deemed paid foreign tax credit rules available to corporate shareholders. Later, when the earnings and profits taxed under the election are actually distributed, to the extent the distributed earnings and profits exceed the US tax paid at corporate rates, the earnings and profits are taxable to the US shareholder at individual tax rates (IRC section 962(d)). This election generally is only beneficial if the US shareholder does not plan to receive actual distributions from the CFC for several years after a subpart F inclusion.

All US shareholders of a CFC (including US resident aliens) must file with the Internal Revenue Service, and attach to their Form 1040, a Form 5471: Information Return of US Persons With Respect to Certain Foreign Corporations (IRC section 6038(a)(4)).

In general, the reporting person must provide on Form 5471 the following information regarding the CFC: stock ownership: current year acquisitions and dispositions; US shareholders; GAAP income statement and balance sheet; foreign income taxes; current and accumulated earnings and profits, including any actual dividend distributions during the year; the US shareholder's pro rata share of subpart F income and any increase in earnings invested in US property, and; transactions between the CFC and shareholders or other related persons.

Any US person failing to furnish the required information may be subject to an annual penalty of $10,000 (which can increase to $50,000) and a reduction in any allowable foreign tax credit.

Passive foreign investment company

The PFIC rules, similar to the subpart F provisions, prohibit US persons from deferring US tax on passive investments earned through foreign entities. Thus, the tax advantage an investor in a foreign investment fund may have over an investor in a US investment fund is effectively eliminated. Unfortunately, PFICs can be difficult to identify and, unlike the subpart F provisions, there is no minimum stock ownership requirement for the PFIC rules to apply. Thus, a foreign national who holds a minimal interest in a foreign mutual fund, for example, may be subject to US income tax and reporting requirements under the PFIC regime once US residency is established.

A foreign corporation is a PFIC if it meets either an income or an assets test. In general, a foreign corporation is a PFIC under the income test if at least 75% of the corporation's gross income for the taxable year is passive income. Passive income is defined as income of a kind that would be subpart F foreign personal holding company income (such as dividends, interest, passive rents, and capital gains) with certain adjustments. A foreign corporation meets the assets test if the average market value of the corporation's passive assets during the taxable year is at least 50% of the corporation's total assets. Passive assets are assets that produce passive income, with certain adjustments. Under both tests, attribution rules may apply.

Once a foreign corporation is a PFIC for any year, it remains a PFIC even if the corporation fails the income or asset tests for PFIC status in future years.

A US shareholder is taxed at ordinary income tax rates on any excess distribution with respect to PFIC stock (IRC section 1291(a)). An excess distribution is defined as any actual distribution during a taxable year to the extent it exceeds 125% of the average actual distributions received by the taxpayer in the three preceding tax years (or, if shorter, the taxpayer's holding period before the current taxable year) (IRC sections 1291(b)(1) and (2)(A)).

An excess distribution is allocated ratably over the US shareholder's holding period of the PFIC stock (IRC section 1291(a)(1)). For this purpose, a corporation is not treated as a PFIC on any day in the shareholder's holding period before he/she became a US resident (IRC proposed regulation section 1.1291-1(b)(1)(i)). Amounts allocable to the current year, and tax years before the company became a PFIC, are included in the US shareholder's gross income in the distribution year as ordinary income. Amounts allocable to prior years during which the corporation was a PFIC are taxed at the highest ordinary tax rate in effect for the year to which the income is allocated, without regard to the US shareholder's actual income tax rate, deductions or credits in those years. In addition, an interest charge is applied to recoup any US tax deferral benefit (IRC §§1291(a)(1) and (c)). A US shareholder may claim a direct foreign tax credit with respect to any withholding taxes imposed on a distribution by a PFIC (IRC §1291(g)).

With respect to the disposition of PFIC stock, any gain realized on the sale is treated as an excess distribution and taxed at ordinary income tax rates rather than the more favorable capital gains rates (IRC section 1291(a)(2)). Under proposed regulations, if a shareholder in a PFIC becomes a non-resident for US tax purposes, the shareholder will be treated as having disposed of his/her stock in the PFIC on the last day the shareholder is a US person. Termination of a section 6013(g) election is treated as a change of residence of a spouse resident in the US solely by reason of the election under section 6013(g), a non-resident who is married to a US citizen or resident may elect to be treated as a US resident for the entire tax year. The election remains in effect for all subsequent tax years until suspended (that is, a tax year in which both spouses are non-residents) or terminated.

Generally, a US shareholder of a corporation that is both a CFC and a PFIC is subject to the subpart F regime only, not the PFIC provisions. However, a shareholder of a CFC/PFIC that is not a US shareholder as defined under subpart F (a US person owning stock representing 10% of the voting power of the foreign corporation) is subject to the PFIC rules even though the foreign corporation is a CFC. If the US shareholder ceases to be subject to the subpart F rules (such as, the shareholder disposes of stock so that he/she no longer holds a 10% voting interest in the CFC and is no longer a US shareholder), under the PFIC provisions, the shareholder's holding period is treated as beginning immediately after cessation as a CFC.

To eliminate the punitive tax and interest charges applicable to excess distributions, a US shareholder in a PFIC can make either a qualified electing fund or mark-to-market election.

A PFIC shareholder can make an election to treat a PFIC as a qualified electing fund (QEF). Generally, once a QEF election is in effect, the shareholder is taxed on his/her pro rata share of the PFICs ordinary earnings and net capital gains. A shareholder's pro rata share is the amount the taxpayer would have received if, on each day of the QEF's taxable year, the QEF had actually distributed to each of its shareholders a pro rata share of that day's ratable share of the QEF's ordinary earnings and net capital gains for the year. By electing QEF status and including amounts in income, a US shareholder of a PFIC is exempt from the special tax and interest charges imposed on excess distributions or gain from the sale of PFIC stock since there has been no US tax deferral.

If a US shareholder makes a QEF election after having held the PFIC stock for a period of time, rather than at the time he/ she initially acquires the PFIC stock, he/she may be required to recognize income at the time of the election to recapture any deferral benefit attributable to the prior period. In addition, as a prerequisite to making the QEF election, the shareholder must obtain certain information from the PFIC, including a PFIC annual information statement. The statement must include, in part, a representation that the PFIC will permit the shareholder to inspect and copy the PFIC's permanent records. Thus, the ability of a PFIC shareholder to make a QEF election will depend on whether the PFIC will provide the information required.

The mark-to-market election extends the current income inclusion principle to PFIC shareholders who own marketable PFIC stock. Marketable stock is generally stock that is regularly traded on a recognized stock exchange. PFIC shareholders who cannot, or do not, make a QEF election may avoid the PFIC tax and interest charges by electing mark-to-market treatment.

If a mark-to-market election is made, the difference between the fair market value of the PFIC stock at the close of the tax year and the shareholder's adjusted basis in the stock is included in the shareholder's income. Any excess of the adjusted basis of the PFIC stock over its fair market value at the close of the tax year is deductible by the shareholder. However, deductions are limited to the net mark-to-market gains on the stock that the shareholder included in income in prior years. Any income or loss recognized under the mark-to-market election is treated as ordinary income. Additionally, a shareholder's adjusted basis of PFIC stock is increased by the income recognized under the mark-to-market election and decreased by the deductions allowed under the election.

A US shareholder must file a separate Form 8621: Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, annually, with his/her tax return, for each PFIC for which the taxpayer was a shareholder during the taxable year.

Comprehensive planning

A foreign national's business and investment tax planning strategy designed to mitigate home country tax may trigger US tax consequences once the individual establishes US tax residency. While the concept of anti-deferral is deceptively simple, the application of the foregoing rules is more complex than an overview can adequately convey. Comprehensive pre-arrival US tax planning is necessary and at a minimum should include an evaluation of the assignee's foreign corporation holdings and such corporation's business and investment interests to determine the potential US tax implications. Utilizing applicable elections should be considered, if appropriate. Such tax planning is a sensible investment that may reduce both the assignee's US income tax liability and reporting obligations and the employer's overall assignment costs.

Joan Smyth (jsmyth@kpmg.com)

Biography

Joan Smyth KPMG 2001 M Street NW Washington DC 20036-3310 US Tel: +1 202 533 4404 Email: jsmyth@kpmg.com Joan Smyth is a senior manager in KPMG LLP's Washington National Tax practice where she focuses on international tax issues that arise with respect to US expatriates and foreign national taxpayers. Before joining the Washington national tax practice in 1996, she worked in KPMG's International Executive Services practice in San Jose, California.