Individual shareholders of US Controlled Foreign Corporations face a difficult deadline on 15 December. That’s the last date to file a timely 2017 tax return (assuming all possible extensions have been granted). For those who feel they must comply with the §965 transition tax, this is the last date to make an election to spread the tax over eight years. We have been covering this tax provision at Fix The Tax Treaty since before the Tax Reform legislation was passed (list of posts). Comprehensive coverage of the transition tax is available in a series of posts by John Richardson over at www.citizenshipsolutions.ca. For affected shareholders, the transition tax can destroy the nest egg they have built up over a long career. The purpose of this post is to consider how this injustice can be fixed.
There have been several international tax reform proposals in the past decade, some of which are variations on the final Tax Cuts and Jobs Act (TCJA) package. None of these proposals even considered the interaction of the proposed changes with taxing based on citizenship. One even suggested completely repealing the provision that eliminates US tax on dividends out of previously taxed income because corporate shareholders would no longer be paying US tax on those dividends anyway.
The transition tax is a deemed repatriation of deferred income held overseas. This concept just doesn’t make sense when applied to US citizens who are tax residents of other countries running small businesses where they live.
There are really three different avenues for addressing the injustice inherent in the application of the transition tax to individual shareholders who receive none of the benefits afforded corporate shareholders in the 2017 tax reform:
- Regulatory Relief: Limited relief has been granted in the form of an extension to pay the first of eight annual instalments. However, Treasury and the IRS have determined that they have no authority to exempt individual shareholders of small businesses entirely from the burden imposed by the transition tax.
- Litigation: This is the avenue being pursued by Israeli tax attorney Monte Silver. His position is that the IRS has failed to properly address their obligation to consider the impact of regulations on small businesses under the Regulatory Flexibility Act. Read more (and donate to his effort) on his website.
- Legislation: Congress made this mess, and Congress can fix it. All it takes is an amendment to exempt individual US shareholders (or alternatively, individual US shareholders of small businesses as defined by the Small Business Administration) from the application of the transition tax and GILTI. After all, these shareholders do not get the benefit of tax-free dividends from CFCs or the reduced US corporate tax rate.
One of the obstacles often mentioned when it comes to a legislative fix is the perceived requirement that any change be “revenue neutral”. While this is understandable given the current US budget deficit, it shouldn’t apply to this particular fix because the transition tax liability of individual US Shareholders of CFCs was not included in the original estimates of transition tax revenue.
JCT estimated revenue of $338.8 billion over 10 years from the transition tax. Not all of that was from the actual transition tax; some was the follow-on tax effects of increased dividends, share buybacks, and reduced interest expense due to repatriated cash. If we take the 2016 estimate of “indefinitely reinvested foreign earnings” of Russell 1000 public companies alone, Audit Analytics estimated a total of $2.6 trillion in 2016. If only half of this is in liquid assets taxed at 15.5% (and the balance in illiquid assets taxed at 8%), this would generate a transition tax liability of $352.5 billion. While it is likely that foreign tax credits will offset some of this estimated tax, we haven’t yet considered any additional tax generated by increased dividends and share buybacks. What these numbers indicate is that the JCT estimates are most likely based on tax revenue from publicly listed multinational corporations and do not include any transition tax revenue from nonresident individual US Shareholders. Furthermore, while JCT would have had access to Form 5471 data from all US Shareholders (including individuals), that form does not indicate how much accumulated foreign tax credit might be available should a shareholder make a §962 election, so JCT would have had no way to estimate tax revenue from individual US Shareholders. If revenues from individual US Shareholders weren’t included in the original revenue estimates,then providing relief to these taxpayers will not increase the overall cost of tax reform.
The Way Forward
There is no way to know which of these three avenues (regulatory relief, litigation, or legislation) will ultimately be successful. Fortunately, there’s no reason not to pursue all three in parallel. See Americans Abroad for Tax Fairness for a series of emails to send to the US Treasury and Congressional leaders. See American Small Businesses Against the Repatriation & GILTI Taxes for a summary of Monte Silver’s advocacy on this issue and to donate to his lawsuit. Finally, write to your own Congressional representatives to make sure they are aware of the unjust demands that tax reform placed on US small business owners who live and work (and pay taxes) outside the US.
 Thomas Barthold, JCT Chief of Staff, quoted at https://www.bna.com/early-numbers-show-n57982093122/
Public corporations are required to keep track of deferred taxes. When tax is deferred “indefinitely” because the firm has no plans to repatriate funds from foreign subsidiaries, this amount must be tracked and disclosed as “indefinitely reinvested foreign earnings” under US accounting standards.
Note that Apple’s estimated transition tax liability of $38 billion is approximately equal to 15.5% of their foreign cash holdings of $252 billion, indicating very little in the way of non-liquid assets or offsetting foreign tax credits. Furthermore, Apple’s 2017 annual report (on page 58) reports only $128.7 billion of indefinitely reinvested foreign earnings. So estimating the transition tax liability based on aggregate indefinitely reinvested foreign earnings should give a conservative estimate.
 Apple is buying back $100 billion in shares – http://time.com/5262187/apple-announces-100-billion-share-buyback-after-beating-profit-expectations/