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.[1] If we take the 2016 estimate of “indefinitely reinvested foreign earnings”[2] 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.[3] 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.[4] 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.
[1] Thomas Barthold, JCT Chief of Staff, quoted at https://www.bna.com/early-numbers-show-n57982093122/
[2]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.
[3]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.
[4] Apple is buying back $100 billion in shares – http://time.com/5262187/apple-announces-100-billion-share-buyback-after-beating-profit-expectations/
What’s happening on the ground … Here are two examples of many.
Example 1: I was speaking to a retired doctor in Canada who had used his Canadian Controlled Private Corporation to accumulate his retirement pension. He told me that after 30 years and 30,000 patients he now had now had to put a mortgage on his house so that he could pay the transition tax. (How he will pay the mortgage given that he is no longer working is not clear to me.)
Example 2: I was doing a presentation to a group of U.S. expats in Toronto. One man said that he had been hospitalized over anxiety caused by the transition tax.
What the transition tax and GILTI really mean …
The Section 965 transition tax and GILTI are “legislative arguments” for abolishing the U.S. citizenship-based taxation regime. They show you want happens when the United States, WITH THE ASSISTANCE OF THE TAX COMPLIANCE INDUSTRY, continues the immoral practice of, attempting to impose worldwide taxation, on people who are tax residents of other countries and do NOT live in the United States! As one person asked me:
“Do people who have never even lived in the United States really have to pay the transition tax? Do they really have to turn their retirement pensions over to the IRS?”
The perspective of Congress (to the extent that it has one)
This post demonstrates (what we all know) that:
1. Congress did NOT consider whether these provisions would impact Americans abroad; and
2. Congress didn’t even have any idea that these proposals could/would affect Americans abroad.
3. There was little discussion or awareness of how these provisions might impact the individual shareholders of CFCs who live in the United States (let alone on Americans abroad). We are well aware that the impact of the transition tax on individual shareholders living inside the United States was (arguably) positive, whereas the impact of the transition tax on Americans abroad was “the confiscation of their pensions”.
4. The question of “revenue neutrality” (what would it cost to clarify that the transition tax should not apply to expat small businesses) should not be part of this discussion. As Dr. Alpert demonstrates in this post, Congress never considered that it would get revenue from expat small businesses anyway. Therefore, a clear legislative exemption for Americans abroad should be considered to be a technical fix (where revenue is irrelevant) and NOT a legislative fix (where revenue may be relevant).
The Intent of the legislation – Congress neither considered whether the transition tax would apply to Americans abroad and therefore did not intend for the transition tax to apply to Americans abroad.
So, how could this have happened?
The application of the transition tax and GILTI demonstrate the role that the tax compliance industry has in both (1) determining the industry interpretation of what tax legislation means and (2) enforcing compliance with that industry interpretation.
The compliance industry failed its clients!!
1. In December of 2017 and during 2018 the compliance industry could and should have questioned whether the transition tax applied to the small businesses of Americans abroad. The failed to do so. They enthusiastically embraced the notion of the transition tax applying to the small businesses of Americans abroad. Within hours of the release of the first draft of the TCJA, the compliance industry was ASSUMING that the transition tax DID apply to Americans abroad. The industry could have questioned it’s application to Americans abroad. It did not.
2. In December of 2017 and during 2018 the compliance industry could and should have explored, supported and suggested arguments that the transition tax, if it applied to Americans abroad, also violated various tax treaty provisions. They should have been willing to explore these arguments. They did not. It was pathetic.
3. During 2018, if the compliance industry really supported their clients, they should have made arguments to Congress and to Treasury that the transition tax and GILTI were not intended to apply to Americans abroad and should not be applied to Americans abroad. They should have participated in the discussion. With VERY FEW exceptions the compliance industry failed to support their clients. Instead the industry told individuals impacted by this: You have to just pay this. Just pay this tax etc. Turn your pensions over to the IRS because of an unintended consequence. Just pay it over eight years, …
4. During 2018, if the compliance industry really supported their clients, even if they really believed that the transition tax applied to Americans abroad, they should have explored the various ways that the tax could have been paid – including (but not limited to) the Sec. 962 election. VERY FEW made any effort to understand the mechanics of how the Sec. 962 election could assist some. VERY FEW made any effort to understand the issue period.
The role of the compliance industry in U.S. tax administration …
The transition tax and GILTI are perfect examples of how tax administration in America works. What happens is this:
1. Congress makes some kind of law. Very few if any members of Congress read the law. Almost none of them understand the law. They (as Nancy Pelosi famously said) “pass the law so that they can see what it’s in it”.
2. They then “punt the administration of the law” over to the compliance industry which will ALWAYS interpret the law in the most literal way (without considering intent) and in the way that is most punitive to the individual and beneficial to U.S. Treasury.
Bottom Line:
It’s the compliance industry who makes the law. It’s the compliance industry who determines what it means. It’s the compliance industry that has determined that the transition tax and GILTI apply to Americans abroad.
What people should do:
Different strokes for different folks. Many have made their decisions. Some are still trying to figure out what to do. What is clear is that most members of the compliance industry are of little help to you in making your decisions. If you don’t know what to do and you want to file – maybe you should take a treaty position that the transition tax doesn’t apply to people who are “tax residents” of other countries. (Of course your friendly compliance professional won’t support you in this.)
A lesson for those not currently in the U.S. tax system:
When and if you enter the U.S. tax system it is essential that you learn to do your taxes yourself.
Lessons for those Americans abroad who are in the tax system:
– You are a citizen of a country that makes law that apply to you outside in the United States. This is very bad. But, what’s worse is Congress doesn’t care about you when making these laws. But, it’s even worse. It’s not that Congress doesn’t care about you. It’s that Congress doesn’t care that it doesn’t care!
– Your principal way of interacting with the United States is through its tax system. Most people use compliance professionals. These compliance professionals serve the IRS. They do NOT (as the transition tax debacle demonstrates) serve you.
– The transition tax and GILTI coupled with how tax administration works in America (described above) are the best arguments for renouncing U.S. citizenship I have seen.
When it comes to injustice: #YouCantMakeThisUp!
Additional statistics – the IRS publishes aggregate data for forms 5471 attached to US corporate returns (Form 1120 – so this excludes any 5471s for CFCs owned by individuals or pass-through entities). You can find the data at https://www.irs.gov/statistics/soi-tax-stats-controlled-foreign-corporations. The most recent compilation is from 2014. This shows USD2.7 trillion of deferred income (accumulated E&P not previously taxed) from a total of 90,204 CFCs owned by 14,969 US corporations. While this figure includes some pre-1987 accumulated E&P, after growth from 2014 to 2017, this easily covers the transition tax receipts estimated by JCT. Individually owned CFCs were not considered.
So if individual shareholders were not included in revenue estimates, they should have surplus revenue from those individual shareholders who have complied?