It is no secret that the United States is a world leader in taxation of its citizens. The IRS is often portrayed in pop culture as a mysterious, invincible institution that no one would dare oppose. It even made its way into the Batman series, with the Joker stating that even someone as famously insane as him, was not crazy enough to go against the IRS. The notorious monitoring and taxation of the IRS also reaches out past America’s borders and throughout the world. The now famous Foreign Accounts Tax Compliance Act (FATCA) effectively checkmated foreign financial institutions into breaching their own data protection laws, and put the world en-route toward the system of global reporting and taxation we see today. This influences tax for American individuals living overseas, but can be even more serious for American business owners that have offshore companies. And yes, as far as the IRS is concerned, even Japanese companies are “offshore”.
Up until just recently, there had been one unique beneficial aspect to the US tax code which favorably set it apart from most countries: its treatment of Controlled Foreign Corporations (CFCs).
Most countries’ CFC laws, Japan included, implement what is referred to as a territorial system. This means that the company’s earnings are taxed according to the laws of the country in which it is located, however, with some qualifying conditions. To take Japan as an example, in order to prevent tax avoidance through the use of tax havens, the National Tax Office (NTA) uses its extensive CFC laws to judge whether the foreign corporation is a genuine commercial enterprise in that country, or simply a tax avoidance vehicle. Here is a simplified example: if the corporation has a single Japan-resident shareholder, the company has no physical assets (such as factories), and is located in a country whereby the corporate tax rate is less than 30%; it is deemed a potential tax avoidance vehicle and the corporation’s income is included in the owner’s annual income. In other words, Japan’s high tax rates will apply.
So, simply owning a company in a low tax jurisdiction will not necessarily involve you being able to reduce your Japanese income tax.
However, for over 30 years the United States took a different approach to tax expat Americans with offshore companies. Since the previous major tax change in 1986, rather than using a territorial system like Japan and most countries, the United States began operating under its unique system of worldwide taxation with deferral. This meant if a foreign corporation had non-US-sourced income, that income would not be taxed by the IRS until it was repatriated back to the US or paid to its American owner. In other words, if a corporation was able to book its income offshore, then it could enjoy paying zero US taxes on its earnings so long as the money remained offshore. This is one of the contributing factors as to why companies like Apple were famously able to accumulate hundreds of billions of dollars tax-free, more than the GDP of entire countries, in offshore tax-free jurisdictions.
For those inspired American international business people hoping to join in on this tax-deferral strategy, it should be noted that it is now too late. The train has left the station.
Although the recent Tax Cuts and Jobs Act of 2017 cut individual income tax rates and corporate tax rates, it contained a bitter pill for international business owners. The US abandoned its worldwide-income-with-deferral system in favor of the more globally adopted territorial system. In addition to that, it included a retroactive and immediate taxation of all retained earnings reaching as far back as 1986. Retroactive measures like this are uncommon and can be viewed as punitive and unfair, however, it is argued that this was done for the purpose not of punishing citizens with businesses abroad, but instead to checkmate companies like Apple into paying tax on their hundreds of billions stashed away offshore. One can only presume that if there was any form of grace period, Apple’s teams of accountants could have found ways to move the earnings elsewhere to continue deferring or outright avoiding tax.
Up until now these companies had, from a legal perspective, done nothing wrong. So, to make up for being thrust into an unpredictable tax burden, companies falling under this new tax system will pay reduced rates on these retained earnings. For retained earnings converted to hard assets (factories, equipment, etc.) this “toll tax” will be 8%, while retained earnings held as cash will be taxed at 15.5%.
For young companies, this may not prove to be too much of a burden. However, a great number of Americans with longstanding companies whose profit margins and overall business model relied upon the previous offshore tax regime could be greatly affected. These companies find themselves facing tax on up to 30 years’ retained earnings. For instance, imagine having to pay 30 years’ worth of income tax, using just your present-year cash flow. Even at reduced rates, this is enough to put some businesses in serious financial trouble. Presumably for this reason, the IRS is allowing companies to make payments on this retroactive tax gradually over the course of the next 5 years, with only 8% of the total tax bill being payable in the first year.
For example: An international trade business owned by an American has been operating in Asia since 1997. The headquarters are in Singapore and all revenues are non-Singapore sourced, thereby no income has been taxable in Singapore. It is a reasonably small family business, with an annual income of $50,000. Being in operation for 20 years however, this has added up to total retained earnings of $1,000,000 (which could very well be the elderly business owner’s entire pension savings). Under the new law, the owner of this business is now required to pay a surprise $155,000 in “toll tax” to the IRS. However, for the tax deadline of April 2018; only the first 8% of the total tax bill is due, meaning $12,400.
It should be noted that, unlike automatic extensions for individual non-resident tax returns, there is no extension for CFCs paying this toll tax. If you are a single day late in making the first year’s tax payment, the ability to spread payments across 5 years is forfeited, and the full tax bill becomes immediately payable. In other words, in the above case if the business owner fails to pay his $12,400 tax liability for 2018 on time, it immediately jumps to a liability of the full $155,000 plus late-payment interest accruing on a daily basis.
After the toll tax on previous retained earnings have been paid, foreign corporations must then reassess their business operations going forward. Companies no longer will enjoy tax deferral, nor will they operate under the 15.5% toll tax rate. If an American owns a CFC, and the jurisdiction in which the offshore company is domiciled has a corporate tax rate of above 18.9%; then the corporation’s income could be included on the owner’s personal annual income at his top marginal rate, officially classified as Global Intangible Low Taxed Income (GILTI). In addition, any multinational corporation that also has extensive US gross revenues could be liable for the Base Erosion & Anti-Abuse Tax (BEAT).
As should be expected, the IRS has managed to outdo even itself this time. One could go so far as to call these measures punitive and egregious. What other institution could, in no way unconsciously, decide the new tax acronyms should be GILTI and BEAT?