18 October 2019 - Article
The 2017 Tax Reform was drafted in a hurry and behind closed doors and it is evident in a number of provisions. As well as the headline tax cuts, there have been wide-ranging changes in the corporate income tax rules which particularly affect shareholders of controlled foreign corporations. These have some unexpected consequences for individual Americans with businesses outside the United States.
As part of a series of tax changes aimed at multi-nationals (particularly the tech companies), the foreign tax credit baskets have been adjusted and two new foreign tax credit baskets have been created. These new baskets are for foreign branch income and for shareholders in 10% or more owned foreign corporations. These may sound like purely technical changes worthy of a footnote in a tax journal but in fact they have a surprisingly broad impact.
Most Americans resident in Europe pay European tax on European source income and rely on the foreign tax credit mechanism to offset the local tax against their US tax liability. If you are US citizen who is employed in London for example, you will probably pay more UK tax than you can use to offset against your US tax and therefore as the years go by, you will build up surplus foreign tax credits which you carry forward. As an employee your foreign taxes will be classified as general limitation foreign taxes and can be offset against any other category hitherto except passive income. This means that the employment income tax credits can be used against other employment income. For employees, broadly this position does not change.
However, for those who are self-employed, such as partners in a business or business owners, there has been a very drastic change in the tax basket. The foreign branch income basket is broader than it would seem at first sight. It is in fact nothing to do with branches. It covers income from any foreign business which is sufficiently separate (from the taxpayer's personal activities) that it maintains separate foreign currency accounts. This will catch broadly all Americans who are self-employed, including partners in international firms, foreign business owners and international real estate investors. In particular, many Americans who own their own businesses through a UK company may have checked the box (or made an entity election) so that the company is disregarded for US tax purposes. This avoids a double level of US tax on corporate earnings. Since it is now a disregarded entity, the foreign company will be treated as a branch.
Previously when Congress has changed the foreign tax credit baskets, it has provided transition rules so that carry forward foreign tax credits can be applied as appropriate against the new baskets. However, this Congress was in a hurry and no transition rules have been provided. Arguably it is open to the IRS to provide guidance but this is not on the priority list of guidance published by the IRS.
Many Americans who have very significant balances of foreign tax credit carry forwards may now not know whether these are available to be applied against their self-employment earnings in future. They may find, for example, that they cannot use their foreign tax credit surplus that builds up in the branch basket to offset income that might fall into the general basket such as, for example, tax free lump sums from pensions.
This is a very frustrating position for lawyers and accountants because we really have no guidance from the IRS about how to handle carry forward foreign tax credits in these circumstances. On the one hand, it may be open to the taxpayer to argue the most advantageous position possible in the absence of guidance. On the other hand, for risk averse taxpayers, it is difficult for an adviser to say definitively whether or not a foreign tax credit is available. Let us hope that the IRS comes to the rescue of self-employed non-resident Americans soon – we are certain that Congress did not have these people in its sights even if some of them are partners in law firms.