For Americans resident in European countries with relatively high income taxes the bracket broadening effect of the tax changes will be limited except for those individuals who are not subject to worldwide tax in their country of residence. For example, UK non domiciliaries who claim the remittance basis of tax (now only available for the first 15 years of UK residence), Italian residents claiming the Italian non domiciliary regime and Swiss residents with a forfait agreement will be able to benefit from the lower rates of US income tax and higher standard deduction. Note that all individual tax changes expire on 31 December 2025.
Most European residents will not be affected by the limitation on the deduction for state and local taxes, but more will be affected by the limitation of the mortgage interest deduction to interest on $750,000 principal, down from $1M, for debt incurred after 15th December 2017 and eliminated for home equity lines of credit. The itemised deductions are generally eliminated except for charitable contributions. Many expatriate Americans will have found that itemised deductions were similarly of little practical use. The standard deduction increases to $24,000.
The new pass-through deduction for partnership, LLC and S corporation income will be of limited utility to many expatriate Americans. The deduction is limited to US business income where the business has a significant wage bill or qualified capital assets. It will not apply to non US businesses, but it will be available for US and non US investors in US real estate including REIT investments. This then complements the reduced corporate income tax rate for US real estate investors using a corporate structure.
An item that has attracted relatively little attention but which will affect self-employed expatriate Americans relates to the change in the foreign tax credit baskets. There are now two new foreign tax credit baskets, one for 10 percent shareholders of US owned foreign companies and more significantly a new foreign branch basket. A foreign branch of a business is defined to mean any foreign business which broadly keeps separate books and records, so it is a fairly broad definition and there is no requirement for it to be a branch of any other business. Therefore a partner in a partnership in the UK or elsewhere would from 2018 or 2019 (depending on the relevant fiscal year) find that the partnership income is now in a new basket. Congress has not however provided any transition relief for carry forward foreign tax credits which will now be in a different basket from the income going forward. Potentially this could lead to a significant economic loss to foreign resident taxpayers but possibly the IRS will offer transition relief.
With the cut in the corporate income tax rate to 21% and the elimination of the corporate alternative minimum tax investors will want to look at US inbound investment structures to review whether a corporate structure would result in a preferable tax result. In particular US real estate investors have regularly used pass through structures in order to avoid the high rate of corporate income tax and branch profits tax, but the corollary of this has usually been to accept a US estate tax risk. Investors should now be able to achieve a 21% tax rate on gains and income with a more secure estate tax protection. However, our preliminary analysis shows that a leveraged US real estate investment may still achieve a rate advantage using a pass through structure. Undoubtedly investors will want to review many of their business structures in light of the very significant rate changes. Account will also need to be taken of a new withholding tax on the sale of an interest in a partnership which is actively engaged in a US business, so that the purchaser is now required to withhold 10% of the proceeds of sale on account of the partner's income tax liability, similar to the real estate withholding and like that its effects can be modified by a certificate obtained in advance.
US investors in non US corporate structures will need to review the changes in the controlled foreign corporation (CFC) tax rules since there are a number of changes which increase the risk of CFC status. There are technical changes in the attribution rules which increase the risk that corporate ownership of CFC stock will be attributed to a US shareholder. In addition the former rule which ignored CFC status for less than 30 days in a tax year has been repealed so that inadvertent CFC status as a result of a change in status during a year increases and this also affects a popular planning for ownership of US assets through a company which checks the box immediately after estate tax protection is triggered. Owners of a CFC with accumulated earnings may now find those earnings taxed in 2017 under the repatriation rules.
Fund principals should be pleased that the various proposals to end the favourable treatment of carried interests as long term capital gain has been preserved but the holding period has been increased to 3 years. In practice we do not think that this will impact many fund principals.
Estate and gift tax
The big change here is the large increase in the exempt amount (referred to as the unified credit amount) which increases from an inflation adjusted $5M to an inflation adjusted $10M which means that the effective exempt amount is approximately $11M per person or $22M for a married couple. Like all the individual tax provisions this is time limited and is scheduled to expire in 2025 unless Congress acts to extend it. There have been statements made in Congress that legislators hope to extend these provisions but similar intentions were expressed in 2003 and those rate changes and exemptions were not extended although Congress did act subsequently to modify the exemption and increase it to $5M. One question that has been raised by a number of commentators is whether there would be any potential for claw back if a US person made life time gifts of $11M and then died after the exemption reduced to $5M (inflation indexed). Based on the position in 2011, we would anticipate that there would be no claw back but the IRS is directed to provide guidance.
This offers a big incentive for UK resident Americans to ensure that the exemption amount is used to the greatest extent possible through lifetime gifts. These gifts can be made in trust if the donor is not UK domiciled at the time of the trust creation or by way of outright gifts (or gifts using a partnership structure) if the donor is UK domiciled. Without lifetime gifts the donor risks losing the benefit of the greatly increased exemption amount.
To discuss these changes further, please contact your usual Withers contact, or a member of our London US team.