On December 20, 2017 the “Tax Cuts and Jobs Act was passed in the United States.
CFC’s (controlled foreign corporations) or say Canadian corporations that are controlled by U.S. corporations, or by U.S. citizens or by green card holders will no longer have the luxury of deferring U.S. income tax on active business income. These are the most significant amendments to Subpart F of the Internal Revenue Code.
This transition tax is effective for 2017 for Canco’s with tax years ending on December 31, 2017; otherwise it is effective in 2018 for tax years ending in 2017 but prior to December 31, 2017.
For the following year after this transition tax is effective, a similar taxation under what is called GILTI (or “Global-Intangible Low-Taxed Income”) will apply to that year’s and the following years’ earnings.
The transition tax due this April 17th basically looks at Canco’s undistributed earnings and profits computed at two measurement dates, November 2 & December 31st and selects the greater amount. There is a procedure to pay the transition tax in eight annual instalments.
For the transition tax, a deduction is available from the computation of undistributed E&P, based on prescribed computations that reflect a portion of the undistributed E&P composed of cash assets and other assets. For an individual in the top U.S. marginal tax bracket, the effective tax on undistributed E&P from cash assets is about 17.54% and from non-cash assets it is about 9.06%.
For the GILTI taxation effective for the following year, there presently is no prescribed deduction available to individual shareholders.
The net inclusion arising from the foregoing is treated as “other income” on your U.S. tax return and not as a dividend distribution. If a dividend is paid for the taxation year, it is not taxed if it is regarded as PTI (“previously taxed income”) under the new rules or under the other subpart F rules (that are still there for passive-type income). If there is a distribution in excess of the foregoing income inclusions, it is treated as a dividend to which you may have current Canadian tax thereon, available to claim a current year’s foreign tax credit on your U.S. tax return.
Any inclusion from these new rules has an increase in basis of your shares and any distribution is a reduction to the shares which is supposed to alleviate double taxation on the sale of your shares from the U.S. perspective.
Because the income inclusion is foreign source from a U.S. perspective, if you have certain foreign tax carryovers available from prior years, you can use them to soak-up this transition/GUILTY tax. This will be important if you have not received any distributions/dividends during the year. Again, the composition of your adjusted gross income for U.S. tax purposes will ultimately affect the bottom line as the foreign tax credit allowed for a year is limited to the otherwise U.S. tax is on the foreign source income.
Going forward, it appears to avoid double taxation and the potential mismatch of foreign tax credits as a result in paying tax in one country in one year but not paying tax on the same income to the other country in a latter year, it may be advisable to either commence paying annual dividends or salaries to minimize your exposure. Every situation is different and professional advice is highly recommended.
This new taxation regime is very complex, and we are still waiting for clarification on several matters and the revised IRS Form 5471, which the U.S. foreign information return that carries the minimum $10,000U.S. penalty for not filing.