Tax efficient cash repatriation is a common problem faced by multinational organizations.
When faced with this dilemma, the favorable tax treatment of qualified dividends could be worth considering as it might negate the tax cost associated with the loss of foreign tax credits for some shareholders.
For U.S. tax purposes, a qualified entity can elect to be treated as a corporation or “pass through entity.” Under U.S. tax law, a corporation is regarded as a separate taxpaying entity. Meanwhile, earnings of a pass through entity are not taxed at the entity level. Instead, they are taxed at the partner/shareholder level regardless of whether such earnings are distributed by the entity to the partners/shareholders. As a result of the pass through status, partners/shareholders could incur taxation on income not yet distributed.
It is important to remember that a corporation’s earnings are subject to two layers of tax. They are first subject to tax at the corporate level and then again at the shareholder level as dividend income once earnings are distributed.
Further inequities are found in the disparity in tax rates. While U.S. corporations are subject to graduated rates, a common corporate effective tax rate will be referenced for purposes of this article. Accordingly, let’s proceed with the understanding that corporations in the U.S. are taxed at a maximum federal rate of 35 percent on both ordinary income and capital gains. Meanwhile, individuals are taxed at graduated rates ranging from 15 to 39.6 percent on “ordinary” income and up to 20 percent on “net capital” gain income with an additional 3.8 percent tax on “investment” income.
The U.S. operates under a foreign tax credit mechanism. This means that if earnings of a foreign pass through entity are taxed in the U.S. (even if not distributed), then income taxes paid by that entity in its home country can be taken as a foreign tax credit against the shareholder’s U.S. tax paid on that income.
A foreign corporation’s (non-pass through entity) income and taxes do not pass through to the U.S. shareholder automatically. Instead, a U.S. shareholder is taxed on that income when received as a dividend, without the benefit of a foreign tax credit.
Therefore, if a U.S. individual owns a foreign entity treated as a pass through for U.S. tax purposes, and that entity operates in a jurisdiction whose effective tax rate is lower than the U.S. individual tax rate, the foreign entity’s tax would be eligible for a full foreign tax credit against the U.S. individual’s U.S. tax liability.
For example, consider an individual, John Smith, who is subject to the highest rate of U.S. income tax of 39.6 percent on ordinary income. This person owns a U.S. S Corporation, ABC Company. This company owns a foreign entity, XYZ Worldwide, which is a treated as a partnership for U.S. tax purposes. XYZ Worldwide operates in a country that imposes income tax at a rate of 20 percent and has a tax treaty with the U.S. in effect. If XYZ Worldwide earns $100 of taxable income, it would be liable for tax of $20 in that country. Since XYZ Worldwide is a pass through entity and Mr. Smith owns XYZ Worldwide through ABC Company (also a pass through entity), he would be subject to U.S. tax on XYZ Worldwide’s $100 of income whether or not distributed to Mr. Smith. His U.S. tax on that income would be $39.60, but the $20 of the foreign country tax would be eligible for a foreign tax credit, resulting in $19.60 of tax to be paid in the U.S. Globally, the total tax on XYZ Worldwide’s income would be $39.60 ($19.60 in the U.S. and $20 in the foreign country), or 39.6% (the U.S. tax rate).
Conversely, if an individual owns a foreign corporation, directly or through a U.S. pass through entity, foreign country taxes paid will not be eligible for a foreign tax credit once the foreign company’s profits are repatriated as dividends. We should note that amounts retained by a foreign jurisdiction as a withholding tax are eligible as foreign tax credits. While indirect tax credits are available to U.S. corporations, that will be a topic addressed another time. Meanwhile, dividends received by a U.S. shareholder from an entity eligible for benefits of a comprehensive income tax treaty with the U.S. should be considered qualified dividend income under U.S. tax law and subject to tax at net capital gains rates (maximum 20 percent plus 3.8 percent tax on investment income).
Returning to our previous example, assume XYZ Worldwide, the foreign entity, is treated as a corporation for U.S. tax purposes and remits all of its after tax earnings ($80) to Mr. Smith as a dividend. For simplicity purposes, it is assumed that there is an effective 0 percent withholding tax rate, which could be achieved through treaty benefits or statutorily imposed. Mr. Smith’s U.S. tax liability on the dividend would be $19 (23.8% of $80). Total tax on XYZ Worldwide income would be $39 ($20 in the foreign country, plus $19 in the U.S.). If XYZ Worldwide were to retain its after tax earnings and not remit a dividend to Mr. Smith, his dividend tax of $19 would be deferred until XYZ Worldwide earnings were actually remitted.
Compare this result to the example assuming the tax rate in the foreign country is 15 percent and XYZ Worldwide is a pass through entity. In that instance, total tax on XYZ Worldwide income would remain $39.6 (the same result as our previous example), comprised of $15 due to the foreign country and $24.6 ($39.6 – 15) due to the U.S. However, if XYZ Worldwide was treated as a corporation for U.S. tax purposes and it repatriated it’s after tax earnings, total tax on its income would be reduced to $35, comprised of $15 due to the foreign country and $20 ($85*23.8 percent) due to the U.S.
As such, if a U.S. taxpayer is in the highest tax bracket and operates through an entity in a jurisdiction eligible for treaty benefits, income can be deferred (not repatriated) with no residual U.S. tax cost if the foreign country rate approximates 20 percent or lower. The reason for this is that the overall tax rate after repatriation (foreign and U.S.) would be no greater than the U.S. tax rate, as shown in the examples above.
What these scenarios illustrate is the importance of remaining mindful of the effective tax rate in all operating jurisdictions. Doing so could uncover planning opportunities that exist if your current structure is not satisfying business cash needs in a tax efficient manner.
For questions or comments, contact Jennifer Heider at [email protected] or Mark Chaves at [email protected].