South Florida is known as the gateway to the Caribbean, Central and South America. As such, many South Florida businesses have operations in those parts of the world. As this article discusses, from an income tax planning standpoint, depending on the tax laws of the local jurisdiction, it may be beneficial for some businesses to be structured as flow-through entities; whereas, for other businesses, deferral of U.S. income taxes through a foreign corporate subsidiary may be preferential. Consider the following scenario: B, a United States citizen, is the sole owner of XYZ, Inc., a corporation organized under Florida law and taxed as an S corporation (“XYZ”). XYZ is located in Miami-Dade County where it manufactures widgets and sells them throughout the South Florida market. B is considering expanding XYZ’s widget business into the Caribbean, Central and/or South America.
In general, a U.S. citizen or resident (a “U.S. taxpayer”) is subject to tax on its worldwide income from whatever source. Where income taxes are paid to a foreign government, a U.S. taxpayer is entitled to claim a foreign tax credit on its U.S. tax return, which generally provides for a dollar-for-dollar reduction of U.S. taxes, subject to certain limits. As such, a U.S. taxpayer is not being taxed by two different jurisdictions on the same income. A U.S. taxpayer may attempt to properly defer U.S. taxes on foreign income earned outside the U.S. by establishing a foreign corporation. Under applicable Treasury regulations, certain foreign entities are per se foreign corporations and other foreign entities are taxed as corporations under specific default rules. For those entities that are not per se foreign corporations and are not taxed as foreign corporations under IRS default rules, a check-the-box election may be made by filing IRS Form 8832 to treat any such entity as a foreign corporation for U.S. tax purposes. Any foreign corporation where more than 50% of the stock (by vote or value) of such corporation is owned by “U.S. Shareholders” is taxed as a controlled foreign corporation (“CFC”). For purposes of the immediately preceding sentence, a “U.S. Shareholder” is a U.S. taxpayer who owns, or is considered as owning, 10% or more of the total combined voting power of all classes of stock entitled to vote of a foreign corporation. A U.S. Shareholder of a CFC is currently taxed (i.e. no deferral) on income of the CFC that is “subpart F income”. Subpart F income includes passive income such as dividends, interest, royalties, annuities, capital gains, rent, and certain income from related parties. As such, when attempting to properly defer U.S. taxes on foreign income, it is important that the foreign corporation not have any subpart F income. For all purposes herein, it is assumed that no foreign corporations have subpart F income.
Assume XYZ expands operations directly into Brazil and assume further that Brazil taxes all net income earned therein at a rate of 34%. XYZ earns $100 of net income in Brazil and pays $34 to the Brazilian government. For U.S. income tax purposes, the $100 of Brazilian net income will be reported by XYZ on its Form 1120S and flow through and be included on B’s personal Form 1040. Assuming B is in the highest marginal tax bracket for U.S. income tax purposes, the $100 of Brazilian net income would be subject to U.S. tax of approximately $40. However, B can claim a foreign tax credit on her Form 1040 of $34 (the taxes paid to Brazil, assuming no limits), which reduces, dollar-for-dollar, the $40 of U.S. tax attributable to the Brazilian net income. Such credits avoid the situation where B is paying income taxes in two jurisdictions on the same income. B thus receives $60 of after-tax dollars ($100 less $34 paid to Brazil less $6 paid to the U.S.). Compare the forgoing example with the scenario where XYZ establishes a wholly owned Brazilian sociedad anonima (“SA”), a per se corporation for U.S. tax purposes, to operate in Brazil. The SA would pay $34 to the Brazilian government and distribute the remaining $66 to XYZ as a dividend (assuming no Brazilian withholding taxes). The $66 dividend would be reported by XYZ and flow through to B’s personal 1040. However, B would not be entitled to any foreign tax credits for the taxes paid by SA to Brazil. In effect, the foreign taxes paid to Brazil have been converted from a credit to a deduction. The $66 of dividends would be subject to U.S. tax at the rate of 39.6% (because it would not be a qualified dividend), leaving B with after-tax dollars of approximately $40 ($100 less $34, less $26) compared to $60 of after-tax dollars where XYZ operates directly. Here, there were two levels of tax: one by Brazil and one by the U.S., without any offsetting credits. However, if SA retained the $66 and reinvested it in the business, U.S. taxes would be deferred until a distribution is made to XYZ, albeit still net of Brazilian taxes.
Assume the same facts as above except, instead of Brazil, XYZ expands operations directly into the Bahamas and assume further that the Bahamas imposes no income tax. B’s net after-tax income from XYZ’s operations in Brazil would again be $60 ($100 less $40 in U.S. taxes). No foreign tax credits are available. Alternatively, where XYZ forms a Bahamian limited company taxed as a corporation for U.S. tax purposes (“ForCo”), ForCo would pay no income taxes to the Bahamas and, on distribution of the $100 by ForCo to XYZ, $100 of dividend income (but not a qualified dividend) would flow through to B and B would have net after-tax income of $60. However, if ForCo retained the $100 and reinvested the proceeds into the business, U.S. income taxes are deferred and ForCo is able to reinvest the full $100 on a pre-tax basis (for U.S. income tax purposes).
As the forgoing examples illustrate, where a country imposes income taxes at a rate near or equal to U.S. rates, it may be preferential to operate directly (or through a pass-through entity) in such country to avoid double taxation and avail oneself of the foreign tax credits. In such an instance, deferring U.S. tax with a foreign corporate subsidiary would only create an unnecessary second level of tax on distributions (i.e. a U.S. tax on dividends) that cannot be offset by foreign tax credits and any reinvestment of profits in the foreign business would be net of foreign taxes paid. On the other hand, where a foreign country imposes little to no income taxes (and thus no benefit of foreign tax credits), a foreign corporate subsidiary may be preferential, particularly where profits are to be reinvested in the foreign business; this way, U.S. taxes are deferred and profits may be reinvested on a pre-U.S. tax basis. In such an instance, no U.S. tax is imposed until repatriated to the U.S.
The forgoing is a general discussion only. The facts and circumstances of each business should be carefully analyzed and any U.S. income tax planning tailored accordingly. In addition, tax counsel in the applicable foreign jurisdiction should be consulted to ensure any structure for U.S. tax purposes is efficient for foreign tax purposes as well. Further, the forgoing general analysis may be different where the U.S. has an income tax treaty with a foreign country and such treaty alters the default rules by which income is taxed.