Estonia, the small Baltic country of just 1.3 million people situated halfway between Sweden and Russia, was named “the most advanced digital society in the world” by Wired magazine. According to recent figures, Estonian residents complete their taxes online in under five minutes, 99 percent of Estonia’s public services are available on the internet 24 hours a day, and nearly one-third of its citizens vote via the internet. With these advanced technological features, it is not surprising that its government boasts that Estonia is home to more tech unicorns (i.e., private companies valued at more than $1 billion) per capita than any other small country in the world.
As a result of the high number of technology companies that call Estonia home, one might think that the U.S.’s new global intangible low taxed income (or GILTI) tax was enacted specifically to go after U.S. taxpayers doing business in countries such as Estonia, where intangible assets presumably make up a significant portion of the value of these tech companies. The new GILTI regime, enacted as part of 2017 tax reform, generally triggers immediate U.S. tax on active income earned by a Controlled Foreign Corporation (CFC), other than an annual carve-out for 10 percent of the CFC’s adjusted basis in its tangible depreciable assets used in its trade or business. In essence, all active income above this assumed return is deemed to be from intangibles (regardless of any actual relationship to intangible assets), and is thus subject to the GILTI provisions, which now reach most offshore income that was previously possible to defer from U.S. taxation.
Despite GILTI’s apparent reach, however, and its intended impact of requiring immediate U.S. federal income tax recognition for almost all income earned by a CFC (specifically a CFC without sufficient high-basis tangible assets), Estonia’s tax system, coupled with a few key provisions in the U.S. tax rules, may afford U.S. taxpayers a unique opportunity to avoid immediate taxation under both the Subpart F income and GILTI rules, without paying any current foreign tax.
Estonian Corporate Tax System
The Estonian corporate tax system, which is no longer unique, generally functions as follows. All undistributed corporate profits are exempt from taxation. This exemption covers both active (e.g., trading) and passive (e.g., dividends, interest, royalties) types of income, and also covers capital gains from the sale of any and all assets, including shares, securities, and immovable property. The taxation of corporate profits is postponed, typically until the profits are distributed as dividends. At the time of distribution, the 20 percent corporate income tax applies. For example, a company that has profits of 100 euros (EUR) available for distribution may distribute dividends of EUR 80, with the remaining EUR 20 being used to satisfy the Estonian corporation income tax of 20 percent. From the Estonian perspective, this tax is considered a corporate income tax and not a withholding tax, so the tax rate is not affected by applicable tax treaties. The tax system makes sense in the context of Estonia’s active start-up culture. It allows young, growing companies to maximize the use of cash to grow the business, requiring them to pay into the tax system only when they proceed to actually distribute profits to ownership.
Although the Estonian corporate tax is not payable until a distribution is made from the corporation, according to relevant Estonian tax principles, the corporate income tax arising from the payment of dividends is recognized as a liability and an income tax expense in the period the dividends are declared, regardless of the period for which the dividends are paid or the actual payment date.
Accrual of Foreign Taxes for Relevant US Purposes
For purposes of the high-tax exception to Subpart F income under Section 954(b)(4), the amount of foreign income taxes paid with respect to an item of income generally is the amount a taxpayer would be deemed to have paid under Section 960. In order to determine the deemed-paid tax amount under Section 960, as a starting point, only foreign taxes that would be creditable are taken into account.
For this purpose, Section 905(a) allows the accrual of foreign income taxes, even if the taxpayer generally uses the cash method of accounting, by election. A taxpayer exercising this election must usually continue to use this method for all subsequent years. A foreign income tax generally accrues under U.S. standards when the “all-events” test is met, which is the tax year in which all the events have occurred that establish the fact of the liability and permit the amount of the liability to be determined with reasonable accuracy. The economic performance test is not required to met with respect to the accrual of foreign taxes. Therefore, actual payment is not required in order for a creditable foreign tax liability to accrue for U.S. tax purposes. Generally, the accrual date is the end of the foreign taxable period in which the relevant income is computed. (Until the end of that year, the existence of a tax liability is uncertain). This is the case if no further event after the close of the foreign computation year could remove the liability.
In analogous cases involving taxpayers that were liable for determinable, aggregate amounts, but where the identity of the eventual recipients remained unknown, courts have allowed the determinable amounts to be accrued for U.S. tax purposes as of the year such amounts became fixed. For example, in United States v. Hughes Properties, Inc., the United States Supreme Court allowed a casino to deduct guaranteed jackpots on progressive slot machines, even though the jackpots had not yet been won, because the machines were operated under state regulations requiring that each machine pay guaranteed jackpots equal to a fixed percentage of the amounts wagered, subject to a dollar ceiling. According to the Court, an amount accrues under the all events test when a “fixed and absolute” liability arises, and this liability was created by the state gambling regulation. It was not relevant that the particular winner of the jackpot was not identified until later or that payment of the jackpot might be prevented altogether by the taxpayer’s bankruptcy or loss of its gambling license.
Based on relevant US standards then, the Estonian corporate taxes should be considered to accrue for U.S. foreign tax credit purposes (and thus also for Section 954(b)(4) purposes) in the year the relevant income is earned by an Estonian CFC, given that Estonian law clearly causes the amount to be determinable at that time, notwithstanding that the exact time of payment of the taxes is not yet known. The Estonian corporate income tax is fixed and determinable at the end of the tax year in which the relevant income is earned (i.e., the same tax year that the income is includible for U.S. purposes under the CFC rules).
Where an Estonian CFC earns Subpart F income, the declaration of a dividend in Estonia should cause the accrual of a 20 percent Estonian tax to occur for purposes of Section 954(b)(4). The threshold effective rate of foreign tax for purposes of the exception under Section 954(b)(4) is now 18.9 percent, and thus the 20 percent Estonian tax meets the relevant test.
Relevance of Foreign Tax Credit Redetermination Rules?
It appears that the ability of the taxpayer to claim Section 954(b)(4) on the basis of an accrued foreign tax should not be altered by the Section 905(c) foreign tax credit redetermination rules, even if the tax is not actually paid within two years. Pursuant to Section 905(c), certain U.S. adjustments are made to previously accrued amounts for foreign tax credit purposes in the case of a “foreign tax redetermination.” For this purpose, a foreign tax redetermination is “a change in the foreign tax liability that may affect a taxpayer’s foreign tax credit… [and] … includes … accrued taxes that are not paid before the date two years after the close of the taxable year to which such taxes relate….”
Based on the 905(c) rules, if an accrued tax is not paid within two years after the close of the taxable year for which it accrues, this triggers a foreign tax redetermination of the amount that the taxpayer previously claimed as a foreign tax credit. This rule was illustrated by the staff of the Joint Committee on Taxation as follows:
[A]ssume that in year 1 a taxpayer accrues 1,000 units of foreign tax that relate to year 1 and that the currency involved is not inflationary. Further assume that as of the end of year 1 the tax is unpaid.… If the 1,000 units of tax are paid by the taxpayer in either year 2 or year 3, no redetermination of foreign tax is required. If any portion of the tax so accrued remains unpaid as of the end of year 3, however, the taxpayer is required to redetermine its foreign tax accrued in year 1 to eliminate the accrued but unpaid tax, thereby reducing its foreign tax credit for such year. If the taxpayer pays the disallowed taxes in year 4, the taxpayer again redetermines its foreign taxes (and foreign tax credit) for year 1…
Unlike the above examples, in the case of the Estonian corporate income tax for purposes of Section 954(b)(4), the taxpayers are not seeking to claim a foreign tax credit for the Estonian taxes under Section 960. Rather, they are claiming the high-tax exception under Section 954(b)(4) as to the income, which references the Section 960 rules for certain relevant calculations. For purposes of the Section 954(b)(4) exception, as contrasted with the foreign tax credit rules, however, the failure to pay accrued taxes within two years does not appear to be relevant.
Rather, as Regulation Section 1.904-4(c)(6) seems to make clear, the high-tax exception to Subpart F is calculated on a snapshot basis, in the year of the inclusion. The cited regulation provides relevant rules for categorizing items for foreign tax credit purposes. This regulation clarifies that the high-tax exception to Subpart F under Section 954(b)(4) is calculated in the year of the inclusion, not the year of distribution. Thus, additional taxes withheld on a later distribution of PTI would not cause otherwise low-taxed income to qualify for the exception. Similarly, subsequent reductions in foreign tax should not cause an item to fall out of the high-taxed exception.
Based on the above language from the regulations, the Section 905(c) limitation relating to non-payment of accrued taxes within two years seems unconnected to the applicability of the high-tax exception under Section 954(b)(4) in the year of accrual of the relevant foreign taxes. The timing of the subsequent payment simply is not relevant for purposes of Section 954(b)(4), which employs a snapshot test taken in the year of accrual of the relevant foreign taxes.
US Foreign Tax Credit for Estonian Corporate Tax
When an individual owns the stock of a CFC, the individual generally is not entitled to an indirect foreign tax credit for any foreign corporate income taxes paid by the CFC (unless the shareholder makes an election under Section 962 to be taxed as a corporation for certain purposes). Thus, if an individual U.S. shareholder owns a CFC, he or she may have the opportunity to claim the Section 954(b)(4) exception from Subpart F income for income of an Estonian CFC where a dividend is declared in Estonia in the same amount. However, if and when that Estonian CFC makes an actual distribution of profits to the U.S. individual shareholder, any Estonian tax imposed on the CFC will not typically be creditable by the individual against his or her 23.8 percent U.S. qualified dividend tax. This inability to credit the foreign tax against U.S. tax would result in a relatively high effective U.S. tax rate on the CFC’s profits. On the other hand, it may be possible to trigger a deemed liquidation of such a CFC into an S corporation shareholder, avoid realizing and recognizing any corporate level gain on the deemed liquidation for U.S. purposes, and then claim a credit in the U.S. for any Estonian taxes imposed after the CFC has been deemed to liquidate from the U.S. perspective.
When the assets of a foreign corporation are acquired by a domestic corporation in an inbound Section 332 liquidation (including a deemed liquidation triggered by a check-the-box election of the CFC), Section 332 and 337 benefits generally are available, but pursuant to Section 367(b), the foreign corporation’s U.S. shareholders must recognize deemed dividend income equal to their ratable shares of the foreign corporation’s all earnings and profits amount. Specifically, each exchanging U.S. shareholder subject to this rule must report a deemed dividend equal to the “all earnings and profits amount” attributable to the shareholder’s stock, which is the stock’s ratable share of the foreign corporation’s net positive earnings and profits. Where the CFC is resident in Estonia, with which the U.S. has a treaty, the resulting dividend is a qualified dividend taxable at 23.8 percent. As long as the Estonian tax is imposed subsequent to this deemed liquidation, but is still imposed during the same tax year, the Estonian tax should be viewed as imposed on the U.S. shareholder, and thus creditable by such shareholder, assuming the income and credits are placed in the same basket for Section 904 purposes.
Under Section 904(d), the U.S. foreign tax credit limitation must be computed separately for foreign taxes on each of four separate limitation categories (“baskets”). For taxable years beginning after 2017, there are four baskets: GILTI, foreign branch income, passive category income, and general category income. Passive income generally is the same as FPHC income for Subpart F purposes. For taxable years beginning after 2017, foreign branch income and taxes allocable to that income comprise a separate basket. “Foreign branch income” is business profits attributable to “separate and clearly identified unit of a trade or business located in a foreign country for which the taxpayer maintains separate books and records.” Notably, however, this category of income does not include any item of passive category income. The Section 954(b)(4) income generally would fall into the passive basket where dividends, capital gains, or other passive Subpart F income is earned by the CFC and subject to the exception. Likewise, the taxes imposed on that income should be considered to fall into the same basket, and the Estonian taxes should therefore be creditable against the corresponding U.S. taxes imposed on the deemed dividend.
Example – Using High-Tax Exception to Avoid Subpart F Income
Assume a U.S. shareholder (or group of U.S. shareholders) forms a U.S. S corporation, which in turn forms an Estonian subsidiary (the “CFC”). The CFC engages in trading activities on the U.S. markets for its own account, and is not considered to be engaged in a U.S. trade or business under the trading safe harbor of Section 864(b)(2). As a result of its trading activities, in Year 1 the CFC earns substantial short-term capital gain income, non-qualified dividends, and other Subpart F income totaling $10 million. The CFC declares a dividend in Estonia at the end of Year 1 in an amount equal to the Subpart F income of the CFC, i.e., $10 million, triggering the accrual of a $2 million Estonian corporate tax liability, which will be due on distribution of the profits by the CFC to its owner. The U.S. shareholders elect the high-tax exception under Section 954(b)(4), thus deferring any U.S. recognition of the CFC’s income. The CFC realize income of $10 million in each of years 2 and 3, and again the U.S. shareholders claim the benefits of Section 954(b)(4) in those years.
In year 4, the CFC wishes to distribute its profits of $30 million to its S corporation owner. At that time, the CFC continues to hold a small portfolio of substantially-appreciated securities. If the CFC simply distributed the $30 million cash as a dividend, Estonian corporate tax would first apply to require payment of $6 million of Estonian tax. Additionally, the U.S. shareholder owners of the S corporation would receive $24 million, which would be taxable at 23.8 percent in the U.S., resulting in $5,712,000 U.S. qualified dividend taxes. The Estonian corporate taxes would not be creditable against this U.S. dividend tax imposed on the U.S. shareholders.
On the other hand, if the CFC filed a check-the-box election, electing to be treated as a disregarded entity for U.S. tax purposes as of December 15 of Year 4, the S corporation parent would inherit the appreciated stock with a carryover basis, so that no gain would be triggered on the deemed liquidation. In addition, the CFC’s “all earnings and profits amount”, i.e., $30 million, would be treated as a deemed dividend to the U.S. shareholders, taxable at 23.8 percent in the U.S. As long as the CFC then made an actual distribution of the same $30 million on or before December 31 of Year 4, Estonia would then impose its own 20 percent tax (i.e., $6 million). Because at the time the Estonian tax is imposed, the CFC is treated as a branch of the S corporation parent, the taxes imposed are treated from the U.S. perspective as being paid by the S corporation, and in turn flow up to the ultimate U.S. shareholders, who can utilize that Estonian tax against their related U.S. tax liability. In this way, a global effective tax rate of 23.8 percent is imposed on the income at the time it is actually distributed.
Planning for GILTI Income
Because the high-tax exception of Section 954(b)(4) is available only for Subpart F income, and no similar high-tax exception exists for GILTI, it may make sense to consider restructuring certain streams of income so that they are classified as Subpart F income and may thus be available to benefit from the above Estonian structure. For example, if a BVI CFC, utilizing a staff of its own employees in the BVI, is providing support services to related U.S. shareholders, the resulting income of the CFC would be GILTI income, rather than Subpart F income, because the services are performed in the country of incorporation. However, if the U.S. shareholders of that BVI CFC form a new sister CFC in Estonia, and then the BVI CFC subcontracts its activities to the Estonian CFC, which provides the services from outside Estonia, the resulting income is Subpart F income to the Estonian CFC and the high-tax exception can be claimed under the structure explained above. Alternatively, the Estonian CFC could enter into the service contract directly with the related U.S. shareholders, and the resulting income would be Subpart F income because the services of the CFC are not provided in Estonia.
As noted above, despite GILTI’s apparent reach, with the use of Estonia’s rather unique corporate income tax system, coupled with the U.S. tax rules relating to the accrual of foreign taxes, U.S. taxpayers seem to be afforded an interesting planning opportunity to avoid immediate taxation under both the Subpart F income and GILTI rules, without paying any current foreign tax.