In a series of articles by BDO’s London-based Private Client US Tax Advisory team, it considers the recent US Tax reform through the eyes of the American abroad. In this third instalment, BDO tax partner Mark Walters looks at the US entrepreneur and wealth creator abroad.
The US tax reforms signed into effect by President Trump in December 2017 were the most significant in a generation and were lauded by the President as the ‘biggest tax cut in history’. President Trump also boasted that the reforms would make the tax system so simple that the average American could file their tax return on a postcard.
Whilst it is true that the reforms represented a sizeable tax cut for those living in the US, particularly those with the highest incomes, Americans abroad are unlikely to see any reduction. Americans abroad have always had it tough from a tax perspective, having to comply with their US tax obligations as well as in their country of residence, navigating the difficult path created by two systems to avoid double taxation and in search of symmetry.
Americans who decide to set up a business outside the US have it even tougher, having to deal with additional US reporting obligations and complex Controlled Foreign Corporation (‘CFC’) rules. Some were vainly hoping that the 2017 tax reforms would provide some relief from these onerous reporting obligations and complex CFC rules, but they couldn’t have been more wrong.
The crux of the problem for this small but important group of Americans is as follows: the corporate tax reforms designed to reduce the tax burden on US multinationals and encourage them to repatriate profits to the US were drafted in such a way that they equally apply to individual Americans who ‘control’ non-US companies. The corporate reforms that grabbed the headlines were a reduction in the corporate tax rate to 21 percent (which doesn’t impact individuals), a ‘transition tax’ on undistributed profits held within CFCs (Controlled Foreign Corporations) and new rules for low-taxed, intangible income apply.
The best way to illustrate the impact of the reforms is to use a real life example. Take the example of Tom, a client of ours. Tom is British, as are his parents, he just happened to be born in the US and that makes him a US citizen subject to US tax on his worldwide income. He only discovered this a few years ago and he got his US tax affairs up to date through the ‘streamlined’ disclosure procedure.
Tom is in his 30s; in his early 20s he set up a digital marketing business in London, which now employs around 20 people. To date the company has made modest profits and Tom has chosen to reinvest these profits in new technology and, most importantly for a business like his, recruiting new talent. Tom owns 60 percent of the business (a UK Limited company), 30 percent is owned by an outside investor (not an American) and some equity is set aside for key employees participating in an Enterprise Management Incentive (‘EMI’) scheme. Things are going well; Tom is expecting profits to increase exponentially in the years to come and he is considering opening offices in mainland Europe and perhaps the US.
Up until now Tom has taken a salary and some dividends from the company to fund his relatively modest lifestyle. He has reported these on his US tax returns and he has filed his annual Controlled Foreign Corporation form (Form 5471) with his tax return. As you would expect, Tom has not paid any US tax on the company’s profits that were retained and reinvested.
Now, in 2017, when the tax reforms take effect, everything changes. Tom finds himself subject to the ‘transition tax’, introduced to encourage large US multinationals to repatriate profits to the US. But Tom isn’t a large multinational and he isn’t going to repatriate the company’s profits to the US. No matter, because Tom’s company is a CFC attracting US tax on the undistributed profits on his 2017 tax return, at rates up to 17.5 percent.
As the company’s profits to date have been fairly modest, Tom isn’t too put out by the transition tax. He also assumes he will get a credit for the US tax when he pays himself a dividend and files his UK tax returns, right? Wrong. HM Revenue & Customs (‘HMRC’) does not care that Tom has paid some US tax solely by virtue of the fact that he is a US citizen. The dividends Tom receives are dividends from a UK company and therefore they are fully subject to US tax.
Once Tom has reconciled himself with the fact that his US citizenship has now cost him some additional tax (on top of the cost of fulfilling his US tax return obligation annually), he asks about the company’s future profits. These will be protected from US tax won’t they? Well, possibly not. When the UK Corporation tax rate comes down to 18 percent in April 2019 (assuming it does), the likelihood is that the company’s profits will meet the definition of Global Intangible Low Taxed Income (‘GILTI’) and Tom will pay US tax on profits as they arise, rather than when he decides to distribute them out as dividends.
If this is the case, Tom will get no credit for the Corporation Tax the company pays and, once again, HMRC is not going to allow him a credit against his UK tax. The worst-case scenario is that each £1 of profit the company makes would be subject to 18 percent UK Corporation Tax, then 37 percent US tax, then 38.1 percent UK tax when dividends are paid. This wouldn’t leave Tom with much left to enjoy the fruits of his labour.
Tom decides to consider selling some of the business – he has had an offer on the table for a year or so and the US tax reforms have suddenly made it look more attractive. He has heard that he’ll pay 10 percent tax on the capital gain because he’ll get Entrepreneur’s Relief in the UK. We have had to advise him that he needs to think about the US tax position as well – the tax rate in the US could be anything up to 23.8 percent (including the Net Investment Income Tax), so if he only pays 10 percent to the UK he likely will owe the difference to Uncle Sam.
Tom is understandably feeling rather exasperated by all for this, but he does have options. In reality there are ways to mitigate the impact of the tax reforms by maximising the use of foreign tax credits or, in some cases, by restructuring the business entirely. Tom could also give up his US citizenship, but he needs to be careful because this can trigger an ‘exit tax’.
What is perhaps clear for Tom, and other US citizens in this position, is the value of specialist advice from a tax adviser who can cover both the US and UK tax situation.
BDO’s private client US tax advisory team, based in London, comprises dual qualified US UK tax professionals experienced in the international taxation for ‘US-connected’ clients:
- US citizens living abroad
- Foreign nationals moving to US or with investments in the US
- Businesses looking to expand into or out of the US
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