How to Classify Your Overseas Operations Following Tax Reform Complications

For manufacturing companies that operate overseas, the question of whether to operate as a controlled foreign corporation (CFC) or disregarded entity (DRE) has become significantly more complicated since the passing of the 2017 tax reform reconciliation act, commonly referred to as the Tax Cuts and Jobs Act (TCJA).

The decision-making process might no longer be quite as intuitive for business owners as many of the provisions within tax reform interact to each other differently. While one option may seem like the right answer for a specific concern, it could have adverse consequences with another provision.

Below, we explore the tax implications of operating as a CFC or DRE and considerations your company should keep front of mind as you weigh the options.

Classification Overview

A CFC is a separate non-US legal entity that operates in a foreign country with owners who reside in, or are citizens of, the United States.

A DRE is a separate legal entity operating in a foreign jurisdiction that has made an election to be disregarded for US tax purposes. From a US tax perspective, all the company’s income, taxes, and expenses are considered to be owned by the US owner. In a sense, it’s as if the entity itself doesn’t exist for tax purposes; it does, however, exist for legal purposes.

Questions to Consider

How will your decision affect your current income tax perspective?

Prior to tax reform, US shareholders of CFCs were able to defer income of the entity so the income wouldn’t be taxed in the United States until paid back to the United States in the form of a dividend. Unless, however, the income fell under the anti-deferral regime known as Subpart F. This income would be treated in the United States as if it were distributed even if it hadn’t been and generally applies to passive income such as interest, dividends, rent, royalties, or income from conducting business outside the country of operation.

Tax reform, however, adds new provisions that impact a US shareholder’s deferral, so while the option still exists, deferral is no longer automatic.

US shareholders of DREs don’t have the option for deferral. These companies must immediately recognize all income, even though it might be sitting in another country. As such, a DRE’s income is always going to be taxed in the United States.

How will your foreign tax credits be impacted?

If you’re paying taxes in a foreign jurisdiction where you have operations, these could result in a tax credit in the United States subject to certain limitations. This helps avoid double taxation on that income.

How you apply the foreign tax credit rules, however, could differ for individuals and flow-through entities, like partnerships and S-corporations, compared to C-corporations.

In the past, the CFC classification was generally better for C-corporations than for flow-through-type entities and individuals because flow-throughs and individuals weren’t able to pass through to their individual investors, or use the foreign taxes paid by the CFC as foreign tax credits when the related CFC income was included on their US tax returns.

However, flow-through entities and individuals are allowed to pass through to their investors or credit the foreign taxes paid by a DRE, and thus tended to gravitate toward DREs.  

Now that automatic deferral is no longer an option, companies must ask themselves if they can still use their foreign tax credits. You’ll also need to address your ownership structure and determine if, from a tax law standpoint, owners can use these credits—and if so, what elections they’ll need to make to do so.

How will the new provisions impact my business?

GILTI

Tax reform brought a new category of income in addition to Subpart F known as global intangible low-taxed income (GILTI).

GILTI is intended to deter US-based multinational corporations from directing profits offshore into lower-tax jurisdictions. GILTI essentially turns what was once a deferral system into a world-wide tax system that allows CFCs to have a small return on tangible assets overseas that wouldn’t be taxed in the United States. Everything above this amount becomes taxable in the United States under the GILTI category.

This provision was intended to affect companies that shift intellectual property and its associated profits outside the US without substantial foreign investment–those primarily in the technology industry. However, it affects all businesses with CFCs to the extent their profits exceed 10% of their tangible property investment in the foreign country.

The provision introduces what is essentially a 13.125% minimum tax rate on foreign profits of CFC shareholders. This rate is lower than most global tax rates for multinational businesses.

Foreign tax credits are available to offset GILTI for C-corporations while individual shareholders need to make a Section 962 election, but are limited to 80% of the foreign taxes paid.

C-corporations in general tend to have an easier time using foreign tax credits to avoid some or all of the US tax associated with having a GILTI inclusion. The important thing is to decide whether it’s better for your company to manage GILTI inclusions considering limitations on foreign tax credits or operate as a DRE and essentially be voluntarily taxed on all current income and eligible to use all foreign taxes as a credit to avoid these GILTI restrictions.

Companies that manufacture overseas might have more tangible fixed assets, such as a significant amount of equipment, which may allow for a larger exclusion from GILTI. For such companies, it could be easier to manage GILTI because they can exclude a larger portion of their overseas income due to the qualified business asset investment (QBAI). On the other hand, companies with little QBAI will have nearly all of their income subject to GILTI.

BEAT

The new base-erosion anti-abuse tax (BEAT) provision only applies to businesses with $500 million in gross revenue. CFCs generally receive some sort of payment for the services they’re providing to their US shareholders, but such payment could be subject to the BEAT.

If a company has losses in the United States, because they’re either selling, purchasing or have interactions with a foreign corporation, those payments could potentially end up inducing the BEAT tax if they exceed certain thresholds.

This is an example of why it’s important to watch out for how the different provisions interact. A worst case scenario could be your income being taxed twice because of GILTI income coming from foreign jurisdictions and being subject to BEAT on payments made to CFCs. 

Many companies are converting their CFCs into DREs to avoid BEAT and find it easier to address the complications of a DRE rather than those of BEAT.

What does this mean for my business in the long-term, and should I consider adjusting my operations?

As your business weighs these factors, it’s important to consider how they impact your business model in the long-term. Some argue the GILTI regime and other aspects of tax reform are designed to spur businesses to bring their manufacturing operations into the United States because they might no longer be able to utilize all potential foreign tax credits, increasing their worldwide marginal tax rate.

Likewise, the GILTI regime could encourage technology companies to move intellectual property, and thus its associated profits, either back into the United States, or invest in the generation of intellectual property (IP) within the United States.

For many companies, that’s likely easier said than done. You’ll want to determine whether benefits from tax savings would outweigh the complications that arise from planning and implementing major operational changes.

Conducting forecast modeling can help offer insight into what future tax years could look like for your business. Your company can consider what it would look like if you change your structure, as well as where and how foreign subsidiaries operate. It may not be clear how some provisions will affect others until you begin putting the many pieces of your business together.

We’re Here to Help 

Choosing a structure can have major implications to your business so it’s important to thoroughly evaluate all options and outcomes.

To explore which structure may be best for your business or to have operational planning performed specific to your business, contact your Moss Adams professional.