Until recently, the US tax base has only covered the passive income of foreign corporations owned by US citizens and residents. The recent reforms however mean that rather than moving toward a territorial-based taxation system where only US source income is taxed, as advertised by the US government, the legislation is going in the opposite direction.
US citizens and residents operating businesses in Australia need to look at these changes and act quickly to ensure they are not left with a hefty US tax bill.
What are the changes?
There are good reasons why the US wants to ensure the tax it is owed is collected. Many US multinationals operate and generate revenue largely within the US but have structured their affairs so they are effectively taxed somewhere else. One way they do this is by holding intangible assets - such as software, patents and other intellectual property (IP) - in low-tax countries.
Part of the US corporate tax reform package in 2017 included a charge for “global intangible low-taxed income”, known as GILTI. This reform, amongst other things, imposes an effective 10.5% tax rate on GILTI income for US corporations - the effective tax rate of 10.5% is achieved by way of a tax deduction, reducing the 21% corporate rate that would otherwise apply.
While the GILTI measures are designed to limit the options for companies like Apple or Google to move IP to areas where corporations pay low tax, thus bringing at least some of that income back into the US tax net, the devil for US citizens and residents lies in the detail of the GILTI measures. This is because the GILTI measures not only target corporations but also the activities of individual taxpayers operating businesses outside the US.
The GILTI measures apply to any non-US company in which US citizens and residents have a controlling interest - which causes the company to be regarded as a controlled foreign corporation (CFC) for US tax purposes.
Am I GILTI?
The sheer scope of the GILTI measures mean that any US citizen or resident living in Australia who sets up an Australian company to run a business must consider whether they are caught by the GILTI rules.
To help you identify whether you fall within this category, consider the case of a US citizen/resident who has come to Australia and set up a coffee shop. Let’s assume their company spends $100,000 on equipment, furniture, tables and chairs - i.e. physical assets. The GILTI measures look at the income derived by the Australian company and consider what a fair return might be for the company’s investment in its physical assets. For example, if the coffee shop makes $10,000, the GILTI rules might say this amount represents a fair return on the physical assets.
If the company makes $20,000 however, the additional $10,000 in profit could now be regarded as income from ‘intangibles’ under the GILTI measures. That is, any income in excess of a fair return on the company's physical assets can be deemed to be income from the use of intangible assets under the GILTI rules.
The tax exposure of a US citizen or resident under the GILTI rules therefore comes down to how the US defines ‘intangible’ income. In a practical light, categorising some of the company’s income as being from ‘intangibles’ in the case of a services business like a coffee shop is purely a tax fiction; it is the same return for effort, but under the GILTI rules the income deemed to be from ‘intangibles’ now falls into a special tax category.
How does this affect me and my business?
There are two major problems for a US citizen or resident who is caught by the application of the GILTI measures:
- The first problem is that as the owner of a CFC, they will now be taxed as if they had earned the amount attributed under the GILTI rules directly as an individual.
- The second problem is that, by default, as they are deemed to have earned the income as an individual there will be no US tax credit for any foreign tax paid by the CFC under the GILTI measures.
Returning to the coffee shop example, the Australian company might have paid 27.5% tax in Australia on the profit from the business. Under the GILTI measures however, the US owner will still have to pay individual tax on the full profits to the US Treasury.
If there is no tax credit in the US for the company tax paid in Australia, then the business profits will have a genuine double tax problem - they will be taxed once at the company level in Australia and then again in the hands of the US citizen/resident as an individual in the US. There will certainly be no tax credit allowed to the Australian company for tax paid in the US by the US citizen.
In the absence of any planning therefore, a US citizen/resident owning an Australian company could end up with a 70% tax bill on the ordinary income from running a business in Australia.
What happens now?
The tax changes were introduced in 2017 but only took effect for the 2018 tax year. In other words, the effects are just starting to be felt as 2018 US tax returns are filed. Some good news was announced in March this year, as the US Treasury confirmed the availability of an election under section 962 of the US Tax Code to mitigate the effects of the GILTI charge.
The section 962 election is designed to ensure that an individual does not pay more tax on the earnings of a CFC than if that corporation was domiciled in the US. This election has been available for many years but it has now become much more relevant and attractive for individual shareholders in light of the GILTI rules.
US citizens and residents filing 2018 US tax returns over the next few months will need to not only act quickly to ensure this election is made on time but also need to be aware of exactly how the election operates and whether the new GILTI rules apply to them.
The US Treasury has also proposed making further regulations which could soften the operation of the GILTI rules and minimise attribution if income arises in a high tax country (which Australia currently would be). If these regulations are introduced, a section 962 election may not be needed.
Overlooking the planning options available could be an expensive mistake to make and result in the GILTI measures becoming a disincentive for US citizens and residents to invest outside the US - which is possibly part of the point of the legislation in the first place.
The takeaway for US citizens and residents - or Australian companies in which US citizens and/or residents hold substantial stakes - is that the US tax reforms have increased the US tax base and there are unlikely to be any changes to reverse this change. It’s time therefore for US citizens and residents to look at their exposure to the GILTI measures and take steps to ensure they are not left ‘holding the bill’ from the US tax changes.
If you think GILTI may affect you or need clarification about the US tax changes, please contact us and, in conjunction with our Baker Tilly network in the US, we will assess if you are at risk of paying unnecessary double tax.
The information contained in this document is general in nature and does not constitute specific taxation advice. You should seek separate taxation advice based on your own facts and circumstances before making any decision to act on the basis of the general information in this document.
Any references to foreign taxes / taxation consequences in this document are for illustration purposes only, are not intended to be relied upon and are subject to confirmation by an appropriate foreign advisor.