INTERNATIONAL PRACTICE

By Peter Harper & Janpriya Rooprai

Interaction of Indian and U.S. Tax Laws

High-net-worth individuals and global businesses are affected

Peter Harper is head of CST Tax Advisors in North America, based in Atlanta, and Janpriya Rooprai is head of the U.S.-India practice and U.S. operations head with CST Tax Advisors based in New Delhi

The number of high-net-worth (HNW) Indians is expected to increase by 71 percent in the next five years. We expect to see a direct correlation with the number of HNW Indians and their global family businesses that permanently depart India. It raises a concern for Indian tax authorities to find the best way to protect its revenue base through the collection of tax and information. Tax transparency administered by an overwhelming set of rules in countries like the United States has forced its citizens and residents to comply with worldwide tax and information reporting due to the application of severe penalties. India is fostering tax transparency and exchange of information as parties to the Base Erosio Profit Shifting (BEPS) project (that is, an international framework to combat tax avoidance by multinational enterprises), led by the Organisation for Economic Co-operation and Development/G-20. Indian tax authorities armed with this information provided by foreign revenue authorities or foreign banks will use it to combat tax avoidance and non-disclosure of information. The privacy of information shouldn’t be prized by HNW Indians over creative management of tax costs and compliance obligations. Therefore, up-todate tax compliance is required both under Indian and foreign country laws.

Tax advisors to HNW Indians in the United States need to consider how their advice is impacting HNW individuals in India, particularly if they haven’t been properly disclosing information or paying tax in India.

Effect of Globalization

Globalization has had a dramatic impact on India, its citizens and businesses. India’s elite is growing at a staggering pace. The number of individuals classified as HNW increased by 20.4 percent in 2017.1 HNW individuals are generally understood to be individuals with an accumulated net worth in India’s highest scale of wealth, which is based on their investable assets2 or investments, personally or in family businesses.

A big challenge for the Indian government and Indian tax authorities is the drop in tax revenue attributable to the emigration of more than 7,000 ultra-HNW individuals3 in the last year. This revenue reduction is also because HNW individuals extensively use foundations, trusts and corporate and unincorporated entities not only to protect their assets but also to shield their personal and family wealth from Indian tax authorities.

The leak of confidential financial information as part of various scandals in the last decade (for example, the UBS scandal and the Panama Papers, which revealed the use of secretive financial ecosystems for beating tax in offshore low tax jurisdictions4 ) has shown a pattern of non-compliance by HNW individuals in the context of reporting foreign financial information. This seems like a thing of the past for U.S. citizens and residents as various statutes govern the global information exchange on foreign financial assets and levy severe penalties on any non-compliance. The recent tax reforms in the United States have raised the bar by widening the tax exposure on foreign corporations and financial holdings of U.S. resident shareholders.

Black Money Act

After the introduction of black money (that is, undisclosed foreign income and assets) and the Imposition of Tax Act (2015) (Black Money Act) in India, Indian residents are mandatorily required to report their foreign financial interests and assets. This information reporting requirement has more recently been extended to include certain non-residents. It’s yet to be seen whether this legislation will have a material impact on the attitudes of HNW individuals to privacy and their compliance obligations.

Transition to Other Jurisdictions

Around 45 percent of HNW Indians are moving to jurisdictions like Singapore, the United States and the United Kingdom, where the tax systems and reporting requirements are highly robust. Often, the complexity in administering the global affairs of HNW individuals poses accounting and tax challenges for them. This raises a serious point of discussion—what are the considerations to keep in mind before making this transition from India to other jurisdictions?

It’s critical to address the above question specifically when HNW individuals move to jurisdictions like the United States and become U.S. residents. The interaction between Indian and U.S. international tax law shows that when HNW individuals become U.S. residents, they can’t follow the same approach to privacy that was the building block of their financial plan in India. It’s our experience that HNW individuals having a history of non-compliance in India will be adversely impacted by the U.S. tax system. This is all the more important given that India is one of the 116 countries that are fostering tax transparency and exchange of information as parties to the BEPS project.

This is a watershed moment in Indian tax. The HNW individuals looking to relocate to a country like the United States should reconsider their pattern of non-disclosure.

Tax Residence

The residence rules determine the taxability of a person resident in a country. Both the United States and India tax income of residents on a world-wide basis and non-residents on locally sourced income only. The key difference between the two countries is how they determine whether a taxpayer is a resident. The United States is one of only two countries in the world that classify citizens to always be U.S. tax residents. This is the case regardless of how much time a U.S. citizen spends outside of the United States. In contrast, Indian citizens who are non-resident Indians will only be taxed in India on their Indian-sourced income.

Residence rules in India. A natural person will be an Indian tax resident based on his physical presence in India in a financial year. A natural person may be a resident, non-resident or not ordinarily resident in India during the tax year.5

HNW individuals who are Indian tax residents will be taxed on their worldwide income in India.

An individual is an Indian tax resident if he either resides in India for 182 days or more during the current tax year or resides in India for 60 days or more during the current tax year and for 365 days or more during four tax years preceding the current tax year. The period of 60 days is replaced by 182 days when an Indian citizen or a person of Indian origin6 (PIO) comes on a visit to India, but not for a permanent stay.

A natural person isn’t ordinarily resident if he either has been a non-resident in India for nine out of 10 tax years preceding the current tax year or has been in India for 729 days or less during seven years preceding the current tax year. An individual not satisfying any of the above requirements will be a non-resident in India during the tax year.

A corporate entity7 is an Indian tax resident if it’s formed and registered under the Companies Act (2013), or its place of effective management (POEM) is in India at any time during the current tax year. POEM means the place where key management and commercial decisions necessary for the business as a whole are in substance made. The Central Board of Direct Tax (that is, the Indian tax department) has also issued guiding principles for determining the POEM of a foreign company.8

An unincorporated entity,9 including a limited liability partnership (LLP) is an Indian tax resident if even a part of its control and management is situated in India during the current tax year.

There are often directors, shareholders or partners who reside outside of India and exercise control and management with no physical presence in India. In doing so, they don’t consider the residency aspect in India, which may result in treating the entity as a non-resident and taxable at higher tax rates. There are also instances in which a foreign limited liability company (LLC) partially controlled and managed in India would be considered an Indian tax resident and taxable on its worldwide income.

Global families use trusts or foundations as models to insulate Indian family assets.

A natural person having economic ties in India may still be a non-resident, and a company having POEM in India, even if a foreign company, may still be an Indian resident. The taxable income base of Indians is determined in accordance with “Taxable Income Base,”.

In addition to the above, the recent tax reform under Indian tax law has introduced a significant economic presence test10 for establishing whether corporate entities having a business connection should be taxed in India. This widens the scope of foreign entities being taxable as permanent establishments in India. This is an example of how India shows its solidarity to international standards under the BEPS project.11

Global families use trusts or foundations as models to insulate Indian family assets. This is because India doesn’t have a controlled foreign corporations (CFCs) regime or a transferor trust or grantor trust regime. If these entities are established properly and independently managed, income derived by them won’t be taxable in India.

U.S. residence rules. HNW Indians moving to the United States should be mindful of the interaction of U.S. laws with Indian laws. An alien under the U.S. immigration law is a person who isn’t a U.S. citizen or U.S. national. An Indian national who becomes a U.S. tax resident may have an additional federal, state and city tax burden on foreign sourced income. He may also have onerous information reporting obligations.

A U.S. alien will be a U.S. tax resident under federal tax laws in one of following three ways:

  • Green card test (that is, being admitted to the United States as a lawful permanent resident under the immigration laws);
  • Substantial presence test (that is, being physically present in the United States for at least 31 days in the current tax year and 183 days12 during the past three years including the current tax year); or
  • Electing to be taxed as a U.S. tax resident.

In addition to the U.S. federal tax residency rules, state tax residency rules apply. Residence in a U.S. state is typically determined based on the number of days present, economic interests or family ties within a state. It’s possible for an individual to be a resident of one or more states in the United States.

When an Indian national is also a U.S. resident during a tax year, then tie-breaker rules under the double tax agreement between India and the United States are applied to determine which country has the taxing right. This may result in taxation of income in both countries. However, in most cases, the source country has a primary taxing right (or source taxing right), and the country where the taxpayer is a resident will provide a credit for foreign tax paid and charge further tax to the extent of any tax rate shortfall. In addition to tax exposure in a country, residence rules create an information reporting burden that’s often ignored by HNW individuals moving to another jurisdiction.

HNW individuals need to be careful when establishing Indian business structures in the United States with a possible taxing right being established for the United States under the expanded CFC definition. The Indian domestic law contains a similar burden for foreign structures of HNW individuals in India, specifically when the Indian tax law is applying POEM and economic presence tests adopted pursuant to the multilateral instruments (MLI) under the BEPS initiative. This interaction results in additional reporting requirements even if no income is attributable to the country that’s established the expanded taxing right.

Taxable Income Base

Resident vs. not ordinarily resident vs. non-resident

Resident Not Ordinarily Resident Non-resident
Taxable on worldwide income Taxable on income received or accrued or
arisen in India
Taxable on income sourced in India
Income received in India Income received in India Income received in India
Income accrues or arises in India Income accrues or arises in India Income accrues or arises in India
Income deemed to be received in India Income deemed to be received in India Income deemed to accrue or arise in India
Income received outside India Income received outside India, only if
business controlled or set up in India
Income accrues or arises outside India Income accrues or arises outside India, only
if business controlled or set up in India
Income deemed to accrue or arise outside
India
Income deemed to accrue or arise outside
India, only if business controlled or set up
in India

— Peter Harper & Janpriya Rooprai

Specific Tax Considerations

In India, family-owned and run businesses are the lifeblood of the economy. These recent changes will create greater challenges for family businesses because of structural inflexibility that comes with such intergenerational wealth. HNW individuals who are Indian tax residents will be taxed on their worldwide income in India. Typically, an Indian taxpayer’s taxable income is his total income under five heads (salary; house property; profits and gains from business or profession; capital gains; and other sources), reduced by deductions or charitable contributions. Certain incomes are exempt from tax but are still required to be reported on a tax return.

Often the temporary or permanent departure of HNW individuals from India to another country drives decisions to either transfer or pool assets in a trust in India. Dividend income on investments and the transfer of assets by HNW individuals are taxable in India unless exempt. A transfer of capital assets may involve monetary and non-monetary gifts or the actual transfer of assets to a trust. The tax incidence of these events should be considered before relocation.

Capital gains tax and exemption. A resident or non-resident Indian is taxed on capital gains derived from transferring, selling or exchanging capital assets in India unless those gains are specifically excluded from taxation. Gifts or bequests under a will are specifically excluded from the definition of transfer of a capital asset.

Capital gains tax rates are primarily based on the seller’s residential status, the form of capital asset and the holding period. Examples of different short-term holding periods are: shares or securities listed on a recognized stock exchange in India, equity-oriented mutual funds and zero-coupon bonds (less than 12 months), unlisted shares (less than 24 months) and immovable property (less than 36 months).

Capital gains is the difference between consideration and cost of acquisition adjusted by the inflation index, but in certain cases, no indexation is available. Capital gains can be reduced by an exemption for reinvestment of the amount of net consideration or gains in specific situations, subject to conditions.

Dividend income. In general, Indian companies pay tax on a world-wide basis at a tax rate of 30 percent. To the extent companies proceed to declare dividends out of profits, they’re liable for dividend distribution tax (DDT) (which has been paid unless such dividend is more than INR 1 million (approximately USD 16,000)), which is levied at the effective rate of 20.36 percent. If a company hasn’t paid DDT, the dividend will be taxed at the marginal personal income tax rates of the relevant shareholder.

Transfer of capital assets under gift or will to relatives/non-relatives directly or to a trust with relatives/non-relatives as beneficiaries. As referenced above, gifts among relatives aren’t taxable in India. However, a gift of non-monetary nature (including shares in a family business) to an individual or trust, even if not a taxable transfer for the individual making the gift, is taxable income for the recipient if the value of such gift is more than INR 50,000 (approximately USD 833) or such gift is for an inadequate consideration. The taxable income is the difference between the fair market value13 on the date of transfer and consideration paid.

Transitioning capital assets in an Indian family business to the next generation. HNW Indians and global families generally use trusts or foundations as models to insulate Indian family assets. Ownership of Indian family businesses is held through these trust structures. While a trust structure offers protection of assets and good governance mechanisms, there’s a real risk that any foreign structure will be classified as an Indian resident entity if it’s managed and controlled by people in India. A trust is considered an Indian tax resident if some or all of its control and management is exercised in India. The taxation is based on the form of trust—public or private.

A public trust set up for a charitable purpose that’s registered under the provisions of Indian tax law is exempt from tax in India subject to certain conditions.

A private trust may be revocable or irrevocable. A revocable trust set up by a settlor is disregarded as a trust, and the settlor is taxed for any income of the trust. The settlor has a right to revoke the trust and is entitled to the income and property of the trust for the lifetime of the trust. A trustee of a discretionary (irrevocable) trust that’s set up in India will be taxed as a representative taxpayer of the beneficiaries of such trust. However, if it’s a foreign trust, then a trustee may be a representative taxpayer of the beneficiaries if all the beneficiaries are Indian residents. A determinant (irrevocable) trust is a fiscally transparent entity, but a trustee may be assessed tax in a representative capacity.

The restriction on the quantum of remittance outside India adds complexity to succession planning, specifically when HNW individuals have no other connection with India apart from the assets in India, and they intend to remit all the funds from an estate to someone outside India in the same financial year.

Distribution from trust to resident/non-resident beneficiaries. Distributions from an Indian trust to a resident or non-resident beneficiary during the lifetime of the settlor have the same tax implications as those expressed above. However, if a non-resident isn’t taxable as a result of the application of a tax treaty benefit, then a trustee wouldn’t be liable to pay tax. Trust income taxable to trustees isn’t taxable to beneficiaries at the time of actual distribution.

Distributions from a foreign trust generally aren’t taxable to trustees if the control and management is wholly outside India. No taxability arises until actual distributions are made by a foreign trust to Indian tax resident beneficiaries.

Distribution of capital or corpus from a trust isn’t taxable if the trust was created for specific relatives.

Implication on settlor’s death and termination of trust. Under the Indian trust law, trusts cease to exist or terminate if the purpose of the trust is fulfilled, the trust becomes unlawful or fulfillment of its purpose becomes impossible or the trust is revoked. India doesn’t have estate tax, but termination of the trust due to the death of the settlor has tax implications for irrevocable and revocable trusts, as illustrated in “Tax Implications of Trust Termination,”.

U.S. citizens and residents need to report transactions associated with foreign trusts on Forms 3520 and 3520-A.

Reporting requirements. The Indian government has been constantly showing its support of the BEPS project with an objective to bring transparency and eliminate shifting of profits from high tax jurisdictions to low tax jurisdictions. India has also renegotiated tax treaties with various countries to facilitate its taxing right and exchange of information on par with international standards. These measures are aligned to ensure HNW individuals residing outside India are making proper disclosures and are tax compliant within India.

A taxpayer is required to obtain a permanent account number (PAN) (similar to a tax identification number) in addition to an Aadhar number (similar to a Social Security number). A PAN is generally used on all income tax correspondence.

The filing of income tax returns is mandatory in specific cases, and delay or non-compliance may result in tax, interest and penalties. A taxpayer claiming tax treaty benefits and an Indian resident having any asset (including financial interest) located outside India or signing authority over any account located outside India are mandatorily required to disclose the asset or signing authority irrespective of whether any taxable income is derived with respect to such assets.

Disclosure of foreign financial interests. The Black Money Act requires tax residents in India to disclose information on their foreign financial interests and assets. But, from tax years 2018 to 2019 and onwards, not-ordinary residents and non-resident Indians are also required to report their foreign financial assets, interest, bank accounts and immovable properties. Further, taxpayers with taxable income more than INR 5 million (approximately USD 80,000) on their tax returns in India are required to provide details of the specified assets and corresponding liabilities in India. Non-compliance with the above may result in significant penalties.

While it may be difficult for HNW Indians to imagine today how these changes are going to play out, they should take the Black Money Act seriously, given how effective the Foreign Account Tax Compliance Act (FATCA) has been in ensuring compliance of U.S. citizens.

Indian Exchange Control Law

The Indian exchange control law provides strict rules in relation to cross-broker transfer or remittance of funds or ownership of certain assets. HNW Indians who become U.S. citizens and are non-resident Indians or PIOs may continue to hold assets like real property in India long after they’ve moved outside India. A bequeath by a will or gift of assets in India may also result in HNW individuals or their children holding Indian assets.

An investment, ownership, holding or transfer of Indian funds/immovable property by an Indian resident, foreign national of non-Indian origin, NRI, PIO or an Indian entity or branch office established in India by a person resident outside India is governed under the Foreign Exchange Management Act (1999) and by the Reserve Bank of India (RBI). The specific considerations under the Indian exchange control law are discussed below:

Residence. Foreign remittances in and outside India are grouped based on the residential status of the individual and purpose for which the remittance is made. The term “resident” as defined under the Indian exchange control law deliberates on the purpose of stay (based on type of visa granted) in addition to the duration of stay (being more than 182 days during the preceding financial year), which is the primary test for determining residence under the Indian tax law.14

Tax Implications of Trust Termination

Depends on if it’s irrevocable or revocable

Irrevocable trust Revocable trust
The property settled under an irrevocable trust is treated as
being irrevocably transferred to the trust at the time of
creation of the trust. So, at the time of settlor’s death, there’s no transfer of ownership of the trust property, and it continues to be held by the trust.
Typically, trust property settled under a revocable trust may be re-transferred to the settlor during his lifetime. On the settlor’s death, a revocable trust is recharacterized as an irrevocable trust, and there’s no transfer of ownership of trust property. The trustee assumes the legal ownership of the trust property until it’s distributed to the beneficiaries.
No tax impact on either the settlor, trustee, trust or its
beneficiaries.
Income from trust property is taxable to the trustee instead of the settlor’s estate, unless property is reverted to the settlor’s estate. The settlor’s estate may be taxed at the time of reversion if the property is returned to the settlor’s estate.

— Peter Harper & Janpriya Rooprai

Remittance of funds outside India. The residence rules15 and type of assets group the remittances made by individuals or entities outside India. “Compliance with Residence Rules,”, outlines the circumstances in which a remittance can be made without RBI approval.
However, an approval of the RBI is required if:

  • a remittance is made by a non-resident Indian or PIO out of the balance held in his non-resident ordinary rupee account or sale proceeds of assets or assets acquired by way of inheritance or legacy in excess of USD 1 million per financial year and such legacy, bequest or inheritance was made to a citizen of a foreign state, as a resident outside India.
  • hardship will be caused to a person if the remittance from India isn’t made to such a person.

Resident Indians must comply with the Liberalized Remittance Scheme (LRS)16 for remitting funds for contributions to offshore irrevocable trusts for the benefit of both resident and non-resident beneficiaries. The settlor may only transfer up to USD 250,000 per financial year per person for any permitted17 capital18 or current19 account transaction without prior approval of RBI.

The restriction on the quantum of remittance outside India adds complexity to succession planning, specifically when HNW individuals have no other connection with India apart from the assets in India, and they intend to remit all the funds from an estate to someone outside India in the same financial year. The monetary limitation on remittance shouldn’t encourage HNW individuals to transfer funds privately, as siphoning funds secretly would result in strict scrutiny by regulatory authorities with significant tax and penalties arising under tax and exchange control laws in India.

RBI grants prior permission on a case-by-case basis. RBI will consider cases of genuine hardship. However, the application must outline background facts and substantiate the applicant’s claim for hardship.

In our experience, factors like the amount of remittance, the type of asset, the mode of transfer of assets (will, gift or sale of assets), whether assets were maintained in a trust, the number of family members involved in the scheme, the years available to spread the remittance and payment of taxes will impact remittance planning. Also, RBI amends the restrictions placed under the Indian exchange control provisions from time to time, and the modified restrictions should be applied from the date of amendment.

U.S.-India Tax Considerations

India has signed double taxation avoidance agreements with over 90 countries. Indian tax law offers a choice to a taxpayer to claim treaty benefits against domestic tax law provisions and vice versa. India and the United States have entered into a double taxation avoidance agreement (Tax Treaty) and agreements to ensure compliance with FATCA.

Compliance With Residence Rules

Remittance with or without Reserve Bank of India (RBI) approval

Remittance is made by: No RBI approval required if the remittance is:
A foreign national of non-Indian origin (other than Nepal/Bhutan/Person of Indian origin (PIO)) who:

  • has retired from employment in India;
  • has inherited assets from a person who’s an Indian resident;
  • is a non-resident widow/widower and has inherited assets from her/his
    deceased spouse who was an Indian national resident in India.
Up to USD 1 million in a financial year.
A non-resident Indian or PIO who remits funds from:

  • the balances of a non-resident ordinary rupee account
    but subject to declaration;
  • sale proceeds of assets;
  • assets acquired from legacy/inheritance/deed of settlement.
Up to USD 1 million in a financial year.
An Indian entity in relation to the contribution towards a provident/superannuation/pension fund for an expatriate employee who’s resident
but not permanently resident.
No prescribed limit.
A branch or office established in India by a person resident outside India. No prescribed limit.

— Peter Harper & Janpriya Rooprai

The sweeping changes in the U.S. tax law enacted under the Tax Cuts and Jobs Act (the Act) offer some tax incentives and carry significant costs for global businesses. The movement of the U.S. corporate tax system to a territorial system is a firm reminder to foreign nationals coming to the United States that you’re not in India anymore!

Recent U.S. tax reforms will have a biting impact on some HNW individuals who’ve chosen to immigrate to the United States over other countries and may force them to reconsider their options.

Tax Treaty considerations. The framework of the Tax Treaty prevents double taxation of the same income by allowing an Indian tax resident to claim a credit against his Indian tax liability for income tax paid in the United States on income arising in such country. It provides guidelines on rules of permanent establishment and lays out beneficial tax rates of income streams including dividends, interests, royalties and fees for technical services against high individual marginal tax rates in India. However, benefits under the Tax Treaty are only available if the limitation of benefits article doesn’t deny treaty benefits because a taxpayer doesn’t satisfy the ownership requirements set out therein. The United States hasn’t signed the MLI under the BEPS project, and accordingly, the new provisions don’t affect the India-U.S. tax treaty unless both countries agree to their adoption.

U.S. considerations. Global Indian families that have footprints in both the United States and India need to understand how the two systems interact and the traps to avoid.

While the Act substantially reduced the headline corporate tax rate from 35 percent to 21 percent and exempted the taxation of dividends paid to U.S. companies from foreign subsidiaries, the new rules will almost certainly have a negative impact on HNW individuals who’ve immigrated to the United States. This is because of the extension of the definition of U.S. shareholders as having aggregate ownership of more than 50 percent (and individual ownership of 10 percent or more) in value or stock in foreign corporations. As a result, the foreign corporations are treated as CFCs, and their passive income (commonly known as “Subpart F income”) is attributed to the U.S. shareholders. The scope of the income is further extended to the introduction of the global intangible low income tax (GILTI).

HNW individuals qualifying as non-resident Indians after migrating to the United States should report and pay tax on income generated from assets sourced in India subject to the application of the Tax Treaty.

Foreign entities that are considered CFCs will also need to be reported on Form 5471 and attached to the personal tax return. Failure to complete and lodge this Form can result in USD 10,000 as a base penalty for each form that wasn’t filed and subject to further increase if the default continues. These reforms will have a biting impact for some HNW individuals who’ve chosen to immigrate to the United States over other countries and may force them to reconsider their business and holding structures to mitigate any negative and unintended tax consequences.

Choice of U.S. entity. The U.S. tax cuts make the United States an attractive place for investment. The decision of choice of entity between a corporate and pass-through entity (that is, an LLC) in the United States is similar to the choice between a corporation and LLP in India.

HNW Indians coming to the United States to do business may be lured by the low U.S. corporate tax rate of 21 percent. This is close to the base corporate tax rate in India, which is 25 percent,20 where the annual turnover is less than INR 2.5 billion.

Corporation taxation shouldn’t be chosen over pass-through taxation solely because of the new low corporate tax rate, as a deduction of 20 percent is available for qualified business income earned through pass-through entities subject to specific conditions. This results in an effective tax rate of 29.6 percent from 37 percent. This rate is also close to the base maximum marginal rate of tax in India, which is 30 percent.

Recharacterization of income from Indian corporations received by HNW Indians who become U.S. shareholders. The circumstances in which an Indian corporation or Indian controlled structure will be a CFC under U.S. law have been expanded by the recent changes. Under the reform provisions, there are circumstances in which an Indian corporation with Indian and U.S. subsidiaries will be classified as a CFC pursuant to the downward attribution rules if a U.S. tax resident holds as little as 10.01 percent. This is a game changer and means that it will be very easy to see a situation in which GILTI and Subpart F income derived by Indian-owned CFCs will be attributed to and taxable to HNW Indians who own a minority stake in foreign corporate groups.

The retroactive application of taxes associated with the Act that concern CFCs has meant that HNW Indians who had recently become U.S. shareholders had no ability to plan for these changes. However, this isn’t the case for HNW individuals who are looking to move to the United States after the changes, and they should seek advice from U.S.-Indian tax experts on the best way to structure their entry into the United States.

U.S. grantor trusts rules. Large numbers of first and second-generation Indians are settled in the United States with family businesses and assets in India. It’s very common in India for family businesses to be structured through trust and foundation structures as part of a larger tax and family succession plan. We’ve discussed the taxation of contributions made by a settlor to a trust and subsequent distributions of trust income and trust property from an Indian tax perspective. In the United States, the grantor trust rules apply to tax income of foreign trusts with U.S. resident grantors in a similar fashion. Therefore, it’s important that any tax planning and estate planning for HNW Indians who are immigrating to the United States consider the possible implications of the grantor trust rules under U.S. tax law.

U.S. citizens and residents need to report transactions associated with foreign trusts on Forms 3520 and 3520-A. Failure to complete these forms can result in a penalty as high as 5 percent of the value of the relevant trust’s assets.

Choice between an Indian or U.S. trust for Indian assets. Generally, settling Indian assets in an Indian trust offers ease of administration and management of assets together in a single trust. But, when all beneficiaries are non-resident Indians, an Indian trust can only hold certain assets that are restricted or require RBI approval. In our experience, non-resident Indians are more likely to transfer such assets if they transferred them in an Indian trust rather than their own name. Further a restriction on the amount of funds that can be contributed by a settlor in a foreign trust is governed under the LRS (allowing a maximum contribution of USD 250,000 per financial year) or other schemes like remittance of assets under will or gift (allowing a maximum remittance of USD 1 million per financial year in the case of certain foreign nationals, non-resident Indians or PIOs).

The above restrictions placed under various schemes of the RBI often create liquidity issues for foreign trusts in relation to payments of tax, duty and other costs. For example, in relation to a qualified domestic trust (QDOT)21 created under U.S. law, a U.S. trust may defer the payment of U.S. estate tax on the initial testamentary transfer if it takes property that flows after the first spouse dies. In effect, the payment of the estate tax is at the death of the surviving spouse provided certain conditions are satisfied. One of these conditions require a QDOT to have enough assets to assure taxability under the U.S. tax net. This may be a challenge in cases in which a QDOT receives Indian assets under a will and the RBI doesn’t approve the remittance of all the assets, as these assets are more than USD 1 million in a financial year. Consequently, the remittance will have to be spread over a number of financial years and will cause liquidity issues, as the QDOT will be unable to meet the assurance of the U.S. tax liability because of limitations under the Indian exchange control law.

Advisors should keep HNW individuals informed of the risk of the RBI restrictions on remittance of funds and assets outside India right at the planning stage, as these rules are strictly applied. It’s important to note, however, that the RBI has been attentive to cases with genuine hardship and has allowed remittances of higher amounts. As a starting step, clients should prepare a list of assets that are in India and make conscious decisions whether they intend to retain the assets or transfer them. When there’s no intention to hold the assets in India, it’s best to transfer these assets and remit funds out of India. Conversely, when a client intends to hold the assets, then segregating assets into an Indian or foreign trust is a critical planning exercise, and the client needs a clear understanding of the tax and exchange control laws in India and the applicable foreign jurisdiction.

FATCA

HNW Indians becoming U.S. tax residents also need to consider their U.S. information reporting obligations.22 These include the completion of Foreign Bank Account Reporting (FBAR) Form Fincen 114, which concerns specific interests in bank and financial accounts and FACTA filing requirements on Form 8938, which concerns foreign financial assets. FATCA addresses the tax compliance requirements of U.S. citizens and residents by requiring them to attach the Fincen 114 and 8938 to their personal tax returns.

FBAR filing is in addition to FATCA filing and requires U.S. citizens and residents to report their interest in, or signature or other authority over, foreign financial accounts with an aggregate value that exceeds $10,000 at any time during the U.S. calendar year.

Way Forward

HNW individuals migrating to the United States from India should always be cautious of their tax residency status and ensure they meet their tax and information return compliance obligations in both India and the United States. HNW individuals qualifying as non-resident Indians after migrating to the United States should report and pay tax on income generated from assets sourced in India subject to the application of the Tax Treaty. This may also raise tax obligations in the United States, and to ensure HNW individuals aren’t double taxed, foreign tax credits will need to be claimed in a timely filed tax return.

The different tax treatment of direct and indirect ownership structures in India, such as foundations, closely held corporate groups and trusts, compared with their treatment in the United States under the CFC rules and grantor trust rules is material, and careful consideration should be given to the most appropriate way to structure or restructure the family businesses of HNW Indians in light of these differences.

The Act further highlights just how different the two tax systems are and the expansion of the definition of CFCs, and possible CFC ownership and attribution rules, to a minority shareholder of a foreign corporate group are prime examples of this. However, it’s not these reforms that we believe will be the biggest challenge for HNW individuals—it’s their view that non-disclosure of financial information to tax authorities is the best way to proceed because privacy of their family affairs is more important than being tax compliant.

The question is whether the U.S. approach to tax compliance will force HNW individuals’ migration to the United States to assume their obligation as a responsible taxpayer, and what role will the U.S. Treasury and the Internal Revenue Service have in ensuring tax compliance within India?

Endnotes

1. “Capegemini World Wealth Report 2018,” https://www.capgemini.com/ch-de/wp-content/uploads/sites/26/2018/06/Capgemini-World-Wealth-Report-19.pdf.
2. “Capegemini World Wealth Report 2018” classifies high-net-worth (HNW) individuals based on investable assets of USD 1 million or more, excluding primary residence, collectibles, consumables and consumer durables, www.worldwealthreport.com/download.
3. Euromoney classifies HNW individual clients of private banks with wealth ranging from USD 5 million to 30 million and ultra-HNW individuals with wealth more than USD 30 million, www.bloomberg.com/news/
articles/2018-05-03/the-big-winners-from-india-s-cash-clampdown-are-private-bankers
.
4. Greg Farrell and David Kocieniewski, “UBS, HSBC Offshore Dealings Thrust Into Panama Papers Spotlight,” Bloomberg (April 5, 2016), www.bloomberg.com/news/articles/2016-04-05/ubs-hsbc-offshore-dealings-thrust-into-panama-papers-spotlight.
5. The annual tax year in India is called the “assessment year” and as a general rule, follows the financial year beginning from April 1 to March 31 in the next year.
6. A person of Indian origin has parents or grandparents who were born in undivided India.
7. A corporate entity includes a company formed and registered under the Companies Act (2013), a company formed under corporate laws of another country or an institution, association or body declared by general or special order of the Indian tax department.
8. Circular No. 06 of 2017.
9. Unincorporated entities in India include Hindu Undivided Families, firms or other association of persons. In recent years, limited liability partnerships offering a hybrid mix of corporate and partnership firm features are commonly used in India.
10. “Significant economic presence” means either a transaction in respect of any goods, services or property carried out by a non-resident in India including provision of download of data or software in India, if the aggregate of payments arising from such transaction or transactions during the previous year exceeds such amount as may be prescribed; or a systematic and continuous soliciting of business activities or engaging in interaction with such number of users as may be prescribed, in India, through digital means subject to certain specifications.
11. Base Erosion Profit Shifting project Action Plan 7 provides for purpose of determining permanent establishment with respect to a dependent agent to include an agent having authority to conclude contracts or playing a principal role leading to conclusion of contracts. India, under Article 12, by signing multilateral instruments, incorporated this modification suggested under Action Plan 7.
12. One hundred and eighty three days during the year including the current tax year is counting presence in the United States for: all the days in the current year, one-third of the days in the first year before the current tax year and one-sixth of the days in the second year before the current tax year.
13. The fair market value (FMV) of the shares traded on a recognized stock exchange is the average of the opening price and closing price of a share as on the date of exercise on the recognized stock exchange that records the highest volume of trading in the share on such date. If there’s no trading on the exercise date, the FMV is determined on the closest date when the shares are traded. The FMV of unlisted shares is the value determined by a
Category I merchant banker in India registered with the Securities and Exchange Board of India.
14. Section 2(v) of Foreign Exchange Management Act (1999).
15. Reserve Bank of India, Frequently asked questions, Remittance of Assets, www.rbi.org.in/scripts/FAQView.aspx?Id=33#AN2.
16. Master Direction—Liberalised Remittance Scheme (LRS) (June 20, 2018), https://rbi.org.in/Scripts/NotificationUser.aspx?Id=10192&Mode=0.
17. Reserve Bank of India, Frequently asked questions, LRS, www.rbi.org.in/Scripts/FAQView.aspx?Id=115.
18. Supra note 14, Section 2(e).
19. Ibid., Section 2(j).
20. This base tax rate of 25 percent doesn’t include surcharge and cess (that is, a tax or levy).
21. Internal Revenue Code Sections 2056(d) and 2056A.
22. www.irs.gov/newsroom/taxpayers-with-foreign-assets-may-have-fbar-and-fatca-filing-requirements-in-june.

Reference: Published in a leading journal in the U.S., Trusts & Estates, Nov 2018

Online Business with No Physical Presence May Be Liable for US Sales Tax

In our previous article on the topic of sales tax in September 2018, titled “Understanding Sales Tax in the US” Click here to read the post, we discussed the ways in which US states themselves have taxing powers over sales where there is a sales tax nexus. The sales tax nexus is where your business has a substantial enough presence in a state for the state authorities to deem that you are taxable in such state. Now, however, companies that engage in online sales may be subject to tax obligations regardless of their sales tax nexus under the recent Supreme Court case, South Dakota v. Wayfair.

What happened in South Dakota v. Wayfair?

In South Dakota v. Wayfair, the state of South Dakota was suing Wayfair, an online retailer, for their failure to withhold and remit taxes on online sales inthe state.Wayfair argued against having to do so because under a prior Supreme Court decision, states could only apply sales tax on sellers with a sales tax nexus, which required some sort of physical presence. The Supreme Court decided it was time to take a hard look at this precedent as the growth of online retailers skyrocketed. In doing so, the Court held that states can now require online retailers to collect sales tax if certain revenue or quantity thresholds are met, regardless of whether they have a physical presence in the state.

What are the effects of South Dakota v. Wayfair?

Now, your business will need to withhold sales tax where the business:

  1. Has a sales tax nexus with the state; or
  2. Engages in online sales that meet the threshold level for the state (“Economic Nexus”).

This ruling primarily affects businesses with large eCommerce sales, Software as a Service sales, and digital goods/services sales. Additionally, for foreign companies who transact business in the US, this ruling may affect you even if you do not have a US permanent establishment.

What is the applicable state “threshold” for online sales?

A business will only need to comply with the ruling of South Dakota v. Wayfair if it reaches the particular state’s gross revenue or quantitative transaction threshold. The most popular gross revenue threshold utilized by states is $100,000 or more in in-state sales; whereas, the most popular state threshold based on the number of transactions is 200 in-state sales. It is critical that for each state you transact business in, you review their specific threshold requirements to ensure compliance.

I think my business meets the online sales threshold of a state, what next?

If your business has meets the online threshold of a particular state pursuant to the sales tax rules of such state, you will be required to register for a state sales tax permit and collect sales tax from all buyers in that state. The sales tax permit is obtained from the relevant state tax department.It is imperative that your business file sales tax in all jurisdictions where your business meets the threshold.

Upon receiving the sales tax permit you will be assigned a sales tax filing ‘frequency’ requiring sales tax filing to be made monthly, quarterly or annually. Again, each state has its own requirements and criteria in determining the filing frequency.

It is important to note that the process of determining whether your business is subject to the state sales tax and therefore is required to register for a sales tax permit, is of particular importance as failing to obtain a sales tax permit is deemed as criminal fraud.

How can CST help you?

Navigating through the sales tax rules can become an overwhelming process when trying to focus on the growth of your business in a new market. If you need assistance in analyzing whether your business has a sales tax nexus (physical and/or economical) in a state and whether you are required to be sales tax compliant, please don’t hesitate to get in contact with a member of our team.

Trump Tax Reform Puts Domestic Business First and Foreign Founders Last

Written by: Peter Harper and Janpriya Rooprai
Illustrations by: Janpriya Rooprai

Peter heads CST Tax Advisors in North America and a member of the global executive of CST International. Janpriya is the head of the US-India practice and US Operations Head with CST Tax Advisors.They can be reached directly at [email protected] and [email protected].

ABSTRACT

The Tax Cuts and Jobs Act, 2017 (Tax Reforms) is being marketed as tax reform that is moving the United States (US) corporate tax system away from worldwide taxation towards territorial taxation. This is supposedly being achieved by slashing the corporate tax rate and introducing a non-portfolio dividend exemption. How do we pay for such a boon you may ask? A one-time Robin Hood style transition tax that taxes foreign held retained profits. But wait there is a catch, while we are no longer going to tax foreign sourced dividends repatriated to US companies, we are going to attribute any income to US shareholders to be taxed in the US if we think it is low tax income, under a little mechanism we call global intangible low tax income or GILTI. Does it still sound like a good deal?

This article provides an overview of the sweeping changes to the US domestic tax law and rules on cross-border transactions involving US corporations. It is important for stakeholders of global middle market companies and family businesses to evaluate the impact of these changes on their operations and consider whether structural changes need to be made to their global value chain to ensure they are not paying punitive tax unnecessarily in the US.

Tax Reforms brought in by the Trump administration has introduced sweeping tax reforms for individuals, corporates and pass-through entities.The impact of the US Tax Reforms on individuals has been described as “turbocharge inequality in America” and making the US “more and more like a rentier society.”1 The tax policy changes for foreign corporate entities is also supportive of this position. With certain key amendments having retroactive effect, the policy makers have undeniably rung the bell on foreign corporations leaving foreign businesses and multinational corporations with no time to consider the impact of the reforms and make sound tax planning decisions to address the changes.

In a quest to understand the consequences that the Tax Reforms will have on the international business landscape, in this article we will focus our analysis on two key questions: what do the Tax Reforms mean for foreign corporations planning to enter US markets, and what is in store for existing corporate entities?

Initial analysis that we have undertaken for our clients has shown that the Tax Reforms can result in burdensome and costly compliance requirements even in situations where no further tax may be due. Careful and diligent planning should be undertaken with respect to the Tax Reforms when addressing international tax planning for foreign business owners and investors to avoid unintended and costly results. Foreign investors who are in the process of exploring US markets should be vigilant of the possible tax exposures that can impact their global business.

Concepts underpinning the Tax Reforms

In order to understand the intentions and impact of the Tax Reforms it is perhaps best to first define the underpinning concepts and how they have changed.

Controlled foreign corporation (CFC)2 : A CFC is a foreign corporation with US shareholders owning more than 50% of the stock value or voting power.

The definition of CFC has been expanded via the concept of constructive ownership so that a US person who owns 10% or more of the total combined stock value or voting either directly, indirectly or constructively of all classes of stock of a foreign corporation can be a CFC. This is because foreign subsidiaries of a foreign parent can be considered to be constructively owned by a US subsidiary.

Subpart F income3 :The earnings of a foreign corporation are not taxed in the US until dividends are paid from the foreign corporation to US shareholders. Where the foreign corporation is a CFC for US purposes, Subpart F provides an exception to this “deferral” of tax by attributing certain income of the foreign company to the US shareholders.

Generally, Subpart F income consists of categories of “passive” income such as interest, rent, dividends, royalties etc.

Although the Tax Reforms have not directly changed the definition of Subpart F income, by broadening the scope of who is considered a US shareholder and therefore subject to attribution under the CFC rules and expanding the definition of CFC to include certain foreign corporations, more US taxpayers and foreign corporations will therefore be subject to Subpart F.

Global Intangible Low Tax Income (GILTI)4 : GILTI is defined as a CFC’s income that exceeds 10% of qualified business asset investment excluding intangible assets. GILTI is computed by a CFC’s net tested income (NTI) that exceeds 10% of qualified business asset investment (QBAI). GILTI is computed in the same manner as subpart F income.The formulae of GILTI unlike its name does not include the intangibles owned by business.The tested income of a CFC generally includes CFC’s income not included as subpart F income.

Foreign Derived Intangible Income (FDII)5 : FDII is the portion of intangible income determined on a formulaic basis that is derived from a CFC. This is indeed the intangible component in GILTI which is excluded from its computational provisions.

Dividend Received Deduction (DRD)6 : DRD is a deduction for dividends received from foreign corporations(and other specified 10% owned foreign corporations) after December 31, 2017.

With the introduction of the DRD allowing US corporate shareholders of foreign business to deduct dividends received, Base Erosion and Anti-Abuse Tax7 (BEAT) was introduced to deter US corporations from eroding the US tax base by paying tax-deductible expenses to foreign affiliates then distributing profits tax-free. BEAT is essentially a form of “alternative minimum tax” and applies to US companies with annual average gross receipts of US$500 million for the past 3 years and with a base erosion percentage of 3%.

Key changes of the Tax Reforms

President Trump in a tax reform rally on December 5, 2017 said, “our tax plan is anti-offshoring and 100 percent worker…100 percent pro-America.” But with an economy that fosters large volumes of international trade and encourages business to come to the US, the Tax Reforms appears to be an expensive vaccine shot that is unlikely to encourage a pro-America approach.

Expanded scope of enterprises classified as CFC

Prior to the Tax Reforms, a US shareholder of a CFC was defined as a US person owning at least 10% of a foreign corporation’s voting stock. This definition has expanded its scope to include a US person owning at least 10% in voting stock or value of a foreign corporation.

The expanded scope not only broadens the net for who is considered a US shareholder of a CFC but also checks foreign entities that may be considered CFCs for US tax purposes with the inclusion of indirect ownership. This is an important change in which those with multinational structures should err with caution and carefully manage.

For a foreign corporation to be a CFC,its US owners may be direct, indirect or constructive owners. A direct or indirect ownership is simple flow of ownership from top to bottom as exhibited below:

The laws that determine constructive ownership of a CFC by a US shareholder of a foreign corporation twirls like a snake (refer paragraph above) and creates ownership where there is no direct or indirect flow of ownership. A constructive ownerwith no US shareholder is exhibited below:

This constructive ownership rules of a foreign subsidiary have been extended.8 Prior to the Tax Reform, the provisions specifically excluded a foreign subsidiary held by a foreign holding corporation from being considered a CFC. The expanded definition now includes hybrid indirect ownership. Per the diagram above, we have a situation where a foreign parent company (For Co) has a foreign subsidiary company (For Sub) and a US subsidiarycompany (US Sub).Under the expanded definition, For Sub is now considered a CFC of US Sub with applicationbeginning January 1, 2018.

The retroactive application of these changes highlights the draconian nature of the rules that apply tocompanies and corporate groups for which these rules will apply.

In effect, the number of entities in a structure designated as a CFC will increase considerably. As will the quantum of income that may be included in the US shareholder’s income. It is however, important to note constructive rules of ownership are limited to the determination of a CFC and that attribution of income to a US shareholder requires ownership in CFC.

This is seen in the above diagram. The For Sub is a CFC because it is constructively owned by the US Sub and 10% of its GILTI or subpart F income will be attributable to the shareholder who is a US shareholder.

As well as potentially increasing the Subpart F income attributable to US shareholders, the Tax Reform increases reporting compliance requirements for direct, indirect or constructive shareholders of a CFC, even if no income is included on a US shareholder’s tax return. A US shareholder of a CFC is required to report9 its Subpart F inclusions and certain information concerning CFCs. The Tax Reforms further requires a US person who is an officer or director of a foreign corporation in which a US person owns more than 10% of the total combined voting power of all classes of stock of such corporation entitled to vote or total value of stock of such corporation to comply with reporting requirements on form 5471.

It is important to analyze the application for CFC rules now as the foreign corporation is not given 30 days at the end of the year to determine how it should be classified. Now the CFC rules apply to foreign corporation if its owned either directly, indirectly or constructively “on any day during the taxable year” of such foreign corporation.10

Transition tax and moving to territorial regime for corporations

Prior to the Tax Reforms being introduced, US based multinational enterprises could be taxed only on profits distributed from their foreign subsidiaries. Post these reforms, foreign corporations repatriating dividends to US parent companies are exempt from US corporate tax on profits derived after 1986.

As part of the transactional measures from the old rules to the new rules, a territorial tax system to cover undistributed profits including cash and earnings of a deferred foreign income corporation (DFIC) to be taxable to a US shareholder.11 DFIC is either a CFC or a foreign corporation that has a US corporation (thus is not a passive foreign investment company) as a US shareholder.12 Foreign earnings of a DFIC held in the form of cash and cash equivalents are taxed at 15.5%, and the remaining earnings are taxed at 8%, which may be paid in installments over the prescribed period.13 A US shareholder of DFIC includesits pro-rata share of the income in sub-part F income for the DFIC’s last taxable year beginning before January 1, 2018.14

Interplay between Sub-part F Income and GILTI

Sub-part F income generally includes foreign base company and insurance income. GILTI is an additional tax for US shareholders on CFC’s income and included in the same manner as subpart F income.

Unlike an individual or flow-through entity who is a shareholder of a CFC, a corporate shareholder can claim a deduction of 50% of GILTI and 37.5% of FDII.15 A 50% deduction results in reducing the effective tax rate to 10.5%. A 37.5% deduction for FDII for deemed intangible deduction reduces the effective tax rate to 13.125%. The effective tax rates may reduce further for US corporate shareholders who can claim foreign tax credits in addition to the deductions.

The computational provisions of GILTI exclude prescribed percentages of specified tangible property. In a way it excludes tangible assets of a CFC which seems unnecessary. It supports the Trump administration’s story that this is a tax on foreign owned intellectual property.

As a general rule, GILTI taxes any low tax income that is not caught under subpart F income. For example, subpart F income excluding profits which are taxed in a foreign country not classified within the definition of subpart F income and taxed at a rate greater than 90% of the maximum US corporate tax rate, they are included in GILTI basket.16 This means that any foreign income is effectively taxed to US corporate shareholders at a minimum rate of 10.5% and taxed at rates as high as 37% which is attributed to US individual shareholders.

The engaging discussion for foreign founders here is to evaluate how they continue to own foreign corporations and what form of entity they should consider for doing business in the US.With a temporary reduction of personal tax rates from 39.6% to 37%and a deduction of up to 20% for income derived by individuals directly or through flow through entities, individuals entering US with no foreign business interests may find the tax reform alluring. But individuals owning foreign corporations and coming to the US have to be watchful of the applicability of subpart F and GILTI.

Way forward

As the OECD/G-20 lead Base Erosion Profit Shifting (BEPS) initiative is gaining more traction worldwide and strongly supported with participation from both developed and developing countries like Australia and India, the USis making its domestic tax reporting system more robust with additional reporting compliances of a CFC. The scope of reporting requirements for direct, indirect and constructive US shareholder and inclusive list of anti-avoidance conditions is vicarious to the idea of doing business for global entrepreneurs.

The Tax Reforms are promoted as atransition from worldwide taxation to territorial taxation system for domestic corporations. These reforms are effectively capturing the income of foreign corporations classified as CFCs under different baskets, namely GILTI and transition tax in addition to what was already included as Subpart F income. For large US and foreign corporations, BEAT adds to an already burdensome tax cost for doing business in the US. With this approach, scrutinizing foreign corporations under downward attribution CFC rules will be dissuading US subsidiaries in foreign business structures.

It is therefore imperative for foreign founders moving to the US and becoming US residents to be cautious of their move if they hold interests in foreign businesses. There may be additional costs that their move can place on the business as there is no set off against the income attributable under CFC rules – no deduction and no foreign tax credit. This calls for foreign founders to reexamine their existing structures and undertake diligent planning before entering the US market as the Tax Reforms may result inadditional tax and reporting for a US shareholder.The Tax Reforms in my opinion are likely designed to affect the US business adversely rather than positively.

________________________________________________
1 https://www.newyorker.com/news/our-columnists/the-final-gop-tax-bill-is-a-recipe-for-even-more-inequality
2Section 957
3Section 952
4Section 951A
5Section 250
6Section 245A
7Section 59A
8 Repealed section 958(b)(4)
9Section 6038(a)(4)
10 Section 957
11Section 965
12Section 965(d)(1)
13Section 965(c)(2)
14Section 965(f)
15Section 250
16Section 954 read with section 951A(c)(2)(III)

US Market Entry Guide: Top 3 business drivers that should impact entity choice

If you have a specific US market entry tax question please complete the ‘Have a tax question?’ form on the right hand of the page and subscribe to our mailing list. The first 100 subscribers will get a copy of our US Market Entry e-book!

Choosing between a corporation and a LLC is a difficult task because it requires business owners to trade off benefits.

To quote Simon Sinek, ‘you need to start with the why?’ What is your need? Are you setting up the entity because you have immediate needs like opening an office and employing local people, or are you setting up the entity to bill local customers?

Immediate need in many cases will trump tax planning because without revenue you have no tax and I cannot argue with that logic! If you fall into this category acknowledge this, get your entity formed, and accept there may be some expensive pain down the track when you are forced to restructure your business prior to a transaction.

Understand, what success looks like for you!  Are you building a global business to create long term cash flow or are you trying to create capital value that gives you an asset to sell. You can have start with the former and move to the latter but in our experience people tend to be focused on one or the other. Be real about your goals and make structural choices with this in mind.

Finally, think about your stakeholders (owners of the business). Where are they tax resident and what does the after tax return look like for them? Some choices may benefit stakeholders that are resident of country A more than those in country B. You need to ask yourself if that is ok? You need to be aware of the fact that a future buyer of your business may dictate the deal structure so you will want to be comfortable that the choice you make today will be the right one in 3, 5 or 10 years down the track.

So when other lawyers say that LLCs are better choices than corporations it is important that you understand the context of such a statement. Yes – they are simpler if you are solely considering US corporate law. Comparatively, there is nothing simple about an LLC taxed on a flow through basis that has owners in multiple countries whereas there is something inherently simple about owners based in multiple countries owning shares in a corporation that can retain profit.

US Market Entry Guide: Top 3 practical considerations when choosing between a Corporation and LLC

If you have a specific US market entry tax question please complete the ‘Have a tax question?’ form on the right hand of the page and subscribe to our mailing list. The first 100 subscribers will get a copy of our US Market Entry e-book!

Choosing between a corporation and a LLC is a difficult task because it requires business owners to trade off benefits.

To quote Simon Sinek, ‘you need to start with the why?’ What is your need? Are you setting up the entity because you have immediate needs like opening an office and employing local people, or are you setting up the entity to bill local customers?

Immediate need in many cases will trump tax planning because without revenue you have no tax and I cannot argue with that logic! If you fall into this category acknowledge this, get your entity formed, and accept there may be some expensive pain down the track when you are forced to restructure your business prior to a transaction.

Understand, what success looks like for you!  Are you building a global business to create long term cash flow or are you trying to create capital value that gives you an asset to sell. You can have start with the former and move to the latter but in our experience people tend to be focused on one or the other. Be real about your goals and make structural choices with this in mind.

Finally, think about your stakeholders (owners of the business). Where are they tax resident and what does the after tax return look like for them? Some choices may benefit stakeholders that are resident of country A more than those in country B. You need to ask yourself if that is ok? You need to be aware of the fact that a future buyer of your business may dictate the deal structure so you will want to be comfortable that the choice you make today will be the right one in 3, 5 or 10 years down the track.

So when other lawyers say that LLCs are better choices than corporations it is important that you understand the context of such a statement. Yes – they are simpler if you are solely considering US corporate law. Comparatively, there is nothing simple about an LLC taxed on a flow through basis that has owners in multiple countries whereas there is something inherently simple about owners based in multiple countries owning shares in a corporation that can retain profit.

US Market Entry Guide: What are my entity options?

If you have a specific US market entry tax question please complete the ‘Have a tax question?’ form on the right hand of the page and subscribe to our mailing list. The first 100 subscribers will get a copy of our US Market Entry e-book!

Each year hundreds of thousands of foreign businesses establish US operations. While entity choice may require consideration of corporations, Limited Liability Company’s (LLCs), Limited Liability Partnerships, Limited Partnerships, Professional Corporations and S Corporations, in our experience the two most relevant entity choices for foreign business are corporations and LLCs.

We often find that clients proceed with the establishment of an LLC because there is a perception that they are more cost effective and simpler to establish and manage than corporations. In many cases this is this not the case. Below we have summarized the differences between the two and why corporations can often be a superior choice for foreign business owners.
What is a LLC?

A LLC is an innovation of US law that is governed by state based legislation. It resulted because of the complex and expensive nature of partnership taxation in the US. Partnerships were costly to set up and administer and easy for taxpayers to abuse.

The government wanted to give all taxpayers access to flow through taxation and so LLCs were created and state legislators introduced laws to govern their existence.
LLCs are often referred to as a simpler than corporations from a corporate law perspective because the corporate formalities that govern US corporations do not apply to LLCs. Examples of the formalities are: the requirement to hold annual meetings; take minutes; and sign director resolutions.
The single biggest legal difference between LLCs and corporations is the different level of legal responsibility that a director has over a manager. A director of a corporation owes far more onerous fiduciary obligations to its shareholders than the manager of a LLC owes to its members.

How is a LLC taxed?

The default tax status of a LLC is as follows:

1. for a LLC that has one member it is to be taxed as a disregarded entity (ie sole proprietorship); and

2. for a LLC that has two members it is to be taxed as a partnership.

Disregarded entities and partnerships are taxed on a flow through basis. Alternatively, the owners of a LLC can elect for the LLC to be taxed as a corporation. This will result in the profit of the entity being taxed as corporate tax rates and to the extent that profit is distributed to the members, such profit being taxed as dividends.

 

US Market Entry Guide: Top 10 issues to consider

For many international business owners, the US market is the holy grail of consumer markets. Technology is making it easier than ever to incorporate and start operating in the US.
Every day we are approached by foreign business owners who have established US entities without a proper understanding of that tax, legal and compliance issues associated with operating in the US. Getting it wrong can result in substantial unforeseen costs and penalties.
Based on this experience we have collated a list of our top 10 tax questions to ask and obtain answers to when you are looking to expand into the US. They are a list of things to do, not do, or just be aware of:

1. When forming an entity which state should I choose? All states have their own corporate laws. Delaware is the gold standard when it comes to corporate law in the US. The selection of which state is best should not be a decision that is based solely on whether state income tax or sales tax is payable on your business and should also take into account the corporate laws that best suit your needs and which state is the most geographically relevant to your business;

2. How is my entity taxed? Despite being a complex business tax system, the US system is also a flexible one. For example, in most countries you cannot choose your tax status, whereas in the US if you are an ‘eligible entity’ you can choose to be taxed as a sole proprietor or company if you have one shareholder or a partnership or company if you have two or more. Make sure you choose a status that interacts in a tax effective manner with the tax rules of the country in which your parent company or major shareholders are located;

3. How has have the Trump tax changes made the US more attractive? With the introduction of the trump tax changes the US has become an attractive holding company jurisdiction. This is because the US will no longer tax foreign sourced profits derived by US companies (that are not GILTI) that are repatriated to the US and because the corporate tax rate has been reduced to a flat rate of 21%;

4. Does my entity need a resident director? While US entities do not require resident directors whereas most other countries do, we always recommend that you appoint one as it may be difficult to get a bank account opened;

5. Do all entities need to file income tax returns? Entities that are active or dormant need to file tax returns. Be sure you are on top of tax preparation and compliance deadlines as failure to timely file returns can result in significant penalties;

6. What is the tax year in the US? The tax year in the US is the calendar year so make sure your global tax plan accommodates this if it is different for the tax year in your home country;

7. How do I repatriate US sourced profit? Form a repatriation plan. You need to know how the US tax rules are going to interact with the tax rules of the country in which your parent company is located and have a strategy for repatriation of US sourced profit to the country of your parent company. Profit can be repatriated through a combination of dividends or related party payments such as service fees, interest or royalties;

8. I have formed a repatriation plan does it need to be documented? Ensure your related party dealings are documented. If foreign companies are assisting your US operations in the US you need to document and appropriately price the related party transactions. Failure to do so can trigger costly penalties under US transfer pricing regulations.

9. Can my US entity be a resident in a second country? Understand the tax residency of your US entity. While a corporation can only be a resident of the US if it is incorporated in the US that is not the case in a lot of other countries. You need to ensure that any actions being undertaken by your US entity do not result in it being a resident in another country.

10. I have an independent contractor in the US do I have payroll tax obligations? You need to understand the difference between an independent contractor and employee. In many states in the US an independent contractor can be classified as a common law employee and as a result you will be liable for payroll tax.

Entity Classification of foreign companies and trusts in the US and penalties associated with getting it wrong!

In our experience the area that carries the most risk is the failure of a taxpayer to properly classify an Australian entity under US law.

By way of example:

  • a discretionary trust that is controlled by a US taxpayer will, in many cases, be classified as a grantor trust, and income derived by it will be attributed to the US taxpayer;
  • a unit trust in which a US taxpayer is an owner may be classified as a corporation, and therefore possibly a controlled foreign corporation (CFC) or a passive foreign investment company (PFIC). It follows that there may be circumstances in which income derived by a unit trust could be attributed to a US taxpayer; and
  • a self-managed superannuation fund can be classified as a grantor trust or a non-exempt employee trust, again the outcome being that income derived by the fund would be currently attributed to a US taxpayer.

The impact of this is that investment structures that are tax effective under Australian law are tax neutral or defective under US law. Income that can be distributed to a broad range of beneficiaries under Australian law may be attributable to a single US taxpayer (with or without a credit for the tax paid in Australia) under US law. Furthermore, if you are a grantor or owner of any of the abovementioned entities, you will be required to complete information returns on which you report the income and activities of such entities. These forms are in addition to the FBAR and the IRS Form 8938 and failure to properly complete them can result in substantial financial penalties (see our blog post Penalties for non-disclosure of foreign financial assets.)

Far too often we see foreign individuals living in the US fail to properly classify and report their foreign companies, trusts and superannuation. This leads to hefty penalties from the IRS and increase in professional services fees with the need for tax attorneys and experienced tax advisors to rectify the misreporting.

If you have any questions about how your foreign assets or holdings should be treated for US purposes please reach out to someone in our team today!

Penalties for non-disclosure of foreign financial assets

The FBAR, together with the FATCA regime, requires U.S. taxpayers to disclose foreign financial assets subject to certain threshold requirements. Due to the cross boarder complexities, we often see tax professionals and clients alike misunderstand the requirements.

The FBAR was born as part of an anti-money laundering initiative and was codified under the Bank Secrecy Act 1970 (BSA). Under the administration of the US Treasury, the penalties for any breach or non-compliance of the FBAR provisions were relatively minor. In 2003, the Secretary of the Treasury delegated civil enforcement authority of the FBAR as part of a crackdown on tax evasion and abusive offshore transactions.

The FBAR is required to be filed by all US taxpayers (citizens, green card holders and non-immigrant aliens classified as residents under the substantial presence test) with foreign accounts, or signatory authority over foreign accounts, that have an annual aggregate balance of over US$10,000 at any time during the calendar year. The key here is that it does not apply on a per account basis; rather, it is a combined total value across all foreign bank accounts, financial accounts and certain insurance policies. Where non-disclosure is wilful, the penalty may be up to US$100,000 or 50% of the value of the non-disclosed account at the time of the violation.

The FATCA Form 8938 filing requirements do not replace or otherwise affect a US taxpayer’s obligation to file an FBAR. In many cases, the same accounts are reported on both Form 8938 and the FBAR with the Internal Revenue Code (Code) imposing a $10,000 penalty for failure to disclose the required information on Form 8938.

If a taxpayer does not correct non-compliance within 90 days of receiving an IRS mail notice, the penalty increases by $10,000 for each 30-day period of non-compliance, with the penalty being capped at $50,000.

FATCA Form 8938 is required by US taxpayers with a total value of specified foreign assets exceeding the thresholds outlined below. Where a US taxpayer lives outside of the US, the financial threshold is higher than that of a US taxpayer residing within the US.

US taxpayer in the US Living abroad
Year end During the year Year end During the year
Married filing joint US$100,000 150,000 US$400,000 600,000
Single US$50,000 75,000 US$200,000 300,000

If you believe that you may have an obligation to report your foreign financial assets and have not being doing so, there are remediation programs offered by the IRS that you may be able to enter which will reduce the penalties above. Get in touch with a member of our team to discuss your options.

Streamlined Offshore Procedures vs amended and delinquent filing

The IRS has announced that it will close the 2014 OVDP effective September 28, 2018. For taxpayers that have failed to disclose foreign financial assets and income, this limits avenues to coming into compliant with the U.S. tax requirements.

Clients with foreign holdings, financial assets and business holdings are often unaware of the stringent disclosure requirements in the US and it is very common for taxpayers to be entering into the various programs with the IRS to properly disclose financial assets.

Under certain circumstances and where a taxpayer was completely unaware of their disclosure and reporting requirements, this leaves the following options to get into compliance with IRS requirements:

c. Filing under the streamlined procedures; or

d. filing of delinquent FBARs and amended tax returns.

Streamlined procedures

The streamlined procedures include the streamlined domestic offshore procedures(SDOP) and streamlined foreign offshore procedures(SFOP). The streamlined domestic offshore procedure is available where a U.S. taxpayer does not meet the non-residency requirement contained in section 911 of the Internal Revenue Code (IRC) and is designed for U.S. taxpayers primarily residing in the U.S. The streamlined foreign offshore procedure is available where a U.S. taxpayer meets the non-residency requirement contained in section 911 of the IRC and is designed for U.S. taxpayers not living in the U.S.

The streamlined procedures require amending the last 3 years of tax returns to report undisclosed income from foreign assets, and filing FBAR disclosures for the last 6 years. The program also requires that a taxpayer files a statement to the satisfaction of the IRS that their noncompliance was non-willful. This is of particular importance as the taxpayer will do so under the penalty of perjury which can have criminal penalties. Making a fraudulent statement can carry substantial penalties and carry criminal charges.

In addition to payment of back-taxes, a miscellaneous offshore penalty of 5% is due under the SDOP. There is no miscellaneous penalty under the SFOP. The 5% penalty is on the highest aggregate balance of the taxpayer’s foreign financial assets that are subject to the miscellaneous offshore penalty during the years in the 3-year tax return period and the 6-year FBAR period. For this purpose, the highest aggregate balance is determined by aggregating the year-end account balances and year-end asset values of all the foreign financial assets subject to the miscellaneous offshore penalty for each of the covered years and selecting the highest aggregate balance from among those years.

As you can see, the streamlined procedures were designed for U.S. taxpayers that have non-willfully failed to disclose their foreign financial assets and foreign income.

Delinquent and amended filings

In certain circumstances, it can make more sense to file amended tax returns and delinquent FBARs outside of the streamlined procedures. This will generally be the case where you have foreign financial accounts that have not been disclosed, and where there is no additional income and therefore no further US tax liability.

In our experience, this may be the case where you have failed to disclose your superannuation on an FBAR, and you may need to include rental income from a foreign property in your U.S. tax return, however the property is generating losses.

Taxpayers should file delinquent FBARs if they do not need to use either the OVDP or the streamlined procedures to file delinquent or amended tax returns to report and pay additional tax, but who:

  • have not filed an FBAR,
  • are not under a civil examination or a criminal investigation by the IRS, and
  • have not already been contacted by the IRS about the delinquent FBARs

The IRS will not impose a penalty for the failure to file the delinquent FBARs if you have properly reported on your U.S. tax returns, and paid all tax on, the income from the foreign financial accounts reported on the delinquent FBARs, and you have not previously been contacted regarding an income tax examination or a request for delinquent returns for the years for which the delinquent FBARs are submitted.

The key requirement of filing delinquent FBARs is including a statement explaining why you are filing the FBARs late and that your failure to report is non-wilful. Willfulness has been defined by courts as “an intentional violation of a known legal duty”.

The IRS recommends that amended returns should be filed where a taxpayer has claimed the wrong filing status and has to change income, deductions or credits. This method is advisable where no further tax is due as you are able to disclose the correct income and information without penalties, tax and interest. To the extent further tax should be due upon amending the prior tax returns due to undisclosed income, you may not be able to file amended returns without penalties in which case the streamline process is advisable.