The long arm of the IRS

Written by: Richard Willsher Posted: 07/01/2019

BL60_US taxA year on from the introduction of major tax changes in the United States, it is becoming clear how significant they may be for individuals and businesses in the Channel Islands

Running to More than 1,000 pages of dense legalese and tax-speak, experts in the field are calling the Tax Cuts and Jobs Act (TCJA) the most important piece of taxation legislation to be passed in the United States for 30 years.

However, there is still a lack of full guidance from both the US Treasury Department and the Inland Revenue Service (IRS) on many of the areas covered by the Act. And the courts have yet to judge relevant tax cases. All of which is adding uncertainty to the full implications of the legislation.

The good news

There is, however, some good news for individuals and corporations. There are higher personal tax allowances and lower deduction rates across the board, and the threshold for inheritance tax has doubled to a whopping $11.2 million. 

For corporates, the headline tax rate has fallen from 35% – among the highest in the world – to 21%. This brings the US more or less in line with the average among countries that are members of the Organisation for Economic Co-operation and Development (OECD) club of wealthy countries.

The bad news is that wherever a US citizen may be in the world, there’s still no escaping the watching eyes of the IRS. As Anderson Page, Tax Manager at KPMG in Guernsey, points out: “Because the US has a unique, global view of taxation, wherever a US person puts their money, US tax has an impact on wherever that money goes and who that money is with. Also, wherever money goes into the US from a foreign source, US tax law has an impact on that foreign source within the borders of the US.”

Page’s colleague, Guernsey Head of Tax at KPMG Tony Mancini, adds: “There are a surprising number of US citizens invested into Channel Island investment funds. The reason why our firm has US tax practices here is primarily to deal with their tax reporting requirements.

“There’s also a surprising number of US investors in other Channel Island structures of various shapes and sizes.” 

Who’s affected

The key to getting to grips with the impact of the TCJA is how much wider the US tax net has now become. There’s a new filing requirement, for example, that covers US limited liability companies (LLCs) that are 100% owned by single foreign ‘persons’. This legal term covers companies, partnerships and trusts, as well as individuals, none of which were formerly required to file returns. This will catch a range of investors into the US.

The term ‘US shareholder’ has been redefined. It now includes any US person who owns 10% or more of the value or voting power of a non-US company.

Moreover, if such a US shareholder owns more than 50% of the value or vote of a foreign company, then the company will be deemed to be a controlled foreign corporation (CFC). At the very least, US shareholders or CFCs will face increased IRS reporting requirements and possibly an increased tax burden.

“Additionally,” Page explains, “a new concept of a ‘specified foreign corporation’ (SFC) has been introduced. This means that where a US corporation owns more than 10% of the vote or value of a foreign corporation, that US corporation may have additional filing obligations. The IRS may require more detailed information about their investment into foreign corporations, including reporting their share of foreign earnings of the underlying entity.”

Another change, which is particularly relevant to Channel Islands funds such as private equity structures, affects income from so-called ‘carried interest’, where, for example, a manager of a fund may share in the fund’s profit. 

This was previously taxed as capital gain and therefore at an advantageous rate compared with income tax where a fundholding period exceeded one year. Such treatment will now only apply to holdings lasting three or more years.

In a further move, which may wrong-foot businesses that use debt and claim interest expense against their profits, the amount of interest they can offset will be limited to 30% of earnings before interest, taxes, depreciation and amortisation (EBITDA).

An important principle of US tax law is that citizenship, rather than domicile (as in the UK, for example), determines where US citizens and businesses pay their taxes. So, wherever they live or earn money through work or investment, or wherever US corporations make profit, tax is still payable at home.

The TCJA was aimed principally at US corporations with operations across many jurisdictions. In line with OECD and EU thinking on profit shifting, lack of operational substance and tax avoidance, the US is out to bring back tax revenue to where it thinks it should rightly be taxed. 

The Channel Islands may lack the presence of businesses such as Amazon, Starbucks, Apple and Google. However, corporate entities that the IRS defines as a US LLC, CFC or SFC – and which could be funds, holding companies or others – now fall within the scope of the TCJA.

One significant approach that the IRS has taken is over profits earned on US intellectual property (IP) or other intangible assets. As Linus Ostberg, a Senior Manager within the US tax services practice of Moore Stephens, explains: “They say: ‘We don’t want you to simply set up a foreign company and put your investment in that company and roll up the profits. We’re going to impose rules on the company so that you, as the owner of the company, still have to pay US tax’.”

The IRS has devised the suggestive acronym GILTI – global intangible low-tax income – to corral such feral income into its fiscal fold. Ostberg continues: “It means that, say, an operating business in the UK with US owners in the Channel Islands has to be aware of these rules and see whether or not there should be some restructuring. The same rule would apply to private equity and any fund-related business. They really need to make sure they understand these rules, and when they could apply.”

Implications of the Act

The full ramifications of the Act have yet to be explored, tried and tested, even though it was signed into law in December 2017. Nonetheless, its effects are far reaching and, with the exception of some of the personal taxation provisions, which have time limitations, may stay on the statute books for a very long time to come. 

The implications for some Channel Islands residents and business operations are significant, as Thomas Groenen, PwC’s Partner, International Tax Financial Services, warns. “These tax reforms influence all aspects of businesses with ties to the US. In the context of the financial services sector, this would include asset managers with investments in the US and/or with US investors.

"For instance, it affects the legal form used for business in the US (given the reduction in corporate tax rate) and investment and deal structuring income earned by CFCs, which are subject to tax in the US. Moreover, the changes in the rules require that structures will have to be reviewed regularly to monitor the occurrence of CFCs in structures.”

As we have seen many times in recent years, US laws enacted by one administration can be overturned by its successor. But, as Groenen points out: “It is now a fact that the introduction of the new taxes, anti-deferral mechanisms, territorial system of taxation and so on will require more in-depth tax planning. 

“The main challenge is to ensure US tax considerations of current structures are still optimal. It is also important to plan ahead and use systems that, as much as possible, will stand the test of time and pre-empt any expected changes in US tax law.” 

Such sage advice calls for businesses in the Channel Islands to invest a good deal of time into detailed scrutiny of that voluminous TCJA documentation. 

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