Without forethought, repatriation taxes can cause serious consequences to a company’s tax liability.
Company treasurers or other executives charged with cash management may not even be aware of all the tax rules pertaining to repatriation, only to find out unpleasant news after the fact.
Having repatriation covenants in loan documents, cash flow sweeps, limits on excess foreign cash and similar provisions may incentivize cash management policies that run afoul of the Internal Revenue Code.
So, as the end of the year approaches, here are tips for businesses on how to avoid unexpected repatriation taxes:
< Be careful before borrowing from your foreign subsidiary.
In today’s economy, many small businesses conduct operations overseas. Many partnership and S-corporation companies have expanded into international markets.
You have probably heard in the news that many multinational corporations have billions of dollars parked offshore. Individuals owning interests in partnerships, limited liability companies and S-corporations with foreign subsidiaries do the same.
They know that if the funds are brought back or repatriated, that U.S. taxes will be due at tax rates of up to 43 percent (including the Medicare tax).
< Repatriation taxes on loans from your foreign subsidiary: A tax trap for the unwary.
Internal Revenue Code Section 956 was enacted to require American shareholders of any controlled foreign corporation to include in current taxable income certain CFC earnings and profits that are invested in U.S. property.
Such investments include stock and obligations of related U.S. persons, pledges and guarantees of obligations of related U.S. persons, rights to use intangible property in the U.S., and tangible property in the U.S. An obligation can include notes, loans, intercompany balances and other indebtedness.
For example, if a $1,000 loan is made by a CFC to its U.S. parent company, which is outstanding for the entire year, it could be treated as a $1,000 dividend for tax purposes, notwithstanding that the transaction was structured and documented to be a loan.
The intent of the tax law is to subject the CFC’s earnings and profits to current taxation if, in substance, they were repatriated back to the U.S. The tax code and treasury regulations provide exceptions to the general rule, as is more fully discussed below.
Companies may allow intercompany trade payables to its CFCs to remain uncollected for long periods of time since the related party nature of the buyer and seller allow for this flexibility.
There are exceptions for certain short-term trade receivables between CFC and U.S. parent companies that are settled within 60 days of being incurred and some exceptions where it can be shown that unrelated parties would have extended credit on similar commercial terms.
However, trade payables that remain on the parent company balance sheet for months will eventually be considered “overaged” and the Internal Revenue Service could assert that Section 956 has triggered an income inclusion at the parent level.
< Tax issues with intercompany balances.
Assume the same facts as in the above example, except that instead of a loan, the U.S. parent purchases inventory on open account from its CFC for $1,000. But after two years, the amount payable to the CFC by the parent is still outstanding. Assume further that the CFC generally collects receivables from its unrelated customers within 45 to 60 days of the sale.
The IRS probably would assert repatriation taxes apply and will seek to tax the $1,000 as a distribution to the parent company.
There are complex rules dealing with the computational aspects of investments in U.S. property, including obligations or loans that are subject to Section 956 treatment.
When a CFC makes a loan to its U.S. parent or related person, the shareholder of the CFC includes in its income for the taxable year the yearly average of the amounts of such loans outstanding on the last day of each quarter.
In the following year, the computation would be done again, and income in the second year would be capped at the excess of the second year average number over the amount included in taxable income in the prior year.
Some loans for 30 days or less can be excluded in the computation of the outstanding balance at the end of a quarter.
The computational rules are very complex and should be monitored so as to minimize or eliminate these income exclusions. With planning and cash management, this can be done.
With proper planning, business objectives can still be met, lenders can get the security they want and adverse tax consequences can be minimized or eliminated.
It is best to work with a tax adviser with significant international tax experience when moving cash back and forth in cross-border transactions.
E. Patrick Rush, Certified Public Accountant, is a senior tax manager at Concannon, Miller & Co. in Hanover Township, Northampton County. He specializes in federal and state compliance, international tax reporting and tax research. He can be reached at email@example.com or 610-433-5501.