Adjusting the Globe's Tilt Just A Little: Foreign and U.S. International Taxpayers After the First Fiscal Cliff of 201303/04/2013
The tension leading up to the resolution of the January 2, 2013 fiscal cliff and the passage of the American Taxpayer Relief Act of 2012 (the “Act”) was strong as the entire country seemed preoccupied with the rates, thresholds, credits and deductions that would impact the US taxpayer in 2013. While the focus of the political drama that led to the enactment of the Act was mainly domestic, the inter-relationship between the provisions of the Internal Revenue Code dealing with foreign taxpayers and those dealing with domestic taxpayers means that the Act is not without significance for foreign taxpayers with economic interests in the U.S. economy as well as U.S. taxpayers with interests abroad. The enactment of the new tax rates and new thresholds for deductions and exemptions, combined with the inception of the new Medicare taxes under the Affordable Health Care Act (“ACA”), accentuates and even sharpens existing differences in the U.S. taxation of foreign taxpayers from the taxation of U.S. taxpayers. These include the eligibility of foreign taxpayers for relatively low rates of withholding tax on many forms of investment income (especially for foreign taxpayers resident in countries that are parties to U.S. tax treaties), the exclusion of foreign taxpayers’ non-U.S. source income and most forms of U.S. investment income from consideration in determining the tax rate on which their income from U.S. trade and businesses should be taxed, and the exemption from the ACA tax on unearned income. Less happily for the foreign taxpayer, on the estate and gift tax side, there is the ineligibility of foreign taxpayers for the gift and estate exemptions or credits enjoyed by U.S. taxpayers, which, absent timely planning, increases the likelihood of foreign donors and foreign legatees suffering greater U.S. tax liability in the case of transfers of U.S. property than would be experienced by their U.S. counterparts.
I: Foreign Investors in the United States
A. Income and Medicare Taxes
1. Income Taxes: For purposes of U.S. income tax (including relevant deductions and other offsets) as well as the Medicare taxes, by “foreign taxpayers” I mean “nonresident aliens” under U.S. income tax concepts, i.e., persons who are neither U.S. citizens nor U.S. permanent residents (“green-card” holders) nor U.S. residents for income tax purposes under the “substantial presence” test of IRC Section 7701(b). Many foreign taxpayers who own property interests in the United State are not subject to the same tax regime as U.S. taxpayers because their investments primarily consist of stocks, bonds, licenses, annuities and the like, which pay so-called ”fixed, determinable and periodic” or “FDAP” income. Many forms of bonds and bank deposits owned by foreign taxpayers are excluded from any form of U.S. taxation under IRC Sections 871(h) and IRC 871(i)). Other forms of FDAP income, in the absence of an applicable U.S. tax treaty, are subject to a 30% rate of withholding tax under IRC Sections 871 and 1441. However the United States has entered into tax treaties with more than 60 countries; foreign taxpayers from these countries who are eligible for treaty benefits frequently enjoy a withholding rate of 15% or even lower. Nothing in the Act changes the lower Treaty rates for such foreign taxpayers. Moreover, as explained below, foreign taxpayers are granted an express exemption from the 3.8% Medicare contribution tax on certain unearned income called “net investment income.”
Under IRC Section 871(b), foreign taxpayers who are engaged in a U.S. trade or business, usually through partnerships or limited liability companies treated as partnerships, are taxable under the same individual income tax rates as U.S. taxpayers under IRC Section 1 and the same alternative minimum tax rates as US taxpayers under IRC Section 55. Under the Act, the individual tax rates that were in effect in 2012 (15%, 25%, 28%, 33% and 35%) continue to be in effect in 2013 and beyond, except that single taxpayers who have taxable income in excess of $400,000 and married taxpayers filing jointly who have income in excess of $450,000 will pay tax on taxable income exceeding these thresholds at a rate of 39.6%. Notice that the threshold is based on taxable income rather than adjusted gross income so, for practical purpose, in many cases, the amount of gross income that would be required to be earned to fall under the 39.6% rate category is probably significantly higher than the $400,000 and $450,000 thresholds. Of course, these thresholds, in the case of a foreign taxpayer, only apply to the foreign taxpayer’s U.S. trade or business income as if this were the foreign taxpayer’s entire worldwide income. Since there is no gross-up using the taxpayer’s foreign income or even the taxpayer’s U.S. FDAP income to determine the rate of U.S. tax, the taxpayer’s US source business income (as a percentage of the taxpayer’s worldwide income) in many cases would have to be very high to hit the top 39.6% rate as quickly as would a U.S. taxpayer’s income.
The Act also reintroduces the limitations on itemized deductions and personal exemptions under IRC Section 68 that had been repealed for 2010, 2011 and 2012. In the case of itemized deductions, the threshold for the application of the limitation is adjusted gross income in excess of $250,000 for single taxpayers and adjusted gross income in excess of $300,000 for married taxpayers, adjusted for inflation, and the amount of allowable itemized deductions (other than for medical expenses, investment interest and casualty or theft losses) must be reduced by the smaller of 3% of the excess of a taxpayer’s adjusted gross income over the relevant threshold or 80% of the allowable deductions. The same thresholds now apply for the limitation on personal exemptions, each of which must be reduced by 2 percentage points for each $2,500 by which the taxpayer’s adjusted gross income exceeds the relevant threshold. Foreign taxpayers are generally allowed to itemize deductions only against income from U.S. trade or businesses, which must be allocable or apportioned to the taxpayer’s U.S. source income. A foreign taxpayer is also allowed to take only one personal exemption unless the taxpayer is a resident of Canada or Mexico. The IRS, in prior years before the limitations were temporarily suspended, incorporated the limitations in Form 1040NR (the main U.S. tax form for non-resident taxpayers) in the same manner it has incorporated them in Form 1040, and the same can be expected for 2013 and beyond.
2. Capital Gains Taxes: Many foreign investors owning U.S. assets are not generally subject to U.S. capital gains tax. But foreign investors in U.S. real estate (including U.S. companies whose assets consist primarily of U.S. real estate) are subject to U.S. capital gains taxes when they sell their U.S. real property assets at the same gains tax rates as U.S. taxpayers (and, in addition, are usually required to withhold 10% of the proceeds of sale as a form of tax pre-payment). In addition, a foreign investor is subject to U.S. capital gains tax on the sale of capital assets held as part of a U.S. trade or business. Furthermore, Revenue Ruling 91-32 (1991-1 C.B. 107), which the Obama administration has proposed to incorporate in the Internal Revenue Code, makes the gain on the sale by a foreign investor of an interest in a domestic or a foreign partnership engaged in a U.S. trade or business to be itself subject to U.S. tax to the extent of the foreign investor’s distributive share of the partnership’s unrealized gain or loss from U.S. business activities.
Under the Act, as was the case in 2012, taxpayers whose taxable income would be taxed at a rate lower than 25% do not pay long-term capital gains taxes. Starting in 2013, however, taxpayers whose top marginal rate is at least 25% but not 39.6% (for a single taxpayer, when taxable income is at least $36,251 but not more than $400,000, and for married taxpayers, when taxable income is at least $72,501 but not more than $450,000) would pay capital gains tax at the rate of 15% - while single taxpayers whose taxable income is more than $400,000 and married taxpayers whose taxable income is more than $450,000, would pay capital gains tax at the rate of 20%. Again, notice that the thresholds are based on taxable income rather than adjusted gross income so, for practical purpose, in many cases, the amount of gross income that would be required to be earned to fall into the respective categories could be distinctly higher than the threshold amounts themselves.
3. Qualified Dividends: The Act leaves intact the provision of the Code that requires qualified dividends to be taxed at the same rates as long-term capital gains. Thus, as with capital gains, the question of whether a U.S. person will pay no tax, a 15% tax or a 20% tax on most forms of dividends will depend on the same income thresholds that apply in the case of capital gains tax rates. As mentioned above, for most foreign investors, this provision will have little benefit because dividend income paid to non-U.S. persons is generally subject to the 30% U.S. withholding tax, with substantially lower withholding rates available to foreign investors from countries with which the United States has entered into a tax treaty.
4. Alternative Minimum Tax: As noted above, foreign taxpayers with income derived from a U.S. trade or business are subject to taxation of their U.S. trade or business income at the same rates of income tax as U.S. taxpayers. Similarly, they are also subject to the alternative minimum tax. The Act makes permanent an AMT exemption, indexed for inflation, which, in 2013, will be $51,900 for single taxpayers and $80,800 for married taxpayers. If a foreign taxpayer’s U.S. trade or business income represents only a portion of the foreign taxpayer’s worldwide income, this exemption will effectively shelter, relatively speaking, a larger share of the foreign taxpayer’s U.S. income from the AMT than would be the case with a U.S. taxpayer with a similar portfolio, because again the Code does not require that the foreign taxpayer’s income be grossed up to include foreign income or U.S. FDAP income before applying the exemption.
5. (a) Medicare Tax (Hospital Insurance): Although not part of the Act, the inauguration of the new income and capital gains tax rate structures provided for in the Act coincides with the effective date of the Additional Hospital Insurance Tax on wages and self-employment income under IRC Sections 1401(b)(2) and 3101(b)(2) of the Code and the Unearned Income Medicare Contribution under IRC Section 1411, each of which was passed as part of the Affordable Health Care Act. The rate of the Insurance Tax is 0.9%. It effectively applies to a taxpayer’s combined wages from employment and self-employment income that exceed, in the case of a single taxpayer, an aggregate of $200,000, and in the case of married taxpayers, an aggregate of $250,000. To the extent that a foreign taxpayer’s taxable income represents wages or self-employment income from U.S. sources, the foreign taxpayer is also subject to this tax.
5. (b) Medicare Tax (Unearned Income): The rate of tax for the Unearned Income Medicare Contribution is 3.8% and is imposed on the smaller of a taxpayer’s “net investment income” or the excess of the taxpayer’s “modified” adjusted gross income over the relevant threshold: $200,000 of modified adjusted gross income in the case of a single taxpayer and $250,000 in the case of married taxpayers. “Net investment income” includes income from interest, dividends, annuities, royalties and rents, certain passive income from trades and businesses and, perhaps most significant, net gain from the sale or similar disposition of property other than most property held for use in a trade or business, all reduced by deductions properly allowable to such income or gain. “Modified” adjusted gross income is the same as adjusted gross income for all U.S. taxpayers except for U.S. taxpayers who live abroad and claim a foreign earned income exclusion (who must add the excluded amount to their adjusted gross income). But for foreign investors in the United States, under IRC Section 1411(e), the good news is that “nonresident aliens” are totally exempt from this tax. Thus, a sale of U.S. real property by a foreign person would not incur the Medicare tax on unearned income even though the same sale by U.S. owner would attract the Medicare tax.
6. (a) Trusts: It should be noted that the Act retains the acceleration of income and capital gains tax brackets for U.S. trusts that have been in place since the late 1980’s. Thus, for 2013, a U.S. trust that accumulates income becomes subject to the 39.6% rate of tax for trust income exceeding $11,950. A trust that falls into the highest bracket will also be subject to long-term capital gains tax rates at the 20% rate and will also be subject to the 3.8% Medicare tax on its undistributed net investment income. As with foreign individuals, foreign trusts generally are subject to U.S. withholding taxes on many forms of investment income and are generally not subject to U.S. capital gains tax or the Medicare tax on unearned income. However, to the extent a foreign trust holds an investment that is considered an interest in a U.S. trade or business, it will be subject to U.S. income tax at ordinary rates – but using the accelerated rate brackets to which U.S. trusts are also subject. The acceleration of the tax rates for trusts means that a foreign trust benefits far less from the failure of the Code to “gross-up” the U.S. income of foreign taxpayers by their foreign income for purposes of determining the U.S. tax rates applicable to them.
6. (b) Medicare Tax on Trusts (Unearned Income): The rate of tax is the same 3.8% that applies to individuals and is imposed on the smaller of the trust’s undistributed net investment income for the taxable year or the amount by which the trust’s adjusted gross income exceeds the dollar amount at which trust income begins to be taxed at the highest tax rate, which, under the Act, is 39.6% and in 2012 become applicable for the trust with taxable income exceeding $11,950. IRC Section 1411(a)(2), which imposes the Medicare tax on trusts, does not distinguish between domestic and foreign trusts but the preamble to the Proposed Regulations under IRC Section 1411 (77 FR 72612, 12/05/2012) states that “[t]he Treasury Department and the IRS believe that section 1441 should not apply to foreign estates and foreign trusts that have little connection to the United States (for example, if none of the beneficiaries is a United States person).” It appears, as discussed below, that the Treasury is exploring ways to impose Medicare tax on distributions to U.S. beneficiaries of foreign trusts.
7. Expatriation Tax: Finally, U.S. citizens who give up their U.S. citizenship and certain long-term permanent residents, under IRC Section 877 and 877A, are required to pay a tax on the unrealized appreciation of their assets upon their expatriation. The deemed realization of gain in such cases is more likely to push such taxpayers into the highest income tax brackets for short-term (39.6%) and long term (20%) capital gains and also make them subject to the Medicare tax on unearned income with respect to these deemed gains.
B. Wealth Transfer Taxes
For purposes of this discussion of U.S. transfer taxes, by “foreign taxpayers” or “foreign persons” I mean “non-resident aliens” for gift and estate tax purposes – persons who are neither U.S. citizens nor U.S. domiciliaries. Foreign persons invested in U.S. assets can generally make lifetime gifts of U.S. “intangible” assets such as stocks, bonds, and rights in intellectual property without being subject to U.S. gift tax. But they are subject to U.S. gift tax on gifts of U.S. real property and U.S. tangible property (including at least some forms of cash). U.S. real property and U.S. tangible assets that are owned by foreign investors when they die are, consistent with the gift-tax treatment, subject to U.S. estate tax. But certain “intangible” assets owned by foreign investors when they die are subject to U.S. estate tax, even though lifetime gifts of such property would not have been subject to gift. Thus, foreign investors also have a stake in the Act’s provisions for U.S. gift and estate tax.
Three changes were made to the gift and estate rate schedules in the Internal Revenue Code: a marginal rate of 37% was set for cumulative transfers of amounts with a value in excess of $500,000; a marginal rate of 39% was set for cumulative transfers of amounts with a value in excess of $750,000; and a marginal rate of 40% was set for all cumulative transfers of amounts with a value in excess of $1,000,000. For U.S. donors and decedents’ estates, the 37% and 39% brackets are largely irrelevant because the Act permanently cancels the reversion to a $1 million unified credit contained in the relevant 2001 and 2010 Federal tax laws and leaves intact the $5,000,000 “basic exclusion amount” used to determine the gift and estate tax unified credit as well as the indexing of this amount. Thus, it is expected that for 2013 the basic exclusion amount will be $5,250,000 and, even if inflation continues in the coming years at the same relatively low rate of the past two years, the basic exclusion amount could hit the $6 million mark in six years.
All the good news about the prolongation of the generous unified credit regime put in place by Congress in 2010, however, is of no comfort to foreign persons who own U.S. property because there is no unified credit for gifts by foreign persons and the unified credit for foreign estates is $13,000, which is the equivalent of only a $60,000 basic exclusion amount. Nor do the portability provisions of the 2010 legislation, modified for technical clarification by the Act, apply to the surviving spouses of foreign decedents. This means that all the increases in the marginal rates of gift and estate tax up to 40% have real application to donative transfers or legacies of U.S. property by foreign investors while they are of only notional interest to U.S. persons. As of 2013, a U.S. person who dies in 2013 could effectively transfer a cumulative total of $5,250,000 in adjusted taxable gifts and taxable-estate legacies without any tax but the estate of a foreign person who dies in 2013 owning U.S. property not subject to any state estate tax and who did not make any taxable gifts of U.S. property would pay Federal estate tax in the amount of $2,032,800 ($2,045,800 tentative tax minus a $13,000 unified credit) on the same transfers. A gift by a foreign person of a piece of U.S. real estate worth just $1 million would itself incur a gift tax of $345,800!
That being said, a limited number of foreign persons who are citizens and/or residents of certain countries that are parties to bilateral gift and/or estate tax treaties with the United States may enjoy some indirect benefit from the unrestricted continuation of the $5 million “basic exclusion amount” for transfers of property by or from U.S. citizens and domiciliaries. Under the Treaties with Australia (Article IV of each of the Estate Tax treaty and the Gift Tax Treaty), Finland (Article IV–estate tax only), France (Article 12-estate tax only), Germany (Article 10-estate tax only), Greece (renumbered Article IV–estate tax only but not applicable to immoveable property), Italy (Article IV–estate tax only)), Japan (Article IV) and Norway (Article IV-estate tax only), the United States must allow a credit for the proportion of the U.S. credit equal to the percentage that the U.S. property belonging or passing to a foreign person bears to all of the property that would be subject to U.S. tax if the foreign person had been a U.S. domiciliary. Thus, for example, the estate or heirs of a foreign decedent from a relevant Treaty country who dies in 2013 and whose U.S. real estate equals 50% of the decedent’s worldwide gross estate would be eligible for an exemption of $2,625,000 instead of the $60,000 exemption otherwise available to foreign estates and beneficiaries. A similar credit applicable to estate tax only is conferred by Article XXIX(B) of the U.S. – Canada Income Tax Treaty.
In the case of foreign estate or successions when property passes to a surviving spouse who is not a U.S. citizen, the Treaties with France (Article XI) and Germany (Article X) require the United States to allow an estate tax marital deduction equal to the U.S. applicable exclusion amount without reduction for any such exclusion applied to gifts and the Treaty with Canada allows a similar marital deduction but only equal to the proportionate unified credit provided for under the Treaty. Thus, in the example in the previous paragraph, a 2013 French or German succession would be eligible for a marital deduction of up to $5,250,000 while the 2013 Canadian estate would be eligible for a marital deduction only in the amount of $2,650,000. Again, the effect of the unrestricted enactment of the $5 million “basic exclusion amount” under ATRA has the beneficial effect of increasing these Treaty benefits to amounts far in excess of what was contemplated at the time these Treaty provisions became effective, with the proviso that, as the price of enjoying the benefit of the enhanced marital deduction for non-citizen spouses under the Treaties with Canada, France and Germany, the estates or heirs must agree not to seek to qualify for the marital deduction any property passing to the surviving spouse in excess of the deduction allowed under the Treaty by establishing a qualified domestic trust for the balance of the property passing to such spouse.
Finally, it should also be noted that U.S. beneficiaries of gifts or bequests from U.S. expatriates who were subject to the income and Medicare taxes on the unrealized appreciation of their assets at the time of expatriation are subject to an inheritance tax under IRC Section 2801 at the highest rate of estate tax and with no benefit of the gift and estate tax unified credit or exclusion. This means that all such gifts and bequests will be subject to a 40% inheritance tax in 2013 and beyond.
II: US Investors Abroad
The Act, as already explained, modifies income, capital gains tax, and estate tax rates for U.S. persons, reinstates certain deduction limitations, and also makes permanent the generous $5 million plus gift and estate tax unified credit and the recent exemptions for alternative minimum tax. These changes apply regardless of whether a U.S. person has income from within or without the United States or wherever the U.S. person owns property. Thus, the Act has a bearing in many cases where a U.S. person is a shareholder in a controlled foreign corporation (“CFC”), has an interest in a passive foreign investment company (“PFIC”) or is a beneficiary of a foreign trust.
A. Controlled Foreign Corporations:
1. Income Tax: U.S. taxpayers who own stock in controlled foreign corporations (generally, foreign corporations of which U.S. shareholders, each holding at last 10% of the corporation’s voting control, together own more than 50% of such voting control or the corporation’s economics) that have Subpart F income must pay tax currently on their share of Subpart F income in the year in which it was earned, even though the corporation did not pay a dividend or make a distribution. In an environment where the highest marginal income tax rate has been increased to 39.6%, having such phantom income could push a taxpayer into a higher or even the highest marginal rate. The CFC rules were modified by the Act to extend through the end of 2013 an exemption from inclusion in Subpart F income for certain income from insurance issued by “qualifying” foreign insurance companies under contracts insuring liability, property or the lives of non-U.S. persons considered to be earned by the insurance company in its home country. Similarly, a special rule excluding from Subpart F income certain “qualified” banking or financing income of a controlled foreign corporation was also extended through the end of 2013. Also extended through 2013 is a provision that allows certain dividends, interest, rents, and annuity and royalty income received or accrued from a controlled foreign corporation that is a “related person” to not be treated as Subpart F income if the income would not have been Subpart F income in the hands of the paying corporation. Notice that the increase under the Act for capital gains tax rates will not be relevant because the Subpart F rules essentially treat all CFC income taxable under these rules as ordinary income.
2. Medicare Tax: One of the most important forms of Subpart F income is “foreign personal holding income,” which is defined under IRC Section 954(c) to include many forms of income included under the definition of “net investment income” under IRC Section 1411(c). Thus, many CFC shareholders will begin to pay Medicare tax on at least some of their Subpart F income beginning in 2013. However, while the Subpart F rules do not afford a U.S. shareholder of a CFC with Subpart F income the option of deferring payment of U.S. income tax on that income until it is actually distributed, it is somewhat surprising that the proposed regulations under Section 1411 afford precisely such a deferral election to the same shareholder with regard to the Medicare tax on unearned income. Taxpayers making the election under Treas. Reg. 1.1411-10(g) are required essentially to keep two accounts for cost basis purposes, one for income tax purposes and one for Medicare tax purposes. A taxpayer making the election will, for income tax purposes, reflect an increase in basis for any undistributed Subpart F income on which the taxpayer pays income tax and a corresponding decrease in basis when the income is later distributed but, for Medicare tax purposes, the same taxpayer will make no upward basis adjustment for undistributed Subpart F income when earned by the company and no downward adjustment when the income is finally distributed.
B. Passive Foreign Investment Companies
1. Income Tax: Generally, a passive foreign investment company is any non-U.S. limited liability entity, at least 50% of whose assets are considered “passive” investments or at least 75% of whose income is derived from assets that are considered “passive” investments. The tax on deferred or “excess” distributions of income and gain from a PFIC such as a foreign mutual fund is calculated based on allocating the distribution to each day in the taxpayer’s holding period with respect to the stock. The tax is calculated by multiplying the amount of the distribution allocable to each year in the holding period times the highest U.S. income tax rate in effect in that year and adding these results. Thus, for U.S. taxpayers who receive excess distributions from a trust, the portion of such distribution allocable to 2013 and each year thereafter will be subject to a tax of 39.6%, with interest that is often very costly because of the years that have passed since the income was earned. As with Subpart F income, the increase under ATRA for capital gains taxes will not be relevant because the Subpart F rules essentially treat all PFIC excess distributions as ordinary income.
(a) Excess Distributions: Excess distributions under IRC Section 1291(b) from PFICs that constitute a dividend within the meaning of IRC 316(a) as well as gains arising from a disposition of PFIC stock within the meaning of IRC Section 1291(a)(2) are included in “net investment income.” However, it does not appear that Medicare tax imposed on excess distributions paid after 2013 will give rise to an interest charge analogous to the interest charge on income tax payments on excess distributions under IRC Section 1291.
(b) Mark-to-Market Election: Net gain on most holdings of publicly-traded stock will count as “net investment income” and so, for a taxpayer who owns PFIC stock and makes a “mark to market” election under IRC Section 1296, inclusions and deductions for each year the taxpayer owns the PFIC stock must be taken into account in computing the taxpayer’s “net investment income” for such year.
(c) “QEF” Election: Under IRC Section 1297(b), the definition of “passive income” for PFIC purposes virtually coincides with the definition of “foreign personal holding company” under IRC Section 954(c) and so, in most cases, a taxpayer who has elected to have stock in a PFIC considered as a “qualified electing fund” under IRC Section 1295 will pay Medicare tax each year on the PFIC income reported for income tax purposes for such year. However, as with CFCs, taxpayers who have made a QEF election can make an election under Treas. Prop. Reg. 1.1411-10(g) to defer the Medicare tax until distributions are made by the PFIC or until the US shareholder has disposed of the PFIC stock.
C. Foreign Trusts:
1. Income Tax: A foreign trust is a trust (a) over which a U.S. court does not have primary jurisdiction over the trust’s administration or (b) over which one or more U.S. persons do not have control of all substantial decisions affecting the trust. U.S. beneficiaries of distributions from foreign trusts of current trust income and gains will add these distributions to their other gross income to determine their adjusted gross income and taxable income for purposes of the various rates, deduction limits and exemptions provided under the Act and to determine their U.S. income tax liability. U.S. beneficiaries of accumulation distributions will need to pay additional U.S. “throwback” tax calculated under the default method provided on Form 3520 or using the method provided under IRC Section 667. In a case when a taxpayer determines the additional tax on a taxable accumulation distribution using the default method as provided by Form 3520 (Annual Return to Report Transactions With Foreign Trusts), the amount of the distribution is added to gross income and could push a taxpayer into the 39.6% tax bracket (see e.g., 2012 Form 3520, Instructions for Line 36). In the case when a taxpayer uses the method provided in the Code to determine a taxable accumulation distribution, which effectively recalculates the taxpayer’s highest marginal tax rate by adding the accumulation distribution to the taxpayer’s taxable income in three of the preceding five years, the tax on the distribution is calculated separately from normal income tax rules and is reported as an additional tax on Form 1040 (see e.g., 2012 Form 3520, Instructions for Line 53). To the extent that the determination of income tax on a taxable accumulation distribution under the latter method applies, the determination of the rate of tax imposed on such distributions under IRC Section 677(b) will begin to incorporate in 2013 the 39.6% rate for taxpayers with taxable income in excess of $400,000 (single taxpayers) or $450,000 (married taxpayers filing jointly) and could potentially fully apply to such determinations in 2018, five years from now.
2. Medicare Tax: The proposed regulations reserve a place for the subject of “certain foreign trusts with United States beneficiaries” under Treas. Reg. 1.1411-3(c)(3) but give no further details; the Treasury, as noted above, has confirmed that it does not intend to impose the Medicare tax on foreign trusts that have no U.S. beneficiaries. The calculation of distributable net income for a trust within the meaning of IRC Section 643(a) for income tax purposes and the calculation of net investment income within the meaning of IRC Section 1411(c) for Medicare tax purposes, it should be noted, are not necessarily the same: For example, income from qualified retirement plan assets held by a trust is included in distributable net income but is excluded from net investment income. The Proposed Regulations provide for a form of distribution deduction analogous to the distribution deduction for income tax purposes, under which beneficiaries must add distributions of net investment income to their own net investment income to determine if they owe Medicare tax. However, the failure of the Proposed Regulations to address foreign trust issues means, among other matters, that there is a lack of guidance about the application of the Medicare tax to accumulation distributions after 2013 that will presumably contain accumulations of net investment income beginning with income earned in 2013, although it is clear, from the preamble to the Proposed Regulations, that the Treasury thinks there should be some form of Medicare tax on foreign trusts that have U.S. beneficiaries or on distributions from those trusts to their U.S. beneficiaries. The preamble also acknowledges, by asking for comments on the issue of “the means by which to identify…distributions as net investment income,” that net investment income is classified very specifically in IRC Section 1411(c) to cover dividends, interest, annuities, royalties, rents and gains (excluding income and gains in connection with the ordinary course of a trade or business not considered a passive activity or a trade or business of trading in financial instruments or commodities) while undistributed net income under IRC Section 665(a) is not. Providing a workable method of allocating undistributed net income between “net investment income” and other income without imposing heavy duties of tracing on beneficiaries of foreign trusts would appear to be a severe challenge.
III: Concluding ObservationsA. Income Taxes
Foreign taxpayers were never the principal concern of the frenetic legislative posturing, maneuvering and negotiating that led to the enactment of the Act. The effects of the Act on foreign taxpayers with U.S. interests and U.S. taxpayers with foreign interests are inconsistent and somewhat haphazard.
On the income tax side, those foreign taxpayers who have substantial income from U.S. trade and business activity may be paying tax on some of this income at a higher marginal rate and they may be subject to the same limitations on itemized deductions and exemptions to which U.S. taxpayers are subject. Whether this additional U.S. income tax will represent a real loss of after-tax revenue to the foreign taxpayer will largely depend on the income tax rate of the foreign taxpayer’s home country and whether that country offers an effective credit for foreign (i.e., U.S.) taxes. In circumstances where a foreign taxpayer would be subject to U.S. capital gains tax, the foreign investor has a relative benefit because of the exemption of “nonresident aliens” from the Medicare tax: while the top rate of capital gains tax for a U.S. investor will be 23.8% (unless the gain is derived from certain business activities excluded from the Medicare tax), the top rate for a foreign investor will be 20%. In addition, the fact that the Code does not require a foreign taxpayer’s foreign income or U.S. FDAP income to be factored into the determination of the applicable tax rate on the foreign person’s U.S. income may, in many cases, give the foreign taxpayer a greater benefit from the rise in marginal tax brackets, as well as relatively greater benefit from itemized deductions and the AMT exemption, than would be the case with a comparable U.S. person with the same amount of worldwide income.
B. Doing Business in the United States
Indeed, individual foreign taxpayers who do business in the United States as sole proprietors, through a wholly-owned and disregarded LLC or through a partnership entity may have an incentive to reconsider doing business through a U.S. or foreign corporate entity because, for the first time in several years, the highest individual tax bracket of 39.6% exceeds the highest corporate tax rate of 35%. Of course, investing through a corporate entity runs the risk of a second level of tax ‒ in the case of a U.S. corporation, of withholding tax on dividends to the foreign owner, and, in the case of a foreign corporation, of branch profits tax, each at a rate of 30% unless reduced under an applicable U.S. tax treaty. But if a foreign shareholder is compensated by the corporation by salary and reinvests the profits in the business and then sells the corporation, there would be no U.S. gains tax on the sale because foreign shareholders of U.S. corporations are not subject to U.S. gains tax on the sale of U.S. assets other than U.S. real estate. If the foreign shareholder liquidates the corporation instead, U.S. tax would apply to the sale of the corporation’s underlying assets or their deemed sale if they are distributed to the shareholder as part of the liquidation, but there should be no further gains tax on the liquidation of the corporation itself because a liquidation is treated for U.S. tax purposes as a sale or exchange and, as just noted, foreign investors are not subject to U.S. capital gains tax on the sale of stock in U.S. corporations. This advantage may become even more important to foreign investors if it should become accepted (or even written into the Code, as the administration is currently proposing) to make sales of partnerships engaged in a U.S. trade or business subject to U.S. gains tax.
C. Wealth Transfer Taxes
The increase in the top marginal estate tax rate and the commitment to a policy of maintaining a large exclusion from gift and estate tax makes the relative position of a foreign person owning U.S. property to a U.S. person owning the same property much less favorable and therefore makes the need for effective planning when making inbound investment to the United States even more compelling. One of the trade-offs that often has to be considered in U.S. domestic estate planning, when dealing with property that has a very low basis, is the relative cost of avoiding estate taxation vis-à-vis the cost of losing the “step-up” in cost basis at death (this being less of an issue with high-basis property because estate tax is imposed on the entire value of property while capital gains tax is normally a tax on appreciated value only). This trade-off is also very important to foreign investors in U.S. real property, sales of which by foreign investors (unlike many other forms of U.S. property) are also subject to U.S. gains tax. The 5% increase (15% to 20%) in the top rate of U.S. capital gains tax matches the 5% increase (35% to 40%) in the top rate of estate tax; thus, for U.S. persons, the 20% trade-off in 2012 (35% versus 15%) between estate tax exclusion and inclusion remains the same in 2013 (40% versus 20%) but the imposition of the Medicare tax now narrows the gap between the estate tax rate and the capital gains tax rate from 20% to 16.2% (40% versus 23.8%). But the foreign investor is not subject to the Medicare tax. Thus, the relative 20% trade-off remains the same – and in the case of property that already has a high cost basis, eliminating the exposure to U.S. estate tax clearly has to be the primary objective. When a foreign corporation is used to own U.S. real property and to thus serve as a blocker from U.S. estate tax, the net saving from U.S. taxes may not be as dramatic when dealing with low-basis property as with high-basis property because the capital gains tax rate for sales by corporations (U.S. or non-U.S.) is roughly 35% while the estate tax rate is 40% (a 5% differential) but the benefit of using a foreign corporation as a blocker becomes much greater when the U.S. property has a high basis because, as noted above, the estate tax is a tax on the entire value of the property while the capital gains tax is only imposed on realized appreciation.
D. Conclusion: The Globe’s Tilt in 2013
So, it can be said, that, after concluding its annual rotation around the fiscal sun at the end of 2012, the fiscal globe, from a U.S. perspective, adjusted its tilt just a little in favor of non-U.S. taxpayers with the introduction of the ATRA and ACA tax provisions: The U.S. tax benefits accorded many non-U.S. individuals entitled to invest in the U.S. economy at low treaty withholding rates continues; the policy of setting the rate of U.S. tax on foreign-owned U.S. trades and businesses without reference to U.S. investment income or non-U.S. source income continues even though these rates are increasing; and now foreign taxpayers are exempt from the Medicare tax on unearned income, even in connection with the sale of U.S. real property. But the Act also exacerbates the consequences that flow from the effective denial of any relief from U.S. gift and estate tax for the multitude of foreign taxpayers (other than possibly some taxpayers from certain Treaty countries) who acquire U.S. property without significant estate planning. For them, engaging in proper planning should be an important resolution for 2013.
Michael W. Galligan is a Partner at Phillips Nizer LLP (Trusts & Estates, Tax, Immigration, International Law), a Fellow of the American College of Trusts and Estates Counsel, Academician of the International Academy of International Estates and Trusts, and recent Chair of the International Section of the New York State Bar Association. This article appeared (with some formatting changes) in Leimberg’s Estate Planning Newsletter at http://www.leimbergservices.com/ on March 4, 2013.