United States Tax Alert - 6 November 2012
Year-end considerations for U.S. investment managers with ownership in foreign entities
By Edward Dougherty,Thomas Driscoll, Thomas Butera, Phil Morrison, Gretchen Sierra and Mark Graham
Absent congressional action, the Bush-era individual ordinary income tax rates, including favorable treatment for qualified dividends, will sunset at the end of 2012. U.S. individuals who own interests in foreign entities either directly or through a pass through entity (LP or LLC) should consider the impact of the impending change in rates with respect to qualified dividends.
Many investment managers who establish operations offshore must decide whether a foreign subsidiary should be treated as a pass through entity or as a corporation for U.S. tax purposes. Consideration must be given to both the local country tax rules as well as the U.S. individual tax rules. While pass through status does not provide for the ability to defer income of the non-U.S. entity from immediate U.S. taxation, it does provide a U.S. individual with the ability to claim a direct foreign tax credit under section 901. Compare that to the scenario in which the non-U.S. entity is treated as a corporation for U.S. tax purposes; in that case, the income may be deferred for U.S. tax purposes, but a foreign tax credit is not available under section 902 for any dividends paid by the foreign entity to its non-corporate shareholder(s).
Under current tax rules, the highest individual tax rate imposed on U.S. individuals is 35%. That rate will increase to 39.6% in 2013 if the Bush-era tax cuts are permitted to expire. Qualified dividends, including those paid by a qualified foreign corporation, are currently taxed at the rate of 15%; as of January 1, 2013, however, dividend income will be taxed at ordinary income tax rates, the upper limit of which will be 43.4% (including the new Medicare contribution tax of 3.8% assessed on unearned income including interest, dividends, and capital gains). Thus, U.S. individuals with investments in foreign entities could see a significant increase in their worldwide tax liability beginning in 2013.
For example, assume an investment manager owns an interest in an entity in a country with a low corporate tax rate such as Ireland, which generally imposes corporate income tax at the rate of 12.5%. As of 2013, if the Irish entity is treated as a pass through for U.S. tax purposes, the income earned by such entity would be taxed in the U.S. at the level of the U.S. individual owners at the rate of 39.6%, with a foreign tax credit available for the 12.5% tax paid in Ireland. The resulting worldwide tax burden on the Irish entity would be 39.6%.
However, if the Irish entity is treated as a corporation for U.S. tax purposes, and it pays a qualified dividend, under current tax rules such dividend would be taxed at the rate of 15%. The global tax burden on distributed profits, taking into account the 12.5% tax in Ireland and the inability to claim a deemed paid credit for such tax in the U.S., is 25.625%.
In contrast, if, beginning in 2013, dividends are subject to tax at ordinary income tax rates, plus the 3.8% Medicare contribution tax, treating the Irish entity as a corporation for U.S. tax purposes will yield a global tax cost for distributed earnings of approximately 50.4%. This is a dramatic shift in the global tax burden of the U.S. individual owners when comparing a pass through to a corporate structure.
Any conversion of a non-U.S. entity from treatment as a corporation to a pass through entity (or vice versa) has U.S. tax consequences. Thus, consideration must be given to the consequences of such a conversion for U.S. owners of foreign entities.