Introduction to Corporate Distributions | US Business Tax Law Firm

This essay opens our new series of articles which focuses on corporate distributions. The new series will cover the classification, statutory structure and tax treatment of various types of corporation distributions, including redemptions of corporate stock. This first article seeks to introduce the readers to the overall US statutory tax structure concerning corporate distributions.

Corporation Distributions: Legal Philosophy for Varying Treatment

In the United States, the tax code provisions with respect to corporate distributions were written based on the belief that stock ownership bestows on its owner an inherent right to determine the right to receive distributions from a corporation.

Generally, a corporation can make distributions from three types of sources. First, a corporation can distribute funds from its accumulated earnings, to be even more precise accumulated Earnings and Profits (E&P). Second, a corporation may also distribute some or all of the invested capital to its shareholders. Finally, in certain circumstances, a corporation may distribute funds or property in excess of invested capital.

Moreover, certain corporate distributions may in reality be made in lieu of other types of transactions, such as payment for services. Additionally, some corporate distributions may be made in the form of stocks in the corporation, which may or may not modify the ownership of the corporation and which may or may not entitle shareholders to additional (perhaps unequal) future distribution of profits.

This varied nature of corporate distributions lays the foundation for their dissimilar tax treatment under the Internal Revenue Code (IRC).

Corporation Distributions: General Treatment under §301

IRC §301 generally governs the tax treatment of corporation distributions. This section classifies these distributions either as dividends, return of capital or capital gain (most likely, long-term capital gain). In a future article, I will discuss §301 in more detail.

Corporation Distributions: Special Case of Stock Dividends

The IRC treats distribution of stock dividends in a different manner than distribution of cash and property. Under §305(a), certain stock distributions are not taxable distributions. However, §305 contains numerous exceptions to this general rule; if any of these exceptions apply, then such stock distributions are governed by §301.

Moreover, additional exceptions to §305(a) are contained in §306. If a stock distribution is classified as a §306 stock, then the disposition of this stock will be treated as ordinary income. In a future article, I will discuss §§305 and 306 in more detail.

Corporation Distributions: Special Case of Stock Redemptions

Stock redemptions is a special kind of a corporate distribution. §317(b) defines redemption of stock as a corporation’s acquisition of “its stock from a shareholder in exchange for property, whether or not the stock so acquired is cancelled, retired, or held as treasury stock.”

§302 governs the tax treatment of stock redemptions. In general, it provides for two potential legal paths of stock redemptions. First, if a stock redemption satisfies any of the four §302(b) tests, then it will be treated as a sales transaction under §1001. Assuming that the redeemed stock satisfied the §1221 definition of a capital asset, the capital gain/loss tax provisions will apply.

On the other hand, if none of the §302(b) tests are met, then the stock redemption will be treated as a corporate distribution under §301. Again, in a future article, I will discuss stock redemptions in more detail.

Corporate Distributions in the Context of US International Tax Law

All of these tax provisions concerning corporate distributions are relevant to US shareholders of foreign corporations. In fact, in the context of US international tax law, these tax sections become even more complex and may have far graver consequences for US shareholders than under purely domestic tax law. These consequences may be in the form of higher tax burden (for example, due to an anti-deferral tax regime such as Subpart F rules) or increased compliance burden (for example, triggering the filing of international information returns such as Form 5471 or Form 926).

A failure to recognize these differences between the application of aforementioned tax provisions in the domestic context from the international one may result in the imposition of severe IRS noncompliance penalties.

Contact Sherayzen Law Office for Professional Tax Help Concerning Corporation Distributions

Sherayzen Law Office is an international tax law firm highly-experienced in US and foreign corporate transactions, including corporate distributions. We have helped our clients around the world not only to engage in proper US tax planning concerning cash, property and stock distributions from US and foreign corporations, but also resolve any prior US tax noncompliance issues (including conducting offshore voluntary disclosures). We can help you!

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FDII Export Incentive | Foreign Business Income Tax Lawyer & Attorney

The 2017 Tax Cuts and Jobs Act (the “2017 tax reform” or “TCJA”) enacted a highly-lucrative incentive for US corporations to export directly from the United States – the Foreign-Derived Intangible Income (“FDII”) regime. In this article, I would like to introduce the readers in a general manner to the FDII export incentive contained in the TCJA.

FDII Export Incentive: TCJA

The creation of the participation exemption system posed a problem for the drafters of the TCJA – how does one stop US corporations from running all of their foreign business through a foreign corporation since foreign corporate profits may actually be transferred to the United States tax-free? Among other provisions of this complex law, the drafters utilized two powerful incentives for US corporations to export directly overseas.

The first one was a “stick” – the Global Intangible Low-Taxed Income or GILTI. The GILTI regime established what can be best described as a global minimum tax on the earnings of foreign subsidiaries of a US business entity.

The second approach was a “carrot” – the FDII export incentive. The FDII regime creates a powerful incentive for US corporations to export goods and services from the United States by creating a deemed deduction of a large percentage of corporate export income. In other words, the effective corporate tax rate is reduced through the FDII regime because a portion of a corporation’s export income is being deducted and never subject to US taxation.

FDII Export Incentive: General Description of the Deemed Deduction

The deemed deduction applies only to a US corporation’s FDII. FDII is basically a certain portion of corporate income from foreign sources determined by a formula established by Congress.

The formula requires a multi-step process. The first steps involve the determination of the Deduction-Eligible Income (DEI), Qualified Business Asset Investment (“QBAI”), Foreign-Derived Deduction-Eligible Income (“FDDEI”). Once all of these items are calculated, then the Deemed Intangible Income (“DII”) is figured out.

FDII is calculated last. The basic formula for FDII is: DII times the ratio of FDDEI over DEI.

The last step is to calculate the tax liability which involves the reduction of FDII by 37.5%. Thus, the effective tax rate for a corporate taxpayer (assuming the current 21% corporate tax rate stays the same) with respect to its FDII is only 13.125%.

It should be mentioned that the current deemed deduction will stay at 37.5% only through December 31, 2025. For the years after December 31, 2025, the deemed deduction will go down to 21.875%. This means that the effective tax rate on FDII will be 16.406%. Unless the law changes (which is possible), non-FDII corporate income will continue to be taxed at 21%.

FDII Export Incentive: Net Impact of the Deemed Deduction

Based on even just this general analysis of FDII, we can understand why the FDII export incentive is such an important part of the US corporate tax law. First, in most cases, the FDII deduction is a disincentive to shift foreign-source income from a US corporation to a controlled foreign corporation (“CFC”). A CFC may be subject to taxation under two different anti-deferral regimes, Subpart F or GILTI tax. Subpart F income will just force the recognition of foreign income by the CFC right away without any deemed deduction (i.e. this would be the worst-case scenario).

If the Subpart F rules do not apply, then the corporation may be subject to the GILTI tax. It is true that the effective corporate tax rate for GILTI, after its current 50% deemed reduction is only 10.5%. Nevertheless, FDII”s effective tax rate of 13.125% significantly reduces the difference from that what it would have been otherwise (i.e. between 10.5% and 21%). Moreover, when one factors in the additional administrative, US tax compliance and local tax compliance expenses, this difference may become nonexistent.

Second, the FDII deemed deduction makes US corporations more competitive worldwide, because they may now realize a higher profit margin even if they lower the prices for their products and services sold overseas.

Contact Sherayzen Law Office for Professional Help With FDII Calculations and International Business Tax Planning

If your business engages in selling products or services overseas, there are opportunities for international business tax planning from US perspective. Contact Sherayzen Law Office to take advantage of these opportunities through professional, creative and ethical tax help.

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Business Service Income Sourcing | Business Tax Lawyer & Attorney Delaware

Business service income sourcing is a highly important issue in US international tax law. In this article, I will explain the concept of business service income sourcing and discuss the general rules that apply to it. Please, note that this is a discussion of general rules only; there are important complications with respect to the application of these rules.

What is Business Service Income Sourcing?

Business service income sourcing refers to the classification of income derived from services rendered by a business entity as “domestic” or “foreign”. In other words, if a corporation performs services for another business entity or individual, should it be considered US-source income or foreign-source income?

Importance of Business Service Income Sourcing

The importance of business service income sourcing cannot be overstated. With respect to foreign businesses, these income sourcing rules determine whether the income derived from these services will be subject to US taxation or not. For US business entities, the sourcing of income will be a key factor in their ability to utilize foreign tax credit.

Moreover, in light of the 2017 tax reform, the sourcing rules are now important for qualification of various benefits that the new tax laws offer to US corporations.

Business Service Income Sourcing: General Rule

Now that we understand the importance of the business services income sourcing rules, we are ready to explore the General Rule that applies in these situations. Generally, the services are sourced to the country where the services are performed.

In other words, if the services are performed in the United States, then, the income generated by these services is considered US-source income. If the services are performed outside of the United States, then, the income is considered foreign-source income.

Business Service Income Sourcing: Services Performed Partially in the United States and Partially Outside of the United States

The general rule is clear, but what happens if services were only partially performed in the United States? Here, we are now getting into practical complications and we have to look at the Treasury Regulations.

The Regulations begin with the general proposition that the sourcing of income from services rendered by a corporation, partnership, or trust, should be “on the basis that most correctly reflects the proper source of the income under the facts and circumstances of the particular case.” Treas. Reg. §1.861-4(b)(1)(i). This is the so-called “facts and circumstances test”.

Then, the Regulations clarify that usually “the facts and circumstances will be such that an apportionment on the time basis, as defined in paragraph (b)(2)(ii)(E) of this section, will be acceptable.” Id. In other words, the Time Basis Allocation will be the default method for business service income sourcing, but it is possible to use other tests where it is reasonable to do so.

Curiously, the Regulations provide only one example of business service income allocation that involves a corporation, and this example does not utilize the Time Basis Allocation method.

Business Service Income Sourcing: Time Basis Allocation

The Time Basis Allocation method offers two ways to source income: the “number of days” allocation and the “time periods” allocation. Under the “number of days” variation, the business entity adds together the number of days worked by its employees who worked in the United States and the number of days they worked in a foreign country, figures out the percentages for each country and sources the income according to the percentage allocation. See Treas. Reg. §1.861-4(b)(2)(ii)(F).

Under the “time periods” variation, a tax year is split into distinct time periods: one where the employees of a business entity spent all of their time in the United States and one where they spent all of their time in a foreign country. The compensation paid in the first period is allocated entirely to the United States, whereas the proceeds paid in the second time period is considered to be foreign-source income. Id.

The Time Basis Allocation methodology works better for specific employees rather than a business entity as a whole, particularly the “time periods” variation. Often, a business entity would have its employees working at the same time in the United States and outside of the United States making it very difficult to use the “time periods” allocation. Even the “number of days” allocation becomes fairly complex if one has a large number of employees working back and forth between the countries.

Contact Sherayzen Law Office for Help With Your Business Service Income Sourcing

Sherayzen Law Office is a premier US international tax law firm that helps businesses and individuals with their US international tax compliance, including business service income sourcing. If you have employees who work in the United States and overseas, you need the professional help from our law firm.

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