May 17, 2018 - Haoshen Zhong

How a Green Card Holder Might Avoid Section 965 and GILTI

How a green card holder might avoid section 965 and GILTI with a treaty election

Today’s post is a (sort of) followup to Phil’s Friday Edition post on 2018-03-16.

Here is the 1 paragraph summary to Phil’s post: In the 1990s, the IRS adopted regulation section 301.7701(b)-7, stating that if a US resident elects income tax treaty benefits for a nonresident, then he calculates tax as a nonresident, but he remains a US resident for all other purposes of the Code. In 2008, Congress changed the Code to say that if a green card holder elects income tax treaty benefits for a nonresident, then he ceases to be a US resident.

Phil’s conclusion was that the Code controls: The green card holder who elects treaty benefits is a nonresident alien for all purposes of the Code. In that post, Phil discussed whether the treaty election affects Form 5472 filing requirements. Today, let us look at this question in a context that is somewhat more financially impactful.

Our hypothetical

Let us look at this hypothetical situation (which is not all that hypothetical):

A husband, wife, and their child are Chinese nationals from mainland China.

They family were admitted to the US on a EB-5 visa and became green card holders. The wife and child moved to California for the child’s high school and university education. The husband remained in China to run the family business after getting his green card. He makes occasional visits to the US on the green card but generally lives in China.

The husband and wife did not enter into any marital agreements. The couple started a company in 2000 in mainland China, of which each owned 50% of the shares. The company does business in China has accumulated significant profits which were not distributed or deemed distributed under US tax law before and after the couple became green card holders.

All family held their green cards at the end of 2017.

Let us assume that if the husband were to determine his residence under the China-US income tax treaty, then the treaty would assign his residence to China. There are some procedural issues with the China-US treaty that this post will not discuss. For now, let us assume that were he to make the treaty election, he would be able to do so successfully and survive an IRS challenge.

Deemed repatriation under section 965 and GILTI

In December of 2017, Congress passed laws that changed the US taxation of foreign income significantly.

One of these changes is the new section 965. There are many nuances to section 965, but the general idea is that “United States shareholders” of “deferred foreign income corporations” have income equal to the “accumulated post-1986 deferred foreign income” of the corporation. For most, the extra income is for 2017, though some shareholders of fiscal year corporations have the extra income in 2018.

Another change is GILTI. GILTI is under section 951A. It shares similar concepts as section 965: Each “United States shareholder” of any “controlled foreign corporation” must include his share of the CFC’s GILTI in his income annually. GILTI starts applying in 2018.

I put several terms in quotation marks, because they are defined terms under the Code. For example, if you are not a “United States shareholder” under the Code, then you do not have deemed income under section 965 or GILTI.

Deferred foreign income corporation

United States shareholders of deferred foreign income corporations have deemed income under section 965.

A deferred foreign income corporation is a “specified foreign corporation” which has accumulated post-1986 deferred foreign income. IRC §965(d)(1). We assumed that there is accumulated post-1986 deferred foreign income for this company, though it is good to check for each company. IRC §965(d).

That leaves us with the question of whether it is a specified foreign corporation.

A specified foreign corporation includes any “controlled foreign corporation” and “any foreign corporation with respect to which one or more domestic corporation is a United States shareholder”. IRC §965(e)(1). In our example, the Chinese company does not have any direct shareholders that are US corporations, and there are no US corporations that are related to the Chinese company. This means we need only worry about whether it is a controlled foreign corporation (CFC).

Controlled foreign corporation

In our scenario, section 965 and GILTI only create tax issues if the Chinese company is a “controlled foreign corporation” (CFC). This is what CFC means (IRC §957(a)):

For purposes of this title, the term “controlled foreign corporation” means any foreign corporation if more than 50 percent of–

(1) the total combined voting power of all classes of stock of such corporation entitled to vote, or

(2) the total value of the stock of such corporation,

is owned (within the meaning of section 958(a)), or is considered as owned by applying the rules of ownership of section 958(b), by United States shareholders on any day during the taxable year of such foreign corporation.

Again, we see the term “United States shareholder”. If United States shareholders together own more than 50% of the shares of a foreign corporation, then it is a CFC. We will need to see what this term means to determine the tax results.

United States shareholder

A “United States shareholder” of a foreign corporation is

[A] United States person (as defined in section 957(c)) who owns (within the meaning of section 958(a)), or is considered as owning by applying the rules of ownership of section 958(b), 10 percent or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation, or 10 percent or more of the total value of shares of all classes of stock of such foreign corporation. IRC §951(b).

The husband owns 50% of the shares, and the wife owns 50% of the shares. Both satisfy the percentage ownership. The only question is whether they are “United States persons”.

A United States person has the same meaning as the general definition under section 7701(a)(30). IRC §957(c). This means US citizens, US residents, domestic partnerships, domestic corporations, domestic estates, and domestic trusts. IRC §7701(a)(30). The individuals in our hypothetical are not US citizens, partnerships, corporations, estates, or trusts, but they might be US residents.

Who are US residents?

US residents include lawful permanent residents, aliens who satisfy a substantial presence test (counting days in the US over a 3 year period), and aliens who make a first year election. IRC §7701(b)(1)(A).

Our hypothetical deals with green card holders. We will focus on the lawful permanent resident test, otherwise known as the green card test.

The wife, who lives in the US and makes no treaty elections, clearly is a US resident. She is a US shareholder of the Chinese company.

But what about the husband? Referring back to Phil’s post: Under the 1990s regulations, the husband is a US resident who calculates his tax as a nonresident alien, but he remains a resident for any other purpose of the Code. He remains a US shareholder of the Chinese company. Under the 2008 Code, he is a nonresident alien, so he is not a US shareholder of the Chinese company.

Let us look at the tax implications of these contradictory conclusions.

The 2 tax implications

Suppose the regulation is right: The husband is a US resident who merely calculates his taxes as a nornesident alien.

This means he is a United States shareholder. This means the Chinese company is 100% owned by US shareholders. It is a CFC. This means the wife must take into account her share of the company post-1986 deferred foreign income at the end of 2017. Then, she must take into account half the company’s GILTI each year starting in 2018.

Now, suppose we go by the text of the Code: The husband is a nonresident alien.

This means he is not a United States shareholder. This means there is only 1 United States shareholder: the wife. A nonresident alien’s shares are not attributed to a US citizen or resident under family attribution rules. IRC §958(b)(1). This means United States shareholders own only 50% of the company. This means the company is not a CFC. The wife does not need to take into account any income under section 965 or GILTI.

Pretty significant difference, no?

Before the tax law changes, the most common approach I have seen to the question of “is the green card holder who makes the treaty election a resident for all purposes other than calculating his tax liability” is: “Better safe than sorry. Assume that the husband remains a US resident”. Under the old rules, this meant higher professional fees for filing information returns, but it did not create additional taxes. The penalties for failure to file information forms often were higher than the professional fees

Now, with potentially a lot more taxes on the line, perhaps it is a good idea to take a closer look at the other position.

Be careful about community property

Mainland China and California both are community of acquisitions jurisdictions. This means property acquired after marriage automatically is owned 50-50 between the spouses, regardless of who is the nominal owner.

When community property is the default rule of a jurisdiction, US income respects community property rules. Poe vs Seaborn, 282 US 101 (1930). This means the same problem potentially applies even if the husband were the 100% owner (by title) of the shares.

Only for green card holders

The treaty election issue is for green card holders only. It does not apply to substantial presence residents who make the treaty election, because nowhere in the Code does it say that a substantial presence resident who makes a treaty election ceases to be treated as a US resident. If the husband were a US resident under the substantial presence test, then even with the treaty election, he would remain a United States shareholder.