Foreign Disregarded Entity Election
One strategy available to owners of a Controlled Foreign Corporations to avoid dealing with the CFC rules, including the Global Intangible Low Taxed Income (GILTI) regime, is to make a “check the box” election to treat the corporation as “disregarded”. If there is only one owner, the shareholder is treated as self-employed. If there are multiple owners, it is treated as a foreign partnership.
This means that income earned is therefore reported in the year that it is earned by the corporation, rather than when it is distributed to shareholders. The owner or partners have ordinary income rather than dividends and/or wages.
Since the introduction of the GILTI regime, and the increasing complexity of the Form 5471 used to report Controlled Foreign Corporations, making the Foreign Disregarded Entity (FDE) election is becoming a more attractive option to many US persons.
Making the FDE election has the advantage of giving a much greater degree of flexibility when it comes to the application of foreign tax credits. With GILTI and the Section 962 election, only corporation taxes paid by the entity are allowable as a credit against the potential GILTI income. When making the FDE election, both the corporation taxes and the personal taxes paid on distributions are allowable as a credit. The reporting for a single member FDE is also more simple and less costly than dealing with a Form 5471 and GILTI income.
When reporting a foreign disregarded entity, a separate basket of foreign tax credits is used. This Foreign Branch Income (FBI) basket functions in much the same way as the other foreign tax credit baskets, in that credits can be carried back one year and carried forward up to ten years. This can be particularly useful in years where no foreign corporation taxes are due because of losses carried forward from previous years; but it means that the General Limitation basket credits that a taxpayer may already have cannot be used against the FBI income.
There are other important factors which need to be carefully considered before opting to make an FDE election. Firstly, if the election is made after the initial date of incorporation, the shareholders are treated as if they sold their shares on the date that the election is effective. In the case of a company with pre-existing retained earnings (and goodwill value), generally these earnings would be considered as distributed to shareholders on that day. If a sufficient quantity of the right type of foreign tax credits are not available there is potential for a one-off US tax liability.
Secondly, in the case of a foreign corporation which is not making sufficient distributions on a yearly basis and is instead continuing to retain substantial earnings within the company, there is potential for double taxation in that earnings may incur a US liability when income is earned by the company (if the taxpayers US average tax rate exceeds the foreign rate of corporation tax), and then again in the foreign jurisdiction when this income is eventually distributed. Therefore the FDE election is generally only recommended when income is being regularly distributed from a foreign corporation at a level such that the foreign corporation taxes, plus the personal taxes due on dividends, exceeds the US tax due on the earnings of the foreign corporation. Ultimately, it eliminates any ability to use the entity to "defer" income from the US tax system (though most of the CFC rules are designed to limit the ability to do this anyway).
In all cases you should contact your tax advisor in the first instance when considering making such an election.
This means that income earned is therefore reported in the year that it is earned by the corporation, rather than when it is distributed to shareholders. The owner or partners have ordinary income rather than dividends and/or wages.
Since the introduction of the GILTI regime, and the increasing complexity of the Form 5471 used to report Controlled Foreign Corporations, making the Foreign Disregarded Entity (FDE) election is becoming a more attractive option to many US persons.
Making the FDE election has the advantage of giving a much greater degree of flexibility when it comes to the application of foreign tax credits. With GILTI and the Section 962 election, only corporation taxes paid by the entity are allowable as a credit against the potential GILTI income. When making the FDE election, both the corporation taxes and the personal taxes paid on distributions are allowable as a credit. The reporting for a single member FDE is also more simple and less costly than dealing with a Form 5471 and GILTI income.
When reporting a foreign disregarded entity, a separate basket of foreign tax credits is used. This Foreign Branch Income (FBI) basket functions in much the same way as the other foreign tax credit baskets, in that credits can be carried back one year and carried forward up to ten years. This can be particularly useful in years where no foreign corporation taxes are due because of losses carried forward from previous years; but it means that the General Limitation basket credits that a taxpayer may already have cannot be used against the FBI income.
There are other important factors which need to be carefully considered before opting to make an FDE election. Firstly, if the election is made after the initial date of incorporation, the shareholders are treated as if they sold their shares on the date that the election is effective. In the case of a company with pre-existing retained earnings (and goodwill value), generally these earnings would be considered as distributed to shareholders on that day. If a sufficient quantity of the right type of foreign tax credits are not available there is potential for a one-off US tax liability.
Secondly, in the case of a foreign corporation which is not making sufficient distributions on a yearly basis and is instead continuing to retain substantial earnings within the company, there is potential for double taxation in that earnings may incur a US liability when income is earned by the company (if the taxpayers US average tax rate exceeds the foreign rate of corporation tax), and then again in the foreign jurisdiction when this income is eventually distributed. Therefore the FDE election is generally only recommended when income is being regularly distributed from a foreign corporation at a level such that the foreign corporation taxes, plus the personal taxes due on dividends, exceeds the US tax due on the earnings of the foreign corporation. Ultimately, it eliminates any ability to use the entity to "defer" income from the US tax system (though most of the CFC rules are designed to limit the ability to do this anyway).
In all cases you should contact your tax advisor in the first instance when considering making such an election.
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