A little more than three weeks have passed since the US tax reform bill came into force, on 1 January. Much has been written about it since then, mainly focusing on its treatment of corporations, particularly US entities with overseas operations.
At their Old Bailey offices in London (pictured above), the partners and associates of the Withers law firm, which specialises in advising high-net-worth clients on their tax matters, have been studying the so-called Tax Cuts and Jobs Act (TCJA) in some detail to determine how it is likely to affect their expat American clients and, in some cases, non-American clients who have US interests.
Below, two of Withers’s London tax experts, partners Richard Cassell and Jaime McLemore (both pictured below), share some of their thoughts about the new US tax regime, and its main takeaways for American expatriates and their advisers.
For Americans resident in European countries with relatively high income taxes, the benefit of changes to the US income tax rate will be limited, except for those individuals who are not subject to worldwide tax in their country of residence.
For example, Americans living in the UK who are opting to be taxed under the non-domicile remittance basis (now only available for the first 15 years of UK residence); Americans residents in Italy, who are taking advantage of that country’s new non-domiciliary regime; and Switzerland-resident Americans who enjoy a so-called “forfait agreement” will all now be able to benefit from the lower rates of US income tax, and higher standard deduction.
(Under the forfait, or “lump sum” system, foreign citizens residing in Switzerland who aren’t employed there have the option of being taxed according to their living expenses. Employment elsewhere is okay, as long as Switzerland remains the individual’s official place of tax residence.)
It’s worth noting that all of the individual tax changes being brought in under the tax reform bill will expire on 31 December 2025. This means that on that date, the tax rules will revert to the previous legislation, subject to the future administration’s approach to taxation as of that date.
New and updated deductions
Most Europe-resident Americans will not be affected by the new (and in some states, such as New York, controversial) limitation on the permissible deduction allowed for state and local taxes.
Many, though, may well be affected by a new limitation on the mortgage interest deduction they’re allowed to take, which is now limited to interest on a maximum of US$750,000 principal, down from US$1m, for any mortgage debt incurred after 15th December 2017; and it is eliminated altogether for home equity lines of credit.
Under the TCJA, itemised deductions are generally eliminated, in fact, except for charitable contributions. That said, many expatriate Americans will have found that other itemised deductions were of little practical use anyway. The standard deduction, meanwhile, has been increased to US$24,000, from US$12,000.
A new “pass-through” deduction for partnership, LLC and S corporation income will be of limited utility to many expatriate Americans. That’s because this is limited to US business income where the business has a significant wage bill or qualified capital assets. It won’t apply to non-US businesses, but it will be available for US and non-US investors in US real estate, including REIT (real estate investment trust) investments.
(This, then, complements the reduced corporate income tax rate for US real estate investors using a corporate structure.)
Foreign tax credit baskets change
An item that has attracted relatively little attention, meanwhile, but which will affect self-employed expatriate Americans, relates to the change in the foreign tax credit baskets.
Under the new US tax regime, there are now two new foreign tax credit baskets, one for 10% shareholders of US-owned foreign companies, and – more significantly for some expatriates – a new “foreign branch basket”.
Here, a foreign branch of a business is defined as meaning “any foreign business which broadly keeps separate books and records”, so it is a fairly broad definition, and there is no requirement for it to be a branch of any other business.
Therefore, a partner in a partnership in the UK or elsewhere would, from 2018 or 2019 (depending on the relevant fiscal year), find that the partnership income is now in a new basket.
It is worth noting that Congress has not, at least thus far, provided any transition relief for carry forward foreign tax credits, which will now be in a different basket from the income going forward.
Potentially this could lead to a significant economic loss to foreign-resident US taxpayers, but we think it is possible that the Internal Revenue Service will yet offer transition relief.
US inbound investment structures
With the cut in the corporate income tax rate to 21% and the elimination of the corporate alternative minimum tax, meanwhile, expat American investors may wish to look at their US inbound investment structures, to review whether a corporate structure there would result in a preferable tax result.
In particular, US real estate investors have regularly used pass through structures in order to avoid the high rate of corporate income tax and branch profits tax, but the corollary of this has usually been to accept a US estate tax risk.
Now, though, investing through a corporate structure should be able to achieve a 21% tax rate on gains and income, with a more secure estate tax protection.
However, our preliminary analysis shows that a leveraged US real estate investment may still achieve a rate advantage using a pass through structure.
In any event, investors will want to review many of their business structures in light of the very significant rate changes, ideally with the help of someone who is up to speed on them.
Withholding tax on partnership interest sale
Another area we believe some expatriate Americans will also need to consider, as they prepare to structure their finances and file their taxes going forward, is a new withholding tax that now applies to “non-resident aliens” on the sale of any interest in a non-US partnership which is actively engaged in a US business.
This is because the purchaser is now required to withhold 10% of the proceeds of the sale, on account of the selling partner’s income tax liability. This is similar to the real estate withholding, and like it, its effects can be modified by a certificate obtained in advance.
Controlled foreign corporation tax rules
Americans who lives outside of the US and who are invested in non-US corporate structures, meanwhile, will need to review the changes in the controlled foreign corporation (CFC) tax rules, since the Tax Cuts and Jobs Act introduces a number of changes which increase the risk of qualifying for CFC status.
Essentially, certain technical changes that have been made to the attribution rules will have the effect of increasing the risk that corporate ownership of CFC stock will be attributed to a US shareholder.
In addition, where the former tax code allowed a 30-day grace period in which CFC status was ignored, this has now been repealed, so that inadvertent CFC status, as a result of a change in status during a year, is increased.
What’s more, this also affects a popular planning strategy which has, until now, often been adopted for ownership of US assets through a company, which checks the box immediately after estate tax protection is triggered.
Owners of a CFC with accumulated earnings may now find those earnings taxed in 2017, under the repatriation rules.
Fund principals will be pleased that the favourable treatment of carried interest, as long term capital gain, has been preserved, in spite of some talk of eliminating it, although the holding period has been increased to three years from one year.
In practice we do not think that this will impact many expatriate fund principals.
Estate and gift tax
The big change here is the large increase in the exempt amount (referred to as the “unified credit amount”), which increases from an inflation-adjusted US$5m under the old tax regime to an inflation-adjusted US$10m under the Tax Cuts and Jobs Act. This means that the effective exempt amount that one is able to give as a gift, before the US based donor is required to pay gift tax, is approximately US$11m per person, or US$22m for a married couple.
Like all the individual tax provisions, the increased estate and gift tax exemption is time-limited, and is scheduled to expire in 2025, unless Congress acts to extend it.
There have been statements made in Congress that legislators there hope to extend these provisions, but similar intentions were expressed about this exemption in 2003, and those rate changes and exemptions were not, in fact, extended, although Congress did act subsequently to modify the exemption and increase it to the US$5m that was in force until the Trump administration tax reforms took effect.
Potential for claw-back
Finally, there’s one question that has been raised by a number of commentators: whether there would be any potential for claw-back, if a US person, regardless of residence, made lifetime gifts of US$11m, and then died after the exemption reduced back to US$5m.
The issue in question in such an instance would be, what would happen if a future US administration were to bring the gift tax exemption down from US$11m to US$5m again – would people and estates be required to pay the $6m difference for gifts given under the current rules?
Based on the position in 2011, we would anticipate that no claw-back would be possible, but the IRS has been directed to provide guidance.
This offers a big incentive for Americans to ensure that the exemption amount is used to the greatest extent possible through their lifetime gifts allowance – for example, to younger relatives, as desired.
For UK-resident Americans, these gifts can be made in trust if the donor is not UK-domiciled at the time of the trust creation, or by way of outright gifts (or gifts using a partnership structure) if the donor is UK domiciled.
Without lifetime gifts, the donor risks losing the benefit of the greatly increased exemption amount, which is a temporary opportunity.
Founded in 1896, Withers LLP is headquartered in London, and has offices there as well as in New York, NY; Greenwich and New Haven Connecticut; San Francisco, San Diego, Los Angeles and Rancho Santa Fe, California; Geneva and Zurich, Switzerland; Milan and Padua, Italy; Hong Kong; Singapore; Tokyo; the British Virgin Islands; and Melbourne and Sydney, Australia. It specialises in tax, trust and estate planning, as well as litigation, employment and family law.
American expatriates automatically enjoy a two-month extension on the tax-filing deadline for Stateside Americans, which this year is 17 April. However, even if a taxpayer is eligible for this extension because they live abroad, they are still required to pay interest on any tax not paid by the normal due date, if they end up owing any tax.