U.S. corporations that own foreign subsidiaries have been utilizing certain repatriation planning opportunities in connection with the formation of foreign holding companies.
The formation of a foreign holding company can accomplish a number of business objectives (including centralized management of foreign operations, facilitation of the movement of cash among foreign subsidiaries as well as possible foreign tax savings). If structured properly, a foreign holding company can also put a U.S. corporation in a position to repatriate cash back to the U.S. in a tax-efficient manner.
The U.S. generally does not tax the earnings of a foreign subsidiary that are derived from an active trade or business outside the U.S. until such earnings are repatriated back to the U.S. in the form of a taxable dividend. The following planning opportunity has allowed taxpayers to repatriate cash back to the U.S. in the form of a tax-free return of capital.
Step 1: A U.S. corporation with foreign subsidiaries sets up a new holding company in a foreign jurisdiction that has a favorable treaty network (preferably in a jurisdiction where one of the foreign subsidiaries has business operations).
Step 2: The U.S. corporation contributes its foreign subsidiaries to the newly formed foreign holding company in a transaction that is intended to qualify as a tax-free exchange under Section 351 of the U.S. Internal Revenue Code. The newly formed holding foreign company is referred to as a “basis collector” by some tax practitioners.
Step 3: Several years later, the foreign holding company can make a decision to borrow from a 3rd party and distribute cash to its U.S. shareholder corporation. Alternatively, the new foreign holding company can chose to issue and distribute its own note payable to its U.S. shareholder corporation. The distribution is commonly referred to a "leveraged distribution."
The distribution of cash (or, alternatively, the note) should not qualify as a taxable dividend to the U.S. shareholder corporation to the extent that the foreign holding company does not have any current or accumulated earnings and profits (“E&P”) for U.S. federal income tax purposes in the year of distribution. Instead, the distribution should be treated as a tax-free return of capital to the extent that the amount of the distribution does not exceed the U.S. shareholder’s tax basis in the stock of the foreign holding company.
Step 4: In the following tax year, the foreign subsidiaries that have earnings from operations can distribute cash to the foreign holding company and the foreign holding company can repay its debt owed to the 3rd party lender. Alternatively, the foreign holding company can repay its debt owed to the U.S. shareholder. The repayment of principal on the debt is generally not a taxable event for U.S. federal income tax purposes.
The foregoing transaction has allowed for the active earnings of the foreign subsidiaries to escape taxation in the U.S. in an amount equal to the principal amount of the note payable that is issued by the foreign holding company.
While this planning opportunity appears to be relatively straightforward, it can be a trap for the unwary as there are a number of important things to consider.
A taxpayer will need to monitor potential changes in U.S. and foreign tax laws prior to implementation of the foreign holding company and prior to a possible leveraged distribution as tax laws are subject to change. It should also be noted that other tax-efficient repatriation planning may be more appropriate depending upon the tax profile of your company.
Information contained in this article is not intended as legal or tax advice to any person. All readers must rely on their own legal and tax advisors. If you have any questions regarding this topic or repatriation in general, please contact John Buckun at 312-476-7515.