Introduction – The war against corporations and the shareholders of those corporations
Corporations as entities that are separate from their shareholder/owners
As every law students knows, a corporation is a legal entity that is separate from its owner. As a legal entity that is separate from its owner, a corporation is capable of holding assets, carrying on a business and investing in a way that results in separation of the shareholder(s) from the business itself. It is a mistake to infer that the corporation’s status as a separate legal entity means that the corporation’s income will not be taxed to its shareholders.
Corporations as legal instruments of tax deferral
When corporate tax rates are lower than individual tax rates, there is incentive for individuals to earn and invest through corporations rather than to earn and invest as individuals. In other words, in certain circumstances, corporations can be used to pay less taxes.
Corporations as instruments of tax evasion
In many jurisdictions is it possible to create a Corporation and NOT disclose the identities of the beneficial owners. Because of this circumstance:
1. Corporations (as was made clear in the “Panama Papers Story”) can be used to hide income and assets for either legitimate or illegitimate reasons; and
2. Corporations can be used to avoid the attribution of income earned by the corporation to the shareholders.
Corporations and the rise of @TaxHavenUSA
Interestingly, the combination of FATCA (the USA demands information from other countries) and the unwillingness of the USA to join the CRS (meaning that it will NOT exchange information with countries) has made the United States one of the top tax havens in the world.
Corporations and FATCA
— Citizenship Lawyer (@ExpatriationLaw) July 29, 2017
As described in “The Little Red FATCA Book“, the United States is forcing other nations to report on any and all corporations owned by “U.S. Persons”.
Corporations as the original “tax shelter”?
Excellent background on deferral and why Trudeau Gov is proposing a 73% tax on investment income earned inside a Cdn Controlled Private Corp https://t.co/yWocBk43WV
— Citizenship Lawyer (@ExpatriationLaw) August 5, 2017
The article referenced in the above tweet offers history lesson that includes:
Believe it or not, corporations were the original tax shelter. This statement may sound insane, but it’s true. For a long time, individual income tax rates were substantially higher than corporate income tax rates, and since corporations are viewed as separate and distinct entities for U.S. federal income tax purposes (and taxed accordingly), this disconformity in the tax rates resulted in what is essentially tax arbitrage, whereby taxpayers would use corporations as a tax-planning tool to minimize their tax liabilities.
Most often, this manifested itself in the form of taxpayers contributing assets (e.g., stocks, bonds, real estate, etc.) to corporations that generated various types of passive income, such as interest, dividends, capital gains, rents, royalties, etc. Again, this sounds insane by modern-day standards, because in today’s world any tax advisor worth his salt will tell you that placing assets, appreciated or otherwise, that generate passive income into a corporation is almost never a good idea, specifically because any income or gains realized will be subject to two levels of taxation. As Bittker and Eustice so eloquently put it, “a corporation is like a lobster pot: easy to enter, difficult to live in, and painful to get out of.”
But back in 1934, when the PHC rules were enacted, this is exactly what taxpayers were doing, specifically because the income and gains realized from the contributed assets were taxed at a substantially reduced rate, allowing the income to compound more quickly inside the corporation and greatly increasing the rate of return on such assets. Individual taxpayers were then able to delay the day of reckoning because they would be taxed on the income that had built up inside the corporations only when such corporations either liquidated or paid a dividend, or when they sold their stock, the timing of any of which was very much under the control of such shareholders.
Congress viewed this result as unacceptable because, in its opinion, taxpayers were using corporations to improperly obtain a deferral of tax. It could have easily solved this problem by equalizing the tax rates between individuals and corporations (which it did eventually, sort of, although it took almost a century). But, never being one to take the easy walking trail when the arduous, rockslide-prone mountain pass would just as well suffice, Congress instead chose to enact two complicated mechanisms, the accumulated earnings tax (AET) and the PHC rules, which, while different in their application, had the same ultimate goal: to incentivize corporations to pay dividends to their shareholders on a current basis by penalizing them for not doing so. The AET and the PHC rules are discussed further below.
(Note that in Canada and many other countries, individual tax rates are far higher than corporate tax rates.)
Government responses to prevent the use of corporations to reduce and defer taxes
5 sections of the IRS tax code aimed at attacking tax deferral that cause the most problems for taxpayers – https://t.co/1JSwLVUtOA
— Citizenship Lawyer (@ExpatriationLaw) August 5, 2017
Corporations provide the opportunity to pay lower taxes and defer taxes in two distinct ways:
First, assets owned and income earned by the corporation is NOT earned by the individual. In general income earned by the corporation will not be attributed to the individual.
Second, corporate tax rates may be lower than individual rates. Given that income must be taxed, why not arrange for it to be taxed at the lower rate?
Governments typically attack taxpayer attempts to use corporations to minimize taxes in two ways:
1. The Government imposes penalties directly on the corporations (U.S. PHC – Personal Holding Company tax, etc.)
(See for subchapter G of the U.S. Internal Revenue Code.)
26 U.S. Code Subchapter G – Corporations Used to Avoid Income Tax on Shareholders
PART I – CORPORATIONS IMPROPERLY ACCUMULATING SURPLUS (§§ 531 to 537)
PART II – PERSONAL HOLDING COMPANIES (§§ 541 to 547)
PART III – REPEALED] (§ 551..)
PART IV – DEDUCTION FOR DIVIDENDS PAID (§§ 561 to 565)
Note that a Government must have jurisdiction over the corporation in order to regulate the corporation. The Personal Holding Tax “PHC” is a tax imposed directly on the corporation and NOT directly on the shareholders.
2. The U.S. Government imposes penalties directly on the shareholders (U.S. Subpart F, PFIC, etc.)
These penalties can be in the “form” (you know what is coming) of either “tax penalties” or “reporting penalties”.
Tax Penalties – Subpart F, PFIC, etc.
- See the CFC and Subpart F rules found in subchapter N of the Internal Revenue Code.
26 U.S. Code Subchapter N – Tax Based on Income From Sources Within or Without the United States
26 U.S. Code Part III – INCOME FROM SOURCES WITHOUT THE UNITED STATES
SUBPART F – Controlled Foreign Corporations (§§ 951 to 965)
2. See the PFIC rules in found in subchapter P of the Internal Revenue Code.
26 U.S. Code Part VI – TREATMENT OF CERTAIN PASSIVE FOREIGN INVESTMENT COMPANIES
Note that the CFC and PFIC rules are attempts to punish the use of “foreign corporations”. The U.S. does NOT have tax or regulatory jurisdiction over “foreign corporations”. As a result, the CFC and PFIC penalties are levied on the U.S. shareholders of those corporations.
Reporting penalties – Form 5471, Form 926, Form 8621, etc.
As Donald Dewees, a U.S. citizen residing in Canada learned, the United States will impose very strict penalties for failing to disclose ownership in Canadian Controlled Private Corporations. (You can learn more about this here and here.)
CFC rules in other countries
As described here, many countries have rules which prevent their “tax residents” from using foreign corporations to avoid taxation. Interestingly the U.S. CFC rules were enacted at the same time that Britain enacted its equivalent CFC rules. Russia has (in addition to its “citizenship reporting rules“) Canada (a particularly efficient tax collector) also (who could have known?) has it’s CFC rules. Canada’s robust set of CFC rules is described (in part) as follows:
Canada currently has a robust set of CFC rules. The “foreign accrual property income” or “FAPI” rules are a broad set of anti-deferral rules applicable to passive income earned by a “controlled foreign affiliate” of a Canadian taxpayer. Passive income for this purpose very generally includes income from property (such as rents, royalties, interest and non-foreign affiliate dividends) and income from certain businesses that either have a link to Canada or do not meet certain minimum employee and other requirements. FAPI does not include income from an active business carried on by a foreign affiliate. A Canadian shareholder is generally required to include, in its income for a taxation year, its share of any FAPI earned by any of its controlled foreign affiliates in such year, regardless of whether or not any amount is distributed by the controlled foreign affiliate to the shareholder. A deduction is available in respect of any foreign taxes attributable to FAPI. If FAPI in a controlled foreign affiliate is less than C$5,000, it is not required to be included in the shareholder’s income. There is no “low-tax threshold” or “high-tax kick out” – the FAPI rules apply even if the controlled foreign affiliate is resident in a country that imposes tax at a rate that is equal to or exceeds the Canadian rate. Generally speaking, if FAPI, which is computed using the rules in the Income Tax Act (Canada) (the ITA) and in the Canadian taxpayer’s functional currency, is subject to foreign tax of at least 25%, no additional tax should be payable in Canada.