Loan from Foreign Subsidiary
This article is the first in a series that will address common fact patterns involving international business operations that can result in unforeseen, adverse U.S. tax consequences. We welcome Richard Shapland, Partner, International Tax Services, of Virchow Krause & Company, LLP as a guest author in this series.
Below are two possible scenarios and the resulting tax consequences associated with each:
- U.S. taxpayer ("USCo") is a U.S. “C” corporation which owns 100% of a one foreign subsidiary ("FSub"), incorporated in country F.
- FSub’s sole business activity is the manufacture of widgets in country F using components purchased from unrelated parties and resale of the finished widgets directly to unrelated parties.
- FSub is highly profitable and country F is a low tax jurisdiction (compared to the U.S.)
- FSub does not repatriate its after-tax earnings to USCo but retains the earnings in order to and expand its business operations.
- USCo pays U.S. tax annually on its worldwide income, except for the undistributed earnings of FSub. FSub’s earnings are deferred from U.S. taxation until such time that they are repatriated in the form of a dividend or other inclusion event.
- FSub pays income tax in country F on its earnings.
SLIGHT CHANGE IN THE FACTS
- Suppose that FSub does not need all the funds generated by its earnings and therefore, has a surplus of cash.
- USCo would like to access those funds for its working capital requirements but does not want to recognize dividend income from FSub.
- FSub loans the funds to USCo in exchange for an interest-bearing note.
UNFORTUNATE TAX CONSEQUENCES
- U.S. tax law requires that the loan from FSub to USCo be treated as "constructive dividend" income to USCo (commonly referred to as an investment in U.S. property).
- The amount of the constructive dividend income is effectively equal to the amount of the loan to USCo.
- A “deemed paid” foreign tax credit for the F income taxes associated with the constructive dividend would be allowed to offset USCo’s U.S. income tax on the dividend income, but since F is a low tax jurisdiction, the credit would be negligible.
- NOTE - The same rules would apply if FSub guaranteed, or pledged its assets as security for a loan taken by USCo, instead of making a direct loan.
We welcome the opportunity to discuss these scenarios or to tax-efficient repatriation strategies and international tax planning with you in more detail.
Under U.S. Treasury Department guidelines, we hereby inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used by you for the purpose of avoiding penalties that may be imposed on you by the Internal Revenue Service, or for the purpose of promoting, marketing or recommending to another party any transaction or matter addressed within this tax advice. Further, RubinBrown LLP imposes no limitation on any recipient of this tax advice on the disclosure of the tax treatment or tax strategies or tax structuring described herein.
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