In all the hoopla over the US corporate tax cuts, introduced late in 2017, a change to the way the US Treasury views income earned offshore went almost unnoticed in the world of private clients.
But for American citizens operating businesses in Australia, or Australian companies with a large individual US shareholder, the bite is about to be felt.
The key lies in a sweeping extension of the US tax jurisdiction, which has traditionally covered only the non-business income of corporations owned by US “persons” on an ongoing basis.
In simple terms, any person who is a US citizen is taxed by the US forever, whether they live in the US or not.
People now resident in Australia suddenly discover they need to deal with the problem of being taxed in two countries, either by unwinding or creating structures or dealing with their affairs in a way that means they don’t get double taxed. Frequently, smaller private clients are largely unaware of the vast complexity of the situation they are in.
There are good reasons why the US wants to ensure tax it is owed is collected.
Many of its multinationals operate and generate revenue largely within the nation’s physical borders but have structured their affairs so they are taxed somewhere else.
One way they do this is by holding intangible assets, such as software patents or intellectual property, abroad in low-tax countries.
Part of Trump’s tax cut package included a charge for “global intangible low-taxed income”, known as GILTI for short, which amongst other changes imposes an effective 10.5 per cent tax rate on this income for US domestic corporations.
It was a bid to limit the option for companies like Apple or Google to move IP to areas where corporations pay low tax, and bring at least some of that income back into the US tax net.
But the devil for US citizens lies in GILTI’s detail.
In making the change, the US Congress did not only target international corporations, but also managed to capture the activities of individual taxpayers operating businesses outside the US.
GILTI doesn’t apply just to big companies but to any company overseas in which US citizens have a controlling interest — a controlled foreign corporation, or CFC, as defined by the US.
So, if you are a US person living in Australia, and you set up a company and start running a business, these rules will apply to you.
Your tax exposure then comes down to how the US defines intangible income, and a good example might be to consider a coffee shop.
If a US person comes to Australia, starts a company and opens up a coffee shop, they might spend $100,000 on equipment, furniture, tables and chairs, before they ever open their doors or serve a latte.
The US laws then look at the income and consider what a fair return might be for the company’s investment in assets.
If the coffee shop made $10,000, for example, the US might say the 10 per cent profit can be attributed to a fair return on the physical assets.
But if it made $20,000, the additional $10,000 in profit would now be seen as income from “intangibles”.
In a practical light this is fiction — it is the same return for effort — but under GILTI, the income judged to be intangible now falls into a special tax category.
The first problem is the owner of the company will now be taxed as if they earned that money directly as an individual, rather than through the company.
The second problem is that, by default, there is also no credit for any tax paid in Australia.
Returning to the coffee shop example, the company might have paid 27.5 per cent tax in Australia on the profit from the business, but the US owner will still have to pay individual tax on the full profits to the US Treasury.
If there is no credit from the US for the tax paid in Australia, then the business will have a genuine double tax problem, because there will certainly be no credit from Australian authorities for tax paid in the US.
In the absence of any planning, the US owner could end up with a 70 per cent tax hit on ordinary income from running a business in Australia.
The changes were introduced in 2017 but only took effect for the 2018 tax year. In other words, the effects are just starting to be felt as 2018 returns are filed over the next few months.
Some good news was finally announced in March this year, as US Treasury confirmed the availability of election to mitigate the effects of the GILTI charge. The section 962 election is designed to ensure that an individual doesn’t pay more tax on earnings of a CFC, than if that corporation was domiciled in the US.
But US taxpayers need to act quickly to ensure the election is made in a timely fashion, and need to be aware of exactly how the election and the new rules apply to them.
Corporations may already be well versed in the new rules, but many individuals and small business owners may not have the resources to stay at the forefront of these technical changes.
Overlooking the planning options could be an expensive mistake to make, and GILTI could even become a disincentive for US citizens to invest outside their borders — which is in part the point of the legislation in the first place.
The takeaway for American citizens — or Australian companies in which a US citizen holds a substantial stake — is that the US Treasury has increased the scope of the activity it considers taxable and is not likely to back down.
It’s time to look at your exposure and take steps so you aren’t left holding the bill.