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The Impact of Select US Tax Reform Provisions on Australian Superannuation Funds and Its Beneficiaries

The following article is an abridged version of the working draft submitted to the Australian Tax Institute for publication in Taxation in Australia journal.

The Impact of Select US Tax Reform Provisions on Australian Superannuation Funds and Its Beneficiaries

On February 23, 2018, Australian Prime Minister Malcolm Turnbull and President Trump commemorated the first 100 years of mateship between Australia and the United States. The special bond between the two countries originates back to the Battle of Hamel in 1918, when the Australian army and the U.S. army infantry troops with British tanks fought side by side to retake the French village of Hamel in World War I. Under the leadership of Australian General Sir John Monash, the combined offensive was successfully accomplished in 93 minutes, apparently just three minutes over the calculated battle time.

The era of 93-minute battle offensives are long gone. The Trump-Turnbull agenda will clearly take much longer than the battle which gave rise to the special bond between the two countries. And it should, because the future of the U.S.-Australian partnership for the 21st century is at stake with China’s increasing domination of Asia Pacific and the looming threat of Armageddon from the North Korean peninsula. Truly, weighty matters such as national security and trade were a major topic in the mateship festivities last week.[1] However, what was conspicuously absent from the agenda is the topic of taxes, in particular, the U.S.-Australia Tax Treaty (the “Tax Treaty”) [2] which is in dire need of updating since it first came into force 45 years ago.

As U.S. tax lawyers and U.S. expats ourselves, we cannot fathom how tax has evaded the list of important items on the agenda given the ongoing advocacy by U.S. expats in Australia to fix the Tax Treaty. In just the past decade, American migration to Australia has increased exponentially, making Australia now home to the sixth largest American population in the world.[3] Indeed, Australia is the only country in the world with upside down immigration numbers when it comes to the United States. There are more Americans living in Australia than Australians living in the United States.[4]  

In its current state, the Tax Treaty fails to address and remedy the ongoing double taxation of Australian superannuation funds (“Supers”), which has legislative mandate[5] to provide privatized national social security for Australians in their retirement years.  There is no apparent reference in the Tax Treaty about Supers that would provide any definitive guidance exempting contributions, accrual and distributions from U.S. taxation. Neither Article 18 or Article 19 of the Tax Treaty provide any direction to the Internal Revenue Service (“IRS”) to treat Supers as either foreign pension funds entitled to reciprocal tax treatment in the United States or as state-sponsored privatized foreign social security which would be exempt from U.S. tax altogether. Any attempts to untangle this prevalent ambiguity in the Tax Treaty provisions is often preempted by Article 2(3), which contains the Saving Clause which explicitly reserves the U.S. right to tax its citizens on certain types of income notwithstanding and regardless of the Tax Treaty provisions which may dictate otherwise.[6]

The prospect of having to pay U.S. taxes on Super contributions, accruals and distributions despite the lack of any U.S. connection to the Super whatsoever but for the beneficiary’s U.S. citizenship has soured many U.S. expats to the point where keeping their U.S. citizenship for sentimental reasons can no longer justify the disastrous financial consequences they have suffered (and will likely continue to bear) because of it.  After all, they’ve been through a lot the past few years, spending thousands of dollars to become fully-compliant with their U.S. tax reporting obligations under the Foreign Account Tax Compliance Act (“FATCA”)[7] and Bank Secrecy Act of 1970 as implemented through the Report of Foreign Bank Account and Financial Accounts (“FBAR”).[8] And there is more on the way – just last year, the IRS launched 13 new international tax compliance campaigns that will certainly affect U.S. expats[9] in Australia as well as Australian businesses[10] with U.S. connections.  Those that remain U.S. citizens or green card holders have either  buried their heads in the proverbial sand, opting to lift their heads occasionally to hear only from tax advisors who are willing too eagerly to confirm what they want to hear, rather than saying what needs to be said; or taken up the task of marching down that proverbial yellow brick road like Dorothy in the Land of Oz, in the quest to reason with a feckless wizard  who can make wrongs right (and, if we remember correctly, that story ended with Dorothy’s success coming from helping herself.)

There are other items in the Tax Treaty that need to be addressed of course, and yet, from our perspective, this issue of U.S. taxation of Supers continues unabated and will likely escalate this year with the implementation of the international tax provisions of the U.S. tax reform law, the Tax Cut and Jobs Act of 2017 (the “TCJA”).[11] We note, again, of course, that in this regard, U.S. expats will likely be looking to their Australian financial and tax advisors, who in turn, will look to their U.S. counterparts for definitive guidance on this issue. And this issue is not limited to U.S. expats alone. With Australian Supers as the tax-favoured investment vehicle of choice for many Australian businesses, the TCJA provisions will also affect many Australians that invest in the United States using capital funded by Supers. While everyone is entitled to reach their own conclusion, we would highly recommend channeling their inner Dorothy and taking the opportunity to think for themselves, where these provisions are concerned and not to just accept the tax interpretation of the first U.S. tax advisor who offers an opinion which mirrors exactly what they would like to hear.  And with such a controversial topic as U.S. tax reform this past year, there is clearly no shortage of fake news where its impact on U.S. expats and foreign investments are concerned.

Australian Superannuation Funds

What is it exactly that makes Supers vulnerable to double taxation in the first place?  

The United States is one of the few countries that taxes the worldwide income and estate of its residents, citizens, and foreign persons admitted as permanent residents.[12] Thus, U.S. citizens across the world (“U.S. expats”) are taxed by Uncle Sam on all the income they make, regardless of its currency, location earned, or whether the U.S. citizen has ever set foot on U.S. soil. The consequence of this to the U.S. citizen living abroad is the burden, cost, and headache of meeting annual IRS tax filing and reporting obligations.

For U.S. expats in Australia, the burden of filing and paying U.S. tax on worldwide income is more acute because of the uncertain U.S. tax classification and treatment of Supers under U.S. domestic tax laws and the Tax Treaty. In Australia, Supers enjoy tax-favoured concessional rates on contributions: investment earnings are taxed at preferentially low rates and distributions are generally tax-free.[13] However, a Super falls within the extraterritorial reach of U.S. tax when its owner and beneficiary happens to be a U.S. expat. This is because the concept of privatized social security (which are hybrid pensions) do not exist in the United States.  And to date, neither the U.S. Treasury nor the IRS has provided any definitive guidance on the U.S. tax treatment of Supers in which U.S. expats are members and beneficiaries. The absence of a single definitive approach to the classification, reporting and taxation of Supers for U.S. tax purposes, under the Tax Treaty and U.S. domestic tax laws may give rise to inconsistent U.S. and Australian tax results. 

For U.S. tax purposes, the Super is treated as a fully taxable asset of the U.S. expat such that all contributions and earnings accrued in the Super, as well as distributions from the Super to the U.S. expat would more likely than not be subject to current U.S. taxation, notwithstanding that access to and withdrawals of Super funds are restricted under Australian laws prior to the U.S. expat reaching retirement age.[14]

United States taxation of Supers is a stark departure from the Australian taxation regime, which generally does not treat contributions, accruals, and distributions from a Super as assessable income to its member and beneficiary.  Rather, the Super itself is taxed on amounts contributed to and income that accrues inside the fund. This divergent U.S. and Australian tax treatment of amounts contributed, accrued, and distributed from a Super creates pitfalls and challenges both for U.S. expats who are member beneficiaries of Supers as well as for the Australian financial and tax advisors who advise them.

Impact of the U.S. Tax Cut and Jobs Act

The passage of the TCJA in December 2017 was conspicuously lacking in the proverbial silver bullet that would end worldwide taxation on U.S. expats, much less provide the much-needed clarification on the U.S. tax treatment of Australian superannuation funds and other foreign pension investments. Below we discuss some of the relevant provisions in the TCJA that would likely affect Supers to the extent that these Supers either have (i) member beneficiaries that are U.S. expats, or (ii) engage in trade or business for profit rather than asset preservation in Australia or the United States.

1. One Time Transition Tax

New Code[15] Section 965 imposes a one-time Transition Tax payable by U.S. persons who own a controlled foreign corporation (“CFC”) or at least 10 percent voting stock[16] or value[17] in a foreign corporation[18] (a specified foreign corporation or “SFC”) that is not a passive foreign investment company (“PFIC”). The tax is imposed on the deferred foreign income of such foreign corporation which constitutes aggregate post-1986 earnings and profits (“deferred earnings”) as determined under U.S. tax laws.  The deferred earnings measurement date is the greater of November 2, 2017 or December 31, 2017, depending on which of the two dates produces the higher balance of deferred earnings.  The tax is imposed at different rates –  U.S. corporate shareholders would be subject to a 15.5 percent rate of tax on deferred earnings attributable to cash assets and eight percent rate of tax on non-cash assets.  United States individual shareholders who are subject to the highest marginal tax rate 39.6% of 2017, however, have a higher Transition Tax rate than corporate shareholders, specifically 17.5 percent rate of tax cash assets and nine percent on non-cash.[19]  Every U.S. person abroad who falls under Code Section 965 provisions will have to pay this one-time Transition Tax either in a lump-sum or in instalments over an eight-year period.

MGTL Comment: We understand that you would prefer to not have to deal with another new tax, particularly one that’s terribly disadvantageous for U.S. expats with shares of a foreign corporation.  But listening to fake news that it does not apply won’t make it go away, because the fact is that the Transition Tax does apply to U.S. individuals who own an Australian corporation that is a CFC or an SFC which also has a U.S. corporate shareholder.[20]  The U.S. shareholder individual would have to include in their income their pro-rata share of the deferred earnings of the Australian corporation even before they have actually been distributed and regardless of whether such CFC or SFC is even required to lodge a return with the Australian Tax Office.  This is an obvious impact of the U.S. tax reform that can be easily identified, addressed and resolved with varying degrees of success.[21] 

The more insidious application of the Transition Tax of course concerns Australian trusts which are commonly-used vehicles by everyday Australians to conduct business. In this regard, we are cognizant that there are quite a few Australian structures that would likely fall within the purview of the Transition Tax: public trading trusts and corporate unit trusts (which are treated as companies) as well as discretionary trusts and Supers that are trusts which actively engage in business (either directly or through holding companies or unit trusts).[22]  The latter two, i.e., discretionary trusts and Supers that are trusts would be classified as foreign trusts under U.S. tax laws – would be subject to further scrutiny as potential business or investment trusts which are arrangements created by beneficiaries simply as a device to carry on a profit-making business rather than to simply protect or conserve property for the beneficiaries.[23] If the foreign trust meets the requirements for treatment as a business or investment trust, then it would be classified as an association taxable as a corporation for U.S. tax purposes and effectively bring it within the purview of the Transition Tax provisions.[24]

From our perspective, the Transition Tax is particularly onerous because it applies not only to cash and cash equivalents held outside the United States but also to non-cash “hard” business assets representing an investment of earnings in the business.  Moreover, this Transition Tax appears to penalize individual U.S. shareholders, in particular, because while the imposition of a one-time Transition Tax on foreign deferred earnings on corporate shareholders is the means to an end (i.e., it allows corporate shareholders to participate in the TCJA’s dividend participation exemption regime where foreign source dividends are repatriated on a tax exempt basis via the dividends received deduction mechanism described below), the payment of the Transition Tax by individual shareholders will not facilitate any similar tax- favoured treatment of their foreign source income under the TCJA. [25]

As we have previously noted, the Transition Tax impacts individual and corporate shareholders alike, notwithstanding that U.S. individual shareholders would not be able to participate in the dividend participation exemption regime. If nothing is done, the Transition Tax would be imposed on the U.S. expat in Australia without any corresponding Australian tax (particularly for Supers) to deduct it against or offset.  This is because the Transition Tax does not relate to a foreign source of income (from an Australian perspective) which would essentially lead to double taxation for the U.S. expat with shareholdings in a CFC or SFC, or beneficial interests in a discretionary trust or Super.  Presumably the majority of U.S. shareholders will elect to pay the U.S. Transition Tax ratably over eight years rather than fall under the general instalment schedule which is back-loaded.  Perhaps if an actual dividend is paid in those years and Australian tax is triggered, it may be possible to some extent to obtain foreign tax credit relief against the U.S. Transition Tax owing (although we deem this outcome unlikely).  This seems unlikely, however, in the case of Supers because distributions after retirement would be generally tax free and distributions before retirement would incur penalties for premature withdrawals. To date, the IRS has yet to issue much-needed guidance on how the Transition Tax and existing complex foreign tax credit rules would interact and coordinate.  Once these complex rules have been harmonized and they become effective, cross-border tax practitioners will want to study these rules carefully in the hope of identifying ways of reducing or eliminating double taxation of foreign deferred earnings in the case of a U.S. individual shareholder who is also an Australian national and tax resident.

2. New Dividend Participation Exemption Regime

The Transition Tax is best regarded as a one-time charge[26] on the deferred earnings of foreign corporations owned by U.S. shareholders in order to participate in the new dividend participation exemption regime.  For U.S. corporate shareholders, that charge may be worth it in the long run given that all future dividends received from foreign subsidiaries will be eligible for a 100 percent dividend-received deduction (with respect to the foreign-source portion of such dividend).  Amended Code Section 245A exempts from the U.S. tax base the foreign-source portion of dividends from 10-percent owned foreign corporations that are not passive foreign investment companies (“PFICs”).  Hybrid dividends are not eligible for the 100 percent dividends-received deduction.

MGTL Comment: We stress that the newly-enacted dividend participation exemption regime is available only for corporations and not individuals who are U.S. shareholders.[27] For U.S. individual shareholders, the dividend received from a foreign corporation gives rise to gross income subject to current tax with no dividend participation exemption available. However, foreign taxes paid by the U.S. individual shareholder may be utilized to offset some or all the U.S. tax on such foreign dividend whereas corporate shareholders would not be able to claim FTCs attributable to the tax-free portion of such dividend. 

3. Expansion of Subpart F Income

The Subpart F regime applies to foreign corporations in which U.S. shareholders own (through direct, indirect or constructive ownership) more than 50 percent of the total combined voting power of all classes of stock entitled to vote or total value of stock in the corporation.  Such corporations are classified for U.S. tax purposes as CFCs. If the CFC earns passive-type income such as interest, dividends, rents or royalties and certain other kinds of income (again, subject to complex rules), the U.S. shareholders are generally required to include their pro rata share of such passive income as “Subpart F income”, which is taxed at rates of up to 37 percent.[28]  This Subpart F income inclusion results in the U.S. shareholder recognizing income and paying tax on such amount even though there has been no distribution from the CFC.

MGTL Comment: Self-managed superannuation funds (“SMSF”) with corporate trustees that are owned by U.S. member beneficiaries of the Super would be subject to CFC classification, as would family discretionary trusts with U.S. beneficiaries that qualify for business or investment trust treatment under U.S. tax rules. For a long time, one of the keys to planning around Subpart F income (at least from a structural risk perspective) was to work around the definition of “U.S. shareholder”. After all, a 10 percent U.S. shareholder is the prerequisite to determining CFC status.  If a foreign corporation (or as applicable, foreign trust) did not have any U.S. shareholder (or beneficiary) that owned at least 10 percent of its voting stock, the entity could not be a CFC under the old rules.

However, for taxable years beginning after January 1, 2018, the definition of the term “U.S. shareholder” has been expanded. Amended Code Section 951(b) now defines a U.S. shareholder as a U.S. person who owns, directly or indirectly, 10 percent or more of the total combined voting power of all classes of stock entitled to vote or total value of all shares of classes of stock of the foreign corporation. 

MGTL Comment: We consider this change a significant definitional shift which potentially extends the Subpart F anti-deferral regime to U.S. individual shareholders of Australian companies who hold non-voting preferred shares and Australian discretionary trusts with U.S. beneficiaries for the reasons already previously discussed. It is now more important than ever to monitor each shareholder’s or beneficiary’s U.S. or non-U.S. status for tax purposes and as a corollary, their relative percentage ownership of the foreign corporation in terms of vote and value (or distributive share or allocation of discretionary trust income).  Failure to do so may result in additional U.S. income tax and reporting obligations of U.S. individual shareholders and beneficiaries of Australian companies, discretionary trusts or Supers, respectively.

Another significant change in the Subpart F regime which would expand its reach pertains to constructive ownership rules under Code Section 958(b). Generally, the stock ownership rules under Code Section 958(b) worked to determine when foreign corporate stock owned by another person or entity could be attributed as owned by a U.S. person for purposes of determining if such person was a U.S. shareholder of a CFC, or to treat a foreign corporation as a CFC.

MGTL Comment: Many U.S. expats have structured their shareholdings in order to prevent their foreign corporations from being classified as CFCs.  Of particular note is Code Section 958(b) (1) which clearly established that stock owned by a nonresident alien individual would not be considered owned by a U.S. individual.  This particular provision has helped structure many foreign corporations owned by married couples as non-CFCs where one spouse was not a U.S. citizen.  The good news is that this provision has been preserved. 

 4. New International Tax Provision: The GILTI Regime  

Effective for taxable years after December 31, 2017, all U.S. shareholders of CFCs with foreign intangible assets will be subject to a current minimum tax of 10.5 percent on their GILTI.  Newly enacted Code Section 951A provisions lay out the new rules for determining GILTI, which is derived from the net CFC tested income base minus a deemed minimum return on tangible assets.  The net CFC tested income base is supposed to capture the offshore intangible income not subject to U.S. tax.[29]  Only U.S. domestic corporate shareholders can avail of certain deductions to reduce the GILTI amount to tax under Code Section 951A. Specifically, U.S. domestic corporate shareholders can claim a special deduction for 37.5 percent of foreign-derived intangible income[30] (“FDII”) provided under new Code Section 250 and a 50 percent deduction for GILTI for taxable years beginning after December 31, 2017 and before January 1, 2026.[31]  Corporate shareholders can also claim foreign tax credits of up to 80 percent of foreign taxes paid on such CFC-tested income based on the inclusion ratios provided under Code Section 951a such that no residual U.S. tax would be owed on GILTI to the extent that the foreign tax rate is at least 13.125 percent.[32]

Unlike corporate U.S. shareholders, individual U.S. shareholders cannot claim any of the deductions available to corporate shareholders (i.e., the 37.5 percent FDII deduction and 50 percent GILTI deductions as discussed above). Thus, individual U.S. shareholders would be exposed to the full income inclusion which would be taxed at rates up to 37 percent. What is even worse, the definition of CFC-net tested income includes virtually all forms of income, including services income and operating income from businesses that require little or no fixed assets that would be qualified business asset investment.

MGTL Comment: Since its enactment, tax practitioners have wrestled with the application of GILTI to clients, asserting that actual calculations reveal more than a 10.5 percent minimum tax is imposed on more than just intangibles income.  Falling short of its intended target, the GILTI tax applies across the board to U.S. individual shareholders of CFCs regardless of whether or not their CFCs own off-shore intangible property (“IP”). Individual shareholders would also be disadvantaged because they would be ineligible to claim the FDII or GILTI deductions available to corporate shareholders (including foreign tax credits for foreign taxes paid) altogether.  Therefore, their only option is to work within the GILTI provisions itself, which provides very limited options to manage GILTI tax except to load up on tangible property investments to increase its specified tangible property basis which would lead consequently to decrease the net CFC tested income base for the GILTI tax. In this regard, the obvious issue that arises for Supers that increase their tangible property investments is the extent to which such acquisitions can be funded from Super funds versus third party indebtedness and the degree of active management of such tangible property investments (for example, rental real estate) that would be entailed to reduce or eliminate their potential GILTI tax exposure.

Along with the Transition Tax, the GILTI tax is likely going to have widespread adverse implications for U.S. citizens living in Australia who own non-U.S. corporations, particularly those that are corporate trustees of Supers or discretionary trusts or even Supers that are business or investment trusts for U.S. tax purposes due to lower tangible property requirements.  For example, a U.S. shareholder who solely owns an Australian private limited company that is a corporate trustee of a Super or discretionary trust may be subject to full blown GILTI tax if the company does not have tangible property.  In that case, even though the corporate trustee would not have been required to lodge any Australian tax returns, the U.S. shareholder of the corporate trustee would be required to include the corporate trustee’s corporate income on her U.S. personal income tax return with no deductions or foreign tax credits permitted. It remains to be determined whether Australia would recognize the GILTI tax as a creditable tax for Australian tax purposes, given that the U.S. GILTI tax paid is imposed on Australian source income and not U.S. source income.

5. Taxation of Pass-Through Entities

New Code Section 199A provides a 20 percent deduction on qualified business income (“QBI”) received by a U.S. individual taxpayer from non-corporate taxpayers such as partnerships, S corporations, trusts and estate and sole proprietorships. A full 20 percent deduction would effectively reduce the maximum marginal personal income tax rates on such QBI from 37 percent to 29.6 percent for trusts and individuals.  The deduction is the lesser of: (a) 20 percent of the taxpayer’s combined qualified business income; or (b) the greater of either (x) 50 percent of the W-2 wages paid with respect to the qualified trade or business; or (y) the sum of 25 percent of the W-2 wages with respect to the qualified trade or business plus 2.5 percent of the unadjusted basis, immediately after acquisition of all qualified property (currently being used and depreciated as part of a qualified business). The relevant W-2 wages base includes all wages, including withholding amounts and deferred compensation amounts. The deduction expires after December 31, 2025.

We note that QBI for purposes of this deduction (with certain exclusions) is income that is effectively connected to a U.S. trade or business other than: (1) specified trade or business; or (2) the trade or business of performing services as an employee. The specified trade or business expressly includes health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services or any trade or business where the principal trade or business is the reputation or skill of one or more of its employees. It also includes services such as investing and investment management, trading or dealing in securities, partnership interests or commodities.[33] We further note that QBI excludes guaranteed payments, and compensation paid to a partner.

MGTL Comment: Based on the above rules, it would appear the predominant strategy for U.S. partners and shareholders of pass-through entities (which are not engaged in a specified trade or business) to qualify for the 20 percent QBI deduction would be to invest in tangible depreciable property and generate W-2 wages. However, this strategy would not only involve a shift in the manner in which some cross-border entities conduct their U.S. business from Australia but also increase their exposure to permanent establishment risk in the United States. The shift in business operations may spread capital too thinly just to avail of reduced rates facilitated through the Code Section 199A deduction. Moreover, the 10-percent return on the tangible assets is merely a legal fiction.  If tangible assets are acquired or moved merely to avoid GILTI tax, there is the real risk that the capital invested in those tangible assets may yield a return that is actually well below the fictional 10-percent return.

At the end of the day, a U.S. expat residing in Australia will often be indifferent to the amount of QBI deduction.  This is because an Australian resident individual investing in a U.S. flow-through, e.g. partnership, will be subject to Australia worldwide taxation on the income in any case.  Any reduction in U.S. tax payable though the QBI deduction will correspondingly decrease the available foreign tax credit for Australian tax purposes, and the individual will still end up with the same global tax bill where Australian tax rates are higher than the U.S. tax rates.  This seems an unlikely scenario for U.S. expats in Australia given the combined U.S. federal and state income tax rates for U.S. tax resident individuals are currently at 43 percent while Australian tax resident progressive tax rates are at 30 to 45 percent. Where the QBI deduction could make a difference though is in situations where there is a foreign tax credit mismatch, such as where an Australian individual is investing in a U.S. LLC.  In those cases, a reduction of U.S. tax burden could lead to a reduction of global tax payable.

6. Taxation of Foreign Partners in US Partnerships

Last July 2017, the United States Tax Court issued a landmark decision in Grecian Magnesite v. Commissioner[34] (“Grecian Magnesite”) which settled a long-standing dispute between the IRS and taxpayers concerning the capital versus ordinary treatment of the sale of a foreign partner’s interest in a U.S. domestic partnership.  In Revenue Ruling 91-32,[35] the IRS took the position that a foreign partner’s share of gain from a partnership interest would be treated as effectively connected income (“ECI”) to the extent the seller would have been allocated ECI if the partnership sold its underlying assets (and ultimately, subject to ordinary tax rather than capital gain treatment).  This revenue ruling had become so entrenched and well –settled over 23 years that it was given appropriate deference in the tax communities.  However, in Grecian Magnesite, the Court disagreed with the IRS position and held that the foreign partner’s gain from the sale of its partnership interest (to the extent not attributable to U.S. real property interests) is not ECI and therefore is not subject to U.S. taxes.  On December 15, 2017, the IRS filed a notice of appeal seeking review of the Grecian Magnesite decision with the U.S. Court of Appeals for the District of Columbia Circuit.[36]  On December 22, 2017, President Trump signed the TCJA which effectively obsoleted any further appellate court review of the Grecian Magnesite case.

MGTL Note: Prior to Grecian Magnesite, there was confusion on whether an Australian partner’s gain from the sale or disposition of his or her U.S. partnership interests constituted ordinary income versus capital gain under conflicting partnership and international tax provisions of the Code.  There was no consistency of outcome.  United States tax advisors to such Australian investors would structure their U.S. investments through pass-through vehicles for U.S.-source capital gains arising from such investment to claim preferential capital gain rates in the United States at 20 percent for individual investors. Indeed, an alternative corporate blocker vehicle for such investment would not have any preferential capital gain rate available; rather, U.S.-source capital gains would be subject to a 35 percent tax rate (pre-TCJA).  However, capital gains arising from investments in the United States by an SMSF entity are taxed at a lower 15 percent rate in Australia, thereby making it more attractive to re-source the capital gain to Australia under the Tax Treaty. This would have been a win-win.

In recent years, Australian tax advisors of Superannuation funds with investments in U.S. real estate through U.S.-based partnerships have also looked into the potential classification of the Super as a qualified foreign pension fund (“QFPF”) under Code Section 897(l)(2).  This provision applies to capital gains recognized by foreign investors (such as foreign partners in a U.S. domestic partnership) arising from disposition of U.S. real property interests (“USRPI”) which included interests in real property (held directly or indirectly) as well as interest in certain corporations and partnerships that hold a substantial amount of U.S. real property.  Code Section 897(l) would exempt new classes of investors (such as qualified foreign pension funds) from the 30 percent withholding tax imposed pursuant to the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”) as well as any distributions received from a U.S. real estate investment trust (“REIT”). Because Code Section 897(l) was recently enacted in December 2015,[37] there is a noticeable lack of guidance on the interpretation of what constitutes a QFPF arrangement, the procedures for obtaining official classification as a QFPF and maintaining classification as a QFPF.[38]  Absent such guidance, a strict literal reading of the QFPF requirements would prevent many privately-held Superannuation Funds such as SMSFs and employer-funded corporate funds from qualifying as QFPFs.

The TCJA amendment to Code Section 864 codifies the IRS position in Revenue Ruling 91-32, an unfortunate development for Australian partners of U.S. partnerships.  Code Section 864(c) treats gain from the sale of U.S. partnership interests by a foreign partner as income that is effectively connected with the underlying U.S. trade or business of the partnership.  Foreign partners must therefore pay U.S. tax on such gain at ordinary income tax rates up to 37 percent rather than 20 percent preferential capital gain rates on capital gain from disposing real property interest or tax-free treatment on other types of capital gain. Furthermore, a new withholding rule was enacted that would require the transferor of a partnership to withhold 10 percent of the amount realized from the sale or exchange of a partnership interest absent a partner certification claiming exemption from the withholding. This new withholding tax is similar to the FIRPTA[39] mechanism which now applies to a broad range of transactions that do not necessarily involve transfer of real property interest, including many tax-free transfers in which taxpayers continue to retain indirect partnership interest.  It remains to be seen whether a QFPF classification under Code Section 897(l)(2) would be successful in exempting gains otherwise now taxable as ECI gain under amended Code Section 894 from U.S. taxation at ordinary tax rates.

7. Corporate Tax Rate Changes

One of the most dramatic provisions in the TCJA is the reduction of the corporate income tax rate form 35 percent to 21 percent for taxable years beginning after December 31, 2017.  It is worth noting that with this momentous cut in the corporate tax rate, the combined U.S. federal and state effective tax rates have now come to an average all-time low of 27 percent which is slightly lower than the prevailing Australian tax rate of 27.5 percent for base rate entity companies, and 30 percent for all other Australian companies.[40] Meanwhile combined U.S. federal and state income tax rates for U.S. tax resident individuals remain high; up to 43 percent compared to Australian tax resident progressive rates of 30 to 45 percent.  Consequently, optimal cross-border tax structures for U.S. inbound business may now likely favour corporate structures rather than pass-through structures to realize significantly lower effective tax rates on U.S.-source income.

MGTL Comment: There are certain traps for the unwary that require careful consideration.  We note that the U.S. corporate tax rate regime would likely cause corporate earnings to be deferred within a U.S. corporate structure rather than distributed out to Australian individual shareholders who would be subject to higher rates of personal tax upon distribution.  The likely increase in corporate earnings and profits may trigger the application of certain corporate tax provisions in the Code which aim to prevent the accumulation of deferred earnings beyond the reasonable business needs. For example, there is a 20 percent accumulated earnings tax imposed on corporate accumulated income, as well as a 20 percent penalty tax on personal holding company income which constitutes undistributed passive income held by a closely-held C corporation such as dividends, rents and royalties.  Passive earnings inside the U.S. corporation may also run afoul of foreign anti-deferral regimes in Australia.

8. Individual Income Tax Changes

The TCJA’s individual tax provisions have received a lukewarm reception overall. While the Act reduced individual income tax rates (generally from the top marginal 39.6 percent to 37 percent, 35 percent, and 32 percent, 24 percent, 22 percent, 12 percent and 10 percent) and nearly doubled the income threshold amounts for each rate bracket, such reduction was not achieved without costs. Indeed, the elimination of personal exemptions and suspension of certain itemized and miscellaneous deductions caused much controversy notwithstanding the increase in standard deduction amounts.  Below are some provisions that would impact U.S. taxpayers living in Australia and elsewhere outside the United States. 

Code Section 164(b) provides limits to the state and local tax deduction for U.S. individual taxpayers. Effective for the next ten years,[41] state, local and foreign property taxes and sales taxes are deductible only when paid or accrued in carrying on a trade or business or production of income. Deductions for state and local income, war profits and excess profits taxes are now significantly limited. However, U.S. individual taxpayers are allowed to itemize deductions of up to US $10,000 for aggregate state and local property taxes not paid or accrued in carrying on business; income war profits and excess taxes. It is important to note that this itemized deduction does not apply to foreign real property taxes at all.

MGTL Comment: This would certainly impact U.S. expats in Australia who may have been deducting their Australian property taxes on their U.S. tax returns as foreign real property taxes on their primary residences in Australia. There is an opportunity, however, to preserve the deduction if U.S. expats were to convert their properties for the active production of business or rental income. We note that such attempts may come at too steep a price as such conversion itself from personal use to business use may give rise to a Capital Gains Tax (“CGT”) even under Australian tax laws.   

Code Section 163(h) reduced the mortgage interest deduction to US $750,000 of acquisition indebtedness incurred after December 15, 2017. However, the deduction is not limited to interest on a taxpayer’s principal residence and could potentially apply to second homes and investment property. Moreover, the $1m limitation remains for debt incurred prior to December 15, 2017.  No more home equity debt interest deductions, however, will be available under the TCJA. 

MGTL Comment: Interest expense for a trade or business or for investments for the production of income is generally not subject to this particular limitation.  One may speculate as to whether interest on a home equity loan, the proceeds of which are used to invest in a business or corporation might be otherwise deductible under a tracing principle under Australian common law or tax doctrines. Also, Supers that are treated for U.S. tax purposes as foreign grantor trusts of the U.S. expat (and therefore Super income and assets would be includible in the U.S. expat’s gross income subject to current U.S. tax) may be able to claim mortgage interest indebtedness acquired on real property and held directly by the Super as a business or investment asset.

Provisions in the TCJA suspend the limitation on itemized deductions under Code Section 68 for the next ten years. The TCJA also suspended all miscellaneous itemized deductions that are subject to the two percent floor under Code Sections 212, 62 and new Code Section 67(g). We note that this would impact the ability to deduct tax preparation services for taxable years beginning after December 31, 2017 and ending before January 1, 2026.

While personal exemptions have been suspended, the standard deductions for individual taxpayers have been increased to the following amounts: $24,000 (joint return or a surviving spouse); $18,000 (unmarried individual with one qualifying child); $12,000 (for single filers). 

MGTL Comment: For a married couple in which both spouses were residents of a foreign country such as Australia and one spouse was a U.S. citizen, it was sometimes advantageous to make a tax election under section 6013(g) to treat the non-U.S. spouse as a U.S. resident, particularly if that spouse had low income because the status of married filing jointly gave access to lower tax brackets, an additional personal exemption and a more generous exemption amount for the alternative minimum tax.  Sometimes this kind of planning could be coupled with the foreign earned income exclusion of section 911 if the effect was to produce very low or no taxable income.  This kind of planning will likely survive tax reform changes, but the calculations have changed since there are no longer personal exemptions and the standard deduction is more generous.  Even if the U.S. citizen spouse continues to have itemized deductions in excess of the standard deduction and alternative minimum tax is not an issue, an existing Code Section 6013(g) election for the non-U.S. spouse may need to be re-examined to determine whether it is still beneficial in light of the loss of the personal exemption.  In some cases, this may come down to measuring the interplay between the amounts of income contributed by the non-U.S. spouse versus the advantage of accessing the more generous brackets for married filing jointly.

Moving expense deductions have been eliminated under Code Section 217 for the next ten years.  However, the deduction is still available for active duty members of the Armed Forces pursuant to their work assignments. It remains to be seen to what extent the loss of the moving expense deduction will affect employee mobility, including employer-sponsored moves.

Code Section 170 provision increases the adjusted gross income limitation (from 50 percent to 60 percent) on cash contributions made to public charities and certain organizations by individuals in tax years after 2017 and before 2026. However, charitable deductions for college event seating rights are no longer allowed. Certain high-tax states like California are likely to attempt to recast a portion of state income taxes as a voluntary contribution to the state, which they hope will be deductible as a charitable contribution, thereby skirting the $10,000 limitation on state and local taxes. Such a move is likely to lead to controversy and litigation.

Deduction for alimony payments are no longer available under Code Section 215. Effective for taxable years ending after December 31, 2018, alimony and separate maintenance payments will no longer be deductible by the payer spouse and not includible in the gross income of the recipient. This includes any divorce or separation instrument executed after December 31, 2018 as well as any divorce or separation instruction executed on or before December 31, 2018 but modified after such date.

9. Estate Tax

The TCJA increased the federal estate and gift tax unified credit (the “Unified Credit”) equivalent amount for estates of decedents dying and gifts made after December 31, 2017 and before January 1, 2026, from the inflation-indexed amount of US$5.4m to US$11.2m.[42]    

MGTL Comment: There is some doubt as to whether provisions of the U.S.-Australia Estate Tax Treaty of 1953 (the “Estate Tax Treaty”) would still be applicable to U.S. and Australian decedents. The issue arises because Australia no longer has any estate tax regime to which the Estate Tax Treaty would apply. Applicable provisions of the Estate Tax Treaty would provide Australian decedents with U.S. situs property with a pro-rata portion of the Unified Credit to shelter their U.S.-situs property from the U.S. estate tax which is currently imposed at a rate of 40 percent. If the Estate Tax Treaty remains relevant, then the increased unified credit amounts under the TCJA would result in a corresponding increase to the amount of U.S. situs assets that Australians may own before they are exposed to the U.S. estate tax.  Therefore, under the TCJA, Australians will be subject to U.S. estate tax of 40 percent on their U.S. situs property only if their worldwide net worth at death exceeds U.S. $11.2m. With proper planning, a husband and wife would be subject to the estate tax only if their worldwide net worth exceeds US$22.4m.  Note, however, in order to obtain the benefit of the increased Unified Credit equivalent amount, the Australian decedent’s estate must file a U.S. estate tax return, or risk reducing the estate’s (or beneficiary’s) basis in the decedent’s U.S.-situs property to US $0.00.   

Another issue that arises is whether a dual citizen decedent’s beneficial interest in a Super would be treated as personal property of the decedent and therefore classified as U.S. situs property or Australia situs property. Also, it remains to be determined whether a beneficial interest in a Super should be includible in the decedent’s worldwide estate at all, given that a decedent with a Super in accumulation phase would not have any right to access such funds as compared to one with a Super in pension phase (in which case the decedent would have had unrestricted access to the Super at retirement).

Further, for U.S. citizens who are interested in renouncing their U.S. citizenship, the increased Unified Credit equivalent will make it easier for them to avoid the U.S. exit tax imposed by Code Section 877A by allowing them to gift an additional US$5m without the imposition of gift tax.  Thus, with proper planning a U.S. citizen could avoid the U.S. exit tax if her net worth were US$11.99m by making a gift of US$10m. On such gift, there would be no U.S. gift tax payable and she would be under the US$2m net worth threshold for application of the U.S. exit tax.

Hopefully, our highlights of the TJCA provisions that will likely impact Australian Superannuation funds with U.S. beneficiaries and/or investments in the U.S. helps underscore the importance of prioritizing tax as an agenda item in future Australia – U.S. talks. A commitment to amending the Tax Treaty to address the treatment of Australian superannuation funds with U.S. beneficial owners would definitely be a small yet monumental step in reinforcing the mateship bonds that our two great nations forged 100 years ago in that little town of Hamel.  The world we live in is a very different one than what existed in those days, yet one thing remains the same: fostering a truly “long-term great friendship”[43] has always been one that involves more a battle for hearts and minds than territories.

 

 

[1] Marsha-laine Dungog, JD, LLM (US TAX), of Moodys Gartner Tax Law LLP, is a U.S. tax lawyer admitted to practice in California and Michigan. She received her undergraduate degree from the University of the Philippines; law degree from Golden Gate University School of Law; and LLM in Taxation from Georgetown University Law Center. She can be reached at mdungog@moodysgartner.com.

[2] Convention for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income, Australia-U.S. (Aug. 6, 1982), 35 U.S.T. 1999 (hereinafter the Tax Treaty), as amended by Protocol signed on September 27, 2001.

[3] https://usa.embassy.gov.au/news/ambassador-hockey-welcomes-prime-minister-turnbull (site visited February 19, 2018).

[4] Comment by economist Lyman Stone in https://www.smh.com.au/national/why-australia-is-now-home-to-the-sixth-largest-american-population-in-the-world-20150512-ggznm3.html (July 4 2015).

[5]In November of 2016, the Australian Parliament passed legislation to implement superannuation reforms to make the widely popular superannuation system more sustainable for its aging population by increasing flexibility and incentives for savings. See Superannuation (Objective) Bill 2016 which sets out a clear objective for Superannuation: to provide income in retirement to substitute or supplement the Age Pension. See https://www.treasury.gov.au/Policy-Topics/SuperannuationAndRetirement/Superannuation-Reforms (site visited February 2, 2017).  The provisions of the Superannuation Reform package pertaining to a formal legislated objective for the superannuation system was split from the other elements of the reform package that was passed by Senate in November 2016.  Rather, the legislated objective provision was referred by the Senate to the Senate Economics Legislation Committee (SECL) for inquiry and report by February 14, 2017.  The SECL report, issued last February 2017 recommended passage of the Superannuation Bill 2016 provision on legislated objective and can be accessed at the following link: https://www.aph.gov.au/Parliamentary_Business/Committees/Senate/Economics/SuperObjectiveBill2016/Report (as of March 21, 2017).

[6] For a detailed analysis of the Tax Treaty provisions on Super taxation, please see “What U.S. Workers Need to Know About Australian Superannuation Plans”, Vol. 46 Tax Mgmt. Intl J. No. 8 (Aug. 11, 2017);

[7] The Foreign Account Tax Compliance Act enacted as revenue offset provisions of the Hiring Incentives to Restore Employment Act of 2010.  It became effective on July 1, 2014.

[8] See, The IRS enforcement initiatives under the Bank Secrecy Act of 1970 which was one of the first laws to fight money laundering in the United States. Available at: https://www.irs.gov/businesses/small-businesses-self-employed/bank-secrecy-act (site visited February 20, 2018).

[9] See Miranda Brownlee, SMSF Warned on New IRS Compliance Campaign (November12, 2017) available at: https://www.smsfadviser.com/news/16062-smsfs-warned-on-new-irs-compliance-campaign

[10]  See, Large Business and International Launches Compliance Campaigns available at https://www.irs.gov/businesses/large-business-and-international-launches-compliance-campaigns

[11] P.L. 115-97 as signed into law on December 22, 2017.

[12] IRC § 7701(b)(6). Lawful permanent resident, otherwise known as a “U.S. Green Card” holder.

[13] Indeed, Supers are a trillion-dollar industry in Australia.  As of December 2017, Supers have amassed total aggregate assets of $2,530 billion or rounded, $2.5 Trillion See, Superannuation Statistics, issued on December 2017 published online by the Association of Superannuation Funds of Australia (ASFA) available at https://www.superannuation.asn.au/resources/superannuation-statistics (site visited February 19, 2018).

[14] See “What U.S. Workers Need to Know About Australian Superannuation Plans”, Vol. 46 Tax Mgmt. Intl J. No. 8 (Aug. 11, 2017). See Marsha Dungog, U.S. Taxation of Australian Superannuation Funds, 84(2) Tax Notes Int’l 177 (Oct. 10, 2016).

[15] Code means the Internal Revenue Code of 1986 as amended from time to time; Title 26 of the United States Code.

[16] For foreign corporations with taxable year ending December 31, 2017.

[17] For foreign corporations with a taxable year beginning before December 31, 2017 and ending after January 1, 2018.

[18] With at least one U.S. domestic corporation shareholder

[19] For an explanation on the divergent corporate and individual shareholder rates for the Transition Tax, see New York State Bar Association Report No. 1388 on Code Section 965 dated February 6, 2018 published in Tax Notes Today, 2018 TNT 26-15.

[20] We note in this regard that there is currently some ambiguity in the interpretation of Code Section 965(e) with respect to SFCs, and whether the Transition Tax only applies to SFCs that have 10-percent U.S. shareholders that are domestic U.S. corporations or whether it would also apply to U.S. shareholders that are individuals provided there is also another U.S. shareholder that is a U.S. domestic corporation.

[21] For a discussion of the ins and outs of the Transition Tax provisions, see Marsha Dungog, James Meadow The Top Ten U.S. Tax Reform Change That Will Impact Every Day Canadians at (January 18, 2018).

[22] We note that public trading trusts and corporate unit trusts would also be subject to the Transition Tax if these entities were treated as companies under Australian domestic laws.

[23] See Treas. Regulations Section 301.7701-4(b), (c).

[24] With such a dismal outcome in light of the steep Transition Tax rates that would immediately apply, we query whether classification of a Super as a foreign grantor trust or Code Section 402(b) trust for U.S. tax purposes would yield a better result given that the U.S. expat member beneficiary would at least dodge the silver bullet that is the Transition Tax. There is no one-size-fits-all treatment under these alternatives, and the outcome would have to be assessed on case by case basis.

[25]  For further reading on the adverse impact of the Transition Tax on U.S. individual shareholders compared to U.S. corporate shareholders, see  James Meadow, The U.S. Transition Tax for 2017: More Sad News for Many U.S. Citizens Residing Abroad (February 12, 2018) available at https://moodysgartner.com/us-transition-tax-2017-sad-news-many-us-citizens-residing-abroad/

[26] As explained above, individual U.S. shareholders, who are simply not allowed to play, are still subject to Transition Tax.

[27] Corporate shareholders however are not left completely unscathed.  Any loss arising from the subsequent sale of the foreign subsidiary stock would be calculated using the U.S. corporate shareholder basis in the foreign subsidiary stock after it has been reduced by dividend participation exemption amounts previously claimed.

[28] We note that Subpart F income of foreign corporations in higher tax rate jurisdiction would not trigger Subpart F income tax to its U.S. shareholder if such income was subject to an effective rate of income tax greater than 90 percent of the maximum U.S. domestic corporate tax rate under Code Section 954(b)(4).

[29] The new definition of intangible assets under PL 115-97 greatly expanded the existing definition of intangible property under the 1982 Tax Equity and Fiscal Responsibility Act. Basically, intangible property is now anything that is not tangible property.

[29] The deduction is reduced to 37.5 percent for years after December 31, 2025.

[30] The foreign derived intangible income concept aims at foreign IP that has not yet been subject to U.S. tax.

[31] The deduction is reduced to 37.5 percent for years after December 31, 2025.

[32] See The Conference Report to Accompany H.R. 1, H. Rept. 115-466 Tax Cuts and Jobs Act (December 15, 2017) available at  https://www.congress.gov/congressional-report/115th-congress/house-report/466/1.

[33]Whether engineering or architectural services fall within the general definition remains to be clarified as the Conference Agreement did exclude these fields (yet somehow arguably fall within the general definition).

[34] Grecian Magnesite Mining, Indus. & Shipping Co. v. Commissioner, No. 19215-12, 149 T.C. No. 3, 2017 BL 243353 (July 13, 2017). Full docket history and party submissions available at:   https://ustaxcourt.gov/USTCDockInq/DocumentViewer.aspx?IndexID=7153838

[35] 1991-1 C.B. 107 corrected by Ann. 91-86.

[36] https://ustaxcourt.gov/USTCDockInq/DocketDisplay.aspx?DocketNo=12019215

[37] See Protecting Americans from Tax Hikes Act of 2015 (the “PATH Act”), enacted December 18, 2015.

[38] To date, the Service has yet to propose any temporary, proposed or final regulations under Code Section 897(l)(2) as well as publish other administrative pronouncements interpreting Code Section 897(l)(2) and other Code Sections impacted by such classification.

[39] Code Section 897(a).

[40] See https://www.ato.gov.au/Rates/Changes-to-company-tax-rates/#Baserateentitycompanytaxrate (visited February 19, 2018).

[41] Taxable years beginning after December 31, 2017 and before January 1, 2026.

[42] See, Section 11061 of the TCJA amending Code Sections 2010(c)(3) and 2001(g).

[43] See, Australia US seek common ground on trade, China at https://www.reuters.com/article/us-usa-australia/trump-australias-turnbull-seek-common-ground-on-trade-china-idUSKCN1G72FY (February 23, 2018).