The repatriation tax and the 962 election
The US 2017 tax reform has made it very problematic for an American residing in Israel to conduct business through an Israeli corporation. Operating through an Israeli corporation exposes the expat to two new taxes: repatriation tax and GILTI (Global Intangible Low Taxed Income). This article will discuss the little-known 962 election; the specific instances in which it might be used to reduce repatriation tax liability; and the potential risks involved in using it.
A numerical example is helpful. An American living in Israel has been operating a family restaurant for 30 years through a wholly owned Israeli company. After paying Israeli corporate income tax on profits over the years, the company has $500,000 in retained earnings held in cash and cash-equivalents (securities), which the expat is counting on for retirement. Under the repatriation tax, the expat is now personally liable for $87,700 (17.54% of $500,000) of that amount. The tax rate is 9.05% for non-cash assets. Compare this to rates multinational corporations pay: 15.5% for cash/securities and 8% non-cash. The reason expats pay more is because the top 2017 individual rate (39.6%) is higher than the top corporate rate (35%).
How is this tax paid? In eight annual payments, with the first payment of 8% (or $7,016) being due June 15, 2018. Should that or any other annual payment be a single day late, the entire $87,700 is due immediately.
Let’s assume that the expat has no personal foreign tax credits to use to offset to the repatriation tax. In other words, in previous years the expat has already used all personal income tax paid in Israel to offset US income tax.
Section 962 of the US Internal Revenue Code (“IRC”) may help. Section 962 allows the expat to be treated as a corporation solely for purposes of the repatriation tax (and other Subpart F income which taxpayers rarely have).
Why does this help? Simple. If we assume an average Israeli corporate tax rate of 25% over the past 10 years, then approximately $125,000 ($500,000 at 25%) of Israeli corporate tax has been paid. As the Israeli corporation had no US tax liability, it has $125,000 in available foreign tax credits to use to offset the repatriation tax. AND IF the expat utilizes the 962 election, there are two potential benefits: (1) ability to use the corporate taxes paid in Israel to offset the Repatriation tax, and (2) enjoy the slightly lower corporate repatriation tax rate.
In the real world, situations are rarely black and white, i.e., lots of corporate credits but no personal credits. For example, if the expat has some personal tax credits available, the point at which the 962 election becomes beneficial requires analyzing different numerical scenarios, taking into account many factors, such as gross-up rules under IRC Section 78. However, in cases where the Israeli corporation has a significant pool of unused tax credits and the expat has none, the 962 election may make sense. The drawbacks to the 962 election? There is one major drawback, which seriously makes the election unattractive in many cases: distributions from the corporation. What happens when the Israeli corporation finally distributes the $500,000 to the expat? If no 962 election was made, no additional US tax is paid by the expat (IRC 959). A 30% Israeli tax on dividends, however, may be due.
And if 962 election was made? Bad news: All the distributions out of the accumulated earnings, beyond what was paid on the Repatriation tax, are subject to US tax (IRC 962(d))! Ouch. At what rates? Most likely at personal marginal rates. Double ouch.
An example will help illustrate this. Under 962, let’s assume that the $125,000 in corporate tax credits eliminated any repatriation tax liability.
Upon future distribution of the $500,000, the expat would pay US taxes at the marginal rate, or as much as $185,000 ($500,000 at 37%, the highest marginal rate) less a credit for Israeli dividend withholding tax (30%-33% currently) i.e., an extra 4%-7% US tax in this example
Does an IRC 962 election make sense in the context of the repatriation tax? Maybe, but most likely in the limited situations where the amount of Israeli corporate tax credits are far greater than the personal income tax credits available, and/or when the expat has no plans to withdraw the money in the corporation.
As always, consult experienced tax advisers in each country at an early stage in specific cases.