Ready to re-organize? Global impacts of an entity change

Pros and cons of pass-through conversion to a C-corp

globe on the moneyIs now the time for pass-throughs to convert to a C-corporation? Businesses large and small are evaluating the impacts of the newly enacted Tax Cuts and Jobs Act, dusting off old strategies, re-evaluating them and exploring new approaches to their operations to leverage benefits of new tax changes. In corner offices and boardrooms alike, the 21 percent corporate rate and other changes are prompting pass-through entities to debate the pros and cons of converting to a C-corporation.

In particular, international business operations underwent a sea change as it relates to cross-border taxation. During Grant Thornton’s recent webcast, “Pass-through to C-corp conversion: Things to consider,” Cory Perry, senior manager, Washington National Tax Office, explained that “This sea change has completely reworked the calculus when evaluating the pass-through vs C-corp conversion when you have foreign operations or sales. The result of stark differences in treatment between the way that C-corps and pass-throughs are taxed related to foreign operations clearly seem to be trending in favor of C-corporations.”

Under the new international tax rules, corporate ownership of foreign operations is more favorable in many ways when compared to non-corporate ownership. When evaluating legal entity choice, consider the following changes resulting from the new tax reform legislation:

  • A move to a quasi-territorial system with 100 percent dividends received deduction (DRD). The new DRD system is only applicable to corporations; pass-throughs are still subject to a world-wide tax system.
  • One-time tax. Tax reform has ushered in a one-time tax on previously unrepatriated earnings held offshore in foreign corporations.
  • Significant anti-base erosion provisions. Key changes include a minimum tax on “global intangible low-taxed income” (GILTI) and other provisions which are especially of concern to large pass-throughs.
  • Incentives for foreign derived intangible income. “There are some incentives which can be considered the carrot and the stick,” Perry said. “The stick is the new minimum tax and the carrot is an incentive to earn foreign sourced income by the domestic entity via foreign sales or services.”

Before converting, consider these questions:
  • How do you currently operate? Do you operate through foreign branches or disregarded entities, controlled foreign corporations (CFC) or a combination of both? “This could have one of the most significant impacts on the decision-making process because there are different rules that apply depending on whether you’re operating through a branch or a CFC and whether you’re operating domestically through a C-corp or a pass-through,” explained Grant Thornton’s Perry. In addition, he cautioned that there are some additional costs to consider. For example, a pass-through with foreign branches looking to convert to a CFC may incur a “toll” cost or an exit charge associated with that change.
  • What would be the tax cost associated with reorganizing the foreign structure of a domestic group? Would there be a cost to change the foreign entity’s tax classification? What would be the cash flow impact on a go forward basis? “If you are pulling the cash back frequently there’s also the cash flow impact consideration that needs to be performed when you’re switching entities, changing status or incorporating branches because there might be different rules associated with taxes with cross- border implications,” Perry explained.
  • Would the change impact positively or negatively your tax position in non-U.S. countries? For example, pass-throughs looking to convert to a C-corp should determine whether they still quality or can qualify for “treaty” benefits.
  • Do you generate income from export sales or services provided to non-U.S. persons? There are several specific incentives and rules that would be applicable to domestic corporations that make sales to another country or provide services to a person located abroad. Perry explained that there are some preferential regimes or deductions that could be available if you’re in a C-corporation setting as a result of foreign sourced income. In addition, indirect or transfer taxes can be triggered in some cases when converting from a pass-through to a C-corp.

Many pass-throughs are considering re-organizing in 2018 based on both significant changes in tax rates and a number of preferential provisions that only apply to C corporations.
Incongruity amongst taxpayers
Global minimum tax: An entity comparison While the global minimum tax (GILTI) focuses on intangible low-tax income, it impacts all earnings except for certain limited returns allocated to depreciable tangible assets so it also takes into account services income or sales of products abroad. In the example below, a U.S. corporation with a CFC with $1,000 of GILTI income, will be entitled to a 50 percent deduction against that income and a foreign tax credit to help offset the resulting U.S. tax. The pass-through, on the other hand, is not entitled to an indirect credit for the foreign taxes and does not earn a 50 percent deduction. The result is a fairly significant difference.
C Corp versus Pass-through - Example 1
Pass-through vs C-corp: Tax rate comparison Just as significant is the differences in effective tax rates between the two types of entities. Thanks to the new tax legislation, a C-corp is subject to a 21 percent tax rate in comparison to a maximum 37 percent rate for individual owners of pass-throughs. “Because C-corps are going to benefit from a deemed paid credit or an indirect foreign tax credit, it is actually going to pay no additional incremental tax,” Perry explained. “Under this new regime, they are fully shielded by an indirect foreign tax credit whereas a pass-through is going to pay $370 or 37 percent of taxable income.”

The result is an effective global tax rate on the C-corp of 20 percent (the taxes it bore in the foreign country) and a 57 percent effective tax rate for pass-throughs (20 percent paid locally and an additional 37 percent paid in the U.S.).
C Corp versus Pass-through - Example 2
The global minimum tax calculation below provides a C-corp vs pass-through comparison. Without a deemed paid credit or 50 percent deduction, pass-throughs are subject to a 37 percent rate on all U.S. earnings and will bear double on the foreign effective tax rate. The C-corp, however, fares better because of a 50 percent deduction it receives on the 21 percent rate. The result is that the lowest rate the C-corp will pay from a U.S. perspective is 10.5 percent and as its foreign tax credit increases, the U.S. incremental rate declines until it hits 0 percent.
GILTI-Is it a global minimum tax
Global impacts and considerations: When asked to identify which considerations would have the most impact on their entity decision, the majority of Grant Thornton’s webinar attendees whose organizations have international operations indicated the significant disadvantage faced by a pass-through with global intangible tax-taxed income would have the most impact on their decision to convert to a C-corp. The second most important consideration is the new deduction for foreign derived intangible income (available only to C-corps) and the conversion costs.

Clearly, the choice to make an entity change is not a simple one. Below are a few of the primary considerations pass-throughs should take into account when making a decision to convert to a C-corp:
  • Hybrid structures. Organizations with foreign operations might want to consider a hybrid structure that is a mixture of a partnership for domestic operations and a corporation for foreign operations, or a combination of the two in order to leverage tax benefits from each entity form.
  • Base erosion anti-abuse tax. Entities with a significant amount of sales ($500M or more) would do well to consider the impact of the base erosion anti-abuse tax. Similar to the Alternative Minimum Tax, it is applied based on base erosion payments and can have a fairly significant impact.
  • Territorial system benefits. While clearly a move to a quasi-territorial system may benefit C-corps, there are other discretionary distribution considerations to take into account in order to understand the real impact to your organization.
  • S-Corps can defer the one-time tax. S-corporations may elect to defer payment of tax on foreign deferred income inclusions until certain triggering events have occurred.
  • Section 367 and potential gain on incorporation of foreign branches. The Tax Cuts and Jobs Act allows for loss recapture on the transfer of a foreign branch to a foreign corporation.

Perry also cautioned there are numerous provisions and considerations, tax and non-tax alike, that must be analyzed before making the conversion decision. “While it may seem like a fairly clear decision tree in the international area, there are a number of provisions and a number of complexities associated with each of the calculations to consider,” he said. “You really need to take a closer look at your foreign operations and international tax strategy and think about what it means going forward because the old system and the old rules might not work quite as well as they used to.”

Not sure where to start? Grant Thornton is here to help. Reach out to our professionals below.

Dustin Stamper
Director, Washington National Tax Office
T +1 202 861 4144

Cory Perry
Senior Manager, Washington National Tax Office
T +1 202 521 1509