How to classify your overseas operations following tax reform complications

For manufacturing companies that operate overseas, the question of whether to operate as a controlled foreign corporation (CFC) or disregarded entity (DRE) has become significantly more complicated since the passing of the 2017 tax reform reconciliation act, commonly referred to as the Tax Cuts and Jobs Act (TCJA).

The decision-making process might no longer be quite as intuitive for business owners as many of the provisions within tax reform interact to each other differently. While one option may seem like the right answer for a specific concern, it could have adverse consequences with another provision.

Below, we explore the tax implications of operating as a CFC or DRE and considerations your company should keep front of mind as you weigh the options.

Classification overview

A CFC is a separate non-U.S. legal entity that operates in a foreign country with owners who reside in, or are citizens of, the United States.

A DRE is a separate legal entity operating in a foreign jurisdiction that has made an election to be disregarded for U.S. tax purposes. From a U.S. tax perspective, all the company’s income, taxes, and expenses are considered to be owned by the U.S. owner. In a sense, it’s as if the entity itself doesn’t exist for tax purposes; it does, however, exist for legal purposes.

Questions to consider

How will your decision affect your current income tax perspective?

Prior to tax reform, U.S. shareholders of CFCs were able to defer income of the entity so the income wouldn’t be taxed in the United States until paid back to the United States in the form of a dividend. Unless, however, the income fell under the anti-deferral regime known as Subpart F. This income would be treated in the United States as if it were distributed even if it hadn’t been and generally applies to passive income such as interest, dividends, rent, royalties, or income from conducting business outside the country of operation.

Tax reform, however, adds new provisions that impact a U.S. shareholder’s deferral, so while the option still exists, deferral is no longer automatic.

U.S. shareholders of DREs don’t have the option for deferral. These companies must immediately recognize all income, even though it might be sitting in another country. As such, a DRE’s income is always going to be taxed in the United States.

How will your foreign tax credits be impacted?