Cross-border business owners can face significant double taxation when foreign taxes paid at the corporate level cannot be used as U.S. foreign tax credits. Planning how a foreign business is structured and how an eventual exit will occur can help preserve those credits, but the most effective strategies often need to be implemented well before a sale.
The Setup
Picture a U.S. business owner who spent years building a real estate development company south of the border. The operating entity is a Mexican corporation that is profitable, well-run, and, for U.S. tax purposes, what’s known as a controlled foreign corporation, or CFC. A CFC is a foreign company more than 50% owned by U.S. persons.
The company holds a highly appreciated piece of land with very little tax basis, and the owner is ready to exit. The question most owners ask at this point is a reasonable one: “I’m going to pay tax in Mexico on this sale. Can I use that as a credit against my U.S. tax?”
The answer depends almost entirely on a decision the owner made, or failed to make, years earlier: how the business was structured for U.S. tax purposes, and what exactly gets sold at the exit.
When the Corporation Sells, the Tax Belongs to the Corporation
In the most common exit, the Mexican company sells the land itself. Mexico taxes the gain at the corporate level, commonly 30%. The after-tax cash now sits inside the company, and the owner still must get it out.
When the company distributes that cash, the U.S. taxes the owner on the distribution. This is where the foreign tax credit that the owner was counting on disappears. The Mexican tax was paid by the corporation, not by the owner personally. A U.S. individual generally cannot claim a credit for foreign taxes paid by a foreign corporation he owns. The “indirect” credit that once let certain U.S. shareholders claim credit for a foreign corporation’s taxes applied only to U.S. corporations, never to individuals, and was repealed in 2017.
The result is two full layers of tax on the same gain. As a simple illustration, on $10 million of gain, Mexico may take about $3 million at the corporate level. The remaining $7 million comes out as a dividend and, even at preferential U.S. dividend rates (about 23.8% including the net investment income tax), the U.S. takes roughly another $1.7 million. That is a combined burden of about 47%, with the owner’s Mexican tax producing no U.S. credit at all.
There are two ways to structure around this, but both work best when they are planned for early.
Solution #1: Check-the-Box From the Beginning
U.S. tax law lets many foreign entities choose their U.S. tax classification by filing IRS Form 8832, the “check-the-box” election. A Mexican company that is eligible can elect to be treated as a partnership (or, with a single owner, a disregarded entity) for U.S. purposes, even though Mexico continues to treat it as a corporation.
If the owner makes that election at formation, before the land appreciates or if even owned by the business, the exit looks completely different. For U.S. purposes, the company is transparent. When it sells the land, the U.S. treats the owner as having sold his share of the land directly, and the Mexican tax paid by the entity is treated as paid by the owner. That tax passes through and can be claimed as a direct foreign tax credit against the U.S. tax on the same gain, in the same year, and in the same category of income.
Instead of stacking, the two countries’ taxes largely overlap. The combined burden generally lands closer to the higher of the two countries’ rates, rather than the sum of both. In our example above, depending on other tax items on the individual return, the tax burden would go from 47% to 30%.
Timing is everything here. The election cannot simply be made later, once the land is valuable. For U.S. purposes, converting an existing foreign corporation into a partnership is treated as a taxable liquidation of the corporation. The built-in gain is taxed in the U.S. immediately, often as net CFC tested income (formerly known as Global Intangible Low-Taxed Income, or GILTI) at ordinary rates, even though nothing has been sold. Mexico does not recognize the election and taxes nothing until the real sale happens later. By then, the Mexican tax falls into a different foreign tax credit category than the GILTI and cannot be used to offset it. The credits simply do not line up, and a late election can make the double tax worse, not better.
Solution #2: Sell the Stock Instead of the Asset
If the company is already a corporation and the land has already appreciated, a second option is to change what the owner sells. Rather than having the Mexican company sell the land, the owner sells his shares in the Mexican company to the buyer.
Now the seller is the shareholder, not the corporation. Mexico generally taxes nonresidents who sell shares of Mexican companies, particularly companies whose value comes from Mexican real estate, and the U.S.-Mexico tax treaty permits Mexico to do so. Because that Mexican tax is imposed on the owner personally, it can be credited directly against his U.S. tax on the same gain.
However, there are potentially three issues with this solution
First, source of the income. U.S. taxpayers can only claim a credit on foreign sourced income. U.S. tax law normally treats a U.S. resident’s gain on selling stock as U.S.-source income, which would leave no room for a foreign tax credit. However, gain on the sale of CFC stock is recharacterized as a dividend to the extent of the company’s earnings, and that dividend is foreign source. Therefore, this could only work if the company had high earnings and profits to amount to the same, which is unlikely since the sole revenue producing asset is the property, which is now being sold.
Next, it is critical to coordinate with a Mexican tax professional because higher tax rates or transfer taxes on this type of transaction can greatly lessen the benefits. Any benefit may be worthwhile if you are too far down the road for other options; however, this is very relevant if planning from the beginning.
Lastly, are concerns of the buyer. A buyer who acquires the shares inherits the company’s low tax basis in the land and its Mexican tax history. That can affect price and usually means more due diligence and stronger indemnities. The tax savings to the seller should be weighed against what the buyer will ask for in return.
Plan the Exit Before the Exit
The same land, sold for the same price, can produce very different results depending on structure:
- Corporation sells the land: Mexican tax at the corporate level, U.S. tax again on the distribution, and no usable credit.
- Checked the box at formation: the Mexican tax passes through to the owner as a credit against the U.S. tax on the same gain.
- Owner sells the stock: the Mexican tax falls on the owner personally and might be credited, but there are several things that must be considered.
What does not work is waiting until the asset is valuable and then checking the box. At that point, the election itself becomes a taxable event, and the credits do not line up.
Thinking through an exit, restructuring, or sale involving a foreign operating company? The cross-border tax team at Hone Maxwell LLP regularly advises U.S. owners of foreign businesses on CFC planning and foreign tax credit structuring, including exactly this kind of sequencing analysis, before an election or transaction is finalized.
Contact our office to talk through your structure while there’s still time to plan around it.
Controlled Foreign Corporation Tax Credits FAQs
1. Why can’t a U.S. business owner always claim a foreign tax credit for taxes paid by a foreign company?
A U.S. individual generally cannot claim a foreign tax credit for taxes paid by a foreign corporation they own. If the foreign company pays tax on an asset sale and the owner is later taxed in the U.S. when the proceeds are distributed, the result can be two layers of tax without an offsetting credit.
2. How can a check-the-box election affect foreign tax credits?
When an eligible foreign entity makes a check-the-box election at formation, it may be treated as a partnership or disregarded entity for U.S. tax purposes. This can allow foreign taxes paid by the entity to pass through to the owner and potentially be claimed as credits against U.S. tax on the same income.
3. Why is timing important when making a check-the-box election?
Making the election after significant appreciation has occurred can trigger a taxable event for U.S. purposes, even though no actual sale has taken place. The resulting U.S. tax and later foreign tax may not fall into the same foreign tax credit categories, preventing the credits from lining up.
4. How can selling stock instead of business assets affect the tax outcome?
A stock sale may cause foreign tax to be imposed directly on the shareholder rather than the corporation, potentially creating an opportunity for a U.S. foreign tax credit. However, the result depends on factors including the source and character of the income, local tax consequences, the company’s earnings and profits, and the buyer’s willingness to acquire the entity rather than its assets.
