• U.S. International Tax Planning for Offshore Hotel and Resort Developments
  • June 19, 2008
  • Law Firm: Holland & Knight LLP - Tampa Office
  • Development of hotels and resorts outside of the United States presents a variety of structural issues for U.S. federal income tax purposes when the hotel/resort (the property) is beneficially owned by U.S. persons. The primary issues involve (1) whether the property should be owned by a foreign entity that is characterized as a corporation or a flow-through entity (e.g., a partnership) for U.S. federal tax purposes; (2) whether the U.S. owners should hold their beneficial interests in the foreign entity directly, or through an entity that is characterized either as a C corporation, an S corporation or other flow-through type of entity; and (3) whether the U.S. persons themselves are individuals or entities, such as trusts, that are taxed as individuals, or are corporations.

    The resolution of the structuring issues typically depends on the effective tax rate that the property is subject to in the local operating jurisdiction and the tax character of the U.S. owners. For example, the lower the effective foreign tax rate, the more likely it will be beneficial to own the property in a foreign entity that is characterized as a corporation in order to defer U.S. taxation on the income earned. The higher the effective foreign tax rate, in the case of individual U.S. owners, it is more likely that the property should be owned by a foreign entity characterized as a flow-through entity for U.S. federal income tax purposes, minimizing double taxation by allowing the foreign taxes paid with respect to the property to be credited against the U.S. owners’ U.S. tax liability. This alert will discuss these and other international tax planning issues that should be considered whenever U.S. persons are the beneficial owners of an offshore hotel or resort development.

    U.S. Taxation of Foreign Operations

    The U.S. employs a “worldwide” tax system under which U.S. persons, corporate or individual, generally are taxed on all income, whether derived in the U.S. or abroad. In addition to the direct taxation of a U.S. person, income earned by a U.S. person indirectly, through foreign corporate subsidiaries usually is not subject to U.S. federal income tax until the profits are repatriated to the U.S. person in the form of a dividend. Certain anti-deferral regimes, however, may cause the U.S. person to be taxed currently with respect to certain categories of passive or highly mobile income earned by foreign corporations in which the U.S. person is a shareholder, regardless of whether any distributions are made. The main anti-deferral regime in this context are the controlled foreign corporation (CFC) rules (discussed in greater detail later in the alert).

    Unlike domestic corporations, foreign corporations generally are subject to U.S. federal income taxation only on two categories of income:

    •  certain passive types of U.S. source income (e.g., interest, dividends, rents, annuities and other types of “fixed or determinable annual or periodical income,” collectively known as FDAP)

    •  income that is effectively connected to a U.S. trade or business
    FDAP income is subject to a 30 percent withholding tax that is imposed on a foreign person’s gross income (subject to reduction or elimination by an applicable income tax treaty) and income that is effectively connected to a U.S. trade or business is subject to tax on a net basis at the graduated tax rates generally applicable to U.S. persons.

    Availability of Credit for Foreign Taxes

    To mitigate against the potential double taxation that may result from such a system of worldwide taxation, a foreign tax credit (FTC) is allowed in the U.S. for income taxes paid to foreign countries to reduce or eliminate the U.S. tax liability imposed on foreign-source income, subject to certain limitations.

    When a domestic corporation receives a dividend from a foreign corporation in which it owns 10 percent or more of the foreign corporation’s voting stock, the domestic corporation is treated as having paid a portion of the foreign taxes paid by the foreign corporation and therefore, may claim a credit for such foreign taxes. Other than foreign withholding taxes, however, a U.S. individual taxpayer is not allowed a similar credit for taxes paid by a foreign corporation when such individual receives a dividend from a foreign
    corporation.

    Elective Treatment of Certain Foreign Companies

    Under regulations issued by the U.S. Department of the Treasury, U.S. taxpayers have the option to treat certain entities formed in foreign jurisdictions as either corporations or as tax transparent for U.S. tax purposes. Not all foreign companies are eligible for such elective treatment, and care should be taken in selecting the type of entity utilized to own a foreign property, so that if the ability to make such an election is desirable, the opportunity is not forfeited by the choice of entity in the jurisdiction in which the property is located. In particular, tax transparency is relevant to issues such as the ability of U.S. individual owners to claim a foreign tax credit for taxes paid by the property-owning entity, and under the CFC regime, if the property-owning entity is to pay dividends to a foreign holding company.

    In general, under these entity classification elections, which apply for all federal tax purposes, unless the taxpayer elects otherwise, a domestic “eligible” entity will be treated as (1) a partnership if it has two or more members, or (2) disregarded as an entity separate from its owner if it has a single owner. Similarly, for a foreign “eligible” entity, unless the taxpayer elects otherwise, such an entity will be treated as (1) a partnership if it has two or more members and at least one member does not have limited liability,
    (2) an association if all members have limited liability, or (3) disregarded as an entity separate from its owner if it has a single owner that does not have limited liability.

    Taxation of Qualified Dividends

    The Jobs and Growth Tax Relief Reconciliation Act of 2003 (the 2003 Act) added a provision to the Internal Revenue Code that limits the rate of taxation on “qualified dividend income” to a maximum U.S. federal income tax rate of 15 percent.

    To be eligible for this reduced rate, the dividends must be received from either a domestic corporation or a qualified foreign corporation (QFC). A QFC is defined as any foreign corporation that is: (1) incorporated in a possession of the United States; or (2) eligible for the benefits of a comprehensive income tax treaty with the United States which the secretary of the treasury determines is satisfactory for this purpose and which contains an exchange of information provision (the “treaty test”). Also, if a foreign corporation’s stock is readily tradable on an established securities market in the United States, the foreign corporation will be treated as a QFC with respect to dividends on that stock.

    Importantly, even if a foreign corporation is organized in a qualified foreign jurisdiction, any dividend received from that corporation will not be treated as qualified dividend income if the corporation is a passive foreign investment company (PFIC) for the current or the preceding taxable year. A foreign corporation is classified as a PFIC if it satisfies: (1) an income test; or (2) an asset test. Under the income test, a foreign corporation will be characterized as a PFIC if 75 percent or more of its gross income for the taxable year consists of “passive income.” Under the asset test, a foreign corporation will be characterized as a PFIC if the average percentage of its assets during the taxable year that produce passive income or that are held for the production of passive income is at least 50 percent.

    Unlike a PFIC, a CFC is eligible to pay qualified dividends. A CFC is generally defined as a foreign corporation that is more than 50 percent owned (directly, indirectly, or constructively) by 10 percent U.S. shareholders. If a foreign corporation is classified as a CFC, the corporation’s direct or indirect U.S. shareholders will be currently taxed on any Subpart F income the corporation earns, regardless of whether the income is actually distributed. If a foreign corporation is characterized as both a CFC and a PFIC for the current taxable year, it will not be treated as a PFIC for those shareholders who qualify under Subpart F as U.S. shareholders unless it was a PFIC before 1998. Accordingly, any dividends received from a QFC that is both a PFIC and CFC will be eligible for the 15 percent tax rate, at least for those U.S. individual shareholders who own 10 percent or more of the QFC’s voting stock.

    Structuring Suggestions for Offshore Properties

    In view of the foregoing rules, in general, the following organizational structures may provide tax efficiencies and benefits for the U.S. owners of the properties:

    • In the case of low or no tax jurisdictions, in general, using a foreign corporation to own the property will allow for the deferral of U.S. taxation on the profits earned from the property. Such income, whether from the sale of development parcels, condominium units, or other real property used in a trade or business, or from the active operation of a resort or hotel business, should not be taxable to the U.S. shareholders under the CFC regime. Therefore, such income would become taxable to the U.S. shareholders of such foreign corporation when they receive dividends from the foreign corporation.
      • In the case of U.S. individual owners of such foreign corporation, if the foreign corporation that owns the property itself is not a QFC, consideration should be given to forming a holding company that will qualify as a QFC in an appropriate treaty jurisdiction (e.g., Cyprus, the Netherlands, Australia, etc.) and making an election to treat the property- owning company as tax transparent for U.S. tax purposes. This will allow the property-owning foreign company to pay dividends to the QFC holding company without adverse consequences under the CFC regime, and then allow the QFC to pay dividends to the U.S. individual shareholders as qualified dividends, subject to a maximum tax rate of 15 percent.
    • In the case of jurisdictions with relatively high rates of tax:
      • U.S. corporate owners, in general, may prefer to have the property owned by a foreign corporation to allow for deferral of U.S. tax on the profits until a dividend is paid. Because such a corporate shareholder will be eligible to claim a foreign tax credit for taxes paid by the foreign property-owning corporation, the U.S. corporate shareholder will mitigate, if not eliminate, the double taxation that would otherwise occur when it receives a dividend from the foreign property-owning corporation.
      • U.S. individual owners, on the other hand, in general, will prefer that the foreign-owning entity be treated as tax transparent for U.S. tax purposes, so that the foreign taxes paid by the property-owning company will flow through to the U.S. owners for U.S. tax purposes. Thus, although such individual owners will not get the benefit of U.S. tax deferral on the income from the property, their ability to claim a foreign tax credit for the foreign taxes paid will mitigate, if not eliminate, double taxation on the income from the property.

    Conclusion

    Tax planning and structuring for offshore resort projects is a complex undertaking that becomes even more complicated when the ownership interests are held by U.S. taxpayers. Careful legal and tax analysis is essential in order to minimize the tax impact on operations, as well as when the profits are ultimately repatriated to the beneficial owners.