What Does It Take To Exclude Foreign Income?

At this point of the tax season I usually lament not having won the lottery since last year’s tax season. I would travel extensively, most likely overseas.

That would put me out of the country, and you may have heard that there is a tax “break” for people who work outside the country.  I sincerely doubt it would apply to me in my imaginary lottery-fueled world, but let’s talk about it.

If you work overseas, you get to exclude up to $100,800 of earned income – such as salary – from U.S. tax. This sounds like a great deal, and usually it is, but remember that you would have been allowed a credit for income taxes paid the other country. If the foreign taxes are the same or higher than the U.S. taxes, the effect of the income exclusion is likely a push. If the other country has lower taxes than the U.S., however, this could be a very sweet deal for you.

There are ropes to claiming this exclusion. You have to meet one of two tests. The first test is being outside the U.S. for at least 330 days during the year. Think about this for a second. You take a job in Japan for a couple of years, but your family stays in the U.S. This means that you can see them up to 35 days a year – or forfeit the exclusion. I suppose they could travel to Japan instead, but you get the idea.

There is a second way, and that is to be a “bona fide” resident of the foreign country. This is hard to do, as it means that your home is there and not here. “Home” in this context does not just mean a place where you hang clothes and keep food in the refrigerator. The tax Code wants more: it wants your “main” home to be overseas.

Does this happen much? You bet. Think an American expatriate – perhaps retired military or someone who married overseas. I have family for example who have lived in England for decades. They have gone to school, worked, married and raised children there. They would easily qualify for the foreign income exclusion under the bona fide test.

What if one works overseas but still maintains ties to the U.S.? Can one also be a bona fide citizen of another country?

You can expect the IRS to be skeptical, especially if you leave a house or family behind. This is the IRS equivalent of New York Department of Revenue not believing you when you tell them you moved to Florida.

Let’s look at one someone who recently tried to make the bona fide argument.

Joel Evans took a job on Sakhalin Island in Russia, which has to count as going to the end of the world. He was working the oil rigs, both on land and offshore. His normal schedule was 30 days on followed by 30 days off. A 30- day stretch gave him the flexibility to return frequently to the U.S.  

He had a house in Louisiana, and somewhere in there he got divorced. His daughter moved into his house for a while. He returned to Louisiana whenever he could. He eventually married a second time, and his wife moved into, and his daughter moved out of, his house in Louisiana.

He claimed the foreign income exclusion for years 2007 through 2010. The IRS said no and wanted over $31,000 in back taxes from him

He had absolutely no chance under test one, as he spent way more than 35 days annually in the U.S. He argued instead that he was a bona fide resident of Russia.

I give him credit, I really do. It was his only argument. He spent a lot of time in Russia. He learned a little Russian. He fixed up a place to stay. He made friends. He even dated some Russian women, which I presume he ceased doing when he got remarried.

But that isn’t the test, is it?

The test is where his main home was. He pretty much gave his hand away when he kept returning to Louisiana almost every thirty days.

The Tax Court agreed with the IRS and disallowed his foreign income exclusion. He was not a bona fide resident of Russia, and he could not exclude his foreign earned income. He had failed both tests.

Let’s state the obvious: he had no chance winning this one.

In my practice, almost everyone relies on the 35-day test, and it is common to monitor the 35 days like a hawk. I suppose if I were an expat (that is, living overseas) preparing taxes for other expats, I would see the bona fide test more frequently. There are not too many bona fides who would need my services in Cincinnati.

Which rule – the 35 day or the bona fide – would trip me up when I hit the lottery?

Neither. It takes earned income – think self-employment or a salary – to power the foreign earned income exclusion. I have no intention of working.

The Sysco Merger and the Double Dummy

Recently a financial advisor called me to discuss investments and, more specifically, Sysco’s acquisition of U.S. Foods.  I had to read up on what he was talking about.

The Sysco deal is a reverse triangular merger. It is not hard to understand, although the terms the tax attorneys and CPAs throw around can be intimidating. Let’s use an example with an acquiring company (let’s call it Big) and a target company (let’s call it Small).

·        Big creates a subsidiary (Less Big).

·        Less Big merges into Small.

·        Less Big ceases to exist after the merger.

·        Small survives.

·        Big now owns Small.

Voila!

This merger is addressed in the tax Code under Section 368, and the reverse triangular is technically a Section 368(a)(2)(E) merger. Publicly traded companies use Section 368 mergers extensively to mitigate the tax consequences to the companies and to both shareholder groups.

In an all-stock deal, for example, the shareholders of Small receive stock in Big. Granted, they do not receive cash, but then again they do not have tax to pay. They control the tax consequence by deciding whether or not to receive cash (up to a point).

Sysco used $3 billion of its stock to acquire U.S. Foods. It also used $500 million in cash.

And therein is the problem with the Section 368 mergers.

It has to do with the cash. Accountants and lawyers call it the “basis” issue. Let’s say that Sysco had acquired U.S. Foods solely for stock. Sysco would acquire U.S. Foods' “basis” in its depreciable assets (think equipment), amortizable assets (think patents) and so on. In short, Sysco would take over the tax deductions that U.S. Foods would have had if Sysco had left it alone.

Now add half a billion dollars.

Sysco still has the tax deductions that U.S. Foods would have had.

To phrase it differently, Sysco has no more tax deductions than it would have had had it not spent the $500 million.

Then why spend the money? Well… to close the deal, of course. Someone in the deal wanted to cash-out, and Sysco provided the means for them to do so. Without that means, there may have been no deal.

Still, spending $500 million and getting no tax-bang-for-the-buck bothers many, if not most, tax advisors.

Let’s say you and I were considering a similar deal. We would likely talk about a double dummy transaction.

The double dummy takes place away from Section 368. We instead are travelling to Section 351, normally considered the Code section for incorporations.  

 

Let’s go back to Big and Small. 

·        Big and Small together create a new holding company.

·        The holding company will in turn create two new subsidiaries.

·        Big will merge into one of the subsidiaries.

·        Small will merge into the other subsidiary.

In the end, the holding company will own both Big and Small.

How did Small shareholders get their money? When Big and Small created the new holding company, Small shareholders exchanged their shares for new holding company shares as well as cash. Was the cash taxable to them? You bet, but it would have been taxable under a Section 368 merger anyway. The difference is that – under Section 362 – the holding company increases its basis by any gain recognized by the Small shareholders.

And that is how we solve our basis problem.

The double dummy solves other problems. In a publicly traded environment, for example, a Section 368 merger has to include at least 40% stock in order to meet the continuity-of-interest requirement. That 40% could potentially dilute earnings per share beyond an acceptable level, thereby scuttling the deal. Since a double dummy operates under Section 351 rather than Section 368, the advisor can ignore the 40% requirement.

The double dummy creates a permanent holding company, though. There are tax advisors who simply do not like holding companies.

Sysco included $500 million cash in a Section 368 deal. Assuming a combined federal and state tax rate of 40%, that mix cost Sysco $200 million in taxes. We cannot speak for the financial “synergies” of the deal, but we now know a little more about its tax implications.