International Tax Provisions of the Tax Cuts and Jobs Act
The Tax Cuts and Jobs Act (“TCJA”) recently passed by Congress and the President represents a true game changer for U.S. corporations, foreign corporations doing business in the U.S., and individuals and pass through entities with international investments and transactions. This article highlights international tax implications of the new law.
- The new rules are very wide-reaching, often completely different than the superseded rules that existed for years, and portions are incredibly complex. Additional guidance in the form of Treasury Regulations is expected.
- The changes do not entirely move the U.S. out of the “worldwide income” taxation regime and into the “territorial” regime, but they move us much closer in that direction.
- The U.S. tax structure’s taxation of international offshore income now more closely resembles the systems used by most other industrialized countries.
- The law does not mention “corporate inversions,” but its new structure essentially removes the incentive to utilize them. It encourages investment in the U.S., and removes the incentive corporations had under old rules to leave cash earnings outside the country.
- A completely new, one-time tax is assessed on past built up earnings held offshore by many U.S. investors of foreign companies, and the first portion of that tax, for calendar year taxpayers, may be due in April of 2018. This stealthy tax will surprise many investors. It is based in part on cumulative “Earnings and Profits” of the company, which will involve computations requiring data from inception through 2017. The tax is payable whether or not any cash is actually repatriated, because it is based on a deemed distribution. This is described by many as the Act’s new “toll charge.”
- In addition to the one-time tax, an annual tax may apply to companies that earn a high rate of return on overseas investments in intangible property. A new deduction is provided for U.S. companies that sell products or license services overseas. Both of these provisions are described as part of the Act’s “anti-base erosion rules.”
- Overall, the changes are designed to incentivize U.S. companies to bring or leave property or operations (including employees) in the U.S., in exchange for tax breaks that lower a company’s tax. Meanwhile, the country’s tax base will increase because the system no longer encourages a company to divert assets out of the country or delay bringing useful funds back.
This article is written with the assumption that its readers have some level of familiarity with U.S. taxation of international operations, although it will provide some background for those less familiar. Some aspects of international taxation have not been changed, and this article is not intended to provide an overview of the system. Instead, it will focus on some of the most widely-relevant areas changed by the TCJA.
Background – International Taxation 101
One can only understand U.S. taxation of international operations by distinguishing between two competing systems – (1) worldwide taxation and (2) territorial taxation – and by understanding the concept and historical use of Controlled Foreign Corporations.
Historically, U.S.-based individuals and corporations have been required to report and pay U.S. income taxes on their worldwide income. This results in some income being taxed both by a foreign country and by the U.S. Use of a “foreign tax credit” allows U.S. companies to reduce their U.S. taxes by the amount of taxes paid to foreign countries on that same income. While subject to a number of limitations, this regime attempts to avoid double-taxation that otherwise would unfairly burden U.S. taxpayers.
Unlike the U.S., nearly every other industrialized country in the world uses a territorial system, where the country only taxes the income that is earned within its borders.
The concept of Controlled Foreign Corporations is pervasive under both old and new law, and their treatment differs from other types of taxpayers.
Controlled Foreign Corporations (“CFCs”)
Worldwide taxation generally put U.S.-based companies at a disadvantage compared to foreign-based entities. All income (including overseas income) was taxed by the U.S., and the complex math behind the foreign tax credit did not always allow it to mitigate double taxation. Add to this the fact that the U.S. tax rates have been higher than nearly any other industrialized country’s corporate rate, and you had a system that right out of the gate placed U.S.-based multinational companies at a huge disadvantage when competing with overseas competitors. They were faced with a higher tax applied to a broader base than their competitors, and to achieve the same level of after-tax profit, they had to be more efficient (which is difficult when U.S. labor costs are relatively high), or price their products higher, which could drive buyers to their competitors’ products.
To legally circumvent worldwide taxation and attain equal footing with non-U.S. based competitors, many U.S. taxpayers formed foreign subsidiaries, or even underwent “corporate inversions,” whereby the U.S. company or its subsidiary took the form of a CFC. A CFC is simply a corporation that is not based in the U.S., but is owned/controlled by a U.S. taxpayer (often, but not necessarily, another corporation). Because CFCs are based in other countries rather than the U.S., they were not subject to the worldwide taxation regime. They may be subject to their foreign host country’s taxation, but their income became subject to U.S. taxation only when repatriated (brought back into the U.S., often via dividends paid to its U.S. owner).
The historical CFC can be best viewed as a legal tax-deferral structure. As long as the money stayed out of the U.S., the U.S. taxation of that company’s earnings was deferred. Note that foreign entities that are disregarded as separate from their owners (known as “check the box entities”), as well as flow-through entities, are not CFCs. They, instead, generally remain subject to the worldwide income regime.
What the TCJA attempts to do – broadly
For starters, the TCJA reduces the top corporate income tax rate from 35% to 21% – much closer to the average corporate rate assessed by other countries.
It also completely upends CFC’s deferral features – in two ways. First, a tax of either 15.5% (for liquid assets) or 8% (for non-liquid assets) will be due on PAST cumulative, deferred earnings. This one-time tax will be payable over an 8-year period, with the first payment, representing 8% of the total tax, due for most calendar year taxpayers by April 15, 2018.
Observation: Although this deadline coincides with the filing deadline of many taxpayers’ 2017 tax returns, an extension of time to file the tax return does not extend the time to make this payment. The computations necessary to determine the tax may be very complex and time-consuming.
The second way the TCJA upends CFC’s deferral features is by imposing an annual tax on gross CFC income that exceeds a certain rate of return.
It also provides an incentive, though, in the form of a reduced tax rate on a portion of income, for taxpayers who earn foreign income derived from the use of U.S.-based intangibles.
These, and many other features of the Act are discussed in more detail below.
Change to a Territorial Tax System (but not completely)
Mandatory 8% or 15.5% toll charge on tax-deferred foreign earnings
The TCJA provides a one-time transitional tax on a U.S. 10%-or-more shareholder’s pro rata share of the foreign corporation’s post-1986 tax-deferred earnings. This is accomplished as somewhat of a deemed dividend, in that it occurs whether or not any funds are transferred. One of two tax rates will be applied to the earnings: 15.5% (in the case of accumulated earnings held in cash, cash equivalents or certain other short-term assets) or 8% (in the case of accumulated earnings invested in illiquid assets, like property, plant and equipment). The foreign corporation’s post-1986 tax-deferred earnings subject to tax is the greater of the earnings as of November 2, 2017 or December 31, 2017. It excludes earnings and profits that were accumulated by a foreign company prior to attaining its status as a specified foreign corporation, but allows post-1986 accumulated earnings deficits of any foreign corporations to offset tax-deferred earnings of other foreign corporations (netting generally may be used among all affiliated group members).
Timing of payment
The U.S. shareholder may elect to pay the transitional tax over a period of up to eight years. The first payment is due for most filers by April 15, 2018 for calendar year U.S. taxpayers. At that time, and each of the next four years, 8% of the tax is due. In years five, six and seven, respectively, the remaining 15%, 20%, and 25% of the tax is due.
Additional delay of payment allowed for S corporations
The TCJA allows shareholders of S corporations that in turn own specified foreign corporations to defer the toll charge until a “termination event” occurs, including a sale of the S corporation stock, cessation of status as an S corporation, or a liquidation of the S corporation.
Exemption of foreign dividends
The TCJA exempts 100% of the foreign-source portion of dividends received by a U.S. corporation from a foreign corporation (other than a Passive Foreign Investment Corporation (PFIC) that is not also a Controlled Foreign Corporation (CFC)) in which the U.S. corporation owns at least a 10% stake. It does not allow the same exemption to U.S. individual shareholders; the exemption applies only to C corporations. The effective date is generally for distributions made after December 31, 2017. Some additional specifics are noted below.
- The exemption applies only if the stock of the foreign corporation has been held for more than one year.
- No exemption is allowed for any dividend received by a U.S. shareholder from a CFC if the dividend is deductible by the foreign corporation when computing its taxes. (This refers to so-called “hybrid dividends.” Dividends are not usually deductible under U.S. law, but are sometimes deductible in foreign jurisdictions.)
- No foreign tax credit or deduction is allowed for any portion of a distribution that is also exempt under this provision (no double-dipping!).
- A special rule applies to the sale of foreign corporations. The TCJA applies the dividend exemption to gain on the sale of foreign stock only to the extent of its earnings and profits (E&P), and clarifies that the dividend exemption will apply on the gain from the sale of lower tier CFCs to the extent of that CFC’s E&P. Only for determining loss on the sale of stock of a 10% owned foreign corporation, a U.S. parent would reduce its basis in the stock of the foreign corporation by an amount equal to the exempt dividend it received from that foreign corporation.
- The TCJA allows an exemption for a U.S. corporation’s distributive share of a dividend received by a partnership in which the U.S. corporation is a partner if the dividend would have been eligible for the exemption had the U.S. corporation directly owned stock in the foreign corporation.
Anti-base erosion rules
Anti-base erosion rules, as the name suggests, refer to an attempt to prevent the U.S. tax base from eroding. The TCJA includes some positive and negative encouragement toward this end (a stick and a carrot, if you will), both geared toward taxpayer’s utilization of intangible assets. Two predominant provisions stand out from the others: The “GILTI” stick that applies to foreign-based entities (CFCs), and the “FDII” carrot that applies to U.S.-based taxpayers who earn money overseas.
GILTI – the Stick
The TCJA imposes a new tax on a U.S. shareholder’s aggregate net CFC income that is treated as global intangible low-taxed income (“GILTI”). GILTI is gross income in excess of extraordinary returns derived from tangible depreciable assets, excluding effectively connected income (ECI), subpart F income, high-taxed income, and dividends from related parties. The extraordinary return base is equal to 10% of the CFCs’ aggregate adjusted basis in depreciable tangible property. Under these rules, only 80% of the foreign taxes paid on the income will be allowed as a foreign tax credit. All CFCs are aggregated for purposes of the computation. For taxable years beginning after December 31, 2017 and before January 1, 2026 the highest effective tax rate on GILTI is 10.5%. For taxable years beginning after December 31, 2025 the effective tax rate on GILTI is 13.125%.
Observation: The one-time toll charge described earlier is just that (one-time). However, this portion of the anti-erosion rules will cause CFCs that are extraordinarily profitable overseas, or whose overseas profits are derived too heavily from intangible sources, to pay a tax in the U.S. based on the deemed excess. This will discourage companies from stockpiling cash earned from offshore intangible property out of the country. How? This feature will tax excess earnings before they are repatriated, and not allow the dividend exclusion described earlier on such income.
FDII – the Carrot
Foreign derived intangible income (“FDII”) is income derived by U.S. companies in connection with property sold, leased, or licensed to, and services provided to, foreign persons. For taxable years beginning after December 31, 2017 and before January 1, 2026, FDII is effectively taxed at a lower rate than normally would apply (21% for corporations). Specifically, it allows an effective tax rate of 13.125%. For taxable years beginning after December 31, 2025, the effective tax rate on FDII is 16.406%.
Proceeds from sales, leasing, or licensing, and revenue from services provided to a related foreign person are included only if the related foreign person sells the property to an unrelated foreign person, and the taxpayer establishes that the ultimate sale is for foreign use. Income from services provided to related foreign persons is included if the taxpayer establishes that the related person does not perform substantially similar activities for U.S. persons.
Observation: This provides a tax break for U.S.-based companies that sell or lease property outside of the country. It thereby encourages companies to remain based in the U.S.. It is unclear to what extent this benefit will apply to flow-through entities, which have their own new 20% deduction of flow-through income created by the TCJA. Practitioners expect a flurry of Treasury Regulations to begin materializing that address this and other ambiguities in the new law.
A number of other provisions were created that are designed to prevent the U.S. tax base from eroding, described briefly as follows:
Change in intangibles definition
The TCJA changes the definition of intangible property to include workforce in place, goodwill and going concern value and “any similar item,” the value of which is not attributable to tangible property or the services of an individual. It also confirms the authority of the Treasury Department to require certain valuation methods.
Separate branch FTC baskets
The TCJA establishes a separate foreign tax credit basket for branches, and appears to establish another one for GILTI income (described above). These join the existing baskets of general and passive income, resulting in four baskets. This change reduces a corporation’s ability to utilize foreign tax credits generated by one type of activity against income created by another.
Export sales source rule
The TCJA amends the “source of income” rules under Sec. 863(b). For property manufactured in the U.S. and sold overseas, this will result in more income “sourced” to the U.S. for purposes of the foreign tax credit. This will produce a smaller foreign tax credit, but other portions of the Act will in many cases mitigate this damage.
Other foreign tax credit changes
Indirect foreign tax credits will be available only for Subpart F income. No credits will be allowed with respect to any dividends associated with exempt dividends. Applicable to C-corporations only, foreign tax credits will be used on a current year basis and will not be allowed to be carried forward or back.
Inbound base erosion rule
The TCJA creates a new base erosion anti-abuse tax (“BEAT”). It applies only to certain very large companies. Specifically, the BEAT applies to corporations (other than RICs, REITs, or S-corporations) that are subject to U.S. net income tax, and have average annual gross receipts of at least $500 million, and that have made related party deductible payments totaling 3% (2% in the case of banks and certain security dealers) or more of the corporation’s total deductions for the year. A corporation subject to the tax generally determines the amount of tax owed under the provision (if any) by adding back to its adjusted taxable income for the year all deductible payments made to a foreign affiliate (“base erosion payments”) for the year (the “modified taxable income”). Base erosion payments do not include cost of goods sold, certain amounts paid with respect to services, and certain qualified derivative payments. The excess of 10% (5% in the case of one taxable year for base erosion payments paid or accrued in taxable years beginning after December 31, 2017) of the corporation’s modified taxable income over its regular tax liability for the year (net of an adjusted amount of tax credits allowed) is the base erosion minimum tax amount that is owed. For tax years beginning after December 31, 2025 the rate is increased from 10% to 12.5%. The rate for certain banks and security dealers is 1% higher than the rates described above. Premiums related to reinsurance of life and property and casualty contracts are specifically included as base erosion payments.
Odds & ends
The new “toll charge,” dividend exemptions, and base erosion rules represent what many would agree are the most significant changes in the Act that impact international activities, but many more provisions were created that are worth mentioning, as follows:
Transfers of active business assets offshore
Transfers of property from the U.S. to another country generally result in taxable gain. Prior to the TCJA, an exception existed that allowed property used in an active trade or business to avoid this treatment, and instead qualify as a tax-free organization, reorganization, or liquidation. The exception is removed with the passage of TCJA.
Overall domestic loss
For purposes of the foreign tax credit, the TCJA provides an election to increase the percentage (but not greater than 100%) of domestic taxable income that may be offset by any pre-2018 unused overall domestic loss and re-characterized as foreign source.
Definition of U.S. shareholder/stock attribution rules
The definition of a U.S. shareholder was changed to include any U.S. person who owns 10% or more of the total value (as well as voting power) of shares of all classes of stock of a foreign corporation. Related to this, U.S. corporations will be deemed to own the foreign stock that is owned by the U.S. corporation’s foreign parent for purposes of determining CFC status. The TCJA clarifies that the provision is intended to target transactions that avoid subpart F by “de-controlling” a foreign subsidiary so that it is no longer a CFC. So brother/sister foreign corporations owned by a U.S. subsidiary’s foreign parent would be a CFC and such U.S. subsidiary U.S. corporate tax filings would require additional information tax reporting.
Observation: This is relevant to whether or not Form 5471 must be filed (and which portions of this complex form must be completed), the one-time repatriation tax, and GILTI income, and will result in more entities being subject to new requirements via attribution.
Repeal of 30-day controlled foreign corporation rules
Under the TCJA, foreign corporations will be considered as CFCs as soon as the ownership requirements are met and the entity is subject to the subpart F and base erosion rules. Under the old rules, an entity was not considered to be a CFC unless held for at least 30 days. The TCJA thus closes a loophole.
CFC “look-through” rules
Currently, Sec. 954 of the Internal Revenue Code (“IRC”) allows dividends, interest and royalties received by one CFC from another CFC to qualify as deferred income, rather than immediately taxable income. This feature was a temporary one, set to expire after 2019. The TCJA did not intervene to make this feature permanent. Thus, the rule expires after 2019, and such income will be taxable unless otherwise exempt.
The Act maintains IRC Sec. 956 “investment in United States property” rules
Both the House and Senate bill repealed or modified existing Sec. 956 rules, and it was therefore anticipated that the final law would as well. However, the TCJA adopted no such change. Any investments by a CFC into U.S. property, including loans to CFC shareholders and guarantees of U.S. shareholder debt, will continue to trigger subpart F income for such U.S. shareholders.
Observation: Without this rule, entities might circumvent dividend treatment under the CFC regime by categorizing cash transfers as loans to their parent companies, rather than dividends.
Sale of a U.S. partnership interest held by a foreign person
Gain from the sale or exchange of a partnership interest is treated as effectively connected income (“ECI”), and, therefore, is subject to U.S. tax, to the extent the partnership is engaged in a U.S. trade or business and the foreign partner would have had ECI had the partnership sold all of its assets. There is also a provision that would require the partnership to withhold 10% of the amount realized on the sale or exchange of the partnership interest unless the transferor certifies that the transferor is not a nonresident alien individual or a foreign corporation.
A previous version of the Act proposed unfavorable changes to the tax treatment of interest charge domestic international sales corporations (“IC-DISC”). Those proposed changes were dropped, however, and the tax treatment of the IC-DISC structure survives.
Observation: While the treatment survives, the tax rate savings impact of an IC-DISC is somewhat muted as a result of other tax rate changes in the Act. Its benefit for individual taxpayers that receive DISC dividends relates solely to the difference between the 23.8% top tax rate that generally applies to dividend income (including the net investment tax at 3.8%) and the top rate an individual would pay on pass-through income for entity that pays commissions to the IC-DISC. Under the Act, for S-corporation and LLC owners the owners receive a 2.6% decrease in the top rate, and potentially pay tax on only 80% of their S-corporation income. This makes the effective rate differential smaller. So assuming a pass-through owner with a DISC paying tax on operating earnings is subject to a top tax rate of 29.6% (37% x 80%), this would still result of permanent tax rate savings of 5.8% when compared to the 23.8% top dividend tax rate on DISC dividends. So if the volume of foreign sales is there, IC DISC’s still makes sense.
It should be apparent that the Tax Cuts and Jobs Act imposes significant new burdens on both U.S. and foreign taxpayers. International taxation was complex before these changes, and the new concepts do not simplify it at all. We have a new regime – not the worldwide income structure left behind, or a territorial system sported by many countries, but sort of a pseudo-territorial structure all our own. We most certainly will see voluminous new Treasury Regulations and other guidance to follow.
Owners of controlled foreign corporations (“CFCs”) are encouraged to very quickly undertake any necessary computations of accumulated earnings, which may be very time-consuming; and prepare for the first payment of the new repatriation tax that for most taxpayers is due by April 15 of this year.
If you would like to discuss these matters further, contact Stuart Lyons, international tax practice lead, or your BNN advisor at 1.800.244.7444.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.