As part of yesterday’s historic passing of the Tax Cuts and Jobs Act (the Act), the U.S. international tax world has been redefined. The Act contains significant international tax provisions that will drastically change the way U.S. multinationals are taxed and conduct business abroad as well as change how foreign multinationals will conduct business in the U.S. Qualifying U.S. corporations will soon benefit from a 100 percent dividends received deduction (DRD) with respect to dividends paid from certain foreign subsidiaries (i.e., the participation exemption system). Consequently, the foreign earnings of foreign subsidiaries owned by such U.S. corporations will generally not be subject to U.S. federal income tax at the corporate shareholder level assuming it’s an actual dividend distribution, not a deemed inclusion.
This fundamental change to a hybrid territorial system via a participation DRD comes with a one-time “repatriation tax.” The bifurcated effective tax rates for this repatriation of foreign earnings are 15.5 percent (for cash and cash equivalents) and 8 percent (for other earnings). The repatriation tax is assessed on the undistributed, non-previously taxed post-1986 foreign earnings and profits (E&P), based on the higher of E&P as of Nov. 9, 2017, or Dec. 31, 2017 (the use of fixed measurement dates is intended to prevent the reductions of E&P prior to enactment).
This hybrid territorial system also does away with the indirect foreign tax credits (FTC) under section 902 which are no longer allowable on future foreign earnings, with some exceptions. The Act also expands the scope of the current subpart F anti-deferral regime by implementing the following base erosion measures: 1) a minimum tax on global intangible low-taxed income (GILTI), 2) a limitation of interest expense to 30 percent of adjusted taxable income, and 3) a base erosion and anti-abuse tax (BEAT). The Act includes several other provisions targeted at cross-border transactions, including a deduction, in part, for foreign-derived intangibles income (FDII), revised treatment of certain payments in hybrid transactions or with hybrid entities, rules for outbound transfers of intangibles, new U.S. sourcing rules related to inventory, changes to gain recognition and reductions in tax basis on certain transfers related to foreign branches.
This is the first in a series of communications addressing U.S. international tax reform that we will publish over the coming weeks. What follows is a high-level outline of the major U.S. international provisions included in the Act.
Participation exemption system for taxation of foreign income
The Act provides an exemption for certain foreign income by means of a 100 percent deduction for the foreign-source portion of dividends received from specified 10 percent-owned foreign corporations (i.e., the participation DRD). The DRD is available only to C corporations that are not regulated investment companies (RICs) or real estate investment trusts (REITs).
The DRD is not available for any dividend received by a U.S. shareholder from a controlled foreign corporation (CFC) if a deduction would be taken locally by the CFC to the extent of the dividend distribution to the U.S. parent and with respect to any income, war profits and excess profits tax imposed by any foreign country (hybrid dividend).
No foreign tax credit or deduction is allowed for any taxes paid or accrued with respect to any portion of a distribution treated as a dividend that qualifies for the DRD.
A domestic corporation is not permitted a DRD for a dividend on any share of stock that is held by the domestic corporation for 365 days or less during the 731-day period beginning on the date that is 365 days before the date on which the share becomes ex-dividend with respect to the dividend.
Repatriation tax (deemed repatriation at two-tier rate)
In order to level the playing field prior to the establishment of the participation DRD, corporations will be required to pay a repatriation tax on offshore earnings. Specifically, the Act requires that for the last taxable year beginning before Jan. 1, 2018, any U.S. shareholder of a specified foreign corporation must include in its income, the pro rata share of the accumulated post-1986 deferred foreign income of the corporation. Further guidance is expected as to whether U.S. individuals would be included as “U.S. shareholders of a specified foreign corporation,” however, the intent of the provision appears aimed at corporations who themselves are U.S. shareholders of a specified foreign corporation. The application of the two-tier rate is accomplished by making a portion of that pro rata share of deferred foreign income deductible, resulting in a reduced tax rate of 15.5 percent for the included deferred foreign income held in liquid form (i.e., cash or cash equivalent assets) and 8 percent for the remaining deferred foreign income (i.e., illiquid assets), determined as of Nov. 2, 2017, or as of Dec. 31, 2017 (“measurement dates”). A corresponding portion of the credit for foreign taxes would also be disallowed, thus limiting a foreign tax credit to the taxable portion of the included income. The increased tax liability generally may be paid over an eight-year period.
Special rules are provided for S corporations
A special rule permits deferral of the repatriation tax liability for shareholders of an S corporation. S corporations are required to report the includible repatriation amount as well as the amount of deduction that would be allowable and provide a copy of such information to its shareholders. Any shareholder of the S corporation may elect to defer his (her) portion of the net tax liability at transition to the participation exemption system until the shareholder’s taxable year in which a triggering event occurs. The election to defer the tax is due not later than the “original” due date for the return of the S corporation for its last taxable year that begins before Jan. 1, 2018.
Three types of events may trigger an end to deferral of the net tax liability. The first type of triggering event is a change in the status of the corporation as an S corporation. The second category includes liquidation, sale of substantially all corporate assets, termination of the company or end of business, or similar event, including reorganization in bankruptcy. The third type of triggering event is a transfer of shares of stock in the S corporation by the electing taxpayer, whether by sale, death or otherwise, unless the transferee of the stock agrees with the Treasury Secretary to be liable for net tax liability in the same manner as the transferor. Partial transfers trigger the end of deferral only with respect to the portion of tax properly allocable to the portion of stock sold. If a shareholder of an S corporation elects deferral under the special rule for S corporation shareholders and a triggering event occurs, the S corporation and the electing shareholder are jointly and severally liable for any net tax liability and related interest or penalties. The period within which the IRS may collect such liability does not begin before the date of an event that triggers the end of the deferral. If an election to defer payment of the net tax liability is in effect for a shareholder, that shareholder must report the amount of the deferred net tax liability on each income tax return due during the period that the election is in effect. Failure to include that information with each income tax return will result in a penalty equal to 5 percent of the amount that should have been reported.
After a triggering event occurs, a shareholder in the S corporation may elect to pay the net tax liability in eight installments, subject to rules similar to those generally applicable absent deferral. Whether a shareholder may elect to pay in installments depends upon the type of event that triggered the end of deferral. If the triggering event is a liquidation, sale of substantially all corporate assets, termination of the company or end of business, or similar event, the installment payment election is not available. Instead, the entire net tax liability is due upon notice and demand. The installment election is due with the timely return for the year in which the triggering event occurs. The first installment payment is required by the due date of the same return, determined without regard to extensions of time to file.
Recapture from expatriated entities
The provision denies any deduction claimed with respect to the mandatory subpart F inclusion and imposes a 35 percent tax on the entire inclusion if a U.S. shareholder becomes an expatriated entity within the meaning of section 7874(a)(2) at any point within the 10-year period following enactment of the Tax Cuts and Jobs Act. An entity that becomes a surrogate foreign corporation that is treated as a domestic corporation under section 7874(b) is not within the scope of this recapture provision. Although the amount due is computed by reference to the year in which the deemed subpart F income was originally reported, additional tax arises and is assessed for the taxable year in which the U.S. shareholder becomes an expatriated entity. No foreign tax credits are permitted with respect to the additional tax due as a result of the recapture rule.
Shareholders of surrogate foreign corporations not eligible for reduced rate on dividends
Any individual shareholder who receives a dividend from a corporation which is a surrogate foreign corporation as defined in section 7874(a)(2)(B), other than a foreign corporation which is treated as a domestic corporation under section 7874(b), is not entitled to the lower rates on qualified dividends provided for in section 1(h). The provision applies to dividends received from foreign corporations that first become surrogate foreign corporations after date of enactment.
New base erosion measures: Foreign-derived intangible income partial deduction and global intangible low-taxed income minimum tax and partial deduction
The Act adds section 951A to the Internal Revenue Code which would require a U.S. shareholder of a CFC to include in income its GILTI in a manner similar to subpart F income. In general, GILTI would be the excess of a shareholder’s CFCs’ net income over a routine or ordinary return. The deduction for FDII and GILTI is available only to C corporations that are not RICs or REITs. The deduction for GILTI applies to the amount treated as a dividend received by a domestic corporation under section 78 that is attributable to the corporation’s GILTI amount under new section 951A. Although GILTI inclusions do not constitute subpart F income, GILTI inclusions are generally treated similarly to subpart F inclusions. Under the new 21 percent corporate tax rate, and as a result of the deduction for FDII and GILTI, the effective tax rate on FDII is 13.125 percent and the effective U.S. tax rate on GILTI (with respect to domestic corporations) is 10.5 percent for taxable years beginning after Dec. 31, 2017, and before Jan. 1, 2026. (See below example for illustrative purposes.)
Limitations on income shifting through intangible property transfers
The Act also includes changes to the definition of intangible property. Under the Act, workforce in place, goodwill (both foreign and domestic) and going concern value are intangible property. The provision codifies use of the realistic alternative principles to determine valuation with respect to intangible property transactions in connection with taxing the transfer of intangible property by a domestic corporation to a foreign corporation.
Hybrid disallowance rules for related-party amounts paid or accrued in hybrid transactions or with hybrid entities
The Act includes anti-hybrid rules denying deductions for any disqualified related-party amount paid or accrued pursuant to a hybrid transaction or by, or to, a hybrid entity, for example, interest and royalties paid to related foreign persons, where the payments either are not includible or are deductible in the hands of the recipient in its residence country. The Act also includes the denial of a dividends received deduction for hybrid dividends received from a CFC and treats hybrid dividends as subpart F income if received by a CFC. The Act expands the provisions of the hybrid disallowance rules to branches (domestic or foreign) and domestic entities, even if such branches or entities do not meet the statutory definition of a hybrid entity.
Foreign tax credit changes
The Act repeals section 902 indirect foreign tax credits (i.e., the deemed paid credit) with respect to dividends received by a domestic corporation that owns 10 percent or more of the voting stock of a foreign corporation.
The Act creates a new FTC limitation basket for foreign branch income. Foreign branch income is the business profits of a U.S. person which are attributable to one or more qualified business units (QBUs) in one or more foreign countries. Business profits of a QBU shall not, however, include any income which is passive category income.
The Act modifies the source of income from sales of inventory and now the source is determined solely on the basis of production activities. Thus, gains, profits and income from the sale or exchange of inventory property produced partly in, and partly outside, the U.S. is allocated and apportioned on the basis of the location of production with respect to the property. For example, income derived from the sale of inventory property to a foreign jurisdiction is sourced wholly within the U.S. if the property was produced entirely in the U.S., even if title passage occurred elsewhere. Likewise, income derived from inventory property sold in the U.S., but produced entirely in another country, is sourced in that country even if title passage occurs in the U.S. If the inventory property is produced partly in, and partly outside, the U.S., however, the income derived from its sale is sourced partly in the U.S.
Overall domestic loss allowance
The Act increases the overall domestic loss (ODL) allowance by providing an election to increase the percentage (but not greater than 100 percent) of domestic taxable income offset by any pre-2018 unused overall domestic loss and recharacterized as foreign source.
Subpart F changes
Repeal of active trade or business exception
The Act repeals the active trade or business exception under section 367.
Sales by U.S. persons of stock
In the case of the sale or exchange by a domestic corporation of stock in a foreign corporation held for one year or more, any amount received by the domestic corporation which is treated as a dividend for purposes of section 1248, shall also be treated as a dividend eligible for the participation DRD under section 245A.
Reduction in basis of certain foreign stock
Solely for the purpose of determining a loss, a domestic corporate shareholder’s adjusted basis in the stock of a specified 10 percent-owned foreign corporation is reduced by an amount equal to the portion of any dividend received with respect to such stock from such foreign corporation that was not taxed by reason of a DRD.
Sale by a CFC of a lower-tier CFC
If for any taxable year of a CFC beginning after Dec. 31, 2017, an amount is treated as a dividend under section 964(e)(1) because of a sale or exchange by the CFC of stock in another foreign corporation held for one or more years, then: (i) the foreign-source portion of the dividend is treated as subpart F income of the selling CFC, (ii) a U.S. shareholder with respect to the selling CFC includes in gross income for the taxable year of the shareholder with or within the taxable year of the CFC ends, an amount equal to the shareholder’s pro rata share (determined in the same manner as under section 951(a)(2)) of the amount treated as subpart F income under (i), and (iii) the deduction under section 245A(a) is allowable to the U.S. shareholder with respect to the subpart F income included in gross income in the same manner as if the subpart F income was a dividend received by the shareholder from the selling CFC.
Branch recapture - Inclusion of transferred loss amount in certain asset transfers
Under the Act, if a domestic corporation transfers substantially all of the assets of a foreign branch to a specified 10 percent-owned foreign corporation with respect to which it is a U.S. shareholder after the transfer, the domestic corporation includes in gross income an amount equal to the transferred loss amount, subject to certain limitations.
Base erosion and anti-abuse tax
The Act provides for a base erosion and anti-abuse tax (BEAT) which imposes a new alternative minimum tax at a rate of 10 percent for certain large multinational corporations. The BEAT applies to domestic corporations that are not taxed on a flow-through basis and are part of a group with at least $500 million of annual domestic gross receipts (including effectively connected amounts earned by foreign affiliates) over a three-year averaging period, and which have a “base erosion percentage” of 3 percent or higher for the tax year (or 2 percent for certain banks and securities dealers). BEAT applies to foreign corporations engaged in a U.S. trade or business for purposes of determining their effectively connected income tax liability. It does not apply to S corporations, RICs or REITs. The BEAT generally imposes an AMT-like tax on certain amounts paid by U.S. taxpayers to certain related foreign recipients to the extent the amounts are deductible by the U.S. taxpayers. However, the BEAT tax does not apply if the foreign recipient elects to be subject to U.S. income tax on the amounts received. In calculating the U.S. income tax liability imposed under such an election, deemed expenses are allowed as a deduction. A foreign tax credit of 80 percent of applicable foreign credits are allowed against the U.S. tax liability imposed by this provision if an election is made.
The base erosion minimum tax amount is the excess of 10 percent of the modified taxable income of the taxpayer (5 percent for 2018), for the taxable year over an amount equal to the regular tax liability of the taxpayer for the taxable year reduced by the excess (if any) of the credits allowed under Chapter 1 against such regular tax liability over the sum of: (1) the credit allowed under section 38 for the taxable year which is properly allocable to the research credit determined under section 41(a), plus (2) the portion of the applicable section 38 credits not in excess of 80 percent of the lesser of the amount of such credits or the base erosion minimum tax amount (determined without regard to this clause (2)). For taxable years beginning after Dec. 31, 2025, two changes are made (1) the 10 percent provided for above is changed to 12.5 percent, and (2) the regular tax liability is reduced by the aggregate amount of the credits allowed under Chapter 1 (and no other adjustment is made). (See below example for illustrative purposes.)
Information reporting requirements
As in regard to BEAT, the Act will require the following additional reporting requirements under section 6038A:
(A) the name, principal place of business, and country or countries in which organized or resident of each person which: (i) is a related party to the reporting corporation, and (ii) had any transaction with the reporting corporation during its taxable year;
(B) the manner of relation between the reporting corporation and the foreign person; and
(C) transactions between the reporting corporation and each related foreign person.
The penalties under sections 6038A(D)(1) and (2) are both increased to $25,000.
To conclude, while Congress has been touting its Act as one that will create simplicity, in actuality it creates greater complexity.
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The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.