Well, not so fast! We hope you stop to think about what this new tax law means for you and your business before you file it under “passed.” If you own an international business or plan to expand your U.S. or foreign business operations to other countries, you must revisit your legal entity structure or plans before you embark on any changes. Depending on your facts and circumstances, you may find that the new tax law has both advantages and disadvantages.
In December 2017, Congress passed the House and Senate Conference Committee Agreement, which the President has signed into law. The enacted version, called the “Tax Cuts and Jobs Act of 2017,” is the most comprehensive piece of tax legislation to be enacted in over 30 years. In addition to the many domestic tax impacts, this legislation will also significantly alter the international tax landscape for all worldwide multi-national corporations with U.S. business operations.
The scope of the legislation is broad, and most tax practitioners currently believe there will be further changes to the legislation as it needs to be reconciled with the protocols and obligation of the United States to the World Trade Organization, the Organization for Economic Co-Operation and Development, and other worldwide political and economic unions like the European Union, ASEAN, etc.
Given the broad scope of this legislative change, this article will discuss the significant provisions that we believe will have the most direct and immediate impact on our clients. As additional guidance is released by the Internal Revenue Service and the Treasury, we will provide updates as they relate to the international tax consequences of the 2017 tax reform.
Dividend Received Deduction
The most significant impact of the 2017 tax reform is the transition away from a worldwide tax system and toward a hybrid territorial tax system. Previously, the U.S. taxed U.S. individuals and corporations on their worldwide income, regardless of where the income was derived. For example, if a U.S. C corporation owned a Mexican subsidiary corporation, the U.S. corporation would be taxed upon receiving a dividend from its Mexican subsidiary corporation. This was frequently criticized, particularly as other major economies moved toward a territorial tax regime. To transition toward a hybrid territorial system, new Section 245A was enacted. This new Section provides a 100-percent dividends received deduction for the foreign-source portion of dividends received by a U.S. C corporation from its foreign subsidiaries. Under the example, the U.S. parent corporation will not be taxed on dividends received after 2017.
A dividends received deduction (“DRD”) is a federal tax deduction applicable to corporations (not individuals) receiving dividends from related entities. In the case of Section 245A, the purpose of the deduction is to eliminate U.S. taxation on dividends resulting from foreign business activity.
The DRD does not come without limitations. First, the DRD specifically applies to the foreign-source portion of a dividend received by such domestic corporation from a “specified 10%-owned foreign corporation” in which such domestic corporation is a “United States shareholder.” For purposes of the DRD, a “specified 10%-owned foreign corporation” is any foreign corporation (1) other than a passive foreign investment company (PFIC) that is (2) not a controlled foreign corporation with respect to which any domestic corporation is a United States shareholder.
Second, the definition of a U.S. shareholder is also updated. Under current law, a U.S. shareholder is defined as any U.S. person that owns 10% of the voting stock of a foreign corporation. Under the expanded definition, a U.S. shareholder also includes any person that owns 10% of the value of the stock of a foreign corporation. Additional changes to the definition of a U.S. shareholder for international tax reporting purposes are discussed below.
Third, the DRD does not apply to a U.S. shareholder receiving a dividend from a CFC if the dividend is a hybrid. A hybrid dividend is an amount received from a CFC for which a deduction would be allowed under Section 245A and for which the specified 10-percent owned foreign corporation received a deduction from taxes imposed by a foreign country. Instead, hybrid dividends are treated as subpart F income to the recipient CFC in the tax year of receipt and, therefore, included in the gross income of the U.S. shareholder to the extent of the shareholder’s pro-rate share of subpart F income.
Fourth, the 2017 tax reform includes a minimum holding period requirement in order to claim the DRD. The U.S. corporate shareholder must meet the ownership requirements for more than 365 days during the 731-day period beginning on the date that is 365 days before the date on which the shares become ex-dividend. Traditionally, the ex-dividend date is the day on which all shares bought and sold no longer come attached with the right to be paid the most recently declared dividend. This may not be an important date for closely held companies, but the date is significantly more important for companies with many shareholders, particularly those that trade on exchanges.
Fifth, no credit or deduction is allowed for any foreign income taxes paid or accrued with respect to any portion of a dividend that qualifies for the deduction. In effect, these foreign tax credits will be eliminated, putting the significant time and money companies have dedicated to monitoring foreign tax credit positions at risk.
Sixth, and finally, the credit is only available to U.S. C-corporations. S-corporations, RICs, and REITs must continue to include income distributions in income.
The other half of the transition to a hybrid territorial tax regime involves the repatriation – deemed or otherwise – of the estimated $2.5 trillion dollars currently held in foreign subsidiaries. This “toll charge” is widely seen as a one-time charge applicable to the foreign earnings currently held offshore by U.S. taxpayers (corporate and non-corporate). Other economies have used similar methods to transition from a worldwide system of taxation to something more akin to a territorial system.
The 2017 tax reform amends Section 965 to require U.S. shareholders of CFCs to include in income the shareholder’s pro rate share of the deemed repatriation amount. The deemed repatriation amount is measured as of the taxable year beginning before January 1, 2018, and certain measures were taken to ensure an accurate portrayal of a CFCs untaxed E&P. For instance, the deemed repatriation amount is the greater of the CFC’s post-1986 E&P as of (1) November 2, 2017, or (2) December 31, 2017, that were not previously subject to U.S. tax.
The toll charge operates as a one-time tax on foreign earnings that would otherwise have been repatriated at the historical U.S. corporate income tax rate of 35%. Under the new regime, the effective rate for the portion of the deemed repatriation equal to the U.S. shareholder’s aggregate foreign and cash and cash-equivalent assets is 15.5 percent. The effective rate for the remainder is 8 percent.
U.S. shareholder’s may elect to pay the net tax liability resulting from the deemed repatriation in eight annual installments. Each installment must be made by the due date for the tax return for the respective tax year, without regard to extensions. No interest is charged on the deferred payments, provided they are timely paid. They payments for each of the first five years equals 8 percent of the net tax liability, the sixth is 15 percent, the seventh is 20 percent, and the remaining 25 percent is payable in the eighth and final year. Under an acceleration rule, certain triggering events accelerate the due date of all remaining installments to the date of the relevant event. Such events include failure to pay an installment payment and liquidation or sale.
Changes to Subpart F Rules
In addition to the expanded definition of a U.S. shareholder, as discussed above, the 2017 tax reform addresses a number of other issues related to the definition of a U.S. shareholder, as well as other functions of the Subpart F rules.
First, related to the definition of a U.S. shareholder, the tax reform modifies the existing stock attribution rules. Currently, Section 958(b)(4) prevents domestic corporations, partnerships, and trusts and estates from being treated as owning stock held directly or indirectly by their foreign shareholders, partners, beneficiaries, or owners. In effect, that provision prevented foreign subsidiaries of foreign-parented groups not held under U.S. entities from being treated as CFCs. The modification to this rule would repeal Section 958(b)(4) so that the foreign subsidiaries of foreign-parented groups with at least one controlled U.S. subsidiary or an interest in at least one U.S. partnership would be treated as a CFC, even if they are not held directly under a U.S. entity.
Second, under current law a U.S. shareholder of a foreign corporation is required to include amounts in income under Subpart F for a tax year only if such foreign corporation has been a CFC for at least 30 consecutive days in that tax year. The modification to this rule eliminates the 30-day requirement. The modifications, including these two and the updated definition of a U.S. shareholder discussed above, significantly increase the number of foreign entities treated as CFCs and the number of U.S. persons treated as U.S. shareholders. Naturally, that means more direct and indirect U.S. shareholders will need to report subpart F income from foreign CFCs, increasing the necessary precautions that must be taken to ensure compliance with U.S. income tax filing obligations.
Base Erosion Provisions
The 2017 tax reform introduces a new type of income called “global intangible low-taxed income,” (“GILTI”) (pronounced guil-ty). The provision requires a U.S. shareholder of a CFC to include in its gross income its GILTI amount. The factors used to determine the GILTI amount are beyond the scope of this article, but fundamentally the GILTI tax is designed to target the excess income foreign subsidiaries have over a 10% rate of routine return on tangible business assets (this rate of return having been determined by Congress).
The taxable GILTI amount is subject to a 50% deduction through 2025 (thereafter, 37.5%) and is subject to tax at a rate of 21 percent. GILTI is grossed-up by 100 percent of the foreign taxes deemed paid or accrued with respect to the income, then the foreign tax credits are available for up to 80% of the foreign taxes. The foreign tax credit allowance creates a unique problem for Section 904, so the new provision limits foreign tax credits in two ways. First, GILTI income is a separate Section 904(d) category, meaning only foreign tax credits deemed paid as a result of a GILTI inclusion can offset a GILTI inclusion. Second, Section 904(c) is amended to prevent the carryforward of GILTI foreign tax credits.
The 2017 tax reform also introduces Section 250, which allows a domestic corporation to claim a deduction for an amount equal to 37.5% of its foreign-derived intangible income (“FDII”). Again, FDII is a new term for the code determined by reference to other newly defined terms for the code, the complexity of which we will not address in this article. Effectively, when combined with the GILTI rules above, the FDII deduction is intended to subject U.S. domestic corporations to a reduced rate of tax on income derived in connection with their intangible assets, including sales to, or services performed for, foreign customers. The tax is applicable without regard to whether the income is earned by U.S. corporation or by its CFCs.
Combined, the GILTI and FDII provisions function to decrease the advantage U.S. corporations currently have exploit intangible property held offshore. As noted above, many tax professionals expect the combined effect of these provisions will be challenged by the WTO. As a result, taxpayers should anticipate future changes to one or both of these provisions.
Finally, the 2017 tax reform expands the definition of “intangible property” under Section 936(h)(3)(B) to include goodwill, going concern value, workforce in place, and any other item the value or potential value of which is not attributable to tangible property or the services of an individual. Effectively, this provision legislatively overturns recent Tax Court cases that held such assets were beyond the scope of the statutory definition of “intangible property.” Additionally, the previous law stated that intangible property under this provision was required to have substantial value independent of the services of an individual. The updated provision has no such requirement, meaning “transfers” of such assets by a U.S. person to a foreign corporation will be subject to Section 367(d) or Section 482.
There are a number of miscellaneous provisions that have received little public attention, but nevertheless may have a significant impact on U.S. multinationals.
First, the 2017 tax reform repeals the active trade or business exception under Section 367(a). Previously, transfers of assets to foreign subsidiaries could be considered tax-free if the subsidiary foreign corporation used the assets in an active trade or business. The updated version of Section 367(a) states that when a U.S. person transfers property to a foreign corporation to be used in the active conduct of a foreign trade or business, the foreign subsidiary corporation will not be treated as a corporation for purposes of determining gain on the transaction. Therefore, gain will need to be determined on each transfer of assets to a foreign subsidiary corporation.
Second, under current law the source of a taxpayer’s income from the sale of inventory property produced in the U.S. and sold outside of the U.S. was generally (subject to many regulations) sourced 50 percent to the place of production and 50 percent to the place of sale. This was based on the longstanding legal principle called the title passage rule. The 2017 tax reform modifies this rule and provides that the source of the income is determined solely based on the location of production.
Finally, U.S. multinationals previously could elect to allocate and apportion interest expense among U.S. source income and foreign source income based on either the adjusted tax basis or fair market value of assets. Under the new law, interest expense must be allocated and apportioned based on the adjusted tax basis of the assets.
This is a brief introduction to some of the changes that can be expected from the newly enacted 2017 tax reform. Tax professionals expect some of these changes to be challenged by the WTO, OETC, and other economic trade unions, but without a doubt this significant piece of tax reform will have a dramatic impact on international tax compliance, reporting, and planning. Because the new tax law continues to be interpreted and understood, now is a good time to work with your tax advisor to form an idea how this will impact you or your business.