The Tax Cuts and Jobs Act of 2017 (Tax Act) has brought significant changes to international taxation. This article summarizes some of the more salient international tax features contained within the Tax Act. From an international tax perspective, the new tax law embraces a limited territorial system (as exists with most U.S. trading partners), seeks to protect the U.S. tax base from perceived cross-border erosion, and creates an incentive for intangible property (IP) investment in the United States at a globally attractive effective tax rate of 13.25 percent.
Due to the complexity of the new rules – which were written in a very brief timeframe with little to no input from the business and economic community on their implications – the U.S. Treasury and IRS are expected to be issuing significant guidance over the next 12 to 18 months.
A Territorial Tax Regime
The U.S. corporate tax system has been converted from a worldwide tax deferral system to a limited hybrid territorial regime (depending upon the facts and how heavily a company is invested in hard assets of foreign subsidiaries). The hybrid system retains the controlled foreign corporation (CFC) provisions, but with some modifications. In essence, the U.S. tax system moves to a quasi-global consolidation. A 100 percent dividends-received deduction (DRD) is permitted for U.S. C corporations that own 10 percent or more of a foreign corporation (referred to as a specified 10-percent-owned foreign corporation) that meet certain conditions. Foreign tax credits (FTCs) are eliminated on exempt actual-foreign-source dividends (deemed-paid credits under Section 902 are eliminated entirely). The DRD is not available for dividends received from a hybrid dividend. A hybrid dividend is one where the foreign entity receives a deduction or other tax benefit from taxes imposed by the foreign country. Individual owners of flow-through U.S. or foreign entities are not entitled to the DRD territorial tax regime.
Mandatory Repatriation “Toll Charge”
The Treasury Department estimates that U.S.-owned foreign corporations have about $3 trillion of foreign earnings that have been U.S. tax deferred. There is a one-time mandatory Subpart F inclusion, where U.S. shareholders owning at least 10 percent of certain foreign corporations include in income for the foreign corporation’s last tax year beginning before 2018 the U.S. shareholder’s pro rata share of the aggregate net post-1986 accumulated earnings and profits of the specified foreign corporation (SFC) – to the extent such earnings and profits have not been previously subject to U.S. tax – determined as of Nov. 2, 2017, or Dec. 31, 2017, whichever is higher. For this purpose, earnings and profits are determined without regard to distributions made during the taxable year that includes the measurement date, unless made to another SFC. The mandatory inclusion applies to all U.S. persons meeting the applicable conditions, whether or not they are eligible for the new participation exemption system.
Determining the mandatory inclusion amount will require historic studies and updated calculations to pinpoint the various relevant tax attributes (such as earnings and profits, tax pools, basis, separate limitation losses, overall foreign losses, overall domestic losses, expense allocation methodologies, reorganizations, etc.). The provision includes several anti-abuse rules intended to prevent taxpayers from reducing earnings and profits subject to the mandatory deemed repatriation inclusion and deferring its application to a later year.
The earnings and profits are subject to a reduced tax rate (15.5 percent) for domestic corporations with respect to cash and cash equivalent assets on the balance sheet, and an 8 percent rate for the balance. The cash and cash equivalent balances are computed at Dec. 31, 2017, and the average of Dec. 31, 2016 and 2015. The greater of the two is used. A deduction is allowed for domestic corporations based on a percentage of the mandatory inclusion amount to arrive at the reduced tax rate. Since the deduction is based on the U.S. corporate tax rate, U.S. individuals that are U.S. shareholders will likely pay a higher tax rate than 15.5 percent and 8 percent. For 2017, the individual tax rate is 39.6 percent versus the U.S. corporate tax rate of 35 percent. For fiscal-year foreign corporations subject to the mandatory inclusions, the rate U.S. individuals pay will be even greater given the U.S. individual rate only drops from 39.6 percent to 37 percent in 2018, whereas the U.S. corporate tax rate in 2018 drops from 35 percent to 21 percent. An election can be made to pay the tax over eight years interest free, with owners of S corporations – and regulated investment companies (RICs) and real estate investment trusts (REITs) – permitted to make an election to defer payment indefinitely until a “triggering event” occurs.
Taxpayers with carryover net operating losses (NOLs) may consider the election to forego use of the NOL to offset the mandatory repatriation inclusion if they find it advantageous to use foreign tax credits rather than letting them expire or if they find the NOL more valuable against higher rate future income. Foreign tax credit carryforwards from prior years are available to offset the inclusion.
Global Intangible Low-Taxed Income
Starting in 2018, a U.S. shareholder of any CFC must include in gross income its global intangible low-taxed income (GILTI) in a manner generally similar to inclusion of Subpart F income. GILTI is the excess of the U.S. shareholder’s net CFC’s tested income over the shareholder’s net deemed tangible income return, which is an amount equal to the excess of 10 percent of the aggregate of the shareholder’s pro rata share of the qualified (hard) business asset investment (QBAI). (U.S. shareholders can defer a 10 percent return on their hard assets; the rest is a GILTI inclusion.)
For any amount of GILTI included in the gross income of a domestic corporation, the U.S. corporation gets a 50 percent deduction (37.5 percent after Dec. 31, 2025) and can potentially credit 80 percent of foreign income taxes imposed on the GILTI inclusion, subject to expense apportionment. Expense apportionment may increase the rate of foreign tax credits needed to offset the U.S. tax on the GILTI inclusion to a U.S. corporation. Ignoring expense apportionment, if the foreign tax rate on the GILTI is at least 13.125 percent (before 2026), there will be no U.S. residual tax on the GILTI inclusion. Individual owners of CFCs or individual owners through U.S. flow-through entities that own CFCs do not get the 50 percent deduction or the underlying foreign tax credit against their GILTI inclusion. Individuals may want to consider the pros and cons of making a Section 962 election to mitigate GILTI. The GILTI foreign tax credit for U.S. corporate shareholders is in its own separate GILTI basket, and is a year-by-year foreign tax credit calculation with no allowance for carryovers or carrybacks of excess GILTI foreign tax credits.
Foreign-Derived Intangible Income
For U.S. domestic corporations for taxable years beginning after Dec. 31, 2017, and before Jan. 1, 2026, a deduction is permitted equal to the sum of 37.5 percent of its foreign-derived intangible income (FDII). After Dec. 31, 2025, the deduction for FDII is reduced to 21.875 percent.
The FDII of any domestic corporation is the amount that bears the same ratio to the corporation’s deemed intangible income as its foreign-derived, deduction-eligible income bears to its deduction-eligible income. In other words, a domestic corporation’s FDII is its deemed intangible income multiplied by the percentage of its deduction-eligible income that is foreign-derived.
Deduction-eligible income means, with respect to any domestic corporation, the excess of the gross income of the corporation determined without regard to certain exceptions to deduction-eligible income over deductions (including taxes) allocable to such gross income (referred to as deduction-eligible gross income). The exceptions to deduction-eligible income are the Subpart F income of the corporation determined under Section 951; the GILTI; any financial services income (as defined in Section 904(d)(2)(D)); any dividend received from a CFC with respect to which the corporation is a U.S. shareholder; any domestic oil and gas extraction income; and any foreign branch income (as defined in Section 904(d)(2)(J)).
Foreign-derived, deduction-eligible income means, with respect to a taxpayer for its taxable year, any deduction-eligible income of the taxpayer that is derived in connection with property that is sold by the taxpayer to any person who is not a U.S. person and that the taxpayer establishes, to the satisfaction of the Secretary of the Treasury, that this is for a foreign use, or for services provided by the taxpayer that the taxpayer establishes are provided to any person, or with respect to property, not located within the United States. The deduction only applies to domestic C corporations (other than RICs and REITs), and is not available for individuals, or individuals that own a flow-through entity or S corporation.
This provision provides a reduced tax rate on certain qualifying income related to certain sales of property to foreign persons for foreign use (e.g., export sales and services provided for foreign persons).
This provision appears to have been intended to establish the United States as an attractive jurisdiction as an intangible property principal under certain circumstances. The rate of tax on the FDII is 13.125 percent. (100 - 37.5 = 62.5 x 21 percent = 13.125) This is the same rate of tax on the GILTI. The new Tax Act is attempting to take out the historic foreign bias of owning intangibles for U.S. domestic corporations by attempting to level the playing field with respect to U.S. versus foreign ownership of intangibles.
Other International Items
The Tax Act affects several areas of international tax planning. Below are some of the highlights:
- The benefits of the deduction against the mandatory inclusion are denied and a 35 percent U.S. tax is imposed without eligibility for a foreign tax credit if a U.S. shareholder does an inversion transaction within the 10-year period following enactment of this provision.
- Base erosion and anti-abuse tax (BEAT) of 10 percent (5 percent in 2018) is imposed on deemed base erosion payments for foreign-owned U.S. groups (and certain U.S. owned groups that make BEAT payments to their foreign subsidiaries) with average annual gross receipts of $500 million or more. This includes interest, royalties, payments under a qualified cost-sharing agreement, service payments, items disguised as derivatives, purchase of depreciable and amortizable property, reinsurance premiums, and payments to inverted groups. NOLs cannot be used to offset the BEAT.
- Business interest expense is limited for all U.S. taxpayers to 30 percent of earnings before interest, taxes, depreciation, and amortization. In 2022, the limit becomes 30 percent of earnings before interest and taxes.
- 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 previous dividend received from that corporation that is exempt by the DRD.
- If a domestic corporation transfers substantially all the assets of a foreign branch to a specified 10-percent-owned foreign corporation, the domestic corporation recaptures any previously deducted losses from that foreign branch, irrespective of the value versus the basis of the assets.
- Prior to the Tax Act, a U.S. person could transfer the assets used in the active conduct of a foreign trade or business and foreign goodwill and going concern value from a branch to a foreign corporation tax-free, provided it met a tax-free provision of the Internal Revenue Code (subject to a branch loss recapture rule). This was referred to as the active trade or business exception. This has been struck from the IRC, making incorporating foreign branches extremely difficult taxwise going forward. The Tax Act also made clear that foreign goodwill and going concern value are now 367(d) intangibles subject to the outbound super-royalty provisions when transferred from the United States to a foreign corporation.
- The definition of a U.S. shareholder for determining who owns 10 percent or more of a foreign corporation in testing the foreign corporation for whether it is a CFC and subject to the Subpart F provisions is now either 10 percent vote or value. Prior to the Tax Act it was just those that held 10 percent or more vote to determine who is in for the test.
- Foreign-based company oil-related income is repealed from Subpart F income.
- A U.S. shareholder who avoided Subpart F shipping income by investing the assets was required to report Subpart F income when the assets decreased. This has been repealed.
- The limitation of Section 958(b)(4) on downward attribution is repealed. This can make foreign groups that have a U.S. subsidiary in them CFCs.
- To be a U.S. shareholder of a CFC, the U.S. person had to hold the shares for an uninterrupted period of 30 days or more during the year. That rule has been repealed. This means a U.S. shareholder of a CFC is the one who holds the CFC on the last day of the year, irrespective of how many days they held the shares.
- A deduction is denied for any hybrid transaction. This is for interest or royalties paid from the United States to a related party where there is no corresponding inclusion, or the related party is allowed a deduction.
- The sale-sourcing rules have been amended to source income to where the property is produced (manufactured). The 50/50 sourcing rule of Section 863(b) has been modified.
- The fair market value method for determining allocation of interest expense for determining FTCs has been repealed.
- Taxpayers can make an election to increase the percentage from 50 percent to 100 percent of their pre-2018 unused overall domestic losses.
- A foreigner’s gain on the sale of a U.S. partnership interest that generated U.S. effectively-connected income is taxed as U.S. effectively-connected income. This overturns Grecian Magnesite Mining, Industrial & Shipping Co. SA v. Commissioner of Internal Revenue, 149 T.C. no. 3 (July 13, 2017).
- A new foreign tax credit basket is created for foreign branch or flow-through income. Given that GILTI income goes into its own foreign tax credit basket and the change to the sourcing sale rule, among other changes, U.S. individuals and U.S. corporations that are in an excess general limitation FTC position may find it difficult going forward to generate foreign source general limitation income to use up those excess credits.
The Tax Act has significantly altered the international taxation landscape. The playbook that international tax specialists have been using has been turned completely on its head. The new playbook is heavy in the need to do numbers crunching. Given the short time in which the Tax Act was completed, there will be unintended results. Planning may be difficult until the Treasury Department and IRS provide needed guidance and clarity.
Andrew M. Bernard Jr., CPA, is a managing director for Andersen Tax in Philadelphia and a member of the
Pennsylvania CPA Journal Editorial Board. He can be reached at firstname.lastname@example.org.
Julie Leighton, JD, is a tax associate for Andersen Tax in Philadelphia. She can be reached at email@example.com.