US International Tax Reform: Overview of New US Tax Landscape and Planning Opportunities for US and Foreign Companies

International Services | Fernando R. Lopez | Jan 08, 2018

Congress bestowed a tremendous holiday gift to the global corporate community in the form of a significantly reduced U.S. corporate tax rate and full expensing of plant and equipment acquisitions that effectively lays out the red carpet to foreign companies. In addition, the tax bill’s shift to a territorial tax regime results in a virtual ban on IRS corporate taxing authority beyond the U.S. border. As summarized below, key domestic and international provisions of the tax bill combine into an integrated international tax package that effectively renders the U.S. one of the most tax-friendly places in the world to base global business operations.

Reduction of U.S. Corporate Rate

On the domestic side, the tax bill reduces the U.S. corporate rate from 35% to 21%. This is below the top capital gains rate for individuals (i.e., 23.8% including the 3.8% Medicare surtax) and is now below the worldwide average corporate rate of 22.96%. In addition to now being one of the most competitive corporate rates in the world and a welcome relief to domestic companies, the reduced rate should entice more foreign companies to invest and do business in the U.S. market.

Effective date. The provision applies to taxable years beginning after December 31, 2017.

Implementation of Territorial (Participation Exemption) System

The key international tax feature of the tax bill is the implementation of a territorial tax system whereby foreign corporate earnings (not related to low taxed intangibles) will be exempt from U.S. tax. The bill authorizes the Treasury to issue regulations implementing the bill, but as it stands, the U.S. tax exemption for foreign earnings will be applied via a 100% dividend received deduction (DRD) on distributions from a 10 percent owned foreign corporate subsidiary to a U.S. parent company. There is a 6 month holding requirement and no foreign tax credit or deduction will be allowed for any taxes (including withholding taxes) paid or accrued with respect to a dividend that qualifies for the DRD.

Effective date. The provision applies to distributions made after December 31, 2017.

Taxation of Deferred Foreign Income

U.S. companies currently hold approximately $2.6 trillion of accumulated earnings offshore in foreign subsidiaries. These amounts have benefitted from U.S. tax deferral, which means that they have not been subject to the U.S. corporate tax of 35% as long as the foreign subsidiaries have not distributed the income. As part of transitioning to a territorial system whereby foreign source income generated after December 31, 2017 will be exempt from U.S. tax, the government plans to tax the full amount of foreign earnings accumulated prior to January 1, 2018, whether the funds are repatriated or not. The deferred post-1986 earnings subject to the tax would be the greater of the two amounts measured at the following two dates, regardless of the foreign corporation’s tax year or its financial accounting period: November 2, 2017 and December 31, 2017.  The accumulated amounts will be taxed at significantly low, one-time rates of 15.5% for cash and cash equivalents and 8% for non-cash amounts. In addition, the bill permits U.S. companies to pay the related tax liability in 8 annual installments as follows: 8% for the first five years, 15% the 6th year, 10% the 7th year, and 25% in the 8th year.

Existing foreign tax credit carryforwards and NOLs may be utilized to offset the transition tax. Although foreign tax credits generated with the required deferred income inclusion are subject to a partial disallowance, any remaining unused tax credit may be carried forward 20 years.

Effective Date. The provision is effective for the last taxable year of a foreign corporation that begins before January 1, 2018, and with respect to U.S. shareholders, for the taxable years in which or with which such taxable years of the foreign corporations end.

Reduced Tax on U.S. Pass-Through Income

The new bill also bestows substantial relief upon individual taxpayers that operate their business activities via U.S. pass-through entities like sole proprietorships, limited liability companies, partnerships, and S corporations. Under current law, individual owners of such pass-through entities pay tax on their profits at the owner’s individual tax rate. As of January 1, 2018, individuals will be permitted to deduct 20 percent of their qualified business income in computing their taxable income, thereby lowering the top effective marginal rate to a top rate of 29%. A limitation based on the greater of 50 percent of W-2 wages paid, or the sum of 25 percent of W-2 wages paid plus a capital allowance, is phased in above a threshold amount of taxable income. The same phase-out also applies to owners of professional services (law, medicine, accounting, financial and business advisors, etc.). In both cases, the phase-out begins at $157,500 for individual taxpayers and $315,000 for couples filing jointly. The phase-outs are aimed at deterring taxpayers from attempting to convert wages or other compensation for personal services to income eligible for the 20-percent deduction under the provision.

Effective Date. For taxable years beginning after December 31, 2017 and before January 1, 2026.

Miscellaneous Provisions

Other relevant international provisions in the bill include the following:

As part of the move to a territorial system, the bill repeals the deemed-paid (section 902) foreign tax credit with respect to dividends received by a domestic corporation from a 10 percent owned foreign corporation.

Foreign branch income must now be allocated to a specific foreign tax credit basket. Foreign branch income is the business profits of a U.S. person which are attributable to one or more qualified business units in one or more foreign countries.

Currently, gain on the sale of a controlled foreign corporation is treated as a deemed dividend and as is taxed as ordinary income to the extent of the foreign company’s earnings and profits. Under the bill, this deemed distribution will be exempt from U.S. tax.

When undertaking the renovation of existing cross-border structures in order to take advantage of the territorial tax regime, some U.S. companies may find it useful to transfer directly held foreign branch assets to a foreign corporate subsidiary. The bill anticipates the undue benefit that could arise from such planning where branch assets that have generated losses for U.S. tax purposes will now generate foreign source income that will be exempt from U.S. tax. In order to mitigate the double benefit, the bill provides that a domestic corporation will be required to recapture the full amount of the loss as U.S. source income. In addition, section 367(a) active trade or business exception will no longer be available to offset the U.S. toll charge resulting from such outbound transfers of branch assets.

New section 951A provides that a U.S. shareholder of a CFC must include in gross income its global intangible low-taxed income (“GILTI”) similar to inclusions of subpart F income.  GILTI refers to income from intangibles that may easily be transferred to foreign affiliates. The GILTI rules impose a minimum tax on a US shareholder’s foreign earnings that exceed a standard rate of return on the CFC’s assets. Specifically, the GILTI amount is the excess of a shareholder’s net CFC tested income over the shareholder’s net deemed tangible income return. The net CFC tested income refers to the excess of a shareholder’s pro rata share of the tested income of each CFC in which it is a shareholder over the aggregate of its pro rata share of the tested loss of each such CFC. A CFC’s tested income is the excess of the gross income of the shareholder (excluding the corporation’s ECI, subpart F income, gross income excluded from foreign base company income, and dividends received from a related person). A CFC’s tested loss is the excess of deductions (including taxes) properly allocable to the corporation’s gross income—determined without regard to the tested income exceptions—over the amount of gross income. The net deemed tangible income return is an amount equal to 10 percent of the aggregate of the shareholder’s pro rata share of the qualified business asset investment (“QBAI”) of each CFC with respect to which it is a U.S. shareholder over the amount of interest expense taken into account in determining net CFC tested income. QBAI is the aggregate of the adjusted tax basis in depreciable tangible personal property used in the CFC’s trade or business. GILTI is calculated at the U.S. shareholder level and the formula is as follows: GILTI = Net CFC Tested Income – (10% QBAI). GILTI tax is paid at the new US 21 percent corporate rate provided by new section 250 after applying a 50% deduction. The tax may be offset by up to 80% of foreign tax credits. The effective tax rate on GILTI is 10.5 percent.

Foreign-Derived Intangible Income (FDII) represents the income of U.S. corporations from US-based intangibles to the extent the income is related to marketing property or services abroad. The FDII amount is calculated by multiplying a domestic corporation’s deemed intangible income by the percentage of its deduction eligible income that is foreign-derived.  The calculation is as follows:  FDII = Deemed Intangible Income X   (Foreign Derived Deduction Eligible Income/Deduction Eligible Income). FDII tax is paid at the new U.S. 21% rate after applying a 37.5% deduction. The deduction provides a reduced tax rate for export derived intangible income in order to incentivize U.S. corporations to maintain their intangible assets in the U.S. The effective tax rate on FDII is 13.125 percent. U.S. individuals or non-corporate entities with foreign-derived intangible income will be subject to full U.S. tax rates on such income.

Foreign-based company oil related income will no longer be subject to U.S. tax inclusion as subpart F income.

There is no longer a requirement that a foreign corporation must be controlled for 30 days before subpart F inclusions apply.

A provision to eliminate income shifting through intangible property transfers that are subject to sections 367(d) and 482. The provision clarifies the authority of the Treasury to specify the method to be used to determine the value of intangible property, both with respect to outbound restructurings of U.S. operations and to intercompany pricing allocations by amending section 482 as well as the grant of regulatory authority under section 367 regarding the use of aggregate basis valuation and the application of the realistic alternative principle.

Under U.S. anti-inversion rules, where a foreign company acquires sufficient property or shares of a U.S. company in an inversion transaction, the foreign company is treated as a U.S. company for all U.S. tax purposes (i.e., a surrogate company). The bill provides that shareholders of companies that have completed an inversion (i.e., “Surrogate Foreign Shareholders”) will not qualify for the preferential capital gains rate on distributions from such surrogate foreign companies.

For inbound companies that have substantial U.S. gross receipts, the bill imposes a tax on base erosion payments. A base erosion payment means any amount paid or accrued by a U.S. company to a foreign person that is a related party of the taxpayer and with respect to which a deduction is allowable. Base erosion payments would include items such as royalties and management fees, but not cost of goods sold nor amounts paid or accrued for services if the services meet the requirements for eligibility for use of the services cost method described in the Regulations. The tax amount is computed under a complex formula and the payment will likely need to be reported on Form 5472.

International Tax Planning for Existing and Proposed Structures

As a result of the paradigm shift in the U.S. taxation of businesses caused by tax reform, the determination of the most efficient U.S. structure for cross-border operations has changed.  In effect, the tax reform bill has pulled the rug out from under existing cross-border structures and replaced it with a new playing field that require business owners to take a fresh look at their cross-border arrangement to determine if they are in the most efficient setup.

U.S. business owners that currently earn foreign income via a U.S. flow through structure may find that the use of a corporate structure may reduce overall tax costs.  This is especially the case where there is licensing or other income from intangibles.  Since most US-based businesses doing business abroad typically have a mix of U.S and foreign source income, analysis and modeling should be undertaken to determine whether a corporate or flow through structure (or a combination of both) will be most efficient.

Companies with a current presence in the U.S. should also review cross-border activities to determine whether there are viable modifications to intercompany transactions and transfer pricing that could yield tax benefits.  Companies without a current presence in the U.S. should be revisiting the idea of putting operations here given the size and purchasing power of the U.S. market combined with one of the most attractive tax regimes in the industrialized world.

Finally, since calendar year foreign companies with calendar year shareholders need to report the deemed repatriation on their 2017 tax returns, relevant shareholders should get to work asap on calculating their earnings and profits and tax pool amounts.  The Treasury has issued initial guidance in the form of Notice 2018-07 and will soon follow up with more detailed regulations. As non-cash amounts will be subject to a lower rate, it will be important to carefully review the pending regulations in order to maximize earnings and profits that may be characterized as non-cash.

For a complimentary consultation on the impact of this week’s tax reform, please contact Fernando Lopez, International Tax Director for Prager Metis CPAs at flopez@pragermetis.com

2019-03-29T17:44:25-05:00