International Tax Provisions
As mentioned in our last two updates recapping changes in the individual and business tax provisions, legislation passed December 20, 2017 and is expected to be signed by the President after the new year, making sweeping changes. As this is the biggest rewrite to the Internal Revenue Code since the 1986 Act, there are fundamental changes to the taxation of multinational entities included in this legislation.
In general, the agreement shifts the US from a system of worldwide taxation, closer to a system of territorial taxation. Of course, there continue to be several exceptions to the general rule, some of which may lead to surprising results. Below we discuss some of the changes we think may have the biggest impact on our clients, and our related observations.
Introduction of US Participation Exemption
The final Bill creates a dividend-exemption system for taxing US corporations on foreign earnings of their foreign subsidiaries when those earnings are distributed. Previously, distributed earnings would be taxed at the applicable corporate tax rate, generally 35%, which stopped many large multinational groups from bringing the cash back to the US. Since these dividends will no longer be taxed, the foreign tax credit provisions have also been modified. The Bill does this in what they call a participation exemption which is provided for in new Internal Revenue Code Section 245A.
In order to qualify for the exemption, a domestic corporation must own at least 10% of the Specified Foreign Corporation (SFC) to receive a 100% Dividends Received Deduction (DRD) for the foreign source portion of dividends received from the foreign corporation. If the foreign subsidiary earns US source income, a portion of the dividend would be reclassified to US source, and subject to the domestic dividend deduction rules. The exclusion is only available to domestic C Corporations that are not real estate investment trusts, regulated investment companies, nor passive foreign investment companies.
In addition to the 10% ownership voting power requirement, the domestic corporation will need to hold the stock for over 365 days in a 731-day period, beginning on the date that is 365 days before the date on which the dividend is paid.
The deduction will not apply for any amount received by a Controlled Foreign Corporation (CFC) for which the foreign corporation received a deduction or other tax benefit related to taxes imposed by a foreign country, known as a hybrid dividend. In addition, with respect to tiered CFCs, a hybrid dividend paid from a lower tiered CFC to an upper tier CFC will be treated as Subpart F income, and be required to be included in gross income of the US shareholder on their pro-rata share of Subpart F income.
The exclusion is not available to S Corporations, partnerships, individuals or trusts, therefore foreign corporations owned by a US person other than a C Corporation will continue to pay the applicable dividend tax rate. As mentioned in our previous article related to the new individual tax provision, there has been no change in the rates related to dividend income.
While the rule moves the US closer to a territorial tax system, the legislation keeps the Subpart F regime in place and adds additional rules which could result in immediate US taxation.
As a transition to the Participation Exemption, the new legislation provides a mandatory inclusion of accumulated post-1986 deferred income determined as of November 2, 2017 or December 31, 2017 (whichever is greater). This means accumulated earnings of specified foreign corporations that have not been repatriated before January 1, 2017 will be subject to taxation under the transition rule. The rule is written as such that the effective tax rate will be 15.5% to the extent attributable to liquid assets (generally cash and accounts receivable) and 8% to the extent attributable to other assets. An SFC is defined as a foreign corporation that is a Controlled Foreign Corporation (CFC), or foreign corporation that has at least one US shareholder owning at least 10% of the voting power, or value, of the foreign corporation. The mandatory repatriation is written as a new part of the Subpart F regime.
If a US shareholder has multiple SFCs, the accumulated earnings of each SFC are aggregated when determining the tax due. This allows accumulated deficits from one foreign entity to potentially offset accumulated earnings of another. A portion of foreign tax credits attributable to the accumulated earnings pool will be allowed to offset the transition tax.
Taxpayers may elect to pay the transition tax in eight installments. If elected, rather than paying in eight equal installments, the bill requires that the payments for each of the first five years are equal to 8% of the net tax liability. The sixth installment equals 15% of the net tax liability, increasing to 20% for the seventh installment, and 25% in the final installment. Payment is accelerated upon certain triggering events, which include an addition to tax for failure to timely pay any installment, a liquidation or sale of substantially all the assets of the taxpayer (including a title 11 case), or a cessation of business by the taxpayer.
The new law has repealed a section of the code which prevented downward attribution from a foreign entity. The broad nature of the new legislation will likely result in more entities being classified as a CFC, and therefore subject to the mandatory repatriation rules. For example, assume a foreign parent company owns 100% of a US domestic C Corporation and 100% of a UK Corporation. In addition, assume a US person owns 10% of the foreign corporation. Under the current regulations, a domestic corporation is not attributed stock owned by a foreign entity. However, with the repeal of this rule, the US C Corporation will be attributed stock ownership of the UK Corporation, effectively resulting in the UK Corporation being deemed a CFC. Since a US person owns 10% of the foreign parent company, that person will be allocated Subpart F income in accordance with the mandatory repatriation provisions.
We believe the repeal of this specific paragraph of the Internal Revenue Code was intended to render certain inversion transactions, to avoid CFC classification, ineffective. However the broad language included in the legislation seems to capture more taxpayers than intended. We expect (and hope) for regulatory guidance that will fix this issue.
Mandatory Repatriation Provisions – S Corporations
A special rule is applicable to US shareholders of an S Corporation regarding the timing of when the payment is due. Each shareholder of the S Corporation may elect to defer paying its net tax liability on its mandatory inclusion until the tax year that a triggering event occurs. In addition to the triggering events for corporations discussed earlier, termination of the S Corporation and a taxpayer’s transfer of S Corporation stock will be considered a triggering event. When an S Corporation triggering event occurs, a shareholder may elect to pay the liability in equal installments over an eight-year period after the triggering event has occurred. However, if the triggering event is a liquidation, sale of substantially all assets, cessation of business, or a similar event, the election will only be available with the consent of the Secretary.
The agreement provides a favorable deferral regime for S Corporation shareholders. Not only can they elect to defer payment of the tax liability until a triggering event, but once a triggering event occurs they can elect to pay the tax liability on an installment basis.
Global Intangible Low-Taxed Income
The new law includes an additional Subpart F provision which imposes a minimum tax on US multinational’s foreign earnings that exceed an amount equal to the standard rate of return on the foreign company’s assets. The law refers to this as “Global Intangible Low-Taxed Income” (GILTI). Corporate shareholders will be allowed a deduction of 50% of GILTI for 2018 through 2025, which would be decreased to 37.5% beginning in 2026. Therefore, the effective tax rate of a corporate shareholder on this type of income will be 10.5% until 2026 when the lower deduction rate is applicable.
Because the deduction is only for corporate shareholders, non-corporate shareholders will be subject to tax on 100% of GILTI, based on applicable rates. However, the new legislation does clarify that applicable US shareholders can make an Internal Revenue Code Section 962 election, which would subject the income to corporate tax rates. Therefore it is possible a non-corporate shareholder could be taxed at 21% instead of their effective personal income tax rate.
There are a few other rules surrounding this type of income, including foreign tax credits, offsetting losses, and relevant definitions, therefore analysis will be needed to determine when this tax applies and what the true effective tax rate will be in each situation.
The rule is intended to ensure the US receives its “fair share” of taxes related to intangibles generating income offshore in low or no tax jurisdiction. Many have heard how Apple and Google have managed to keep their intangible property offshore and lower their overall worldwide effective tax rates. This rule is meant to address some of these issues.
Deduction for Foreign Derived Intangible Income
The Bill provides for a preferential rate on deemed intangible income attributable to export activities, providing for a 13.125% effective tax rate on excess returns earned directly by a US corporation from foreign sales of property (including licenses and leases) or services, which would increase to 16.406% starting in 2026. It does this by allowing a US corporation a deduction equal to 37.5% of its Foreign-Derived Intangible Income (FDII).
There is a complex set of rules for determining the amount FDII. At a high level, it is a US corporation’s amount of deemed intangible income that is attributable to sales of property (including licenses and leases) to foreign persons for use outside the United States, or the performance of services for foreign persons, or with respect to property outside the United States.
A US corporation’s deemed intangible income is generally its gross income, not attributable to a foreign branch or CFC, reduced by related deductions. There are additional rules surrounding when foreign related-party transactions will qualify for the deduction.
This deduction provides an incentive to encourage US corporations to keep certain production activities in the US. This rule is somewhat similar to benefits offered in patent box regimes provided in other countries.
Base Erosion and Anti-Abuse Tax (BEAT)
The agreement implements a new base erosion-focused minimum tax intended to reduce the US tax benefit of cross-border related party payments made by large multinational corporations. The tax is the excess of 10% of the modified taxable income of the taxpayer over an amount equal to the regular tax liability, reduced by certain general business credits. To determine its modified taxable income, a taxpayer computes it taxable income without regard to any base erosion payment, or the base erosion percentage of any allowable net operating loss deduction.
The tax applies to domestic C Corporations that are part of a group with at least $500 million of annual gross receipts over a three-year period and have a “base erosion” percentage of 3% or higher. The legislation provides that revenue from all members of a controlled group must be aggregated to determine whether the $500 million threshold is met for application of the tax. Generally foreign corporations are excluded from being a member of a controlled group in the US, however, for purposes of this tax that exclusion does not apply. In addition, there is nuanced language which changes the standard related party rules, which should be given careful attention.
Generally, base erosion payments are deductible cross-border payments made to foreign related parties. The Bill excludes payments subject to 30% withholding tax and purchases of inventory included in cost of goods sold. If payments for services meet certain requirements provided for in current regulatory guidance under Treasury Regulation §1.482-9, and the payments for services have no mark-up component, those payments may also be excluded.
At first glance, many companies may think this tax does not apply because they do not have gross receipts over $500 million. However, the aggregation rules mentioned above may make this determination more difficult. For instance, the revenue of a foreign parent company, as well as revenue from foreign subsidiaries owned by the foreign parent company, will likely need to be included when determining whether the group exceeds $500 million of gross receipts. Upon reviewing the detailed language, which decreases certain ownership percentages for determination of who is included in the controlled group, smaller foreign-owned multinationals may be surprised to find the tax is applicable to their US company.
The BEAT provision contains plenty of complex language and definitions. We anticipate additional guidance and clarification will be issued in 2018 to help taxpayers and practitioners navigate these new rules.
The above items do not come close to covering all of the changes included in the new international tax provisions. The changes encompass everything from foreign tax credits, taxation of multinational transactions, Subpart F income inclusions, to nuanced definitions included in the current law and penalties for failure to file. Based on these broad changes, it is more important than ever to ensure your tax advisors understand the tax impacts of doing business internationally. If you have questions about how you or your business may be impacted, please contact us.