The new tax law, commonly known as the Tax Cuts and Jobs Act of 2017 (the “Act”), which amended the Internal Revenue Code of 1986 (the “Code”), will substantially impact strategies for U.S. businesses with overseas operations, as well as foreign businesses that operate in the U.S. The Act’s international tax provisions implement a series of complex and interrelated rules that more pointedly reward companies for bringing foreign earnings back to the U.S., and penalize corporate structures and tax strategies that shift income abroad.
The Act’s overarching change to existing law is transitioning the international taxation system to a territorial model where income is taxed based on where it is earned. Previously, the system followed a “worldwide” model where U.S. businesses were taxed on all of their income regardless of where it was earned, which incentivized the parking of earnings and assets offshore to the disadvantage of the domestic economy. To bring about a clean shift from a worldwide system to a territorial system, the Act taxes (on a one-time basis) earnings that were previously parked offshore but have not yet been taxed in the U.S., and then shields future international earnings from U.S. tax by way of a deduction for dividends received from foreign sources. This way, foreign income that was untaxed under the old worldwide system will now be taxed, but income earned under the new territorial system will not be. As a stop-gap, the Act also levies a tax on certain income from intangible assets and imposes a “base erosion minimum tax” to disincentivize companies from gaming the system in the future. It also changes certain requirements applicable to foreign corporations and passive foreign investment companies and modifies the rules for foreign tax credits.
This Tax Alert attempts to de-mystify and put into context some of the more esoteric of these new provisions.
THE NEW LAW
1. “Deemed” Repatriation of Foreign Income (Code § 965)
Background/Prior Law. Section 965, enacted in 2004, allowed a controlled foreign corporation (CFC) to make a one-time distribution of its earnings to its U.S. Shareholders at a reduced effective tax rate of 5.25 percent. A controlled foreign corporation is a foreign corporation in which more than 50 percent of the stock (measured by voting power or value) is owned directly, indirectly or constructively by U.S. Shareholders (in short, a U.S. person or entity that owns at least 10 percent, by vote or value, of the CFC) on any day during the corporation’s taxable year. The intent of this one-time “tax holiday” was to spur domestic consumption and investment. Section 965 expired in 2005.
The Act. Instead of providing another voluntary tax holiday, Section 965 now imposes a mandatory one-time tax on a U.S. Shareholder’s share of the undistributed post-1986 earnings and profits of a CFC, measured as of November 2, 2017, or December 31, 2017, whichever date results in a larger amount of earnings being subject to the tax. This is essentially a “deemed” or “constructive” repatriation of foreign earnings into the U.S.
- Tax Rate: Section 965 imposes a 15.5 percent tax on deferred income invested in cash or cash equivalents and an 8 percent tax on deferred income invested in illiquid assets. The tax does not apply to deferred income attributable to income that is effectively connected with a U.S. trade or business or to subpart F income.
- Tax Payment Period: Section 965 allows U.S. Shareholders to pay the tax in installments over an eight-year period. Specifically, 40 percent of the tax liability must be paid within the first five years (at 8 percent per year), 15 percent in the sixth year, 20 percent in the seventh year, and 25 percent in the eighth year.
The amendment to Section 965 is effective for the last taxable year of a foreign corporation that began 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.
Impact. Because the deemed repatriation tax is retroactive – i.e., it applies to earnings that accumulated on dates before the tax itself existed – strategic planning will do little to insulate a business from owing tax under the revised provision. Furthermore, the Act’s change to the stock attribution rules of Section 958 for determining CFC status and the effective date of that change will increase the number of corporations that are subject to the repatriation tax.
From a cash flow perspective, the election to pay the tax in installments should ease the effect on cash outflows. As of this writing, several companies have announced that they will repatriate the majority of their overseas earnings this year. From a transactional perspective, buyers in corporate acquisitions may wish to include a representation in stock purchase agreements regarding whether the target has made the election. The repatriation tax should also be considered in corporate valuations.
2. Foreign Source Dividends Received Deduction (New Code § 245A)
Background/Prior Law. Under prior law, U.S. corporations were fully taxable on dividends from foreign corporations, although tax credits were available for any foreign taxes paid with respect to those dividends.
The Act. The Act adds new Section 245A to the Code, which generally allows corporate U.S. Shareholders to deduct 100 percent of the foreign source portion of dividends received. Regulated Investment Companies and Real Estate Investment Trusts are not eligible for the deduction. A corporate U.S. Shareholder is eligible for the deduction only if it meets the one-year holding period requirement with respect to the foreign corporation stock. Foreign tax credits are not allowed for any taxes paid or accrued with respect to any portion of a distribution treated as a dividend that qualifies for the above rules. These rules are complex and limitations apply.
New Section 245A applies to distributions made after December 31, 2017.
Impact. A U.S. Shareholder can avail itself of this new dividends-received deduction if it meets the requirements of new Section 245A. Businesses may want to review their existing corporate structures to fall within the purview of the new provision.
3. Tax on Global Intangible Low-Taxed Income (GILTI) (New Code § 951A)
Background. Subpart F of the Code deals with the U.S. taxation of amounts earned by a CFC. In general, subpart F sets forth the various rules under which certain undistributed income of a CFC is included in the gross income of the U.S. Shareholder.
The Act. The Act adds a new Section 951A to subpart F, which introduces the concept of “global intangible low-taxed income” and includes this income in a U.S. Shareholder’s subpart F income.
- Global Intangible Low-Taxed Income. Global intangible low-taxed income (GILTI) is a synthetic, formula-determined amount of income derived from offshore intangible assets that is now subject to U.S. taxation under subpart F. Generally, GILTI is the excess amount of a U.S. Shareholder’s “net CFC tested income” over a deemed 10 percent rate of return on its share of the CFC’s basis in its depreciable tangible assets.
- Purpose of GILTI Inclusion. The intent behind this new tax is to target the income derived by U.S. companies that previously shifted intangible, income-producing assets offshore. While the assumption of a set rate of return on intangible assets is not inherently unreasonable, why 10 percent was selected versus some other number is unknown. Importantly, land is not included among the assets that are taken into account in computing the deemed 10 percent return.
New Section 951A applies to taxable years of foreign corporations beginning after December 31, 2017, and to taxable years of U.S. Shareholders in which or with which such taxable years of foreign corporations end.
Impact. While the changes to the international tax rules are aimed at making the U.S. a more competitive place to do business, expanding the reach of subpart F to tax a “synthetic” or “phantom” return from foreign intangibles will result in a greater tax expense to many businesses. The GILTI rules also provide an incentive for U.S. Shareholders to locate plant and equipment assets outside the U.S., so as to maximize their foreign tangible assets for purposes of the 10 percent GILTI return calculation.
4. Deduction for Foreign Derived Intangible Income (FDII) (New Code § 250)
Background. Prior to the Act, many policymakers and analysts believed that the U.S. tax system, which taxed U.S. corporations at a relatively high marginal tax rate on income earned both domestically and internationally, made the U.S. a less attractive jurisdiction to do business in. A parallel concern was that U.S. exports were also at a chronic competitive disadvantage.
The Act. New Section 250 introduces the concept of “foreign-derived intangible income” (FDII) to the international tax regime and allows U.S. corporations (although not REITS and RICs) to deduct from gross income 37.5 percent of their FDII. The net effect of this deduction is that the effective rate of tax on the amount of FDII that is included in income is just 13.125 percent.
- Foreign-Derived Intangible Income. In technical terms, FDII is an amount of income equal to the ratio of the corporation’s export sales to its total sales, multiplied by the corporation’s deemed intangible income (which is determined by subtracting from the corporation’s total net income the portion that is deemed to be attributable to the corporation’s tangible assets, such as equipment, which is computed as 10 percent of the adjusted tax basis of the tangible assets). Like the GILTI provision, land is not included in calculating the 10 percent deemed return.
- FDII Deduction as an Export Subsidy. The tax policy for including the FDII deduction in the international tax regime is not entirely clear. As of this writing, the FDII provision is being attacked as an impermissible export subsidy.
New Section 250 applies for taxable years beginning after December 31, 2017.
Impact. If the FDII provision survives, it will generally work to the advantage of businesses (and more specifically, corporations) that rely on export sales. The FDII deduction will thus become a valuable tax attribute of export-heavy businesses that should be considered in corporate valuations and acquisition transactions. Businesses not organized as corporations may wish to consider alternative structures to avail themselves of the FDII deduction.
5. Erosion of the U.S. Corporate Tax Base (New Code § 59A)
Background/Prior Law. Under the prior tax regime, many U.S. businesses engaged in “base erosion” strategies to shelter income from U.S. taxation. These strategies involved three key steps: the shifting of earnings or other assets into foreign subsidiaries; the enjoyment of those earnings or assets by way of some inter-company transaction (such as a loan or licensing arrangement); and the taking of deductions arising from the inter-company transaction (such as interest payments on the loan or licensing fees paid).
The Act. The Act introduces new Section 59A, which establishes a new tax to stop base erosion. This provision will have a substantial impact on the international business strategies of high-income businesses.
- Base Erosion Minimum Tax: Under new Section 59A, an applicable taxpayer is required to pay a tax equal to the “base erosion minimum tax” amount for the taxable year. The base erosion minimum tax amount is the excess of 10 percent of the “modified taxable income” of the taxpayer for the taxable year over an amount equal to the regular tax liability of the taxpayer for the taxable year reduced (but not below zero) by various credits. Modified taxable income generally means the taxable income of the taxpayer computed without regard to “base erosion payments” – i.e., any amount paid or accrued by a taxpayer to a foreign related party with respect to which a deduction is allowable (although certain payments for services and costs of goods sold do not count). For taxable years beginning after December 31, 2025, the 10 percent rate described above changes to 12.5 percent, and the use of credits in determining the regular tax liability is altered.
- Applicability of the Tax: The tax applies only to taxpayers whose average annual gross receipts for the previous three taxable years ending with the preceding taxable year is $500,000,000 or more. Certain attribution rules apply in determining whether this income threshold has been reached.
- Reporting Requirements: Taxpayers subject to the base erosion minimum tax will also be subject to new reporting requirements under Section 6038A, which will include information on the reporting entity, related party, the transactions and any information the Treasury Department deems necessary. Failure to comply with the new reporting requirements would subject the reporting corporation to a $25,000 penalty.
The provision applies to base erosion payments that are paid or accrued in taxable years beginning after December 31, 2017.
Impact. U.S. businesses will need to review their existing structures to determine whether the base erosion minimum tax will affect them. Because the threshold for the tax’s applicability is based on the past three years’ income, it will be difficult for businesses to mitigate the effects of the tax in the near term.
In addition to the provisions discussed above, the Act implemented a number of other technical changes, including changes to the rules governing controlled foreign corporations under Sections 951-58, passive foreign investment companies under Section 1297, and foreign tax credits under Section 902.
The Act substantially changes the U.S.’s international tax rules. While the Treasury Department is likely to promulgate regulations interpreting the Act’s more complicated provisions, such regulations are likely years away. Consequently, businesses should scrutinize their existing corporate structures and proposed transactions in light of this new landscape.