International Tax Provisions in the U.S. Tax Reform Bill
In a move to a territorial tax regime, the new U.S. tax reform bill that was passed into law late last year makes significant changes to the taxation of foreign income. All shareholders of foreign corporations – both U.S. and non-U.S. individuals – should take careful note of the new provisions that affect their income, tax deductions, and accounting procedures.
Participation exemption
The Tax Cuts and Jobs Act (H.R. 1) establishes a participation exemption tax system for foreign income. “Specified 10 percent-owned foreign corporations” can elect a 100 percent Dividends Received Deduction (DRD) for the foreign-source portion of dividends received by a U.S. corporation, effective for distributions made after December 31, 2017.
A minimum 366-day holding period is required for the DRD to qualify. Certain “hybrid dividends” are exempt from DRD, and hybrid dividends received by one controlled foreign corporation (CFC) from another CFC are treated as subpart F income.
One-Time Transition Tax
When transitioning into this new tax system, a one-time tax will be assessed on shareholders who own 10 percent or more of a foreign corporation. Their post-1986 untaxed earnings will be taxed at 15.5 percent on cash and cash-equivalent assets, and 8 percent on non-cash assets. An election can be made to spread the tax pickup over 8 years.
Individuals, partnerships, estates and trusts are all subject to the transition tax, while there is a deferral for S corporations and special rules for REITs. The tax is effective for the last tax year of a foreign corporation that begins before January 1, 2018. For U.S. shareholders, it is effective for the tax years in which or with which such tax years of foreign corporations end. For calendar-year foreign corporations and U.S. shareholders, the tax liability starts immediately in the 2017 tax year.
Active Trade or Business Exception
Certain outbound transfers of property used in an “active trade of business” are no longer eligible for an exception from the general non-recognition override provision. H.R. 1 repeals this exception for transactions occurring after December 31, 2017. As a result, the incorporation of a foreign branch or the establishment of a foreign company is now taxable.
In addition, certain loss recapture rules may apply to corporations that later incorporate a foreign branch for losses incurred after December 31, 2017.
New Categories of Income
The new tax system established two new categories of income associated with foreign corporations:
- Foreign-derived intangible income (FDII) – FDII is income that is derived from: sales or other dispositions of property to a foreign person for a foreign use; a license of intellectual property to a foreign person for a foreign use; and services provided to a person located outside of the U.S.
Effective for tax years beginning after December 31, 2017, domestic C corporations are allowed a deduction of 37.5% (21.875% for tax years beginning after 2025) of foreign-derived intangible income (FDII), subject to a taxable income limitation.
- Global Intangible Low-Taxed Income (GILTI) – Generally speaking, GILTI is the income earned by foreign corporations in which a U.S. person directly or indirectly owns 10 percent. The new tax regime requires U.S. shareholders to include their share of GILTI in their gross income, eliminating the deferral of taxes on a significant portion of foreign earnings.
However, H.R. 1 also includes a partial deduction on GILTI for C corporations. Corporate U.S. shareholders (other than regulated investment companies, REITs and S corporations) are allowed a deduction of 50 percent of the GILTI inclusion, effective in the foreign corporation’s tax years beginning after December 31, 2017 (37.5 percent for taxable years beginning after 2025) and for tax years of U.S. shareholders in which or with which such tax years of the foreign corporation end.
Like the FDII deduction, the GILTI deduction is limited by taxable income. A foreign tax credit for corporate U.S. shareholders is also allowed as a deemed payment of 80 percent of the “inclusion percentage.”
Base Erosion and Anti-Abuse Tax
H.R. 1 also imposes a base erosion and anti-abuse (BEAT) tax equal to the base erosion minimum tax amount (BEMTA) of a foreign corporation, effective in tax years beginning after December 31, 2017. This tax affects corporations that are applicable taxpayers, which is defined as a corporation with a base erosion percentage of at least three percent and average gross receipts of $500 million or more for the last three years. S-corporations and REITs are exempt from this definition.
The corporation is required to pay the greater of its regular tax liability or its BEAT tax liability. Payments included in cost of goods sold (COGS) are not subject to the BEAT tax. Qualified derivative payments are also excluded, as are amounts charged at cost under the service cost method if tax is imposed and withheld under 1441 or 1442.
Intangible Property Transfers
The new tax bill amends the definition of intangible property (IP) to include workforce in place, goodwill, and going concern value. It further provides statutory authority for the IRS to value IP on an aggregate basis if doing so would achieve a more reliable result than an asset-by-asset approach. This change effectively limits the amount of income shifting that can be done through intangible property transfers by making these transfers subject to Section 367(d) or 482.
Other Provisions
H.R. 1 contains a myriad of other changes affecting foreign corporations doing business in the U.S., such as new anti-hybrid provisions, changes to subpart F income rules, and modified foreign tax credits. And clearly, these corporations are also impacted by the corporate tax law changes that affect all U.S. businesses, such as the corporate rate reduction, new interest expense limitation, and changes to state and local tax deductions.
Altogether, this new tax regime creates a whole new tax landscape for foreign corporations, as well as major opportunities for the tax professionals who advise them.