On Nov. 2, 2017, the House released its proposed tax reform bill, and the Senate issued its version of the tax reform proposal exactly one week later. While the tax reform bill passed through the House on November, 16, 2017, it still awaits action in the Senate. Now that the House version has passed and we await the results of the Senate, the resulting bill could include the most significant changes in U.S. international tax law in over 30 years.
International Corporate Tax Provisions Under the House Bill
Territorial Tax Regime Replaced the Worldwide Tax System
A U.S. corporation can deduct 100 percent of the dividends received from its 10 percent-or-greater owned foreign subsidiaries. A six-month holding period requirement must be met to qualify for the deduction. Investments in U.S. property by a Controlled Foreign Corporation (CFC), currently taxable as deemed dividends under Sec. 956, would also be eligible for the exemption, so that a foreign subsidiary could freely lend its earnings to its U.S. parent or otherwise invest its earnings in the U.S. without U.S. taxation.
The exemption does not apply to amounts treated as gains from the sale of stock in a foreign subsidiary to the extent that such gains exceed the deemed dividend under Sec. 1248. The capital gain will be subject to full U.S. corporate tax. For purposes of determining loss (but not gain) from the sale of foreign subsidiary stock, the U.S. shareholder’s basis would be reduced by the amount of any exempt dividends received from the subsidiary.
Branches of the U.S. parent would remain subject to the worldwide tax regime (with a foreign tax credit). Branch losses would remain deductible against U.S. income, but would be subject to new recapture rules if the branch’s assets were transferred to a foreign corporation.
Foreign Tax Credit Changes
In conjunction with the introduction of a participation exemption system, the new rules would repeal sections 901 and 902. The would also repeal the ability of 10 percent of U.S. corporate shareholders to claim an indirect foreign tax credit with respect to dividends received from a foreign subsidiary.
Mandatory Repatriation Tax
U.S. companies would be required to pay tax on their accumulated foreign earnings at tax rates of either 7 percent or 14 percent. It is currently estimated that the foreign earnings of U.S. multinationals kept offshore are $2.6 trillion. The approach taken by the House would tax these foreign earnings, which have previously been escaping U.S. taxation under the deferral mechanism.
The 7 percent rate would apply to earnings invested in business assets; the 14 percent rate would apply to earnings held in cash or cash equivalents. A taxpayer could elect to pay the tax over eight years. Foreign tax credits would be disallowed proportionately to the extent of the rate reduction.
The mandatory repatriation will be treated as a subpart F income inclusion of the taxpayer’s foreign subsidiary earnings at the end of the last taxable year beginning before January 1, 2018 (the “transition year”), i.e., 2017 for calendar year taxpayers. The subpart F income inclusion is then eligible for a dividends received deduction to achieve the 7 percent tax rate or 14 percent tax rate.
The deemed repatriated earnings that can be included in income will be equal to the greater of the amount of post-1986 undistributed earnings held by foreign corporations on November 2, 2017 or as of the end of 2017. This is without regard to any distributions during the transition year.
Special rules are provided for cases where some foreign subsidiaries have deficits in Earnings and Profits (E&P). These rules attempt to achieve a netting of foreign corporations with E&P deficits against foreign corporations with positive E&P. This occurs by allocating the E&P deficits proportionately to reduce the inclusions from foreign corporations with positive E&P. However, this rule may prevent full access to foreign tax credits from CFCs with positive E&P.
Foreign taxes paid or accrued by the foreign corporation with the deemed repatriated dividend are disallowed proportionately to the extent the dividends received deduction is allowed.
Current Taxation of Foreign High Returns
Under new section 951A, a U.S. shareholder of a CFC would be subject to a minimum tax on the CFC’s earnings. The shareholder would be required to include in gross income 50 percent of its “foreign high return amount.” The foreign high return amount generally would be the excess return of the CFC from owning valuable IP offshore.
More specifically, a U.S. shareholder’s foreign high return amount would be calculated as the excess of the shareholder’s “net CFC tested income” for the taxable year over the “applicable percentage” of the shareholder’s aggregate share of “qualified business asset investments” with respect to each of the shareholder’s CFCs. The applicable percentage would be equal to the Federal short-term rate plus 7 percentage points. Net tested income would mean the aggregate “tested income” of all CFCs over the aggregate “tested loss” of all CFCs. “Qualified business asset” investment would be defined as a CFC’s adjusted bases in depreciable tangible property that is used in a trade or business.
As is the case for subpart F income, the inclusion in income by a U.S. shareholder of a foreign high return amount would allow the U.S. shareholder to claim a deemed-paid credit for foreign taxes under section 960, but generally limited to 80 percent of foreign taxes paid on such income. Further, a separate foreign tax credit basket would be created for foreign high return amounts under section 904, with no carry-forward available for excess credits.
Permanent Extension of Section 954(c)(6)
The look-through rule under § 954(c)(6), which excludes from foreign personal holding company income certain payments between related CFCs, and which is currently scheduled to expire for taxable years beginning after December 31, 2019, would be made permanent under the proposal.
New rules would limit a U.S. shareholder’s interest deductions. Under new § 163(n), a U.S. corporation’s interest deduction relative to the worldwide group’s interest deduction could be no greater than 110 percent of the U.S. corporation’s Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) relative to the worldwide group’s EBITDA.
New Section 4491 would impose a 20 percent excise tax on “specified amounts” paid or incurred by a domestic corporation to a related foreign corporation. This is if the worldwide group’s three-year average of such amounts exceeded $100 million.
This provision would effectively subject the earnings of a foreign subsidiary which sells or otherwise provides value to the U.S. market to the 20 percent U.S. corporate rate, though under the second amendment, foreign tax credits equal to 80 percent of foreign taxes paid would be allowed if a special Effectively Connected Income (ECI) election were made.
A “specified amount” would mean any amount allowable as a deduction or includible in Cost of Goods (COGS), inventory, or the basis of a depreciable or amortizable asset, but excluding interest, amounts paid or incurred for certain securities and commodities, and amounts paid or incurred for services under the total services cost method with no markup under the section 482 regulations. Amounts subject to tax under Section 881(a) would also be excluded in the same proportion as the tax rate imposed under that section (as reduced by any applicable treaties) bears to 30 percent.
The excise tax would not apply, however, if the related foreign corporation elected to be treated as engaged in a U.S. trade or business and to treat the specified amount as ECI under new Section 882(g). If such an election were made, the domestic corporation would not be allowed a deduction for the specified amount. Instead, the foreign corporation would be allowed a deduction against its (elected) ECI equal to the “deemed expenses” with respect to the specified amount. Section 884 branch profits tax would also apply to the amounts treated as ECI.
International Tax Provisions Under the Senate’s Proposal
On November 9, 2017, the Senate Finance Committee (SFC) released its version of a comprehensive tax reform proposal aimed at reducing rates and providing other tax relief for corporations, individuals, and pass-through entities. Here is a breakdown of the SFCs international tax provisions:
Territorial Tax System
The Senate proposal is very similar to the House Bill in that it provides for a 100 percent dividends received deduction for the foreign-source portion of dividends received from specified 10 percent-owned foreign corporations by domestic corporations that are U.S. shareholders.
Mandatory Repatriation Tax
Similar to the Ways and Means Committee bill, a U.S. shareholder of a foreign corporation must include in income for the subsidiary’s last tax year beginning before January 1, 2018: the shareholder’s pro rata share undistributed, non-previously taxed post-1986 foreign earnings. E&P is only considered to the extent it was accumulated during periods when the foreign corporation had at least one U.S. shareholder. For purposes of this provision, the portion of the E&P comprising cash or cash equivalents is taxed at a reduced rate of 10 percent, while any remaining E&P is taxed at a reduced rate of 5 percent.
Consistent with the Ways and Means Committee bill, foreign tax credits triggered by the deemed repatriation are partially available, to offset the U.S. tax at the election of the U.S. shareholder, the tax liability would be payable over a period of up to eight years.
Global Intangible Low-Taxed Income
The proposal includes a new provision designed to tax currently Global Intangible Low-Taxed Income (GILTI). GILTI is the excess of the shareholder’s net tested income over the deemed tangible income return, which is defined as 10 percent of the shareholder’s basis in tangible property used to produce tested income.
The proposal requires that the amount of GILTI included by a U.S. shareholder be allocated across all of such shareholder’s CFCs, based on the CFC’s proportionate share of tested income. In addition, the shareholder can claim a foreign tax credit for 80 percent of the taxes paid or accrued with respect to the tested income of each CFC from which the shareholder has an inclusion.
In addition to the immediate inclusion of GILTI, the proposal allows a domestic corporation a deduction of 50 percent (for tax years beginning before December 31, 2017 and ending before 01.01.2026) to 37.5 percent (for tax years beginning after December 31, 2026) of the lesser of the shareholder’s GILTI plus foreign derived intangible income or its taxable income. The effect of the 37.5 percent deduction should effectively result in the taxation of GILTI at a 12.5 percent tax rate.
Finally, the bill provides a rule intended to incentivize returning valuable IP without any significant U.S. tax consequences to the U.S., by providing that if a CFC holds intangible property on the date of enactment, the Fair Market Value (FMV) of the property on the date of any distribution is treated as not exceeding its adjusted basis.
Treatment of Hybrid Transactions
The proposal includes a provision that would deny the deduction for any disqualified related-party amount paid pursuant to a hybrid transaction or by a hybrid payment. A disqualified amount is any interest or royalty paid or accrued to a related party to the extent that: (1) there is no corresponding inclusion to the related party under the tax law of the country of which such related party is a resident for tax purposes, or (2) such related party is allowed a deduction with respect to such amount under the tax law of such country.
Under the proposal, a corporation with excess base erosion payments for the taxable year must pay a tax equal to the excess of 10 percent (12.5 percent for tax years beginning after December 31, 2025) of its taxable income over its regular tax liability reduced by the general business credit and the research credit. For purposes of this provision, a base erosion payment generally means any amount paid or accrued by a taxpayer to a foreign person that is a related party of the taxpayer and with respect to which a deduction is allowable.
The Senate proposes to increase information reporting under sections 6038A and 6038C to require certain taxpayers subject to the new base erosion provisions to report information such as base erosion payments, information for determining the base erosion minimum tax, and other information deemed necessary by the Secretary of the Treasury. Additionally, it proposes to increase the penalty from $10,000 to $25,000 for failure to comply with Section 6038A and increases the penalty for failure to comply within 90 days after IRS notification to $25,000 for each 30-day period thereafter.
Additional Provisions Not Included in Ways and Means Committee Bill
Codification of Rev Rul. 91-32
Under the Senate proposal, gain or loss from the sale or exchange of a partnership interest is effectively connected with a U.S. trade or business to the extent that the transferor would have had effectively connected gain or loss had the partnership sold all of its assets at FMV as of the date of the sale or exchange. The proposal requires that any gain or loss from the hypothetical asset sale by the partnership be allocated to the selling partner(s). In addition, the transferee of a partnership interest is required to withhold 10 percent of the amount realized on the sale or exchange of a partnership interest unless the transferor certifies that the transferor is not a nonresident alien individual or foreign corporation. This will be the opposite result to the recent Tax Court’s decision in Grecian Magnesite Mining v. Comm’r, 149 T.C. 3 (Jul. 13, 2017).
Other International Provisions Specific to the Senate Bill Would:
- Modify the definition of section 936(h)(3)(B) to include workforce in place, goodwill, and going concern value;
- Terminate IC-DISC as of January 1, 2019;
- Impose a limitation on claiming lower rates on dividends from certain corporations subject to 7874 (anti-inversion rules);
- And impose a separate foreign tax credit limitation category for branch income.
To learn how the international tax reform may affect your business, contact your local Sikich representative or learn more at www.sikich.sikichdevelopment.com. If you would like to stay up-to-date on all tax reform proposals and changes, be sure to bookmark the Sikich Insights page, where we regularly post industry news and updates.