U.s. Tax Reform: International Provisions
| Publication year | 2018 |
| Author | By Emily P. Graham |
By Emily P. Graham1
The Tax Cuts and Jobs Act (the "Act") was signed into law on December 22, 2017 as H.R. 1, enacting sweeping changes to U.S tax law. The new top corporate tax rate as of New Year's Day is 21-percent, down from 35-percent.2 The Act involves major changes to international tax.
The first change to U.S. international tax law under the tax reform is a shift from a worldwide tax system toward a territorial system. This will be accomplished by (1) imposing a one-time deemed repatriation charge on previously deferred offshore income under IRC Section 965 and (2) providing for a dividends received deduction ("DRD") of 100-percent on foreign income going forward, under IRC Section 245A. There are new rules regarding the migration of intangibles under IRC Section 367, with a broader definition of intangibles and a repeal of the active trade or business exception. Effecting both IRC Section 367 and IRC Section 482, there are valuation changes on the migration of intangibles. There are also new rules for passive and mobile foreign income: a new tax on Global Intangible Low-Taxed Income ("GILTI"), and a IRC Section 250 deduction for GILTI and Foreign Derived Intangible Income ("FDII"). Revisions have been made to Foreign Tax Credits, stock attribution rules, the definition of a U.S. shareholder under IRC Section 951, and to subpart F. There is another new tax, the Base Erosion and Anti-Abuse Tax ("BEAT") under IRC Section 59A, which functions as a minimum tax on foreign income.
This article provides an overview of these and other new provisions specifically effecting international tax for business. The IRS has signaled it will provide further guidance on many of these provisions.
The Act repositions the U.S. tax system from a worldwide system of international business taxation to a semi-territorial one. Future foreign profits can now be distributed and repatriated tax-free. Similar to the territorial system in France,3 the U.S. territorial system is accomplished by a 100-percent deduction for foreign sourced dividends, under new IRC Section 245A. However, the U.S. territorial system is more limited than other countries' territorial systems, such as that of France,4 because the U.S. does not provide a deduction for foreign capital gain.5 Foreign profits stockpiled offshore prior to tax reform will incur a one-time repatriation charge to equalize with the new DRD, under new IRC Section 965.
A. One-Time Deemed RepatriationAs part of the transition to a quasi-territorial system, IRC Section 965 imposes a one-time repatriation "toll charge" on previously deferred foreign income for shareholders of a specified foreign corporation. The toll charge is based on the greater of accumulated post-1986 deferred foreign income as of November 2, 2017 or December 31, 2017, which is added as additional subpart F income.6
A specified foreign corporation ("SFC") is a controlled foreign corporation ("CFC") or a 10-percent owned foreign corporation, owned within the meaning of IRC Section 951(b). IRC Section 958(b)(4) attribution rules are repealed as of the transition year, thus expanding ownership for SFCs, determining constructive stock ownership by IRC Section 318(a)(3) attribution rules. The goal was to eliminate CFC de-control strategies, which were widely used in the past to avoid subpart F by utilizing IRC Section 958(b)(4) to prevent downward attribution. Now, a U.S. corporation can be a SFC purely by attribution rules. There are impacts for private equity, portfolio companies, and asset management funds that have complex organizational structures, often including domestic partnerships and domestic "blocker" corporations. The corporation with at least one ten-percent U.S. shareholder cannot be a Passive Foreign Investment Company ("PFIC").7
Under IRC Section 965, the portion includes the pro rata share of a SFC. The Act excludes previously taxed earnings and profits ("E&P") and effectively connected income. Dividends distributed by a SFC during its last taxable year before 2018 do not reduce this inclusion, with the exception of dividends distributed to another SFC. This exception is to prevent "double counting" and "double non-counting" of E&P.
Netting of E&P with accumulated E&P deficit is allowed. Hovering deficits may be used to offset the U.S. shareholder's increased subpart F income.8 Associated foreign income taxes are not deemed paid. To calculate the netting, the U.S. shareholder tabulates its pro rata share of the foreign E&P deficits and then calculates its pro rata share. Intragroup netting of E&P deficits and positive deferred foreign income is allowed among U.S. shareholders of an affiliated group when there is a shareholder who has a net E&P surplus and another has a net E&P deficit.
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Qualified deficits, determined as of November 2, 2017, can reduce the mandatory inclusion. Taxpayers may elect to preserve a Net Operating Loss ("NOL") and opt out of utilizing that NOL as an offset against the mandatory inclusion.
In effect, the transition tax rate is not equal to the new regular corporate tax rate. Instead, the transition tax rate will be equal to either: (1) 15.5-percent for the portion of inclusion equal to the U.S. shareholder's aggregate foreign cash and cash equivalent assets; or (2) an effective rate of eight-percent for the remainder. These rates result from a deduction against the mandatory inclusion, at the rate of the U.S shareholder's top marginal income tax rate in the transition year. There is no exclusion for cash or cash equivalents that are held by legal or regulatory obligation cash held to meet working capital needs, cash sourced from U.S. operations, or cash used to fund acquisitions.
Part of the foreign taxes paid or accrued relating to the additional subpart F income is not deductible. This is 55.7-percent of foreign taxes otherwise deemed paid on the portion attributable to the aggregate cash position plus 77.1-percent of the foreign taxes otherwise deemed paid relating to the remainder of the mandatory inclusion. There is no provision to carry forward treatment of any excess credits.
There is a claw-back for a domestic corporation that inverts within the meaning of IRC Section 7874(a) within ten years following the enactment of the Act. No deduction or foreign tax credit ("FTC") is allowed on this inclusion and a 35-percent tax on the entire inclusion is imposed.
An election can be made to pay the toll charge in annual installments over eight years (eight-percent the first five years, 15-percent the sixth year, 20-percent the seventh year, and 25-percent the eighth year.) A triggering event, such as a late installment, may accelerate payment.
IRS Notice 2018-07 lists related regulations to be issued to clarify points such as double-counting of cash position, E&P, and consolidated groups.
B. Election to Increase Percentage of Domestic Taxable Income OffsetIRC Section 904(g) now provides an election to increase the percentage (by no greater than 100-percent) of domestic taxable income offset by any pre-2018 unused overall domestic loss that was recharacterized as foreign source by the Act.9
C. Dividends Received DeductionUnder the new IRC Section 245A,10 the new "participation exemption" system of taxation allows a domestic C corporation (that is not a regulated investment company (a "RIC") or a real estate investment Trust (a "REIT")) to deduct 100-percent of the "foreign-source portion" of dividends11 received from a SFC.12 The tax policy seeks to limit arbitrage where payments are treated differently under U.S. and foreign taxation, such as relating to issues of treatment as equity or debt.
A CFC that is treated as a domestic corporation for purposes of computing taxable income under Treasury Regulations Section 1.952-2(b)(1) may take a DRD. In other words, the corporation taking a DRD can itself be a CFC if it receives a dividend from a SFC which counts as subpart F income.
No DRD is available for any dividend received by a U.S. shareholder13 from a CFC if the dividend is a hybrid dividend. A hybrid dividend is an amount received from a CFC which is eligible for a Section 245A DRD deduction, but is disqualified for receiving an additional tax benefit. Such a CFC to CFC hybrid dividend would be treated as subpart F income14 and a pro rata share of U.S. shareholder income.15 As with the mandatory inclusion, there is no DRD for dividends from passive foreign investment companies ("PFIC"s).16
There is a holding period requirement of 365 days in the 731-day period beginning 365 days before the ex-dividend date. The other requirements for the DRD must be met throughout this time as well.
The new paragraph five in IRC Section 904(b) disallows an FTC associated with a dividend that qualifies for the DRD.
D. Transfers Involving Ten-Percent Owned Foreign Corporations 1. DRD for Gain Treated as a Dividend, but No Deduction for Other GainAlthough the DRD under new U.S. tax law functions similarly to the DRD in France,17 unlike the French and other European participation exemption systems,18 the U.S. does not provide for an exemption for gain on the sale of a foreign owned corporation, unless that gain is treated as a dividend under IRC Section 1248(a)(1)(j). At least U.S. tax law allows some potential gain to be recharacterized as a dividend, to the extent of available E&P in a lower-tier CFC.
2. Basis Reduction to Determine LossTo calculate loss upon sale of applicable foreign stock, basis in the stock of the SFC is reduced, but not below zero, in the proportional value amount of dividends that qualify for the participation exception. Any reduction in basis under this IRC Section will be disregarded if that basis has already been reduced under IRC Section 1059, which applies to any nontaxed portion of extraordinary dividends.
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3. Sale by a CFC of a Lower-Tier CFCThe new subpart F rules and IRC Section 245A...
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