The Tax Cuts and Jobs Act brought many changes to U.S. taxpayers. If you or your company has international operations, considering how tax reform impacts your situation is important.
Tax reform has a substantial impact on businesses.
Considerations for All International Taxpayers
Deemed repatriation: Under the new law, generally U.S. shareholders owning at least 10 percent of a foreign corporation must include in income their pro-rata share of the undistributed, non-previously-taxed post-1986 foreign earnings of the corporation. The income inclusion occurs in 2017 for earnings and profits of foreign corporations on a calendar year and 2018 for foreign corporations on a fiscal year-end. The earning and profits inclusion amount is reduced by any aggregate foreign earnings and profits deficits, and a deduction is allowed such that a corporate shareholder's effective tax rate is either 15.5 percent or 8 percent. The 15.5 percent rate applies to the foreign corporation’s aggregate foreign cash position and the 8 percent applies to the remainder. The deduction is calculated based upon a 35 percent tax rate, regardless of the type of taxpayer, so an individual’s effective tax rate may be different. The net tax liability can be spread over a period of up to 8 years via an installment election. The net income inclusion for individuals or individual owners of pass-through entities are taxed at ordinary income rates rather than qualified dividend rates. A deferral option is available for S corporation shareholders.
Global intangible low-taxed income (GILTI): Under the new law, a U.S. shareholder of any Controlled Foreign Corporation (CFC) has to include in gross income its global intangible low-taxed income (GILTI), i.e., the excess of the shareholder's net CFC tested income over the shareholder's net deemed tangible income return (10 percent of the shareholder's pro rata share of qualified business assets of the CFC). The GILTI is treated as Subpart F income. Only 80 percent of foreign tax is available as a credit against U.S. taxes related to GILTI.
Subpart F changes: The new law made several changes to the taxation of Subpart F income of U.S. shareholders of CFCs. Among other things, the new law expands the definition of U.S. shareholder to include U.S. persons who own 10 percent or more of the total value (not just vote) of shares of all classes of stock of the foreign corporation. In addition, the requirement that a corporation must be controlled for 30 days before Subpart F inclusions apply has been eliminated.
Multinational Corporation Considerations
Deduction for foreign-source portion of dividends: The new law allows domestic corporations that are 10 percent shareholders in foreign corporations a 100 percent dividends received deduction for the foreign source portion of dividends received from the foreign corporation. The U.S. corporation generally needs to own the stock in the foreign corporation for more than a year. No foreign tax credit is allowed for taxes paid and accrued as to any dividend for which the deduction is allowed, and the dividend amount is not treated as foreign source income for purposes of the foreign tax limitation. In addition, if there is a loss on any disposition of stock of the specified 10 percent-owned foreign corporation, the basis of the domestic corporation in that stock is reduced (but not below zero) by the amount of the allowable deduction. Additionally, certain hybrid dividends do not qualify for the deduction.
Sales or exchanges of stock in foreign corporations: Under this new law provision, if a domestic corporation sells or exchanges stock in a foreign corporation held for over a year, any amount it receives which is treated as a dividend for Code Sec. 1248, impacting gain from certain sales or exchanges of stock in certain foreign corporations, purposes, will be treated as a dividend for purposes of the deduction for dividends received discussed above. Similarly, any gain recognized by a CFC from the sale or exchange of stock in a foreign corporation that is treated as a dividend under Code Sec. 964, impacting miscellaneous provisions, to the same extent that it would have been so treated had the CFC been a U.S. person is also treated as a dividend for purposes of the deduction for dividends received.
Incorporation of foreign branches: Under the new law, if a U.S. corporation transfers substantially all of the assets of a foreign branch to a specified 10 percent foreign corporation, the U.S. corporation includes in gross income an amount equal to the transferred loss amount, subject to limitations.
Deduction for foreign-derived intangible income and Global Intangible Low-Taxed Income (GILTI): Under the new law, in the case of a domestic corporation, a deduction is allowed equal to the sum of 1) 37.5 percent of its foreign-derived intangible income (FDII) for the year, plus 2) 50 percent of the GILTI amount included in gross income, see above. Generally, FDII is the amount of a corporation's deemed intangible income that is attributable to sales of property to foreign persons for use outside the U.S. or the performance of services for foreign persons or with respect to property outside the U.S. Coupled with the 21 percent tax rate for domestic corporations, these deductions result in effective tax rates of 13.125 percent on FDII and of 10.5 percent on GILTI. The deduction rates are reduced for tax years after 2025.
Base erosion prevention: To prevent companies from stripping earnings out of the U.S. through payments to foreign affiliates that are deductible for U.S. tax purposes, a base erosion minimum tax applies to corporations, other than Regulations Investment Companies, Real Estate Investment Trusts, and S corporations, with 1) average annual gross receipts of $500 million or more, and 2) that made deductible payments to foreign affiliates that are at least 3 percent (2 percent in the case of banks and certain security dealers) of the corporation's total deductions for the year. The tax is structured as an alternative minimum tax and applies to domestic corporations, as well as on foreign corporations engaged in a U.S. trade or business in computing the tax on their effectively connected income.
Other new law provisions limit income shifting via intangible property transfers, deny deductions for related party payments in hybrid transactions or with hybrid entities, and deny qualified dividend status to dividends received by individuals from surrogate foreign corporations resulting from inversions. Finally, the new law introduces a series of modifications to the foreign tax credit system, as well as a number of other international reforms.
Considerations Moving Forward
There is much for individual taxpayers with international ties and multi-national companies to consider. A review of your situation under the new tax landscape is important. In addition, you need to consider:
- Consider whether GILTI may apply to your foreign subsidiaries and plan for this in your estimated tax payments.
- For corporations, assess whether you have FDII eligible income and plan for this in your estimated tax payments.
- For non-C corporations, consider whether a C corporation structure may make sense given the deduction for foreign source dividends, the allowance of a 50 percent deduction of GILTI income, and FDII.
- For individual and pass-throughs, if GILTI applies to foreign subs, consider structure changes to benefit from foreign tax credits on GILTI income.
Inbound Tax Considerations related to Tax Reform
Tax reform’s impact also affected non-U.S. taxpayers doing business in the U.S. It will also be important for inbound tax planning purposes to review how new tax laws affect existing tax structure, including related compliance prior planning.
Reduced Corporate and Individual Tax Rates
The U.S. corporate tax rate has dropped to a flat 21 percent. At the same time, the maximum U.S. individual tax rate was reduced to 37 percent, and the individual personal exception ($4,050 in 2017) was eliminated.
International tax structures created prior to tax reform should now be re-evaluated to determine whether they still produce the most favorable tax result. Transfer pricing strategies should be evaluated. And, the loss of the individual personal exemption may create the need for a non-resident individual to file a U.S. tax return.
Changes to Interest Deductibility Rules
Historically, only foreign-owned U.S. corporations and U.S. branches of foreign corporations were subject to U.S. interest deductibility limitations. Under tax reform, generally, all U.S. entities and U.S. branches are now subject to interest deductibility limitations. Broadly speaking, the limitation applies to interest expense in excess of the sum of the following:
- Business Interest Income
- 30 percent of a taxpayer’s Adjusted Taxable Income (ATI) for the applicable tax year
- Floor plan financing
Disallowed interest expense may be used in future years, subject to future year calculation limitations.
Certain exceptions apply. Taxpayers with gross receipts of U.S. $25 million or less are generally exempt from the limitation rule. Additionally, certain trades or businesses are exempt from the limitation including certain regulated utilities, real property and farming businesses.
Structures which utilize debt should be evaluated to determine whether the structure will limit U.S. interest deductibility, especially when the interest payment is made to a related party and U.S. withholding tax applies.
Limitations on Deductibility of Certain Hybrid Transactions
Tax reform introduced a deduction limitation on hybrid payments to related foreign persons. A hybrid payment occurs when a payment is both:
- A “Disqualified Related Party Amount”
- Pursuant to a hybrid transaction or by a hybrid entity
A disqualified related party amount includes any interest or royalty paid/accrued to a related party to the extent the amount is not included in income of the related party under the tax law of their resident foreign county, or the related party payee is allowed a deduction with respect to such amount under the tax law of such country, thereby offsetting the income payment.
The term hybrid transaction generally refers to a transaction, or series of transactions. Whereas, a payment is treated as interest or royalties under U.S. law, but under applicable foreign jurisdiction law is treated differently. A hybrid entity is an entity classified one way for U.S. tax purposes and differently for foreign jurisdiction purposes (e.g. corporation for U.S. purposes and a partnership for foreign jurisdiction purposes).
The IRS is authorized to issue regulations to encompass specific transactions. Considerable ambiguity exists over which types of transactions will no longer be eligible for a U.S. deduction when the foreign jurisdiction allows for favorable treatment.
Structures which include interest and royalties to foreign-related parties need to be analyzed to determine whether such payments are no longer deductible, resulting in a significant increase in U.S. taxation.
Base Erosion and Anti-Abuse Minimum Tax (BEAT)
The BEAT creates a minimum tax for certain U.S. corporations remitting deductible payments to foreign-related parties. The BEAT applies only to U.S. C-corporations who meet the following thresholds:
- Average annual gross receipts of at least US $500 million for the three-year period ending before the current year
- The base erosion percentage is 3 percent or higher
- The base erosion percentage is generally the total deductible payment made to related parties divided by deductible expenses.
If the U.S. corporation meets both BEAT thresholds, the U.S. corporation will then need to compare its regular tax liability to a minimum amount. The final tax liability will be the larger of the regular tax liability or minimum amount. For 2018, the minimum amount is 5 percent of taxable income adjusted for certain deductions such as related party payments. For 2019-2025 the rate is 10 percent; the rate is 12.5 percent thereafter.
Companies who make BEAT payments should address whether the minimum tax is applicable and make appropriate adjustments to estimated tax payments. In addition, this provides an opportunity to address the company’s transfer pricing policy.
Other Considerations
In addition to the above listed items, there are numerous tax considerations which existed before tax reform that should now be re-evaluated including, though not limited to:
- Tax and legal considerations of operating as a U.S. corporation vs U.S. branch.
- Tax treaty analysis to confirm foreign taxpayers are eligible for favorable taxable presence standards and reduced withholding rates.
- Evaluation of applicable state of organization.
- Evaluation of applicable foreign jurisdiction of foreign shareholder.
- Determination of appropriate debt and equity mix.
- Analysis of applicable pricing for related party transactions considering both U.S. and foreign jurisdiction transfer pricing principles.
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