Article Prepared by FGMK Tax Partner Fuad Saba
The Tax Cuts and Jobs Act of 2017 (the Act) constitutes the most significant revision of the Internal Revenue Code (the Code) since the Tax Reform Act of 1986, and reforms U.S. international tax rules by transitioning taxpayers to a “territorial tax system,” adding a “toll charge” on undistributed earnings and profits (E&P) of US-owned foreign corporations, eliminating the core of the indirect foreign tax credit (FTC) statute, and making changes to the current Subpart F anti-deferral provisions. The Act also brings in provisions relating to “foreign derived intangible income” (FDII), “global intangible low-taxed income” (GILTI) and the “base erosion and anti-avoidance tax” (BEAT). The Act will impact both U.S. and foreign corporations in tax years ending after 2017. This article focuses on the international tax aspects of the Act that likely will impact business operating in the “middle-market.”
100-percent Dividends Received Deduction (DRD) for the Foreign-source Portion of Dividends (“Territorial Regime”).
New Code Section 245A grants a 100-percent DRD for the foreign-source portion of dividends received by a U.S. corporation after 2017 from foreign corporations with respect to which it is a U.S. corporate shareholder. The foreign-source portion of dividends from such “specified 10-percent owned foreign corporations” includes only the portion of undistributed E&P that is not attributable to effectively connected income (ECI) or dividends from an 80-percent owned domestic corporation, determined on a pooling basis. The term U.S. Shareholder is that defined under Section 951(b).
- Dividends resulting from passive foreign investment company (PFIC) “purging distributions” are not treated as dividends for purposes of the DRD.
- No DRD is allowed for any dividend received by a “U.S. shareholder” from a controlled foreign corporation (CFC) if the dividend is a hybrid dividend, meaning an amount received from a CFC for which a deduction would be allowed under Section 245A and for which the specified 10-percent owned foreign corporation received a deduction (or other tax benefit) from taxes imposed by a foreign country.
- When a CFC with respect to which a domestic corporation is a U.S. Shareholder receives a hybrid dividend from any other CFC with respect to which the domestic corporation is also a U.S. shareholder, the hybrid dividend is treated as Subpart F income of the recipient CFC for the tax year of the CFC in which the dividend is received and the U.S. shareholder must include in gross income an amount equal to the shareholder’s pro-rata share of the Subpart F income.
- The Act contains a minimum holding period requirement that must be satisfied in order to claim the 100-percent DRD. The U.S. corporate shareholder must meet the ownership requirements for more than 365 days during the 731-day period beginning on the date that is 365 days before the date on which the share becomes ex-dividend.
- Solely for purposes of determining whether there is a loss on the sale or exchange of stock, a U.S. corporate shareholder is required to reduce (but not below zero) the adjusted basis of its stock in a foreign subsidiary by the amount of any portion of a dividend not subject to U.S. tax pursuant to new Section 245A.
Notably, U.S. Shareholders that are not domestic corporations are not eligible for the new 100% DRD. This raises the possibility that non-corporate U.S. Shareholders may choose to restructure their ownership of their specified 10-percent owned foreign corporations. It remains to be seen whether the IRS will issue any anti-abuse rules in that regard.
Transfers of “Specified 10-percent Owned Foreign Corporations,” and Transfers of Property to Foreign Corporations.
- The Act creates a new Subpart F rule for lower-tier CFCs. If a CFC sells the stock in a foreign corporation that it has held for at least one year, resulting in a “dividend” (meaning, gain re-characterized as a dividend to the extent of the lower-tier CFC’s E&P, pursuant to Section 964(e)(1)), then: (i)the foreign-source portion of the dividend is treated as Subpart F income in the hands of the selling CFC; (ii) the U.S. shareholder is required to include its pro-rata share of that Subpart F income in its gross income; and (iii) a deduction under new Section 245A is allowable to the U.S. shareholder with respect to the Subpart F income, as if it were a dividend received directly by the shareholder from the selling CFC.
- The Act requires a U.S. corporation to recapture post-2017 branch losses when substantially all of a foreign branch’s assets are transferred to a ten-percent owned foreign corporation. This provision sets the recapture amount (the transferred loss amount) equal to the branch’s previously deducted loss amount after 2017 (and before the transfer), reduced by any taxable income of the branch in subsequent years but before the close of the transfer year, and any gain related to an “overall foreign loss’” (OFL) recapture amount. The new provision only applies in situations in which the domestic corporation is treated as a U.S. Shareholder of the transferee foreign corporation that is a specified ten-percent owned foreign corporation.
- The Act specifies that, when Section 1248 applies to a sale or exchange by a domestic corporation of stock in a foreign corporation held for at least one year, the amount re-characterized as a dividend must be treated as a dividend to the U.S. shareholder to which the 100-percent DRD of new Section 245A applies.
Taxation of Deferred Foreign Income on Transition to the Territorial/Participation Exemption System of Taxation.
The Act introduces a one-time “toll charge” on the undistributed, non-previously taxed post-1986 foreign E&P of certain US-owned corporations, as part of the overall transition to a territorial system. New Code Section 965 increases the Subpart F income of a “specified foreign corporation,” for the last tax year of such corporation that begins before 2018, by the corporation’s accumulated deferred foreign income. Any U.S. Shareholder of the specified foreign corporation must include in income the pro-rata share of the increased Subpart F income. The transition tax does not apply to E&P accumulated by a foreign company prior to attaining its status as a specified foreign corporation.
“Qualified deficits” are permitted to reduce the mandatory E&P inclusion. The U.S. shareholder first combines its pro rata share of foreign E&P deficits in each specified foreign corporation with an E&P deficit and then allocates the aggregate deficit amount among the specified foreign corporations with positive accumulated deferred foreign income.
Participation Exemption Applied to Mandatory Inclusion.
The Act permits U.S. Shareholders to deduct a portion of the increased Subpart F inclusion attributable to pre-measurement date deferred foreign income. After giving effect to the deductions, pre-measurement date accumulated deferred foreign income is taxed at a 15.5-percent effective tax rate to the extent of the U.S. shareholder’s “aggregate foreign cash position,” and at an 8-percent effective tax rate to the extent the inclusion exceeds the aggregate cash position. The “cash position” of a specified foreign corporation includes cash, net accounts receivable, and the fair market value of actively traded personal property, commercial paper, certificates of deposit, federal and state government securities, foreign currency, and certain short-term obligations.
- The Act includes an exception to the normal three-year limitations period for tax assessments to ensure that the assessment period for tax underpayments related to the mandatory inclusion (including related deductions and credits) does not expire before six years from the date on which the tax return initially reflecting the mandatory inclusion was filed.
- A U.S. shareholder may elect to pay the net tax liability resulting from the mandatory inclusion in eight annual installments. Each installment payment must be made by the due date for the tax return for the tax year, determined without regard to extensions. No interest is charged on the deferred payments, provided they are timely paid.
- S-corporations also are subject to the toll charge, with the net amount flowing up to their shareholders. S-corporation shareholders may elect to defer payment of the toll tax until the year in which a triggering event occurs (generally a termination of S status, liquidation or sale of substantially all of the assets, or any transfer of any share of stock in such S corporation). If a shareholder elects to defer the tax, the S corporation becomes jointly and severally liable for such tax if not paid.
- Only the foreign income taxes deemed paid or accrued with respect to the taxable portion of the mandatory Subpart F inclusion may be claimed as a credit against the federal income tax attributable to that inclusion. The Act disallows 55.7 percent of the foreign taxes deemed paid with respect to the portion attributable to the aggregate cash position, as well as 77.1 percent of the foreign taxes paid with respect to the remainder of the mandatory inclusion.
Definition of Intangibles and Repeal of the Active Trade or Business Exception.
Weighing in on the side of the IRS in the long-running tax dispute in the Courts regarding the definition of intangible property, the Act amends Code Section 936(h)(3)(B) to explicitly include foreign goodwill and going concern value within the definition of intangible property, and also eliminates the “active trade or business” exception under Section 367(a)(3) that can apply when a U.S. person transfers certain property to a foreign corporation.
Definition of a U.S. Shareholder.
The Act modifies the definition of a U.S. Shareholder to include a U.S. “person” who owns 10 percent of the total vote or value of all classes of stock of a foreign corporation, for taxable years beginning after 2017. This modification will sweep many more foreign corporations into CFC status, and many more U.S. persons will become U.S. Shareholders, likely resulting in a significant increase in Subpart F income inclusions to direct and indirect U.S. Shareholders. NOTE - the change to the attribution rules applies retroactively to the last year of the CFC that begins before 2018, so that foreign corporations may be treated as CFCs, and U.S. persons may be treated as U.S. Shareholders in 2017 even if they were not under prior law.
Elimination of 30-Day Requirement for Subpart F Inclusions.
Under current law, a U.S. Shareholder of a CFC is required to include amounts in income under Subpart F for a particular tax year only if the foreign corporation has been a CFC for at least 30 consecutive days during the inclusion year. The Act eliminates this 30-day requirement, effective for taxable years of foreign corporations beginning after December 31, 2017, and for taxable years of U.S. Shareholders in which, or with which, the taxable years of the foreign corporations end.
The “GILTI” Tax.
The Act requires a U.S. Shareholder to include in income the “global intangible low-taxed income” (GILTI) of its CFCs. The title is deceiving, because this new tax can apply to more than low-taxed income. The full amount of GILTI is includible in the U.S. shareholder’s income, and is then reduced through a 50- percent deduction in tax years beginning after December 31, 2017 and before January 1, 2026 and a 37.5-percent deduction in tax years beginning after December 31, 2025. A U.S. shareholder’s GILTI is determined by calculating the aggregate “net CFC tested income,” which is the excess (if any) of the aggregate of the U.S. shareholder’s pro rata share of the “tested income” of each of its CFCs over the aggregate of such U.S. shareholder’s pro rata share of the “tested loss” of each of its CFCs. Each CFC will, on a stand-alone basis, either have tested income or a tested loss. Next, net CFC tested income is reduced by the U.S. shareholder’s net deemed tangible income return, equaling ten percent of the CFCs’ aggregate qualified business asset investment (QBAI) with some adjustments for interest and foreign taxes, to arrive at GILTI.
- FTCs are available for 80 percent of the foreign taxes imposed on the U.S. Shareholder’s pro rata share of the aggregate portion of its CFCs’ tested income included in GILTI (compared to the 100 percent of such taxes by which GILTI is grossed up).
- GILTI is treated as a separate foreign tax credit “basket” under Code Section 904(d), such that FTCs deemed paid as a result of a GILTI inclusion can only reduce such an inclusion and cannot offset US taxes on income in other “baskets.”
- This rule effectively eliminates deferral in a CFC that has GILTI, and subject a U.S. Shareholder to tax, albeit at a reduced rate, on the CFCs’ combined net income above a routine equity return on tangible depreciable business assets that is not otherwise subject to U.S. tax, or to foreign tax at a 13.125-percent minimum rate (taking into account the combined effects of the 20% reduction in FTCs and the new 21% flat corporate income tax rate).
- Exclusions from GILTI are limited to ECI, Subpart F income, income excluded from foreign base company income under the high-tax exception of Section 954(b)(4), dividends received from related persons, and any foreign oil and gas extraction income.
Deduction for Foreign-derived Intangible Income (FDII).
The Act grants a new benefit to domestic corporations with FDII for tax years beginning after 2017 and before January 1, 2026, in the form of a deduction equal to 37.5 percent of a domestic corporation’s foreign-derived intangible income (FDII,) plus 50 percent of the GILTI amount included in gross income of the domestic corporation. For tax years beginning after December 31, 2025, the deductions allowed will be reduced to 21.875 percent and 37.5 percent, respectively. FDII is computed under a complex formula that aims at quantifying the income earned by a domestic corporation from the exploitation of intangible property. However, the FDII incentive may violate the United States’ World Trade Organization (WTO) obligations, because it could be interpreted as an export subsidy. Time will tell whether the FDII initiative will remain in place or if, like the Foreign Sales Corporation and Extra-Territorial Income incentives before it, the WTO will attack the FDII incentive.
Hybrid Transactions and Entities.
Deductions for interest and royalty payments paid or accrued by a U.S. corporation to a related foreign party pursuant to a hybrid transaction, or made by, or to, a hybrid entity, will be disallowed, if and to the extent that there is no income inclusion by the foreign related party under the tax laws of its country of residence, or if the related party is allowed a deduction with respect to such amount under the tax laws of its country of residence. This is consistent with the OECD anti-base erosion and profit shifting (BEPS) initiative, and particularly the Action Item regarding hybrid instruments and entities.
Interest Expense Deduction Limitation - New Section 163(j).
New Section 163(j) rules apply a limitation on interest expense deductions based on a fixed ratio, and allow for the determination of adjusted taxable income (ATI) to include an addback for depreciation, amortization deductions, and depletion deductions for taxable years before January 1, 2022. Accordingly, new Section 163(j) limits U.S. net business interest expense deductions to the sum of business interest income, 30 percent of ATI, plus floor plan financing interest of the taxpayer for the taxable year. The new Section 163(j) interest limitation applies to the “business interest” of any taxpayer, whether or not the taxpayer is part of an “inbound” group or an “outbound” group, and whether or not the lender is a related party. So, unlike current Section 163(j), new Section 163(j) is not limited to inbound companies and applies regardless of whether the interest payment is to a foreign person or a U.S. person. New Section 163(j) does not apply to regulated public utilities, the real estate industry (by election), the trade or business of performing services as an employee, electric cooperatives, any farming business (by election) and to certain small taxpayers.
Changes to Foreign Tax Credits.
The following provisions apply to taxable years of foreign corporations beginning after December 31, 2017, and to taxable years of United States shareholders in which or with which such taxable years of foreign corporations end.
- The Act repeals Code Section 902, the provision that permitted a domestic corporation an indirect foreign tax credit with respect to dividends received from a 10%-owned foreign corporation.
- The Act modifies Section 960, which permitted a domestic corporation an indirect foreign tax credit with respect to Subpart F inclusions (including inclusions arising from an “investment by a CFC in United States property). This foreign tax credit is now calculated based on current-year foreign taxes paid (rather than a cumulative post-1986 foreign tax pool) with respect to the relevant item of Subpart F income, or the CFC investment in United States property.
- The Act now provides a separate foreign tax credit limitation basket for foreign branch income which is defined as the business profits of a U.S. person that are attributable to one or more qualified business units in one or more foreign countries. However, foreign branch income does not include any income that is otherwise treated as passive basket income.
Base Erosion and Anti-abuse Tax (BEAT).
The Act attempts to combat corporate “base erosion” by imposing an additional corporate tax liability on corporations (other than a RIC, REIT or S corporation) with average annual gross receipts for the three-year period ending with the preceding taxable year of at least $500 million and that make certain base eroding payments to related foreign persons for the taxable year of three percent (two percent for certain banks and securities dealers) or more of all their deductible expenses (other than the NOL deduction, the new DRD for foreign source dividends, the new deduction for FDII and the new GILTI, and qualified derivative payments defined in the provision and certain payments for services).
- A base eroding payment generally is any amount paid or accrued by the taxpayer to a related foreign person that is either deductible or for acquiring property subject to depreciation or amortization, and reinsurance payments.
- Cost of goods sold is not a deductible payment and will not be a base erosion payment.
- A base erosion payment will not include any amount paid or accrued by a taxpayer for services if such services meet the requirements for eligibility for use of the “services cost method”, and meet certain other conditions.
The BEAT has been widely criticized inside and outside the USA as potentially being in violation of the Non-discrimination articles of U.S. tax treaties, since it effectively discriminates against payments made to foreign payees. It also may collide with the principles of the Business Profits article of U.S. tax treaties, by creating, in effect, an indirect tax on the business profits of the foreign recipient of the payment, which – under tax treaties – generally may not be taxed unless the business profits are attributable to a recipient’s U.S. Permanent Establishment.
Sale of Partnership Interest.
A foreign partner’s gain or loss from the sale or exchange of a partnership interest will be treated, after 2017, as effectively connected with a U.S. trade or business to the extent the partner would have had effectively connected gain or loss if the partnership had sold all of its assets in a taxable sale at fair market value and allocated the gain or loss to the foreign partner in the same manner as non-separately stated income and loss. This tax applies to a foreign partner that directly or indirectly owns an interest in a partnership that is engaged in a U.S. trade or business. This is a reversal of the Tax Court decision in the recent Grecian Magnesite case and codifies a long controversial 1991 Revenue Ruling on the matter.
- If the partnership holds any U.S. real property interests (USRPIs) at the time of the sale or exchange, the amount that is treated as ECI under the new provision is reduced by the amount treated as ECI by reason of Code Section 897.
- To give the new tax teeth, Code Section 1446 now includes the requirement that the transferee of a partnership interest must withhold ten percent of the amount realized on the acquisition of a partnership interest if any portion of the gain is treated as ECI under the new provision, unless the transferor certifies that it is not a foreign person. If the transferee fails to withhold, the partnership is required to withhold from the transferee partner an amount equal to the amount the transferee was required to withhold. Therefore, any purchaser of an interest in a domestic or foreign partnership, including an LLC, will need to determine whether any portion of the gain realized by the transferor is ECI to the transferor.
Section 863(b) has applied in the past with respect to income, profits, and gain from the sale of inventory by sourcing such amounts in part to the location of production and in part to the location of sale. The Act amends Section 863(b) to cause such income, profits and gain to be sourced entirely to the place of production rather than by reference to the location of production and sales.
With the above international tax changes to the Internal Revenue Code, taxpayers will encounter a new set of challenges in applying and interpreting the law. The IRS has already released guidance, in Notice 2018-07, regarding the application of the provisions of new Code Section 965 (the “toll charge” tax) and it is hoped that additional guidance will be forthcoming regarding other components of the Act. Should you have any questions regarding international taxation and your business, please contact the author of this article, Fuad Saba, at (312) 818-4305 or on email@example.com.