2017 Tax Reform: Key International Tax Provisions
The tax reform bill (“Tax Cuts and Jobs Act”) has now been passed by both houses of Congress and is expected to be signed into law by President Trump in the coming days. Below is a look at the final provisions relating to concepts of international taxation, including a summary of the most significant and broadly applicable changes.
Participation Exemption for U.S. C Corporations: One key area of change included in the bill relates to the way the U.S. taxes foreign earnings attributable to foreign subsidiaries of U.S. C corporations. Before enactment of the new law, U.S. persons (citizens, residents, and domestic corporations) were generally taxed on their worldwide income. However, foreign income earned by a foreign corporation was generally not subject to U.S. tax until the income was distributed as a dividend to its U.S. shareholders (subject to certain exceptions such as the anti-deferral rules of Subpart F). Additionally, when a U.S. corporation sells/exchanges/transfers stock of a foreign subsidiary, the gain was considered a dividend to the extent the foreign corporation has untaxed earnings and profits (E&P). Also, under pre-Act law, a U.S. corporation that owns at least 10 percent of the voting stock of a foreign corporation was allowed a deemed-paid credit for foreign income taxes paid by the foreign corporation when the foreign corporation distributed a dividend.
The new law makes the following key changes in establishment of a participation exemption system:
- Exemption for Foreign-Source Portion of Dividends: Under the new law, there is a 100 percent exemption (similar to U.S. dividends received deduction) for the foreign-source portion of dividends received from specified 10 percent owned foreign corporations. However, the exemption is only available to U.S. C corporations.
- Sales/Transfers of Foreign Subsidiary Stock: Under the new law, when a domestic corporation sells/exchanges/transfers stock in a foreign corporation, any amount received by the domestic corporation that is treated as a dividend for purposes of Code Sec. 1248 is treated as a dividend for purposes of applying the exemption for foreign-source portion of dividends.
- Adjusted Basis in Subsidiary Stock: Under the new law, the adjusted basis in foreign subsidiary stock is reduced by the amount of any dividend that was exempt from tax as a result of the exemption for foreign-source portion of dividends for purposes of determining the loss (but not gain) on the sale/exchange/transfer of the stock.
- Repeal of Indirect Foreign Tax Credits: Under the new law, no foreign tax credit or deduction is allowed for any foreign taxes paid or accrued with respect to any dividend to which the exemption for foreign-source portion of dividends applies. A foreign tax credit is allowed for any Subpart F income that is included in the income of the U.S. shareholder.
Deferred Foreign Income – Deemed Repatriation: Under the new law, U.S. shareholders owning at least 10 percent of a foreign subsidiary must include in income the shareholder’s pro rata share of the net post-86 untaxed E&P. This is for the foreign subsidiary’s last tax year beginning before 2018. The portion of E&P comprising of cash (or cash equivalents) is taxed at 15.5 percent and any remaining E&P is taxed at eight percent. The U.S. shareholder may elect to pay the tax over a period of eight years. The payments for each of the first five years equals eight percent of the net tax liability. The amount of the sixth installment is 15 percent of the net tax liability, increasing to 20 percent for the seventh installment and the remaining balance of 25 percent in the eighth year.
There is a special rule for S corporation shareholders – they are allowed to elect to maintain the deferral on the foreign income until the S corporation changes its status, sells substantially all of its assets, ceases to conduct business, or the electing shareholder transfers its S corporation stock.
Global Intangible Low Taxed Income: Under the new law, a U.S. shareholder of a CFC has to include in gross income its global intangible low-taxed income (GILTI) in a manner similar to a Subpart F inclusion. GILTI means the excess (if any) of the shareholder’s net CFC tested income over such shareholder’s net deemed tangible income return for such tax year. This is a very complicated and nuanced definition that will need to be examined on a case-by-case basis. However, we can simplify this definition for purposes of identifying potential inclusions by stating that we may have an inclusion where the CFC’s foreign source, low-taxed, trade or business income exceeds 10 percent of such CFC’s adjusted basis in the tangible property used in the associated trade or business.
GILTI does not include any income that is effectively connected to a U.S. trade or business, Subpart F income, foreign oil and gas income, or certain related party payments and would be taxed at a rate of 10 percent. Foreign tax credits are available but are limited to the 80 percent of taxes paid and cannot be carried back or carried forward like other foreign tax credits.
U.S. C corporations will be allowed a deduction equal to 50 percent of the GILTI inclusions.
CFC Modification: Under the new law, the constructive ownership rules are changed so that certain stock of a foreign corporation owned by a foreign person is attributed to a related U.S. person for purposes of determining whether the foreign person is a U.S. shareholder for the CFC determination test. Additionally, the new law changes the definition of a U.S. shareholder from a U.S. person who owns 10 percent of the voting power of stock to 10 percent of the vote or value of the stock of the foreign corporation. Also, the new law removes the 30-day holding period requirement when determining if the U.S. shareholder needs to include their portion of Subpart F income.
Separate Foreign Tax Credit Basket for Foreign Branch Income: The new law establishes a third basket (other than the general and passive basket) for foreign tax credit calculations related to foreign branch income.
Change in Sale of Inventory Sourcing Rule: The new law requires that income from the sale or exchange of inventory produced partly in and partly outside the U.S. must be allocated and apportioned on the basis of the location of production of the property for purposes of determining the amount for foreign source income for foreign tax credit purposes. The previous rule is that 50 percent of the income would be treated as foreign-source income.
Look-Through Rule Applied to Gain on Sale of Partnership Interest: Gain or loss from the sale or exchange of a partnership interest is effectively connected to a U.S. trade or business to the extent gain on the hypothetical sale of the partnership’s underlying assets would have been treated as effectively connected income. Thus, a foreign person that realizes gain on the sale of a partnership interest will be subject to U.S. income taxes to the extent such gain is effectively connected to a U.S. trade or business. This provision applies to sales and exchanges on or after Nov. 27, 2017.
Base Erosion Anti-Abuse Tax: There is a new tax imposed on certain corporations with average annual gross receipts of at least $500 million. This tax may be an issue where applicable corporations are making payments to related foreign persons and a deduction is allowed for such related party payment. The calculation is very complex and will need to be reviewed on a case-by-case basis.
It is important to note that this summary is not encompassing of all international tax provisions in the new law. These provisions are a general effort to switch the U.S. from a worldwide taxing regime to a territorial taxing regime. Furthermore, there is little guidance as to how these provisions will actually be implemented, so any new regulations issued by the Treasury Department will be critically important going forward. Please reach out to your KSM advisor for more information.
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