2018 Tax Alert - International Taxation Section
The following is the Individual Taxation section of the 2018 client advisory "Tax Alert: How the New Tax Laws Will Affect You Now and in the Future."
The full version of this client advisory is available here.
The Act makes dramatic and far-reaching changes to the U.S. international tax rules by: (1) permitting tax-free repatriations of future foreign profits of foreign corporations to their 10 percent U.S. shareholders that are domestic corporations; (2) imposing an immediate tax at a reduced rate on all U.S. shareholders on accumulated earnings of foreign corporations that are controlled foreign corporations ("CFCs") or have 10 percent U.S. shareholders in a one-time deemed repatriation of those earnings; (3) imposing a current tax, similar to subpart F, on a U.S. shareholder's "global intangible low-taxed income" of a CFC; (4) modifying certain aspects of the "subpart F" anti-deferral rules, and (5) enacting several new provisions intended to prevent erosion of the U.S. tax base.
Dividend Received Deduction – The Act changes the taxation of domestic corporations from a worldwide tax system to a more territorial tax system. The new law allows for a domestic corporation to claim a 100% deduction for the foreign-source portion of a dividend received by such domestic corporation from a "specified 10%-owned foreign corporation," in which such domestic corporation is a "United States shareholder." For this purpose, a "specified 10%-owned foreign corporation" is any foreign corporation (other than a passive foreign investment company ("PFIC") that is not a controlled foreign corporation ("CFC")) and a United States shareholder is a United States person that owns (directly or constructively) stock of the foreign corporation representing 10% of the combined voting power and value of a foreign corporation. The deduction is allowed only to a C corporation that is not a regulated investment company or a real estate investment trust.
In addition to owning 10% of the voting power of the foreign corporation, a domestic corporation needs to satisfy a holding period requirement. Specifically, a domestic corporation is not permitted a 100% dividend deduction with respect to a dividend paid on any share of stock that is held for 365 days or less during the 731-day period beginning on the date that is 365 days before the date on which the dividend is paid. Additionally, the foreign corporation must qualify as a specified 10% foreign corporation and the domestic corporation must likewise qualify as a 10% shareholder at all times during the period.
Under the Act, if a domestic corporation transfers substantially all of the assets of a foreign branch to a specified 10%-owned foreign corporation, with respect to which it is a United States shareholder after the transfer, then the domestic corporation must recapture, as U.S. source income, any net branch losses incurred after December 31, 2017, and before the transfer and with respect to which the domestic corporation took a deduction. This provision applies to transfers after December 31, 2017.
Mandatory Repatriation – The Act amends Section 965 to require a United States shareholder (which for this purpose includes domestic corporations, partnerships, trusts, estates, and U.S. individuals that own 10% of the voting power) of CFCs and other specified foreign corporations to include in income, for the last taxable year of such foreign corporation beginning before January 1, 2018, such shareholder's pro rata share of the deemed repatriation amount. Other specified foreign corporations are non-CFC, non-PFIC foreign corporations with a corporate United States shareholder (which for this purpose includes domestic corporations that own 10% of the voting power of such foreign corporation). The deemed repatriation amount is the greater of such foreign corporation's post-1986 deferred foreign income as of (i) November 2, 2017 or (ii) December 31, 2017 and that was not previously subject to U.S. tax (but excluding earnings and profits that were accumulated prior to the foreign corporation becoming a CFC or having a 10% U.S. shareholder). The deemed repatriation amount generally is unreduced by distributions made by the foreign corporation during the taxable year.
This deemed repatriation generally will be taxed at a 15.5% rate to the extent the underlying foreign earnings are attributable to the U.S. shareholder's cash position and an 8% rate for all other amounts. The "cash position" is defined to include cash, net accounts receivable, and the fair market value of similarly liquid assets.
The Act eliminates the active trade or business exception, which generally disallows nonrecognition treatment for transfers of property to a foreign corporation and also eliminates a domestic corporation from being able to claim an indirect foreign tax credit with respect to dividends it receives from a foreign corporation in which it owns 10% of the voting stock. The Act provides an election to increase the percentage of domestic taxable income offset by overall domestic loss treated as foreign-source income.
Global Intangible Low Taxed Income – The Act adds new Code Section 951A, which requires a United States shareholder of a CFC to include in income, as a deemed dividend, the global intangible low-taxed income ("GILTI") of the CFC. After factoring in a deduction that a domestic corporation will be entitled to claim with respect to such income inclusion, a domestic corporation will be subject to U.S. tax on GILTI at an effective rate of 10.5% (that is, 50% of the U.S. corporate tax rate of 21%). But U.S. shareholders who are not C corporations (such as domestic partnerships and their partners) will not be eligible for the 50% deduction and so will end up paying tax on GILTI of approximately 37%. They will not be able to take the 20% deduction on GILTI since that income is foreign income and the 20% deduction is only for domestic income. See the discussion under Section Three, "Taxation of Pass-Through Entities," above.
"GILTI" is defined as the excess of the U.S. shareholder's net CFC tested income over a net deemed tangible income return. "Net CFC tested income" generally means a CFC's gross income, other than income that is subject to U.S. tax as effectively connected income; Subpart F income (including income that would be Subpart F income but for the application of certain exceptions); and foreign oil and gas extraction income, less allocable deductions. The "net deemed tangible income return" generally is an amount equal to (i) 10% of the aggregate of the United States shareholder's pro rata share of a CFC's qualified business asset investment (generally, a quarterly average of the CFC's tax basis in depreciable property used in its trade or business) over (ii) the amount of interest expense taken into account to determine such U.S. shareholder's net CFC tested income.
Special Subpart F Changes – The Act first modifies the rules regarding which corporations are treated as CFCs. The new law expands the stock attribution rules by attributing stock of a foreign corporation owned by a foreign person to a related U.S. person for purposes of determining whether the related U.S. person is treated as a U.S. shareholder of the foreign corporation and, therefore, whether the foreign corporation is a CFC. For example, a U.S. entity with a foreign shareholder may be treated as owning stock in a foreign corporation that is owned by its foreign shareholder. Accordingly, foreign sister companies of U.S. corporations with a common foreign parent corporation generally are treated as CFCs. This change is effective beginning in the last taxable year of foreign corporations beginning before January 1, 2018 and thus applies for purposes of the deemed repatriation described above. The Act also expands the definition of a U.S. shareholder to include U.S. persons who own 10% or more of the total value of a foreign corporation (rather than basing the determination solely on voting power).
Base Erosion – The new law imposes a minimum tax on a domestic corporation's "modified taxable income." The provision is aimed at domestic corporations that significantly reduce their U.S. tax base by making large deductible payments, such as royalties or interest, to foreign related parties. The tax imposed is equal to the excess of: 10%of the corporation's "modified taxable income," reduced by the tax otherwise imposed on the corporation, after reduction for credits, but adding back (i) 100% of IRC Section 41(a) research credit and (ii) 80% of the lesser of (a) the low-income housing credit, the renewable electricity production credit, and certain investment credits allocable to the energy credit, or (b) the minimum tax amount imposed by this provision (determined without regard to the addition of 80% of such credits).
The 10% rate is reduced to 5% for the single taxable year beginning in 2018 and increased to 12.5% for taxable years beginning in 2026. The add-back for certain credits is also eliminated for taxable years beginning in 2026. Each rate is increased by 1% for taxpayers that are members of an affiliated group that includes a bank or a securities dealer.
A corporation's modified taxable income is the corporation's taxable income, increased by certain "base erosion payments." These "base erosion payments" include deductible payments or payments for depreciable property that the corporation makes to a foreign related party, but do not include payments that are subject to tax under IRC Sections 871 or 881 and on which the full amount of tax has been withheld under IRC Sections 1441 and 1442.
The minimum tax is imposed on U.S. corporations and on the income of foreign corporations that is effectively connected with the conduct of a U.S. trade or business. Related parties are treated as a single person for purposes of determining certain aspects of the application of the minimum tax. In order for the minimum tax to apply, the corporation must not be a regulated investment company, real estate investment trust or S corporation; must have average annual gross receipts of at least $500 million for the three preceding taxable years; and must be making base erosion payments that represent 3% or more of all of its deductions, excluding NOL deductions, the new foreign DRD, and the foreign-derived intangible income and GILTI deductions (or, for members of an affiliated group that includes a bank or securities dealer, this applicable threshold is decreased to 2%).
The Act has made substantial changes to the tax laws. There are many "glitches" in the Act that will need to be addressed in technical correction legislation. Since technical correction legislation requires a 60% vote in the Senate (it cannot come under reconciliation rules), there will need to be bi-partisan cooperation to fix the problems that such fast paced passage of the Act produced. Second, technical corrections require unanimous consent by both the majority and minority staffs of the House Committee on Ways and Means and the Senate Finance Committee. If anyone disagrees about the legislative intent of a provision and whether the statute reflects that intent, then the provision is not a technical correction but, rather, a change in policy. Thus it may take quite a while for any technical correction legislation to be passed.
Effective tax planning including choice of entity structures will be made based on the new laws that are now in effect. Only time will tell how these changes will impact individuals, businesses, and the economy.
If you have any particular area of interest or concern regarding how these changes directly affect you or your business, please feel free to contact our tax attorneys,Cheryl Johnson or Jen Green.
This communication is intended for general information purposes and as a service to clients and friends of Verrill Dana, LLP. This publication, which may be considered advertising under the ethical rules of certain jurisdictions, should not be construed as legal advice or a legal opinion on any specific facts or circumstances, nor does it create attorney-client privilege.