As a follow up to our December 20 Tax Alert covering domestic tax provisions included in the Conference Report, this alert provides a comprehensive overview of the Report’s international tax provisions. Read on for highlights on the ways you and your business may be directly impacted.
Transition to Participation Exemption Regime
- Beginning in 2018, there will be a shift from a worldwide income corporate tax system to a participation exemption regime. A U.S. corporation, which owns 10% or more of the vote or value of a foreign corporation's stock will be entitled to deduct the foreign source portion of the dividends it receives from such foreign corporation.
- As part of the transition to this participation exemption regime, the new law triggers an income inclusion to certain U.S. shareholders. U.S. persons. Individuals, corporations, and trusts, holding a specified ownership interest in a foreign corporation with untaxed earnings. The new law will recognize their share of that income and be subjected to 15.5% tax on the earnings invested in cash and cash equivalents, and 8% on all other earnings. This liability may be paid in installments over 8 years.
- S corporations may elect to defer payment of the tax liability until the tax year in which the shareholder has a specified triggering event. Once a triggering event has taken place, the shareholder may elect to pay the liability in installments over 8 years. A triggering event occurs when a corporation ceases to be an S corporation, a liquidation or sale of substantially all the assets of an S corporation takes place, or there is a transfer of a share of stock in the S corporation by the taxpayer.
- Earnings taxed due to deemed dividend treatment will not be subject to additional U.S. federal income tax upon distribution.
Current Year Inclusion of Global Intangible Low-Taxed Income
- A 10% U.S. shareholder of any controlled foreign corporation (“CFC”) is required to include in gross income for the current tax year its global intangible low-taxed income (“GILTI”) regardless of whether it is distributed. GILTI essentially means income that is in excess of the standard rate of return (statutorily assumed to be 10%) on the adjusted tax basis of active foreign tangible business assets. For purposes of this computation, income in excess of that derived from tangible assets would be hypothetically be considered earned with respect to intangibles. GILTI does not include income effectively connected with a U.S. trade or business, Subpart F income and certain related party payments.
- The goal of the GILTI rules is to impose additional tax on U.S. shareholders of CFCs, which derive low-taxed income where the return on assets exceeds 10% annually.
- Foreign tax credits are allowed for foreign income taxes paid with respect to GILTI, but are limited to 80% of the foreign income taxes paid and are not allowed to be carried back or forward to other years.
- Corporate U.S. shareholders generally would be entitled to a deduction of 50 percent of any GILTI.
- Under a 21 percent corporate tax rate, and as a result of the deduction for GILTI, the effective tax rate on GILTI is 10.5 percent for taxable years beginning after December 31, 2017 and before January 1, 2026.
Deduction for Foreign-Derived Intangible Income
- Corporate U.S. shareholders generally would be entitled to a deduction of 37.5 percent of certain foreign-derived intangible income (“FDII”) of a domestic corporation. FDII essentially means income derived from property and services sourced outside of the United States.
- Under a 21 percent corporate tax rate, and as a result of the deduction for FDII, the effective tax rate on FDII is 13.125 percent.
New Base Erosion Tax
- A new “Base Erosion Tax” applies to large multinational affiliated companies that use deductible cross-border payments to substantially reduce their U.S. tax liability. If the cross-border payments to affiliates reduce a company’s U.S. tax liability to less than 10 percent of its U.S. taxable income, as modified, the Base Erosion Tax will apply. The Base Erosion Tax equals the excess, if any, of (a) 10 percent of the taxpayer’s income without taking deductible payments to foreign affiliates into account over (b) the taxpayer’s regular tax liability (taking such deductions into account) reduced by certain tax credits (other than the Research and Development credit).
- The Base Erosion Tax applies to large multinationals, domestic or foreign, that are part of a multinational group with at least $500 million of annual gross receipts (averaged over a 3-taxable-year period), and that make payments to foreign affiliates resulting in deductions equal to 4 percent or more of their total deductions.
Limitations on Transfers of Intangibles
- The new law places limitations on income shifting through cross-border transfers of intangible property by revising and broadening the definition of intangibles and providing the IRS with authority to value intangibles on an aggregate basis to capture the additional value resulting from the interrelation of intangible assets. The definition of intangibles is revised to specifically include workforce in place, goodwill (both foreign and domestic) and going concern value, which are particularly relevant with respect to outbound transfers of intangibles and transfer pricing. The source or value of the intangible is not relevant in determining whether or not it is an intangible.
- Therefore, upon an outbound transfer of foreign goodwill or going concern value, a U.S. transferor should be subject to current gain recognition, or to a special rule that requires inclusion of deemed royalties following such transfer. This is the case even if the value of the transferred property was created exclusively through offshore activities.
- With respect to outbound restructurings of U.S. operations and intercompany pricing allocations, the IRS may specify the method to be used in determining the value of intangibles, particularly with respect to transfers of multiple intangibles. The IRS may specify the use of the aggregate basis valuation instead of an asset-by-asset approach if it achieves a more reliable result. The IRS may require that the valuation of intangibles be based on realistic alternative principles, which are predicated on the notion that a taxpayer will only enter into a particular transaction if none of its realistic alternatives is economically preferable to the transaction under consideration.
Hybrid Entities or Transactions and Payments of Interest or Royalties
- A deduction is denied for certain related party interest or royalties paid or accrued pursuant to a hybrid transaction or by, or to, a hybrid entity. The deduction is denied to the extent that:
(1) there is no corresponding inclusion to the related party under the tax law of the country of which such related party is a resident for tax purposes or is subject to tax, or
(2) such related party is allowed a deduction with respect to such amount under the tax law of such country.
- Disqualified related party interest or royalties does not include any payment to the extent such payment is included in the gross income of a U.S. shareholder under Subpart F.
- A hybrid transaction is any transaction in which interest or royalties are treated differently under U.S. tax law compared to the tax law of the country of the recipient.
- A hybrid entity is any entity which (a) is treated fiscally transparent for U.S. tax purposes but not fiscally transparent in the country of residence, or (b) is treated not fiscally transparent for U.S. tax purposes, but is fiscally transparent for foreign law purposes.
- Further, the IRS is granted authority to issue regulations consistent with this provision to discourage similar abusive devices.
U.S. Tax on Sale of Certain Partnership Interests by Foreign Persons
- The new law provides that a nonresident alien individual or foreign corporation that owns, directly or indirectly, an interest in a partnership which is engaged in any trade or business within the United States will be subject to U.S. tax on the gain or loss on the sale or exchange of all (or any portion) of the partnership interest. The gain or loss will be treated as effectively connected to a U.S. trade or business. The transferee in such transaction would be required to withhold 10% of the amount realized. This change does not otherwise decrease the applicable 15% FIRPTA withholding in the case of sales of U.S. real property interests.
Limitation on Deduction for Interest
- Under old law, special earnings stripping provisions limited a U.S. corporation’s deductions for interest payments to related foreign lenders whose interest income is exempt from U.S. withholding tax. The limitation is no longer targeted at related or international parties, and now broadly applies to all taxpayers, regardless of domestic or foreign status, and applies new rules. Of particular importance, the former safe harbor debt/equity ratio is eliminated.
- The net interest deduction is limited to 30% of the adjusted gross income (down from 50%). Between January 1, 2018 and December 31, 2021, adjusted taxable income will be computed as earnings before interest, taxes, depreciation, and amortization. Beginning January 1, 2022, adjusted taxable income will be computed as earnings before interest and taxes.
- Excess business interest can be carried forward indefinitely and can be utilized in a year where there is “excess limitation”.
In the weeks leading up to President Trump’s signing of the bill, we will continue to keep you informed of the critical changes, which may affect you and your business. In the interim, please contact your Friedman LLP professional for answers to specific questions.