2017 Tax Reform: U.S. to move to a Territorial Tax System?

As expected, the draft tax reform bill released on November 2, 2017, included provisions which, if enacted, will dramatically change the way the U.S. taxes multinational entities. The reforms are intended to level the playing field for U.S. multinationals and encourage the repatriation of the large amounts of cash currently held offshore by U.S. companies.

To move to a territorial system and encourage repatriation of foreign earnings, the bill provides an exemption for foreign source dividends for 10 percent or more U.S. corporate shareholders of a foreign corporation and a one-time deemed repatriation of all earnings and profits (E&P). The current rules under Subpart F will largely remain intact with some revisions, and there will be additional limitations on using the foreign tax credit to offset U.S. tax liabilities. The bill also adds some new rules aimed at preventing ‘base erosion’ by adding a tax on “excess high returns” from offshore activities and adding a stricter limitation on the ability of a U.S. multinational to deduct interest expense.

The bill also includes an excise tax on payments made by U.S. corporations to foreign related parties. The provision has been widely criticized by foreign corporations, and as the bill made its way to the Ways and Means Committee for mark-up additional managers amendments were added that will soften the impact of the tax by allowing foreign tax credits to be used to offset the additional layer of tax.

We expect there to be more changes to come before any of the provisions of HR 1 outlined below become law.

Tax Cuts and Jobs Act: Summary of Key International Provisions

Participation Exemption System for Taxation of Foreign Income

  • Dividend exemption system. Under the exemption system, 100 percent of the foreign-source portion of dividends paid by a foreign corporation to a U.S. corporate shareholder that owns 10 percent or more of the foreign corporation would be exempt from U.S. taxation. No credit or deduction for foreign taxes paid would be allowed, including withholding taxes.
    • Effective for distributions made after 2017.
  • Investment in U.S. Property. Investment in U.S. property by foreign subsidiaries currently results in a deemed dividend to the U.S. shareholder under IRC Section 956. Section 4002 repeals Section 956.
  • Limitation on losses with respect to specified 10 percent owned foreign corporations. For purposes of determining the amount of loss on the sale of the stock of a foreign subsidiary, a U.S. parent corporation will reduce its basis in the stock by the amount of any exempt dividends received.
    • Also, if a U.S. corporation transfers substantially all of the assets of a foreign branch to a foreign subsidiary, the U.S. corporation would be required to include in income the amount of any post-2017 losses that were incurred by the branch.
    • The provisions would be effective for distributions or transfers made after 2017.
  • Treatment of deferred foreign income upon transition to participation exemption system of taxation. U.S. shareholders owning at least 10 percent of a foreign subsidiary, generally, will include a pro rata share of post 1986 earnings and profits to the extent the E&P has not been previously taxed in the US. The amount of E&P subject to tax will be the higher of the balance as of November 2, 2017 or December 31, 2017. The portion of the E&P comprising cash or cash equivalents would be taxed at a 12 percent rate; any remaining E&P will be taxed at 5 percent. Foreign tax credit carryforward amounts would be available to offset the deemed repatriation tax; foreign tax credits triggered by the deemed repatriation would be partially available. Taxpayers could elect to pay the tax due over an eight year period.
    • The provision will not apply to S corporations until it ceases to be an S corporation, substantially all of the assets are sold or liquidated, the S corporation strops conducting business or the stock is transferred.

Modifications Related to Foreign Tax Credit System

  • Repeal of Section 902 indirect foreign tax credits; determination of Section 960 credit on current year basis. Under this provision, no credit or deduction for foreign taxes paid or withheld would be allowed with respect to any dividend income to which the dividend exemption applies. A foreign tax credit would be allowed for any Subpart F income that is included in the current year without regard to pools of income left abroad.
  • Source of income from sales of inventory determined solely on basis of production activities. Under this provision the sourcing of income from the sale of inventory will be based on the location of the production activities with respect to the inventory.
    • The provision would be effective for tax years beginning after 2017.

Modifications of Subpart F Provisions

  • Repeal of inclusion based on withdrawal of previously excluded Subpart F income from qualified investment. Under this provision, the imposition of current U.S. tax on foreign shipping income earned between 1976 and 1986, and previously excluded from U.S. tax under Subpart F where the income was reinvested in certain qualified shipping investments, would be repealed.
    • The provision would be effective for tax years beginning on or after January 1, 2018, and for tax years of U.S. shareholders in which such tax year of the foreign subsidiaries end.
  • Repeal of treatment of foreign base company oil related income as Subpart F income. Under this provision, the imposition of current U.S. tax under Subpart F on certain foreign oil related income (“foreign base company oil related income”) would be repealed.
    • The provision would be effective for tax years beginning on or after January 1, 2018, and for tax years of U.S. shareholders in which such tax year of the foreign subsidiaries end.
  • Section 4203: Inflation adjustment of de minimis exception for foreign base company income. Under current law, a Subpart F de minimis rule states that if the gross amount of Subpart F income is less than the lesser of 5 percent of the foreign subsidiary’s gross income or $1 million, then the U.S. shareholder is not subject to current U.S. tax under Subpart F. Under this provision, the $1 million threshold would be adjusted for inflation.
    • The provision would be effective for tax years beginning on or after January 1, 2018, and for tax years of U.S. shareholders in which such tax year of the foreign subsidiaries end.
  • Look-through rule for related controlled foreign corporations made permanent. Under current law, for tax years of foreign subsidiaries beginning before January 1, 2020, a special “look-through” rule provides that passive income received by one foreign subsidiary from a related foreign subsidiary is generally not includible in the taxable income of the U.S. shareholder, provided such income is not subject to current U.S. tax or effectively connected with a U.S. trade or business. Under this provision, the look-through rule would be made permanent.
    • The provision would be effective for tax years beginning on or after January 1, 2020, and for tax years of U.S. shareholders in which such tax year of the foreign subsidiaries end.
  • Modification of stock attribution rules for determining status as a controlled foreign corporation. Under current U.S. law, a foreign subsidiary is a controlled foreign corporation (CFC) if it is more than 50 percent owned, either by vote or value, by one or more U.S. persons, each of which owns at least 10 percent of the vote or value of the foreign subsidiary. For these purposes, a U.S. person may be treated as constructively owning stock held by certain related persons, affiliates and shareholders. Under this provision, a U.S. corporation would be treated as constructively owning stock held by its foreign shareholder.
    • The provision would be effective for tax years beginning on or after January 1, 2018, and for tax years of U.S. shareholders in which such tax year of the foreign subsidiaries end.
  • Elimination of requirement that corporation must be controlled for 30 days before subpart F inclusions apply. Under this provision, a 10 percent U.S. shareholder would be subject to current U.S. tax on the CFC’s Subpart F income even if the U.S. shareholder does not own stock in the CFC for an uninterrupted period of 30 days or more during the year.
    • The provision would be effective for tax years beginning on or after January 1, 2018, and for tax years of U.S. shareholders in which such tax year of the foreign subsidiaries end.

Prevention of Base Erosion

  • Current year inclusion by U.S. shareholders with foreign high returns. Under current transfer pricing rules, foreign income earned by the U.S. parent directly and where the foreign subsidiary of the U.S. parent owns important assets, undertakes key functions, or bears significant risks in a foreign jurisdiction, that foreign subsidiary is treated as earning more than a routine profit, often resulting in substantial profits being generated at the foreign subsidiary level. Allocating profits in this manner does not trigger taxation under the Subpart F rules, and thus, U.S. tax on these profits are deferred until repatriated.
    • Under this provision, a U.S. parent of one or more foreign subsidiaries would be subject to current U.S. tax on 50 percent of the U.S. parent’s foreign high returns, regardless of whether such income is distributed to the U.S. parent. Foreign high returns is measured as the excess of the U.S. parent’s foreign subsidiaries’ aggregate net income over a routine return (7 percent plus the federal short-term rate) on the foreign subsidiaries’ aggregate adjusted bases in depreciable tangible property, less interest expense. Foreign high returns does not include income effectively connected with a U.S. trade or business, Subpart F income, or income from the disposition of commodities produced or extracted by the taxpayer, or certain related-party payments.
    • Foreign taxes paid with respect to foreign high returns would be creditable up to 80 percent of the foreign taxes paid. There would be no carryback or carryforward of unused credit. Unused credit cannot offset other foreign source income.
    • The provision would be effective for tax years beginning on or after January 1, 2018, and for tax years of U.S. shareholders in which such tax year of the foreign subsidiaries end.
  • Limitation on deduction of interest by domestic corporations which are members of an international financial reporting group. Under this provision, the deductible net interest expense of a U.S. corporation that is a member of an international financial reporting group would be limited to the extent the U.S. corporation’s share of the group’s global net interest expense exceeds 110 percent of the U.S. corporation’s share of the group’s global earnings before interest, taxes, depreciation, and amortization (EBITDA). Any disallowed interest expense can be carried forward for up to five years. This limitation applies in addition of Section 3301 of the bill; the section which denies the greater amount of interest deductions would apply.
    • An international financial reporting group is a group of entities that:
      1. Includes at least one foreign corporation engaged in a U.S. trade or business or at least one domestic corporation and one foreign corporation
      2. Prepares consolidated financial statements
      3. Has annual global gross receipts of more than $100 million
    • The provision would be effective for tax years beginning on or after January 1, 2018.
  • Excise tax on certain payments from domestic corporations to related foreign corporations; election to treat such payments as effectively connected income. Under this provision, payments (other than interest) made by a U.S. corporation to a related foreign corporation that are deductible, includible in costs of goods sold, or includible in the basis of a depreciable or amortizable asset would be subject to a 20 percent excise tax, unless the related foreign corporation elected to treat the payments as income effectively connected with the conduct of a U.S. trade or business. No credit would be allowed for foreign taxes paid with respect to such profits subject to U.S. tax. In the event no election is made, no deduction would be allowed for the U.S. corporation’s excise tax liability.
    • The provision applies to international financial reporting groups with payments from U.S. corporations to their foreign affiliates equal to $100 million or greater annually.
    • The provision would be effective for tax years beginning on or after January 1, 2019.

Author

Charles Edge, Partner  |  Tax 828.236.5818 | charles.edge@dhg.com

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