Tax Reform Substantially Changes US International Provisions for Businesses
The Tax Cuts and Jobs Act contains U.S. international tax provisions that significantly affect both inbound and outbound multinational companies. These are designed to make our international tax system more competitive, drive domestic growth, and protect the U.S. tax base.
The new tax reform law intends to bring the U.S. international tax system more in line with other Organization for Economic and Cooperative Development (OECD) member countries. The legislation also aims to protect the U.S. tax base by imposing certain base erosion provisions which limit or tax payments between U.S. and foreign related parties.
This has also been an area of focus by the OECD through its base erosion and profit shifting (BEPS) initiative. It has yet to be determined whether the base erosion and anti-abuse tax (BEAT) and the foreign-derived intangible income (FDII) provisions will be challenged by the World Trade Organization as unfair trade practices and illegal export subsidies.
Participation exemption system for taxation of foreign income
The new participation exemption system is implemented through a 100 percent dividends-received deduction for domestic C corporations receiving dividends from 10 percent specified foreign corporations. As the United States moves to a territorial system of taxation, there is a transition tax on deferred foreign earnings for all U.S. persons that are 10 percent shareholders in a specified foreign corporation.
Foreign earnings that have not been previously subject to U.S. taxation held in cash and cash equivalents are subject to a 15.5 percent rate, while non-cash amounts attract an 8 percent rate. The tax on the deferred foreign earnings is eligible to be paid over eight years on an escalating scale, and S corporation shareholders may elect to defer the tax until a triggering event (e.g., sale of S corporation stock, liquidation of an S corporation, etc.).
Rules related to passive and mobile income
There is now a 37.5 percent deduction for foreign-derived intangible income for U.S. corporations. In addition, there is a global intangible low-taxed income (GILTI) inclusion provision for income earned in offshore controlled foreign corporations that exceeds a minimum rate of return on tangible assets. This is applicable to all U.S. persons owning these foreign entities.
These provisions employ the “carrot and stick” approach to ensure that moveable intangible income is taxed at a minimum rate of 13.125 percent for FDII and 10.5 percent for GILTI. The FDII provision is similar to “patent box” regimes used by foreign jurisdictions to encourage locating and maintaining intangible property within their jurisdiction by providing a favorable tax rate on income associated with intangibles.
Prevention of base erosion
The BEAT applies to U.S. corporations with $500 million or more in average gross receipts and make base erosion payments that exceed 3 percent of deductible expenses. It operates similarly to the repealed corporate alternative minimum tax (AMT) regime, where the taxpayer pays the higher of its regular tax liability or the liability calculated under the BEAT.
The BEAT adds back the base erosion payments and calculates the liability at a 10 percent rate. Base erosion payments include any amount accrued or paid to a related foreign person that reduces U.S. taxable income but does not include cost of goods sold (COGS), which is a reduction to income.
Notable provisions not included in the final law
Various proposed versions of the tax reform bill included new or removed existing international provisions that ultimately didn’t become part of the final legislation. Most notable among these were the creation of Section 163(n) (which would have limited U.S. interest deductions if U.S. indebtedness exceeded 110 percent of the worldwide group’s indebtedness) and the repeal of IC-DISC. Though IC-DISC is alive and well, consideration should be given to its future benefit under certain scenarios as the benefit may be diminished because of the new pass-through deduction.
Effective dates of new provisions
The international provisions are generally applicable for tax years beginning after December 31, 2017, while the transition tax is applicable to tax years beginning in 2017. In addition, several provisions also have rate changes that are triggered for tax years beginning after December 31, 2025.
How we can help
Our international tax professionals can help you understand and apply these complex provisions based on your company’s specific fact patterns and multinational situations. We can work with you to optimize tax benefits and mitigate exposure to risk.