What Tax Reform Means for Foreign-Owned Companies Operating in the US
The Tax Cuts and Jobs Act offers several rate cuts and improved expensing treatment for pass-through and corporate inbound businesses. There are also several provisions aimed at protecting the U.S. tax base by targeting base erosion payments that inbound companies will need to navigate.
Most provisions are effective beginning in 2018, though many are effective only for seven to 10 years before reverting to prior law, absent further legislation. Their temporary nature, of course, makes business planning a bit more complicated and cumbersome. Further, because it is solely a Republican initiative, these changes may be vulnerable to repeal if the balance of control in Congress shifts.
Corporate tax rate reduction
The corporate rate has been reduced from 35 percent to 21 percent. If your company is structured as a C corporation, you stand to save considerably in taxes. But keep in mind you will need to revalue your net deferred tax assets and liabilities under the new enacted rate for financial statement purposes.
Alternative minimum tax (AMT)
The AMT is repealed for C corporations, but AMT credits carry forward and become refundable over the 2018 – 2021 tax years. The credits may be used to offset current tax, with 50 percent of any excess amounts becoming refundable in 2018 – 2020 years, and any residual AMT credits being refundable in 2021.
New Section 199A
For a dozen years, U.S. companies have benefited from the domestic production activities deduction (Section 199, or DPAD), which provided a 9 percent deduction for qualifying income from activities and items manufactured, produced, extracted, or grown in the United States. The old provision is repealed and is replaced by Section 199A.
Section 199A offers a 20 percent income reduction for pass-through income from partnerships and S corporations allocated to U.S. and non-resident individuals, estates, and trusts. This provisions includes a much broader category of qualifying income but provides for additional limitations on the deduction for higher income taxpayers.
For taxpayers exceeding the taxable income thresholds, the deduction may not exceed 50 percent of wages paid or 20 percent of modified taxable income. Pass-through entities that are limited by the 50 percent of W-2 income rule can use a substitute limit. This allows, for example, a real estate rental business that does not have W-2 wages to qualify for the deduction, based on 2.5 percent of the unadjusted depreciable basis of the building rented.
Corporate net operating loss limitations
Beginning with losses generated during the 2018 tax year, net operating losses (NOLs) for C Corporations will be limited to 80 percent of (pre-NOL) taxable income. While NOLs will be eligible for unlimited carryforward, most carrybacks will no longer be permitted.
Increased Section 179 expensing
Section 179 provides one of the elective provisions allowing the deduction of capital asset costs. In 2017, up to $510,000 of property additions can qualify for deduction under Section 179. For tax years beginning in 2018, the new law raises the maximum amount deductible to $1 million for taxpayers with total qualifying additions below $2.5 million, after which qualification phases out.
Temporary 100 percent cost recovery
For property acquired and placed in service after September 27, 2017, and before 2023, the new law allows a 100 percent first-year deduction for both new and used qualified property. Qualified property is, generally, tangible property and computer software with a recovery period of 20 years or less. However, property does not qualify if it has been used by the taxpayer at any time prior to its acquisition.
Interest expense limits for your business
Interest expense continues to be fully deductible for taxpayers with three-year trailing average annual gross receipts of less than $25 million. Above this level, interest expense limits begin to apply. The disallowance is for net interest expense (interest expense less interest income) in excess of 30 percent of the business’s adjusted taxable income (an EBITDA type calculation through 2021, then switching to EBIT).
Pass-through entities must make a determination at the entity level where the excess interest limitation or excess taxable income is determined, before passing to the individual level, where it may be adjusted by passive limitations or other items. Interest expense, which is limited for an entity, continues to be limited for partnerships (but not S corporations) until the pass-through owner is allocated excess taxable income from that entity.
After 2017, any producer or reseller with average revenues less than $25 million over three years is exempt from the uniform capitalization rules of Section 263A (UNICAP). The UNICAP exemption applies to all producers or resellers (commonly manufacturers, distributors, or retailers, but the rule also applies to developers and producers of real property).
For real estate-related enterprises using the completed contract method, 263A capitalization adjustments will no longer be required if they meet the $25 million test and the contract is expected to be completed within two years.
Entertainment and meal expense restrictions
Most business meals are only 50 percent deductible. The new law expands this rule to include meals provided through an in-house cafeteria or elsewhere on the employer’s premises. Entertainment expense are fully disallowed, eliminating the need to determine when such expenditures are business-related. Documentation of the qualifying nature of entertainment expenses for tax purposes will no longer be necessary.
Base erosion and anti-abuse tax (BEAT)
The BEAT applies to U.S. corporations with $500 million or more in average gross receipts over three years and make base erosion payments that exceed 3 percent of deductible expenses. It operates similarly to the repealed corporate 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.
Downward attribution of foreign stock
Under previous law, foreign subsidiary stock owned by a foreign parent was not attributed down to a U.S. subsidiary, as the constructive ownership rules were modified under the U.S. international tax regime to prevent this. Many inbound U.S. companies used this provision in “decoupling transactions” where the vote and value ownership of a foreign entity was split between the U.S. company and the foreign parent or a foreign subsidiary of the parent. This structure was used to prevent U.S. reporting and application of the anti-deferral rules that U.S. companies are subject to when they own an interest in a foreign corporation.
The new law now allows downward attribution of the foreign stock to the U.S. subsidiary. U.S. companies that use the decoupling structure need to evaluate whether they will be subject to the new section 965 transition tax and the U.S. anti-deferral rules if they own a direct or indirect interest in a foreign entity.
An unintended consequence of modifying this rule is that U.S. companies may be subject to a U.S. reporting obligation for the downward attribution of stock even without a direct or indirect ownership interest. This issue was addressed in Notice 2018-13 and prevents an informational reporting requirement if no direct or indirect interest is owned by the U.S. company.
A U.S. C corporation making interest or royalty payments to a foreign related party is denied a deduction if there is not a local country income inclusion or if there is a deduction against this type of income in the local country. This provision also denies a deduction if the interest or royalty payments are made to a hybrid entity (i.e., an entity treated as fiscally transparent for U.S. purposes and a regarded entity for local country purposes, or vice versa).
Sale of partnership interest by a non-resident person
Historically, the IRS has taken the position that the sale of a U.S. partnership interest by a non-resident person was subject to U.S. taxation, to the extent the sale of the underlying assets constituted U.S. effectively connected income (Rev. Rul. 91-32). In Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner, the tax court concluded that a foreign partner is not subject to U.S. tax on gains from the sale of a partnership interest that conducts a U.S. trade or business unless such gain is attributable to U.S. real estate.
The impact of this decision was short-lived, as Rev. Rul. 91-32, which treated a non-resident person’s sale of a U.S. partnership interest as effectively connected income, was codified with the passage of the new law. In addition, the purchaser of the partnership interest is required to withhold 10 percent on the gross sales price.
Deduction for foreign-derived intangible income
There is now a 37.5 percent deduction for foreign‐derived intangible income for U.S. corporations. There is also a global intangible low‐taxed income (GILTI) inclusion provision for income earned in controlled foreign corporations (CFCs) offshore 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 13.5 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. The deduction rates are reduced for tax years after 2025. The FDII provision encompasses all income, such as the sale of inventory, not just intangible income, as its name implies.
Inbound companies may want to consider structuring sales to other foreign jurisdictions through a U.S. corporation to take advantage of this provision.
How we can help
CLA’s global tax professionals can work with your company’s legal and financial teams to help take advantage of tax reform’s benefits, comply with the new law’s many provisions, and manage your worldwide tax exposure.