Foreign tax reform changes under new tax law

The Tax Cuts and Jobs Act is anything but simplifying with respect to its international tax code provisions. Conceptually, switching to a quasi-territorial tax system, with a few adaptations, is disruptive. Key changes in the act create some surprisingly contradictory economic incentives for those who transact business internationally. The application and interaction of the numerous changes to the Internal Revenue Code's international tax provisions remain unclear in many substantial respects.

The United States has historically taxed worldwide income, meaning U.S. residents and corporations are taxed on all income earned globally. Deferral rules have allowed U.S. corporations to defer payment of tax on income earned abroad by the use of foreign corporations. Subject to limited anti-deferral rules (e.g., the Subpart F rules applicable to controlled foreign corporations), the United States has taxed income earned in foreign corporations to their U.S. shareholders only when paid out to these shareholders. The U.S. corporate shareholders historically also got a credit for foreign taxes paid on this distributed income. The Subpart F anti-deferral rules have caused certain categories of income earned abroad by the controlled foreign corporation to be taxable to United States shareholders even if they don't receive a current distribution of the income.

The act will modify how United States now taxes U.S. residents and corporations, intending to tax them on a mostly territorial basis, meaning that only U.S. income will be taxed, and many of the credits for foreign tax paid disappear. While that concept sounds simple, as applied in the act it is not. Perhaps, the most vexing changes involve the continued taxation of low-taxed foreign income.

A U.S. corporate shareholder will get a dividend received deduction for the foreign-source portion of a dividend paid to them, meaning they pay no U.S. tax on the income; this is the main way the legislation seeks to impose a territorial tax system. But the deemed foreign tax credit attributable to this excluded dividend income is no longer available to the recipient U.S. corporation. Further, no deductions for foreign withholding taxes on the distribution can be taken. Finally, the excluded dividends cannot be taken into account when computing a U.S. shareholder's foreign tax credit limitation.

To level the playing field for past income earned indirectly by U.S. corporations through overseas companies, which has not yet been taxed by the United States, foreign income accumulated in foreign companies and not distributed by Jan. 1, 2018, will now get collectively taxed. This income will be taxed to corporations at a 15.5 percent rate on cash, and at 8 percent on less liquid assets (for individuals and other non-corporate U.S. taxpayers, at 17.5 and 9.05 percent, respectively, with S corporations, alone, being able to electively defer this income acceleration). Corporations can elect to pay the tax over eight years. Estimates vary, but perhaps roughly $2.6 trillion has been parked overseas avoiding U.S. taxation. According to the expressed intent behind the legislation, this money, once taxed, can then enter the United States to be used for investment and growth here. Practically speaking, corporations will have a tough time planning to minimize this tax hit, especially given the effective date making it applicable to tax years ending on or after Dec. 31, 2017. Corporations are left pondering how to account for this amount, to minimize the impact on current operating income. Left unclear is the availability of foreign tax credits and expense allocations to ameliorate the size of this tax hit to corporations.

This tax applies to all U.S. shareholders who own at least a 10 percent share in the relevant foreign corporation, whether they are a taxable corporation, an S corporation, an individual, partnership or trust. Under Internal Revenue Code Section 962, non-corporate 10 percent shareholders can elect to have the corporate tax rates apply. As with so much planning under this new law, financial projections are necessary to inform the decision whether such election makes sense to the non-corporate shareholder.

It is important to understand the new international tax regimes that are intended to bring low-taxed offshore income into the U.S. tax net, rather than being excluded under the new territorial system. The effect of these provisions is to make the new international tax regime, at best, a quasi-territorial tax system. Global intangible low-taxed income is a new category of currently taxed Subpart F income created under the act. Essentially, GILTI is income of a controlled foreign corporation that exceeds a return of 10 percent on tangible assets. It does not necessarily have to have any connection to intangible assets (its name notwithstanding). A 10 percent return on tangible assets abroad is allowed before any excess return over this 10 percent level of return becomes an additional Subpart F inclusion. A U.S. corporation including GILTI in income receives a deemed foreign tax credit based on foreign taxes paid on this income.

The Base Erosion Anti-Abuse Tax, addresses inbound payments and is meant to prevent earnings-stripping through foreign affiliates, especially by non-U.S. companies. It includes an additional tax liability based on deductible payments between a U.S. subsidiary and a related foreign entity. Certain related party payments are added back to financial results, with the total creating a larger tax base, which is then taxed. This creates the possibility of a double tax: taxation in full in the recipient's jurisdiction without allowing for a full deduction in the United States.

Domestic corporations can deduct 37.5 percent of their earned foreign-derived intangible income. This income includes services provided to those outside the United States and sales of property abroad for use outside the United States. As a result of this deduction, a rate of 13.125 percent (i.e., 62.5 percent of 21 percent) is assessed against exports, which provides a substantial indirect export subsidy for U.S. services and product exports. This effect has not gone unnoticed by major U.S. trading partners, the Organization for Economic Cooperation and Development and the World Trade Organization; retaliatory responses from our foreign trading partners are brewing.

Partnership rules can also be impacted under the act's international provisions. For sales or exchanges that occur on or after Nov. 27, 2017, any gain or loss on the sale or exchange of a partnership interest will be considered effectively connected with a U.S. trade or business to the degree that the partner making the transfer would have incurred effectively-connected income had the partnership been dissolved and all assets distributed. The act creates a new 10 percent withholding tax to be collected by the buyers of foreigners' interests in partnerships engaged in U.S. trade or business, setting up a potential trap for the U.S. buyer who is unaware of their withholding agent liability.

Effective Jan. 1, 2018, a non-resident alien is a potential beneficiary of an electing small business trust, expanding the use of S corporations for international estate planning purposes.

These international tax provisions very obviously cross practice areas, impacting corporate, non-corporate and even largely domestic taxpayers. Given their opaque nature, potentially expansive impact and uncertain application, those engaged in international transactions need to be wary of the act's changes. Moreover, the act, in applying policy inconsistently, creates opportunities for tax professionals to utilize the new provisions to their clients' potential advantage. Over time, regulations and other guidance will hopefully be released to clarify the application of these rules. Until then, clients need to be advised of the complexities and uncertainties related to the potential application of the act's international provisions.

This discussion provides a broad overview of key, by no means all, international taxation provisions of the act and should not be viewed as legal advice or a substitute for thoughtful legal analysis and advice regarding specific planning matters.