Taxation of international activities has always been complex and rife with traps for the unwary. The Tax Cuts and Jobs Act of 2017 (TCJA) has completely changed the landscape of international taxation, but not, as one would hope, in the direction of simplification. Rather, it adds a layer of complexity to what was already an complicated system.
The most discussed provision in the TCJA is likely the “transition tax,” which results in a one-time deemed repatriation. The new Global Intangible Low Taxed Income (GILTI) provision may, however, have an even greater impact. In addition, there are several minor tweaks to the existing law that will, for the multinational corporations affected, have significant consequences.
What Is the Transition Tax?
The transition tax is a one-time deemed repatriation of all previously untaxed earnings in foreign corporations that are owned directly or indirectly by U.S. taxpayers. It is referred to as a transition tax because it is intended to purge all of the earnings that were earned by foreign subsidiaries of U.S. companies under a worldwide system of taxation—estimated to amount to trillions of dollars in accumulated earnings. Under this system, when a foreign corporation owned by a U.S. person generated income, the income would generally have been taxed in the local country and then, upon distribution to the U.S. shareholder, subject to U.S. income tax.
Under the new law, the United States has moved to a territorial system of taxation for certain U.S. taxpayers. As such, for qualifying taxpayers with foreign subsidiaries, the income earned in the foreign subsidiary corporation will be taxed in the local country when earned and, upon repatriation to the U.S. shareholder, not be subject to U.S. tax.
A U.S. C Corporation owns 40% of the stock of an Irish company and the remaining stock is owned by a non-U.S. person. Under the worldwide system of taxation, the income earned by the Irish company would be taxed in Ireland when earned and then upon distribution to the U.S. shareholder it would be taxed in the United States as well. Under the territorial system, the same income generated by the Irish subsidiary would be taxed in Ireland when earned and then, upon distribution to the U.S. shareholder, it would not be taxed in the United States.
How Will this Income Be Taxed?
Income that is deemed repatriated under the transition tax provision will be taxed at a very reduced rate. The exact rate will depend on the assets in the foreign corporation and the type of U.S. taxpayer.
What Must Be Disclosed from a Financial Reporting Perspective?
Taxpayers have the ability to elect to pay the transition tax over a period of eight years; however, the tax liability arising from the transition tax must be disclosed for financial reporting purposes.
What is GILTI?
The GILTI provision was introduced to discourage U.S. taxpayers from moving their intangible property (IP) offshore in an attempt to move the high returns associated with that IP outside of the U.S. tax net. This provision is designed to discourage or penalize this type of offshoring of assets.
Because it is difficult to quantify a company’s IP and the specific income that is derived from these assets, the GILTI provision assigns a 10% rate of return on fixed assets of a foreign corporation, and any income in excess of this 10% return is deemed intangible. This intangible income is deemed repatriated in the year earned.
This provision applies specifically to controlled foreign corporations (CFCs) or foreign corporations that have more than 50% control or ownership.
ABC USA Inc. owns 100% of ABC Ireland Ltd. ABC Ireland Ltd. has a net income of $1 million, taxed in Ireland at a rate of 12.5%. ABC Ireland Ltd. has $2 million of fixed assets used in trade or business as well as Subpart F income related to royalties of $200,000.
ABC Ireland’s profit is $875,000 ($1 million of income minus $125,000 of corporate tax). This is reduced by the Subpart F income of $200,000 to arrive at “CFC tested income” of $675,000.
ABC Ireland’s Qualified Business Asset Investment is $2 million; therefore, $200,000 ($2 million QBAI × 10% rate of return) of ABC Ireland’s income will not be GILTI. The difference between this and the $675,000 of CFC tested income (i.e., $475,000) will be GILTI.
How Will GILTI Be Taxed?
The U.S. shareholder of a CFC with GILTI will include its pro rata share of GILTI as a current year inclusion. A C Corporation will receive a 50% dividend received deduction on its GILTI income, and in addition will be allowed an indirect foreign tax credit for the taxes paid, up to 80%.
The GILTI provision is designed to discourage or penalize this type of off-shoring of assets.
Consequently, if GILTI income is earned in a jurisdiction where it is taxed at an effective rate of more than 13%, there will be no residual U.S. corporate tax on this inclusion. If the income is taxed at an effective rate of less than 13% in the local country, there will be a small residual tax in the United States.
For individuals invested in flow-through structures that own CFCs, the GILTI provision will be particularly harsh. An individual’s GILTI inclusion will be taxed at the highest ordinary rate, with no foreign tax credit offset.
How Will the New Rules Affect U.S.-Parented Multinationals with Foreign Subsidiaries?
Due to the new GILTI provision, it will be more challenging for a U.S.-parented multinational with foreign subsidiaries to generate income offshore that will not be taxed in the United States. This will likely result in more structured IP development and other activities taking place in the United States.
Are There Incentives to Increase Domestic Development, Manufacturing, or other Production?
There is a new incentive available for U.S. C Corporations with export sales. The Foreign Derived Intangible Income (FDII) provision provides for a reduced rate of tax (from 21% to 13.125%) for FDII. It allows for the benefit to apply to income from the sale of products or services, so this benefit is available to any industry.
In the past, companies that moved operations overseas to benefit from a reduced tax rate incurred significant administrative costs to establish and sustain the offshore structures. This cost was often an insurmountable hurdle for smaller multinational enterprises, because it outweighed the tax benefit. The simplicity of FDII allows the benefit of a much-reduced rate for smaller enterprises as well.
What Should Multinational Companies Do?
U.S.-parented multinationals should take stock of the TCJA and understand the impact on their operations. For both the transition tax and GILTI, they should model how these provisions will affect their global effective tax rate.
The trend for several years has been for companies to move profits out of the United States, but with the recent reduction in the U.S. corporate rate and with the GILTI provision, it may make sense to reverse the flow of transfer pricing and move functions and income back into the United States.
For individuals and flow-through structures with cross-border activity, there is a greater urgency to understand the impact of the new tax law on their activity, particularly with respect to the GILTI provision. As noted above, individuals would pay up to 37% U.S. tax on their GILTI inclusion without a foreign tax credit offset. In the absence of proper planning, this can result in effective global tax rates of 50–60%, or more. These taxpayers should consider options such as “checking the box” on their foreign subsidiaries, inserting a C corporation blocker, or making an Internal Revenue Code (IRC) section 962 election. The benefits and costs of each of these ideas should be weighed against the specific facts and circumstances for each taxpayer, as each option carries its own challenges.
Will Inbound or Non–U.S.-Parented Multinationals Be Affected?
Inbound or non–U.S.-parented multinationals doing business in the United States will also be affected by the new tax law. The two key areas where the changes will be felt are the interest expense limitation and the new Base Erosion Anti-Avoidance Tax (BEAT).
Historically, the deductibility of interest paid to a foreign related party was limited based upon a combination of the U.S. subsidiaries’ debt-to-equity ratio and adjusted taxable income. Under the new provision, the deductibility of interest expense for all U.S. companies, regardless of whether the interest is paid to related or unrelated parties, is limited to 30% of adjusted taxable income. This may result in more or less deductible interest for U.S. subsidiaries of foreign-parented multinationals, depending upon the particular taxpayers’ circumstances.
The policy behind the BEAT was to combat the stripping of income from the United States in the form of related party payments. Many multinationals have established sophisticated tax structures that result in large deductible payments to related parties in lower-taxed jurisdictions.
The BEAT is similar to an alternative minimum tax; related party base erosion payments are added back to the taxpayer’s taxable income to arrive at the BEAT income, to which a tax of 5–12% (depending on the year) is applied. The regular tax is compared to the BEAT, and the taxpayer pays the tax that is higher.
It is important to note that the BEAT applies only to U.S. companies with $500 million or more in revenue.
The two key areas where the changes will be felt are the interest expense limitation and the new Base Erosion Anti-Avoidance Tax.
Will Any Other Provisions Affect U.S. Taxpayers with Cross-border Activities?
There are a few more minor tweaks to the existing law that will affect a smaller group of U.S. taxpayers. These changes include adjustments to certain foreign tax credit sourcing and basket rules as well as the tax on moving assets out of the United States under IRC section 367. The changes with the greatest impact are the definition changes that relate to CFCs.
One of the changes relates to attribution rules. Under U.S. tax law, taxpayers can be considered owners through direct ownership, attributed ownership, or ownership through a related party. In the past, the related party attribution was limited to situations where the related party was a foreign related party. The TCJA removed this limitation, allowing ownership attribution through related parties. This change may result in far more CFC determinations in situations with foreign-parented multinationals where a U.S. subsidiary has direct minority interest in a brother-sister company, or where a 10% or more U.S. shareholder owns an interest in the foreign parent.
Another change related to the definition of “U.S. shareholder” for purposes of determining what a CFC is. The old law defined a U.S. shareholder as a U.S. person who owned 10% or more of the vote of a foreign corporation; the TCJA defines a U.S. shareholder as a U.S. person who owns 10% of the vote or value in a foreign corporation.
Overall, these underreported, minor tweaks can have a big impact on the overall fact pattern; therefore, it is critical for U.S. taxpayers with cross-border activity to review all of the changes and understand which will affect their structure so they can take any necessary planning steps.
In light of the scope and complexity of the recent tax law changes, it would be wise for all U.S. taxpayers with cross-border activity to contemplate their structure and assess how the new law will affect them. In the absence of proper planning, taxpayers may be struck by unpleasant surprises.