While tax rate cuts and changes to deductions for individuals and businesses have been a focus of tax reform coverage, a significant shift is underway in the U.S. tax treatment of companies doing business overseas. Here’s a quick roundup of some of the central changes to international tax law that will have a profound impact on businesses with cross-border transactions.
The most immediate impact of international tax reform will be a “transition tax” on the mandatory repatriation of accumulated earnings held offshore. This one-time tax is applicable to shareholders who own 10%, directly or indirectly, of a specified foreign corporation (SFC). The base for the tax is deferred income, or the accumulated foreign earnings of the SFC since 1986 that have not previously been taxed in the U.S. Shareholders subject to the tax should work quickly to quantify the earnings and profits (E&P) or deficit in E&P for each relevant foreign corporation.
Two preferential tax rates will be applied to a U.S. shareholder’s allocable share of post-1986 deferred foreign income. A 15.5% rate will be applied to the portion of earnings representing liquid assets such as cash, accounts receivable, certificates of deposit, government securities, etc. An 8% tax rate will be applied to the remainder of the allocated amount.
Since the transition tax will be a substantial sum for many taxpayers, an election is available to pay the tax on an installment basis over eight years or until a triggering event occurs (sale, liquidation, or cessation of the business, failure to pay an installment). The first installment of transition tax is due by the original due date of the shareholder’s return for the last tax year beginning before January 1, 2018. S Corporations are allowed a special election to defer the tax completely until a triggering event occurs or the entity ceases to be an S Corporation. The IRS has not yet specified the method to make these elections.
Territorial Tax System
One of the major talking points surrounding tax reform was a move from the U.S. system of worldwide taxation, whereby all income of U.S. citizens and residents is taxed in the U.S. regardless of the location it was earned, to a territorial system common among our trading partners. A purely territorial system would tax only income sourced to a particular jurisdiction.
To move the U.S. closer to this model, the new tax law uses a “participation exemption” in the form of a 100% dividends received deduction (100% DRD). This deduction is allowed against the foreign-source portion of distributions from specified 10% foreign corporations (those owned at least 10% by a domestic corporation). This DRD is only available to U.S. companies structured as C Corporations, so it will be worthwhile to analyze the entity types in a U.S. group that has ownership in at least one specified 10% foreign corporation.
Expansion of Anti-Deferral Provisions
While the participation exemption effectively excludes foreign-source income from U.S. taxation, provisions of existing law meant to prevent certain types of earnings from being held offshore long-term have been retained under the law and expanded to encompass new categories of income. Specifically, a new category labeled “Global Intangible Low-Taxed Income,” (GILTI) will be taxed currently. GILTI includes not only intangible income, but all income earned by a controlled foreign corporation (CFC) above a 10% return on its depreciable tangible property used to generate the income.
Reduced Tax Rate on High-Margin Exports, Intangibles and Services
Consistent with the goal of bringing profits home to the U.S., the legislation provides for an export incentive in the form of a deduction for foreign-derived intangible income (FDII). Similar to the determination of GILTI income inclusion, income eligible for the FDII deduction is not intangible income in the traditional sense, but income above a 10% return on its depreciable tangible property used to generate the income.
Income eligible for the deduction includes both the sale, lease, license and other disposition of property by a domestic corporation to a foreign person for foreign use and services provided by a domestic corporation to a person outside of the U.S. Through 2025, FDII is 37.5% deductible, with the intention to reduce the effective tax rate on such income to 13.125%. As with the 100% dividends received deduction, the deduction for FDII is only available to C Corporations.
Base Erosion and Anti-Abuse Tax
The base erosion and anti-abuse tax (BEAT) is a new alternative tax computation. A 10% tax rate applies to the modified taxable income of C Corporations, determined by adding back “base-eroding” deductions for payments made to foreign affiliates. BEAT only applies to corporations with a three-year average of at least $500 million in gross receipts and a “base-erosion percentage” of 3% or higher.
Tax reform replaces the previous deferral of items of foreign-source income with a system in which foreign-source income will either be taxed currently or not taxed at all. There are a number of incentives in the new law meant to encourage domestic business activity, but many of the new deductions are only allowed to be used by C Corporations.
Contact your RKL advisor for assistance with determining whether these taxes and incentives apply and to map out actions required for elections, planning or restructuring opportunities. Visit RKL’s Tax Reform Resource Center for more information and insights.