Tax Alert: International Tax Provisions in H.R. 1

Tax Alert: International Tax Provisions in H.R. 1

Nov 09, 2017

On November 2, 2017, the House unveiled its initial bid on comprehensive tax reform - the Tax Cuts and Jobs Act, H.R. 1 (the "Bill").

With respect to the International rules, the Bill introduced sweeping changes to our current system of worldwide taxation. Specifically, the highlights include:

  • Enacting a 100% deduction for dividends received from 10% or greater owned foreign subsidiaries after 2017
  • Enacting a tax (at up to 5% or 12%) on foreign earnings that were still deferred as of those subsidiaries' last tax years ending before 2018
  • Tax on a current basis half of a US shareholder's controlled foreign corporations’ (CFCs') "foreign high return amounts," attributable to CFC tax years beginning after 2017 
  • Cap interest deductions for U.S. tax purposes, in tax years beginning after 2017, by reference to the lesser of:
    • 30% of adjusted taxable income, or
    • 110% of financial reporting group net interest expense multiplied by the ratio of US EBITDA to group EBITDA.
  • Enact an excise tax and impose a 20% excise tax on amounts paid or incurred after 2018 by a domestic corporation to foreign corporate members of the payor's financial reporting group

 

Background

Congressional leaders and the Administration hope to enact the Bill before the 2018 election; ideally, before the end of December 2017.

The proposed legislation introduces “territorial taxation of global American companies” and encourages “stopping corporations from shipping jobs and capital overseas”.  Aside from the tax on previously-deferred foreign earnings as a way to clear the decks for the new participation exemption, and aside from the new provision on “foreign high return amounts,” the Bill does not make major overall changes to the subpart F regime, but makes some notable targeted subpart F changes, including one that implicitly expands the scope of the CFC definition as applied to foreign-based multinationals.

 

Key changes

The participation exemption and the one-time taxation of presently-deferred earnings

Transition tax on US shareholders

The Bill provides that a US shareholder of a “specified foreign corporation” (SFC) would generally have a subpart F income inclusion, in the year in which the SFC’s last tax year beginning before 2018 ends, of the US shareholder’s pro rata share of the “accumulated post-1986 deferred foreign income” of the SFC, net of the US shareholder’s share of deficits (including “hovering deficits”) of other SFCs allocated to the first SFC.

  • “Specified foreign corporation” includes both: (i) any CFC and (ii) any other foreign corporation that has a “US shareholder.”  For this purpose, the definition of “US shareholder” is expanded to include US persons to whom ownership of 10% of the voting shares would ordinarily not be attributed under present law’s special subpart F attribution rules, but whose foreign owners own sufficient voting stock in the foreign corporation to make the US person a 10% voting stock shareholder under the general section 318 attribution rules.

 

Alternative dates for determining the amount of earnings to be included in income

The amount of income subject to subpart F inclusion under the Bill is based on either accumulated post-1986 earnings and profits as of November 2, 2017, or as of December 31, 2017, “without diminution by reason of dividends distributed in the year that includes such date” - whichever is higher.

 

5% and 12% rates 

The amount of the U.S. shareholder’s share of post-1986 E&P that is attributed to cash or cash equivalents (“cash position”) of the SFC is subject to a 12% transition tax.  The remainder of the inclusion is subject to a 5% transition tax. This rate of tax is achieved by allowing a separate dividends received deduction equal to an amount that results in the respective 12% and 5% tax rate with respect to the respective amounts of post 1986 earnings attributed to cash and non-cash assets.

  • The US shareholder’s aggregate foreign cash position is generally based on the average of three amounts:
    • Its pro rata shares of its SFCs’ cash positions on November 2, 2017;
    • Its shares of its SFCs’ cash positions at the close of each of their last taxable years ending before November 2, 2017; and
    • Its shares of its SFCs’ cash positions at the close of each of their next-to-last taxable years ending before November 2, 2017.

 

Foreign tax credits

The transition tax generally could be offset by a proportionate share of the foreign taxes deemed paid upon the inclusions, and by the full amount of the US shareholder’s pre-existing foreign tax credit carryforwards (if any). The inclusion would not trigger overall foreign loss recapture.

 

Deferral of time for payment 

At the election of the US shareholder, the tax liability attributable to the inclusion could be paid in eight equal annual installments. Where the US shareholder is an S corporation, a shareholder of the S corporation could elect to further defer his or her tax liability resulting from the subpart F inclusion of the S corporation under section 965.

 

Dividends by 10% foreign subsidiaries received after 2017 to domestic corporations

The Bill generally would grant domestic (US) corporations a 100% dividends received deduction (DRD) (new Code section 245A) for the “foreign-source portion” of any dividend made after 2017 and received from a foreign corporation (other than a non-CFC passive foreign investment company [PFIC]) by a domestic corporation that is a “US shareholder” in the foreign corporation (a “specified 10-percent owned foreign corporation”).  Section 956 (which generally triggers the inclusion of CFC earnings in the gross income of a US shareholder by reference to “United States property” treated as held by the CFC) would no longer apply to US shareholders that are corporations.

Observation:  This may give companies the opportunity to loan funds back to the U.S. and avoid the imposition of a dividend withholding tax in the CFC’s jurisdiction.

 

In the case of distributions of post-1986 undistributed earnings, the “foreign-source portion” is determined pursuant to rules similar to the present-law rules for determining a dividend’s “US-source portion” (see Code section 245(a)). The foreign-source portion of distributions of pre-1987 earnings generally also would be determined via pooling, but in this case the pool would combine earnings accumulated from March 1913 through the foreign corporation’s last taxable year beginning before 1987. 

 

No foreign tax credits

The Bill disallows foreign tax credits and deductions for any taxes with respect to any dividend for which the DRD is allowed, and repeals section 902 (which treats a foreign corporation’s corporate US shareholder as having paid a portion of the foreign income taxes paid or accrued by the foreign corporation when the shareholder receives a dividend from the foreign corporation). The foreign-source portion of a dividend for which the DRD is allowed is not treated as foreign source income for purposes of the foreign tax credit limitation.

 

Loss limitation

For purposes of computing any loss on the sale or exchange of stock in a specified 10% owned foreign corporation the Bill reduces the basis of such stock by the amount of the DRD derived from dividends with respect to such stock. Special recapture rules apply to increase the recapture of foreign losses attributable to foreign branch operations transferred to specified 10% owned foreign corporations; for example, the branch loss recapture is no longer limited by the amount of total built in gain that would not be recognized but for section 367(a).

Observation: The Bill limits the participation exemption to entities classified as corporations for US federal income tax purposes and does not exempt the income of a domestic corporation’s foreign trade or business from US tax and continues to allow taxpayers to currently take the benefit of losses from foreign branch operations.

 

Income inclusion for foreign “high returns” — new section 951A

Under proposed new section 951A, a US shareholder would include in gross income 50% of its CFCs’ income for the year that is deemed to represent “high” returns on investment. Generally, the provision results in the current inclusion of 50% of a US shareholder’s pro rata share of the aggregate CFC net income not currently subject to US tax, if it exceeds a set percentage of the US shareholder’s pro rata share of the aggregate tangible depreciable asset basis of all its CFCs (so-called “foreign high return amount” [FHRA]).

Observation: Under the 20% US corporate tax rate proposed by the Bill, new section 951A would ensure that the “high returns” on the “tested” income of a US shareholder’s CFCs will bear current worldwide income tax at a rate (across all income of all of a US shareholder’s CFCs) of no less than 10%; for example, in a case where no foreign tax was paid or accrued by a US shareholder’s CFCs. However, the total worldwide tax often will be more than 10%. As a result, if the CFCs paid or accrued foreign income taxes attributable to the “tested” income in the inclusion year, but the average effective rate of such taxes for the year is less than 12.5%, then there would be additional tax imposed by the United States.

 

Against this inclusion the Bill would permit the US shareholder an indirect foreign tax credit for up to 80% of the CFCs’ foreign taxes attributable to the shareholder’s FHRA. The shareholder’s section 951A inclusion and the associated deemed-paid foreign income taxes would constitute their own separate foreign tax credit limitation “basket,” and any excess credits in the basket would essentially be “lost”: they could not be carried over for use in any subsequent or prior year.

The relevant “tested” income of any CFC is generally its residual income after removing ECI, related-party dividends, subpart F income, certain income that would be foreign personal holding company income if not for active business exceptions or the CFC look-through rule, and income that would be subpart F income but for the high-tax exception. The Bill provides for distinguishing credits and losses attributable to the tested income, on the one hand, and other types of income, on the other. Also, many of the rules that apply to subpart F income and section 951(a)(1)(A) inclusions would apply, in the same or modified form, to the FHRA and the section 951A inclusions (e.g., sections 959, 961, 904(h), and 1248(b)).

Effective Date: Taxable years of foreign corporations beginning after 2017 (and the US shareholder years in or with which they end).

 

Excise tax on payments from domestic corporations to related foreign corporations

The Bill generally would impose a non-deductible 20% excise tax on so-called “specified amounts” paid or incurred by a domestic corporation (or by a foreign corporation in connection with the conduct of a US trade or business) to a foreign corporation that is a member of the same “international financial reporting group” (IFRG).  The Bill excludes from the definition of IFRG any group whose annual average of total specified amounts from US members to foreign members does not exceed $100 million for the current and two preceding years. The excise tax also does not apply to a specified amount to the extent it is (or is treated under the election described below as) ECI and is subject to US income tax.

Specified amounts generally include amounts that are, for the payor, (i) deductible, (ii) includible in costs of goods sold, or (iii) includible in the basis of a depreciable or amortizable asset.

Specified amounts do not include, however:

  • Interest;
  • Amounts paid or incurred to acquire an actively-traded commodity or an identified hedge of such a commodity;
  • Amounts with respect to which 30% tax is imposed under section 881(a) (or if the rate of tax imposed is reduced, then the same proportion of the amount as the rate of tax that is imposed bears to 30%);
  • In the case of a payor that elects to use a “services cost method” for purposes of section 482, amounts paid or incurred for services if the amount is the total services cost with no markup.

 

The ECI election

The Bill allows the foreign recipient of a specified amount to make an election to treat the amount as ECI (other than for DRD or section 881 purposes) attributable to a US permanent establishment, and thus save the payor from liability for the excise tax. However, if a foreign recipient makes this election, only “deemed expenses” are allowed as a deduction against such amount. The deemed expenses are the amounts of expenses needed to achieve a net income ratio (the ratio of net income, before interest and income taxes, to revenues) from the specified amount for the year of receipt equal to the net income ratio of the IFRG for that year for the product line to which the specified amount relates, determined on the basis of the IFRG’s consolidated financial statements. Once made, the election applies for all subsequent taxable years unless revoked with the consent of the Secretary of the Treasury.

No foreign tax credit or deduction is allowed for any taxes paid or accrued with respect to any specified amount which the foreign recipient elects to treat as ECI.

Effective Date: The proposal applies to amounts paid or incurred after December 31, 2018.

Observations: As this proposal would impose full US tax on common business transactions including royalties paid to and inventory acquired from foreign affiliates, it would have an adverse impact on a wide range of large multinationals, both US- and foreign-parented.

 

Limitations on Interest Deductibility

Revised section 163(j) limitation

The Bill would rewrite section 163(j) so as to cap deductions for “business interest” by reference to a fixed percentage of adjusted taxable income, similar to that imposed by other countries such as Germany. Under this provision, the “business interest” deduction of every taxpayer (corporate or otherwise) would be limited to the amount of the taxpayer’s business interest income plus 30% of its business’ adjusted taxable income. “Business interest” and “business interest income” are interest paid or accrued on indebtedness properly allocable to a trade or business, and includible interest income properly allocable to a trade or business, respectively. Any disallowed deductions would be carried forward for five taxable years. The proposal would not apply to a business with average gross receipts of $25 million or less, as well as to certain regulated utilities and real property trades or businesses.

 

Additional limitation on deductions of “International Financial Reporting Groups”

In addition to the revised section 163(j) limitation, the Bill would add a new limit (new section 163(n)) on the US interest deductions of certain corporations and members of an IFRG. For section 163(n) purposes, the term “international financial reporting group” is defined more broadly than it is for purposes of the proposed excise tax. For section 163(n) purposes, the IFRG is generally defined as a group of corporations filing a consolidated financial statement that (i) contains either a foreign corporation engaged in a US trade or business, or at least one domestic corporation and one foreign corporation, and (ii) has average gross receipts over a 3-reporting-year period exceeding $100,000,000.

The Bill would limit the interest deductions of a domestic corporation that is a member of an IFRG to the sum of:

  • The “allowable percentage” of 110% of net interest expense of the domestic corporation, and
  • The gross interest income of the domestic corporation.

Any disallowed interest expense can be carried forward for up to five tax years.

The section 163(n) limitation would apply in addition to the other rules for disallowance of interest expense in the Code, and taxpayers would be disallowed interest deductions pursuant to whichever provision denies a greater amount of interest deductions.

A foreign corporation’s US interest deduction would be limited in a manner “consistent with the principles” of section 163(n).

 

Other changes to subpart F

The Bill would make some changes to existing subpart F rules. For example:

  • The CFC look-through rules under section 954(c)(6) would be made permanent.
  • The $1 million de minimis exception from foreign base company income would be indexed for future inflation.
  • The Bill would eliminate the rule in present law that prevents a US shareholder from suffering a subpart F inclusion from a foreign corporation for a taxable year unless the corporation was a CFC for an uninterrupted period of 30 days during that year.
  • Consistent with the SFC definition discussed above in connection with the transition tax, and as noted above in connection with the participation exemption (new Code section 245A), the Bill would permanently modify the stock attribution rules of section 958(b)that apply for several subpart F purposes, including determining whether a US person is a US shareholder, and whether a foreign corporation is a CFC.
  • The requirement that a corporation be a CFC for at least 30 days in order for a US shareholder to have a subpart F inclusion is removed.

 

Changes to sourcing rules for the sale of inventory

The Bill would source income from the production and sale of inventory property (section 863) solely by reference to the location of production activities - thus, not in any part based on the “place of sale,” or “title passage” rule.

Observation:  This change in sourcing will have a potentially dramatic impact on the ability to claim direct foreign tax credits paid by foreign branches of U.S. corporations where the goods are produced in the U.S.  100% of the income generated will be domestic source income and it will become very difficult to generate foreign source income to claim the foreign taxes paid by the foreign branch.  U.S. pass-through entities with foreign distribution subsidiaries which are disregarded for U.S. purposes may need to re-evaluate whether their structure makes sense on a going forward basis.  This will also put further emphasis on the transfer pricing of the goods sold to the disregarded foreign entity. Further, we anticipate this change will create tension for companies striving to comply with the OECD’s Base Erosion Profit Shifting (BEPS) initiative. For example, a key BEPS cornerstone is to align corporate profits with value creation. As such, companies whose value chains are driven more by sales and marketing value drivers as opposed to production capabilities will face double-taxation and/or controversy if these changes are enacted.