On December 22, 2017 President Trump signed into law H.R.1, The Tax Cuts and Jobs Act (the "Tax Act"), which makes significant changes to the US taxation of corporations with international operations. A number of the changes relating to international business and investment conducted by corporations are summarized below.
Corporate tax rate lowered
The Tax Act permanently lowers the top corporate tax rate from 35% to 21%, which impacts both domestic corporations and foreign corporations with US-source income. The lower corporate rate had been expected and adjusts the US corporate tax rate towards the middle of the corporate tax rates applicable in other major economies. While pass-through entities have been significantly favored in recent years, the lower corporate tax rate also enhances opportunities to structure business operations using corporations. The effective tax rate on corporate profits plus the tax on dividend distributions is nearly equal to the highest marginal tax rate (37%) applicable to pass-through entity income. For example, a corporation with $100 of earnings would pay $21 of income tax, and could then distribute $79 as a dividend, which would be subject to tax at a 20% rate, leaving a US shareholder with $63. Similarly, a partner taxed at the top marginal rate on $100 of income would receive $63 of after-tax income. More significant savings using US corporations would be available to non-US shareholders using corporate liquidation planning that would not generate any US tax beyond the 21% corporate rate. However, this does not consider the potential availability of any qualified business income deductions which may be available to the owners of pass-through entities and therefore entity selection planning for business and investment remains a mathematic exercise based on projections for the type of income and the exit strategy for withdrawal of net profits.
Deemed repatriation of foreign earnings
Prior to the enactment of the Tax Act, US owners of non-US corporations could defer taxation on active business income earned by a foreign corporation until the foreign earnings were repatriated to the shareholder in the form of a dividend. Now, as part of the transition to a more "territorial" system of income taxation, the Tax Act provides for a deemed repatriation of previously untaxed foreign earnings. Virtually all US shareholders with a 10% or more interest in certain foreign corporations will be required to include as a deemed dividend the foreign corporation's accumulated post-1986 deferred foreign income, measured as of November 2, 2017 or December 31, 2017 (whichever amount is higher).
US shareholders will be subject to tax regardless of whether any amounts are actually distributed by the foreign corporation. Any amounts deemed repatriated will be treated as previously taxed income, and will not be subject to US income tax again when actually distributed. Foreign taxes on distributions will need to be considered in this analysis. The deemed repatriation rules permit netting, such that a US shareholder may reduce the amount included in their gross income if they hold other controlled foreign corporations with earnings and profits deficits.
The portion of the deemed dividend attributable to cash and other liquid assets of the foreign corporation will be taxed at a 15.5% rate, and all other distributions of earnings will be taxed at an 8% rate. Certain deemed paid foreign tax credits for US corporate shareholders of the foreign corporation may be available to offset the repatriation tax. In an effort to address cash-flow problems that could result from the deemed income inclusion, US shareholders may make an election to include the income over an interest-free 8-year period that provides for income inclusion on a back-ended schedule, such that 8% of the deemed dividend is included in each of the first 5 years, and 15%, 20%, and 25% is included in each of the last three years, respectively. However, the amount of the deemed dividend is fixed as of December 31, 2017, and does not increase.
Interestingly, there is an exception provided to shareholders of S corporations that hold shares in controlled foreign corporations, such that an election can be made to defer repatriation until certain triggering events, including the S corporation ceasing to be an S corporation, a liquidation of the S corporation, or a transfer of S corporation shares.
This repatriation tax accrual has had a dramatic impact on 2017 financial statement reporting for US multi-nationals. Most analysts predict that a substantial portion of the repatriated earnings may be brought back and used for share buybacks. US taxpayers also need to consider the State income tax aspects of the repatriated income inclusion as tax applications vary significantly from State to State.
Dividend received deduction for foreign-source dividends
In further moving towards a more territorial tax system, and partly in an effort to encourage repatriation of future foreign earnings, the Tax Act adds new Section 245A to the Internal Revenue Code. Section 245A provides a 100% deduction for dividends received by a US corporation from a foreign corporation of which it owns 10% or more. The deduction is limited to the foreign source portion of any dividend paid by the foreign corporation. Under prior law, US corporations that received dividends from foreign subsidiaries were eligible for a foreign tax credit under Section 902 for the amount of foreign taxes deemed paid by the foreign subsidiary. Now, as a result of the Section 245A deduction, the Section 902 deemed paid foreign tax credit has been repealed as it is no longer necessary.
There are several limitations on the availability of the foreign-source dividend deduction. First, it is only available to US corporations. Individuals, partnerships, trusts, and estates that are shareholders of foreign corporations are not eligible for this deduction and will continue to be subject to US income tax on dividends received from foreign corporations. An election is available under Section 962 to treat oneself as a US corporation. Second, there are certain holding period requirements such that the US corporate shareholder must own the stock of the foreign corporation for more than 365 days during the 731 day period beginning on the date which is 365 days before the dividend was paid. Third, the deduction does not apply to dividends from passive foreign investment companies (PFICs), which prevents shareholders of PFICs from repatriating earnings without incurring the interest charges that apply to deferred passive earnings under the PFIC regime.
Changes to definition of US Shareholder in determining Controlled Foreign Corporation status
A direct or indirect US shareholder of a controlled foreign corporation ("CFC") is currently taxed on their pro rata share of the corporation’s income from passive sources (referred to as "subpart F income"), regardless of whether the corporation makes any actual distributions to its shareholders. For US income tax purposes, the subpart F inclusions are treated as deemed distributions to the US shareholder and subject to income tax at marginal rates of up to 37%. The Tax Act expanded the definition of subpart F income to include Global Intangible Low Taxed Income (discussed further below).
The Tax Act amended the definition of US Shareholder of a CFC such that a US Shareholder is now US person that holds 10% or more of the total combined vote or value of all classes of stock entitled to vote in the foreign corporation. Under prior law, the definition of US Shareholder only included those US persons with 10% or more of the voting interest in the CFC, such that taxpayers could avoid US Shareholder status by keeping their total vote below 10%, even if they held more than 10% of the value. This type of structuring will no longer be effective.
Secondly, while a CFC is still defined as a foreign corporation of which more than 50% of the total vote or value is owned by US Shareholders, there is no longer a requirement that a CFC be a CFC for an uninterrupted period of 30 days or more in a given taxable year before Subpart F income inclusions apply. This means that a foreign corporation even if a CFC for only 1 day has US tax and reporting exposure starting from January 1, 2018. This exception was previously relied on by foreign persons holding US securities through a foreign corporation to obtain certain estate tax blocker benefits, particularly where the foreign corporation shares passed to US children upon death. Following the change to the definition of a CFC, this type of planning will need to be modified.
Changes to attribution rules
The Tax Act also modified the stock ownership attribution rules that apply for purposes of determining whether a US person is a "US Shareholder" and whether a foreign corporation is a CFC. The attribution rules generally provide that a trust, estate or partnership is considering owning the stock owned by its beneficiaries or partners, as applicable, and that a corporation is considered to own the stock owned by any person owning 50% or more of its stock. The rules previously provided that stock owned by a non-US person would not be attributed down to the trust, estate, partnership or corporation. This limitation has been removed beginning January 1, 2018. Now, for example, stock owned by a non-US beneficiary of a US trust could be attributed down to the US trust, so as to make the trust a US Shareholder of a CFC, depending on the percentage of stock owned.
HR-1 repeals the active trade or business exception under Section 367
Under prior law, US taxpayers that transferred property to foreign corporations were generally subject to tax on any unrealized appreciation in the property at the time of transfer, unless an exception applied. A commonly used exception was available to US taxpayers who transferred property to a foreign corporation for use in an active trade or business. Likely in response to perceived abuses, this exception is no longer available.
Global intangible low taxed intangible income
The Tax Act enacts a new Section 951A, which requires US Shareholders of a CFC to include in income their pro rata share of the CFC's "global intangible low-taxed income". In effect, Section 951A operates to require current income inclusion for US Shareholders to the extent the CFC's income exceeds a normal rate of return (set by statute at a 10% rate of return on assets, as discussed below) and is not otherwise subject to current US taxation. It achieves this result by creating a new category of income, referred to as "global intangible low taxed income" ("GILTI"). GILTI is the CFC's "net CFC tested income", in excess of the CFC's "deemed tangible income return" for such taxable year. Net CFC tested income is basically the net income of the CFC less amounts that are otherwise subject to US income tax (such as subpart F income or income effectively connected with a US trade or business). Deemed tangible income return is basically a standard rate of return proxy (the statute uses 10%) on the net assets held by the CFC.
The standard rate of return is calculated by multiplying 10% by the US Shareholder's pro rata share of the adjusted tax bases of assets used in a trade or business by the CFC. However, the deemed tangible income return is reduced by any interest paid by the CFC to the extent the interest is not taken into account by the US Shareholder in computing the shareholder's net CFC tested income for the year. The effect of this provision is that CFC's that have acquired significant trade or business assets using loans from unrelated parties may need to reduce their "deemed tangible income return" by the amount of interest paid to the third-party, but also may avoid current income inclusion to the extent the funds are used to purchase trade or business assets and interest is paid at less than a 10% rate.
US corporations that are US Shareholders of CFCs benefit from a 50% deduction for any GILTI inclusions as well as a partial foreign tax credit whereas US individuals who are US Shareholders of CFCs will have such income taxed at up to a 37% rate without any deduction or foreign tax credit.
Effect of international business and investment
The reduction of US corporate tax rates from 35% to 21% will likely make it more attractive for US corporations to generate profits in the US. The reduction in headline rates also makes it much more effective for foreign investors to invest in US businesses through corporate structures. This could impact ownership of intangible and intellectual properties as well as transfer pricing policies among international affiliates. Furthermore, the introduction of the territorial system with a 100% dividends received deduction means that the incentives for retaining profits overseas are no longer present. Lastly, there are also now significant limitations on the ability to deduct interest payments which may mean the manner in which US businesses and investments are capitalized may need to change so as to favor higher equity levels for US investments.