by Amanda Varma and Brigid Kelly, Steptoe & Johnson LLP, Washington
A new tax law (P.L. 115-97), often referred to as the Tax Cuts and Jobs Act of 2017 (Act), has dramatically modified the US international tax provisions, impacting both US and non-US headquartered companies.
Among the more significant provisions are the new dividend-exemption system and the introduction of several new anti-base erosion provisions, including GILTI (global intangible low-taxed income), FDII (foreign-derived intangible income), and a base erosion minimum tax (informally referred to as the base erosion anti-abuse tax or BEAT).
Under this new system, often referred to as either a dividend-exemption or participation exemption system, a US corporation is permitted a 100-percent deduction for foreign-source dividends received from certain foreign corporations (owned at least 10% by a US corporation), effective for distributions made after December 31, 2017.
Under prior law, US corporations were generally subject to US tax on dividends received from foreign corporations, though such dividends might carry foreign taxes that could be credited against US tax. Under the new law, no foreign tax credit or deduction is allowed for any taxes paid with respect to a dividend qualifying for the deduction.
Although the Act adopts a dividend-exemption system, foreign earnings of US corporations can still be subject to US tax. The Act retains, with certain modifications, the anti-deferral controlled foreign corporation (CFC) rules (commonly referred to as subpart F) as well as the passive foreign investment company (PFIC) rules.
In addition, as discussed below, the Act creates a new category of foreign income subject to current US tax.
To transition to the new system, the Act imposes a one-time transition tax.
For the last taxable year beginning before January 1, 2018, a US shareholder of certain foreign corporations must include in income its pro rata share of the undistributed, non-previously-taxed post-1986 foreign earnings of the foreign corporation, determined as of November 2, 2017, or as of December 31, 2017, whichever is higher.
The tax on the aggregate earnings and profits attributable to cash and cash equivalent assets is 15.5%, while the tax on aggregate earnings and profits attributable to other assets is 8%, with the potential to credit certain foreign taxes against the taxable portion of the mandatory inclusion.
The tax assessed on a US shareholder’s mandatory inclusion may be paid over an 8-year period, with 8% of the tax paid in each of the first five years, 15% in the 6th year, 20% in the 7th year, and 25% in the 8th year.
Although the new dividend-exemption system applies only to US corporate shareholders, the transition tax can apply to non-corporate US shareholders, including individuals, in certain cases.
One week after the tax reform legislation became law, the Treasury Department and the Internal Revenue Service issued Notice 2018-07, announcing Treasury’s intent to issue regulations for determining amounts included in gross income by a US shareholder for purposes of calculating the transition tax described above.
On January 19, 2018, Treasury and the IRS issued additional guidance related to the calculation of the transition tax (Notice 2018-13).
The notices state that taxpayers may rely on the rules described in the notice (which, among other things, address potential double counting issues and the definition of cash) until regulations are issued.
Global Intangible Low-Taxed Income
The Act creates a new category of foreign income, called global intangible low-taxed income or GILTI, subject to current US tax, which is applicable to US shareholders that own 10% or more of a CFC.
The new GILTI rules, effective for taxable years beginning after December 31, 2017, essentially impose a minimum level of US tax on the foreign profits of US multinationals.
GILTI is calculated as “net CFC tested income” (excluding several categories of income, including income already subject to US tax as subpart F or as effectively connected income) over the shareholder’s “net deemed tangible income return.”
“Net deemed tangible income return” is essentially a deemed routine return on tangible assets, and is 10% of the shareholder’s pro rata share of the qualified business asset investment (QBAI) of each CFC with respect to which it is a US shareholder, over certain interest expense.
QBAI is determined as the average of the adjusted US tax basis (determined at the end of each quarter of a tax year) in “specified tangible property” that is used in the CFC’s trade or business and is subject to US tax depreciation.
In certain cases, the routine return may be small, potentially subjecting a US shareholder to tax on a significant portion of its CFC income.
This may be the case not only where the value of a CFC’s business is primarily intangibles (as no return is given for intangible assets), but also where a CFC has limited tangible assets (as may be the case in a primarily services business), or where a CFC has tangible assets that are largely depreciated.
Where GILTI is includable in the income of a US shareholder, a deemed foreign tax credit is allowable to offset the US tax on GILTI. However, the credit is limited to 80% of the foreign taxes attributable to the tested income of the CFCs.
Under the new 21% corporate tax rate, and, accounting for the deduction for “foreign-derived intangible income” (FDII), described below, the effective US tax rate on GILTI for domestic corporations is 10.5% for taxable years beginning after December 31, 2017, and before January 1, 2026.
Because only 80% of foreign tax credits are allowed to offset US tax on GILTI, the minimum foreign tax rate to eliminate residual tax on GILTI is 13.125% through 2025.
The FDII rules incentivize the development of intangibles in the US by providing a reduced rate of US tax on a domestic corporation’s portion of its intangible income derived from serving foreign markets.
The rules for determining FDII are complex. Very generally, a US corporation’s FDII is the amount of its “deemed intangible income” that is attributable to sales of property (including licenses and leases) to foreign persons for use outside the United States or the performance of services for foreign persons or with respect to property outside the United States.
A US corporation’s deemed intangible income, generally, is its gross income that is not attributable to a CFC, a foreign branch, or to domestic oil and gas income, reduced by related deductions and an amount equal to 10% of the aggregate adjusted basis of its US depreciable assets.
The Act omits, however, a provision in a prior proposal that would have allowed US companies to bring intellectual property back to the United States without US tax.
Some have argued that the FDII rules constitute an export incentive not permitted under the United States’ trade obligations.
The European Union has stated that it will keep “all options on the table” as it considers retaliatory actions against the legislation—including a World Trade Organization challenge.
FDII and GILTI deduction
As referenced above, the Act provides domestic corporations with reduced rates of US tax on their FDII and GILTI.
For taxable years beginning after December 31, 2017, and before January 1, 2026, a US corporation is allowed a deduction in an amount equal to the sum of 37.5% of its FDII, plus 50% of its GILTI (if any), that is included in the income of the taxpayer. For taxable years beginning after December 31, 2025, the deduction for FDII is reduced to 21.875% and the deduction for GILTI is lowered to 37.5%.
Base Erosion Minimum Tax
The Act also creates a base erosion minimum tax (informally referred to as the base erosion anti-abuse tax or “BEAT”), generally designed to curtail excessive base erosion payments, namely, deductible payments to foreign affiliates.
These rules ensure that a US corporation pays at least a 10% tax (5% in 2018 and 12.5% beginning in 2026) on its taxable income after adding back these base erosion payments.
Payments included in the cost of goods sold or otherwise treated as reductions to gross receipts are generally not base erosion payments.
The base erosion minimum tax amount is the excess of 10% (or other applicable rate) of the taxpayer’s “modified taxable income” (generally, taxable income adding back base erosion payments and certain other amounts) for the taxable year over an amount equal to the taxpayer’s regular tax liability, reduced by credits other than the research credit and an amount not exceeding 80% of “applicable section 38 credits.”
The “applicable section 38 credits” include the low-income housing credit and certain energy credits.
The special treatment of the section 38 credits appears responsive to concerns that the minimum tax could have negatively impacted the renewable energy and low-cost housing markets. However, such special treatment is eliminated beginning in 2026.
The minimum tax applies to US corporations, other than regulated investment companies, real estate investment trusts, or S corporations, with average annual gross receipts for the three preceding years of at least $500 million.
The tax does not apply, however, unless the foreign-related party deductible payments made by a US corporation are 3% or more of the corporation’s total deductible payments.
The minimum tax contains several special rules for banks and registered securities dealers. They are subject to a one percentage point higher rate: 6% for 2018, 11% for 2019-2025, and 13.5% thereafter.
In addition, the 3% threshold for foreign-related party deductible payments mentioned above is reduced to 2%.
Further, there is an exception from the definition of base erosion payments for “qualified derivative payments” for taxpayers that annually recognize ordinary gain or loss on such instruments.
Intangible property transfers
The Act also addresses certain issues that have arisen in controversies involving transfers of intangible property.
Specifically, the Act revises the definition of intangible property under section 936(h)(3)(B), which is cross-referenced in key provisions applicable to cross-border transfers of intangibles (specifically, sections 367(d)(2) and 482), to include workforce in place, goodwill, and going concern value.
The legislation also confirms the IRS’s authority to require certain valuation methods. It does not modify the basic approach of the existing transfer pricing rules with regard to income from intangible property.
Although regulations issued in 2016 under section 367 required that outbound transfers of goodwill and going concern value be subject to either gain recognition under section 367(a) or the deemed royalty regime under section 367(d), those regulations did not specifically address whether goodwill, going concern value, and workforce in place are section 936(h)(3)(B) intangibles.
The Act also imposes new restrictions on interest deductibility that are generally applicable to all US corporations.
Under the Act, the amount of net interest that can be deducted by any business with gross receipts of $25 million or more (measured based on average annual gross receipts over a three-year period) is generally limited to 30% of the adjusted taxable income for the year.
This provision thus applies generally to US corporations, regardless of whether US or non-US headquartered.
For taxable years beginning before January 1, 2022, adjusted taxable income is computed without regard to deductions allowable for depreciation, amortization, or depletion. The amount of any business interest not allowed as a deduction may be carried forward and used as a deduction in a subsequent year.
The Act does not include either the House or Senate version of another provision that would have further limited the deduction of interest by US corporations that are members of an international group.
The Act also overrules Grecian Magnesite Mining v. Commissioner, 149 T.C. 3 (2017), with respect to partnership sales and other dispositions.
Under the new rules, gain or loss from the sale or exchange of a partnership is treated as effectively connected with the conduct of a US trade or business (and thus subject to US income tax) to the extent that the transferor would have had effectively connected gain or loss if the partnership sold all of its assets at fair market value as of the date of the sale or exchange (excluding real property gain already classified as effectively connected under the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA)).
Any such gain or loss from the hypothetical asset sale would be allocated to interests in the partnership in the same manner as the ordinary income or loss of the partnership.
Similar to the current FIRPTA withholding and reporting regime, a purchaser of a partnership interest must withhold 10% of the amount realized on the sale or exchange of a partnership interest unless the transferor certifies that the transferor is not a nonresident alien or a foreign corporation. If the purchaser is required to withhold but does not do so, the relevant partnership must withhold the deficient amount from the purchasing partner.
Although reform of the US international tax system has been considered by Congress for years, the Act moved through Congress quickly—there was less than two months between the first introduction of the House of Representatives version of the Act and President Trump’s signature.
Given the speed of enactment, corrections and clarifications of numerous provisions are likely to occur through additional legislation and/or regulatory guidance.