The International Tax Impact of the 2017 Tax Cuts and Jobs Act

Tax Law Update | November.13.2017

by Peter Connors | John Narducci | Stephen Jackson | Michael Rodgers

On November 2, 2017, House Ways and Means Committee Chairman Kevin Brady released the much anticipated “Tax Cuts and Jobs Act of 2017” (“H.R. 1”). H.R. 1, if passed, would arguably represent the biggest change to the tax landscape in three decades. And as can be seen below, the greatest impact of such changes would arguably be felt in the international sphere. The Senate Finance Committee has issued its own tax bill, which will be addressed in a separate update.

The most important changes would involve the following:

  • Creation of a new American Participation Exemption regime, under which certain dividends received by a U.S. corporation from foreign subsidiaries would be completely exempt from U.S. tax
  • Imposition of a 20% excise tax on otherwise deductible payments of large U.S. corporations to foreign related parties
  • Strengthening of the subpart F anti-deferral rules in certain cases
  • Imposition of a repatriation tax, under which all existing unrepatriated foreign earnings of U.S. multinationals would be taxed as though paid currently to the U.S.

The changes impacting the international corporate tax landscape are discussed in further detail below.

Participation Exemption System

H.R. 1 would introduce a new “American Participation Exemption” (“Participation Exemption”) with respect to dividends (but not capital gains) received by a U.S. corporation from foreign subsidiaries. Under the provision, 100 percent of the “foreign source portion” of dividends paid by a foreign corporation to a U.S. corporate shareholder that both (1) owns at least 10% of the foreign corporation and (2) meets certain holding period requirements would be exempt from U.S. tax.

This system appears similar to certain European participation exemptions, such as those in the Netherlands, U.K., or Luxembourg, except for the fact that capital gains and liquidation proceeds would not be exempt. Additionally, portions of the dividend allocable to a U.S. trade or business or U.S. source income of the foreign subsidiary would not be eligible for the exemption, requiring substantial diligence at the level of the foreign payor to determine whether the dividend would qualify for full exemption. In addition, the Participation Regime does not apply to foreign branches. Some participation regimes will exempt both branch income and dividends from a subsidiary in the same fashion.

Additionally, and not surprisingly, to prevent a U.S. corporation from receiving a double benefit, no direct or indirect foreign tax credits would be allowed with respect to any exempt dividend.

Finally, a special rule would require that for purposes of measuring loss (but not gain) on the U.S. corporation’s subsequent sale of an eligible foreign subsidiary, the U.S. company must reduce its basis in the stock of the foreign subsidiary by the amount of distributions exempt from U.S. tax under the new Participation Exemption.

The Participation Exemption would apply to distributions made on or after January 1, 2018.

Ancillary Changes Consistent with the New Participation Exemption

Certain provisions have been added to H.R. 1, presumably for the sole purpose of conforming with the new Participation Exemption regime. Such provisions include the repeal of the indirect credit under section 902 and new limitations on the application of section 956.

Repeal of Indirect Credit under section 902

Under current law, a U.S. taxpayer receives both a direct and indirect foreign tax credit under sections 901 and 902, respectively. The direct credit applies to foreign taxes imposed directly on the U.S. payor, such as withholding tax or foreign taxes attributable to a foreign permanent establishment. The indirect credit applies to foreign taxes imposed on the earnings of a U.S. corporation’s foreign subsidiary, out of which dividends are paid from the subsidiary to the U.S. parent.

Because foreign source dividends would prospectively be exempt from U.S. tax under the new Participation Exemption, there would be a corresponding repeal of the U.S. indirect credit under section 902. This repeal prevents a U.S. corporation from receiving a double benefit by being able to offset U.S. taxes with foreign taxes while no U.S. tax was paid on the income on which such foreign taxes were imposed.

Direct credits under section 901 would still generally be available in other (non-Participation Exemption) situations, unless otherwise expressly provided for. In addition, the deemed paid credit under Section 960 for subpart F inclusions would also be available, however the credit would be modified to apply (1) on a current year basis only and (2) with respect to foreign taxes imposed on the specific item of income treated as subpart F income. This “one year at a time” application would evidence a stark departure from the complicated multi-year pooling system under current law, and would undoubtedly place increased importance on foreign tax management for taxpayers, for whom sophisticated foreign tax credit planning would be at a premium on a prospective basis. 

The repeal would go into effect for tax years of foreign corporations beginning on or after January 1, 2018 and for tax years of U.S. shareholders therein in which or with which such foreign subsidiary tax years end.

Modifications to section 956 – section 956 to no Longer Apply to U.S. Corporations

Section 956 treats certain investments by a controlled foreign corporation (“CFC”) in “U.S. property” as a deemed dividend to the foreign corporation’s U.S. owners. The purpose of the rule is to prevent the functional equivalent of a tax-free repatriation of funds to the U.S. through a more indirect means of transferring value into the U.S. (i.e., through investments in the U.S. or lending funds to the U.S., allowing tax-free use in the U.S. of offshore funds).

Under the Participation Exemption, repatriation of offshore funds to a U.S. corporation will become tax-free in all cases, so the concern advanced by section 956 is obviated to the extent the ultimate U.S. owners are corporations. Accordingly, section 956 is modified under H.R. 1 to apply only to U.S. individuals.

The modifications to section 956 would apply for tax years of CFCs beginning on or after January 1, 2018. 

Deemed Repatriation Tax

In 2004, in an attempt to encourage U.S. multinationals to repatriate earnings trapped offshore, Congress promulgated section 965, a one-year tax holiday for U.S. corporations electing to have dividends paid back to the U.S. from CFCs. Under the provision, subject to certain qualifications and limitations, a U.S. shareholder could receive an 85% deduction on cash dividends repatriated during that one year period, to the extent the amount repatriated exceeded the average dividends paid or deemed paid during a specified base period.

Under a new “deemed repatriation” provision, section 965, which has remained more or less dormant in the Internal Revenue Code for 12 years, would be amended to cause U.S. Shareholders to include the earnings and profits of a greater than 10% controlled foreign subsidiary (“Foreign E&P”) into income as of November 2, 2017 or December 31, 2017 based on which of the two dates would end up yielding the higher income inclusion. In addition to the fact that the reach of this provision would far exceed the scope of typical subpart F inclusions (by virtue of the lowered 10% control threshold), unlike the prior section 965, the inclusion in this case would no longer be subject to a base period limitation threshold.

For these purposes, Foreign E&P is divided into two “baskets”: 1) cash and cash equivalents and 2) PP&E equivalents. Cash and cash equivalents would be taxed at 14% while PP&E equivalents would be taxed at 7%. Foreign tax credit carryforwards would be fully available and foreign tax credits triggered by deemed repatriation would be partially available to offset the U.S. tax. At the election of the taxpayer, the tax liability associated with the deemed dividend would be payable over an up to 8 year period in equal installments of an amount equal to 12.5% of the total tax liability.

In cases where the U.S. shareholder of a CFC is an S Corp, special rules would apply in order to defer recognition of income until S Corp status has either changed or the S Corp was sold. 

Expansion of Scope of Subpart F Income

Three provisions under H.R. 1 would, in contrast to the theme of moving to a system of territorial taxation, actually expand the scope of the subpart F anti-deferral rules.

Change in Constructive Ownership Rules

H.R. 1 would create a new rule that would, for purposes of determining whether a foreign company is a CFC, cause a U.S. corporation to be treated as holding the stock held by a foreign parent that holds at least 50% of the stock of the U.S. corporation. The effect of this rule would be to significantly increase the scope of the Subpart F income rules by causing U.S. companies to potentially have Subpart F reporting obligations with respect to brother and sister companies – a counterintuitive result. The expanded scope of the CFC rules is also likely to result in subpart F inclusions to U.S. shareholders of foreign corporations who suddenly find themselves holding stock in a CFC. CFC status may cause some companies to fall into passive foreign investment company (“PFIC”) status, since the determination of PFIC status is different for CFCs that are not publicly traded. Where the CFC is not publicly traded, the determination PFIC status must be made based on the adjusted bases of assets rather than fair market value.

The new constructive ownership rules would go into effect for tax years of CFCs beginning on or after January 1, 2018.

New Category of Subpart F Income for Foreign High Return Amount

Under a new category of Subpart F income, a U.S. shareholder of a controlled foreign corporation would be subject to U.S. tax on 50% its “foreign high return amount. The “foreign high return amount” is equal to the excess of foreign subsidiaries’ aggregate net income over a routine return (7% plus the federal short term rate) on the foreign subsidiaries’ aggregate bases in depreciable tangible property, adjusted downward for interest expense. The provisions would be contained in new section 951A.

This new category appears to be the product of certain prior tax reform initiatives and proposals, including the Tax Reform Act of 2014, architected by then-chairman of the House Ways and Means Committee, Dave Camp (the “Camp Bill”). Under the Camp Bill, a new subpart F income category would have been created specifically to capture low-taxed income, looking at a CFC’s effective tax rate on a jurisdiction by jurisdiction basis. However, here, unlike the Camp Bill, application of the provision is not tied to the rate at which such income is taxed locally.

The foreign high return amount would not include income effectively connected with a U.S. trade or business, subpart F income, insurance and financing income that meets the requirements for the active finance exemption from subpart F income under current law, income from the disposition of commodities produced or extracted by the taxpayer, or certain related-party payments.

Foreign tax credits would be limited to 80% of foreign taxes considered paid on the foreign high return income and could not be used to offset U.S. tax on other foreign sourced income. Moreover, no foreign tax credit carrybacks or carryforwards would be permitted.

The addition of this new subpart F income category would likely serve to increase the effective rate on various structures of U.S. multinationals who are able to place valuable IP in offshore jurisdictions. The provision will impact the continued viability of those structures.

Moreover, the decision as to whether to operate abroad by way of a foreign branch versus a foreign corporation (e.g., CFC) is likely to be affected due to the fact that the foreign high return amount is limited to 50% of the high return income whereas income earned through a foreign branch would be fully taxable but eligible for a full foreign tax credit. This new category of subpart F income is likely to generate further policy discussions which may lead to further law changes. In the absence of such changes, U.S. multinationals would likely be well advised to reconsider certain existing structures in order to account for the disparate treatment of branches and corporations. 

The new foreign high return amount subpart F income category would go into effect for tax years of CFCs beginning on or after January 1, 2018.

Elimination of 30 Day CFC Requirement

In order to be considered a CFC, a foreign corporation needs to meet the applicable “greater than 50% U.S. ownership threshold” during an uninterrupted period of 30 days during a taxable year. H.R. 1 would eliminate this requirement, thereby increasing the likelihood that a foreign corporation would be considered a CFC.

The 30 day ownership threshold is a significant source of planning opportunities in the outbound corporate tax sphere and its elimination would likely have a substantial impact on expanding the reach of the subpart F anti-deferral rules.

As can be seen, from a policy perspective, H.R. 1 adopts a confusing dual approach whereby it embraces certain territorial principles on the one hand, while on the other hand expanding the worldwide tax reach of the U.S. anti-deferral rules.

The elimination of the 30 day control requirement for CFC status would go into effect for tax years of CFCs beginning on or after January 1, 2018, and for tax years of U.S. shareholders in which or with which such tax years of CFCs end.

New Interest Expense Deduction Limitation

Under current Internal Revenue Code section 163(j), a U.S. company is generally permitted to take a deduction for interest expense, subject to certain limitations. In the case of related party interest expense, a corporation with a debt to equity ratio of at least 1.5 to 1 is limited in the interest expense it can pay to a foreign or U.S. tax-exempt entity (the “Earnings Stripping Rules”). The amount of the limitation under the Earnings Stripping Rules is equal to 50% of adjusted taxable income (roughly, EBITDA) with excess interest expense allowed to be carried forward indefinitely.

H.R. 1 would replace the existing limitation under the Earnings Stripping Rules with a completely new framework, governed by two interest expense disallowance rules. The first rule would apply to all business interest expense (subject to certain exceptions) while the second would apply to related party interest expense in the case of large groups of related taxpayers. Under the first rule, net interest expense would generally be limited to 30% of the taxpayer’s adjusted taxable income. For these purposes, adjusted taxable income is determined similarly to the standard under current law, and would generally approximate EBITDA. In the case of a partnership, the limitation would be calculated at the partnership (rather than the partner) level. Exceptions to these limitations would also be applicable in the case of certain small businesses.

Under the second rule, the applicable limitation would be the more restrictive of the following:

  • 110% of the taxpayer’s share of group EBITDA
  • 30% of the entity’s adjusted taxable income

This rule would apply to large related-party taxpayers. For these purposes, taxpayers would be related to the extent they are members of the same “international financial reporting group” (“IFRG”). An IFRG would be any group of entities which includes (1) at least one foreign corporation engaged in a U.S. trade or business or (2) at least one U.S. corporation and one foreign corporation, provided the group also both prepares consolidated financial statements with respect to such year and has average gross receipts of more than $100 million for the three year period ending in the applicable reporting year.

The new interest expense limitation rules would be effective for tax years beginning on or after January 1, 2018.

Other Base Erosion Prevention Provisions

New 20% Excise Tax

One of the more controversial changes would be the proposed excise tax on payments to related foreign parties. Under this provision, payments (other than interest expense) from a U.S. corporation to a related foreign corporation that are deductible, includible in cost of goods sold, inventory, or includible in basis of depreciable or amortizable assets would be subject to a 20% excise tax unless the related foreign entity elects to treat such payments as income effectively connected with a U.S. trade or business (“ECI”). For these purposes, the relatedness standard is measured by a slightly different IFRG standard than discussed above in the case of related party interest expense. The standard encompasses any group of entities preparing consolidated financial statements with respect to such year and making aggregate annual payments over a three year period of more than $100 million. Therefore, this provision would only impact larger corporate groups of taxpayers. However, it would apply to both U.S. based groups and foreign based groups.

Exceptions to the new excise tax apply in the cases of service payments made at cost (no markup), payments to acquire securities and commodities as defined in section 475(c)(2) and 475(e)(2), respectively, and in the case of certain commodities transactions. Additionally, a taxpayer may elect to treat the deductible payment as ECI in the hands of the foreign recipient that is attributable to a U.S. permanent establishment. In computing ECI, taxpayers would be allowed deemed expenses based on foreign profit margins. Notwithstanding the burden associated with a gross basis 20% excise tax, the ECI election may in many cases prove to be an even less attractive option due to (1) such a payment likely causing the foreign entity payee to have to file U.S. tax returns and (2) such payment also presumably being subject to the branch profits tax, unless reduction to this amount were to be available under an applicable tax treaty. 

A partial foreign tax credit would be allowed in computing the amount due for taxpayers making the ECI election. However, no deduction would be allowed for the excise tax liability.

Because the amount of the excise tax would equal the new top corporate tax rate of 20% under H.R. 1, the net effect of this provision would be a general inability of a U.S. member of an international group to make so-called “base eroding” payments to foreign entities in lower tax jurisdictions, unless such payments were interest expense payments that satisfied the new limitation standards. Large U.S. multinationals, particularly in the IP sphere, would be likely to see a general increase in their effective U.S. tax rate, while smaller businesses may be more likely to see their effective rates go down based on the posted rate being a mere 20%. Moreover, the excise tax would allow the U.S. to tax certain arrangements that might otherwise be blessed under certain arm’s-length transfer pricing arrangements, which would have the effect of moving taxable profits out of the U.S. and into lower-taxed jurisdictions.

Previous proposals for similar non-income tax provisions had included the controversial Border Adjustment Tax, which would have exempted certain outbound transfers (exports) of property while effectively taxing imports at the U.S. corporate rate.  This provision is considerably narrower.

The new excise tax provision would be applicable for amounts paid or accrued after December 31, 2018. 

Other Possible Provisions: Combatting Base Erosion Through Denial of Treaty Eligibility

An earlier version of H.R. 1 contained a provision designed to prevent base erosion by denying a foreign recipient reduced withholding under an otherwise applicable treaty with the U.S. Under the provision, certain payments, including interest, dividends, royalties, and compensation made by a U.S. company to a foreign company that is controlled by the same foreign parent as the U.S. payor would be treated as payments made directly to the parent for purposes of determining eligibility for a reduction in U.S. withholding tax under an applicable tax treaty. In many cases, this could cause a payment that would otherwise be completely free of U.S. withholding tax to be subject instead to the default rate of 30% under sections 871 and 881.

Although it does not appear that this provision will be revived in its original form, it gives a useful preview of the types of avenues that could be pursued under future Tax Reform initiatives to raise revenue that may prove necessary to pay for the cost of a substantial reduction in the U.S. tax rate.

Other Developments

Other notable changes under H.R. 1 would include the following:

  • Income from sale of inventory produced within U.S. and sold without (or vice versa) will be allocated and apportioned between U.S. and foreign sources based solely on the basis of production activities with respect to the inventory (previously it was permissible to split the allocation on a 50/50 basis between the location of production and the location of title passage).
  • The foreign oil related income category would be removed from the ambit of subpart F income.
  • There would be a new inflation adjustment for the lesser of $1 million or 5% of income threshold for the foreign base company income category of subpart F income.
  • The taxpayer friendly related party look-through exception from subpart F income would be made permanent.

Conclusion

H.R. 1 arrives in the wake of a Republican policy agenda to both (1) implement a territorial corporate tax system under which a U.S. resident corporation would be taxed only on its income sourced to the U.S. and (2) simplify what has been called an unnecessarily complicated and “broken” tax code. On the one hand, if adopted, H.R. 1 would appear to at least partially advance this agenda by moving the United States in some ways a significant step closer to a territorial system. On the other hand, H.R. 1 does anything but simplify the complex U.S. rules governing international transactions by adding complexity to an already intricate and complicated web of anti-deferral provisions, aimed instead at furthering a system largely antithetical to territorial taxation. Indeed, under H.R. 1, many aspects of the traditional and oft-criticized worldwide taxation system remain, with certain provisions even experiencing a substantial expansion in scope.