The Tax Cuts and Jobs Act moves the U.S. closer to a territorial tax system

November 06, 2017

Tax Law Alert

Author(s): Frank J. Emmons, Shahzad A. Malik, Sean Clancy

The recently proposed Tax Cuts and Jobs Act would fundamentally change the taxation of outbound activities of U.S. corporations and foreign corporations doing business in the U.S. and move the U.S. international tax regime closer to a territorial system on par with other developed countries. This alert discusses what businesses need to know.

The recently proposed Tax Cuts and Jobs Act (the “Act”) would fundamentally change the taxation of outbound activities of U.S. corporations and foreign corporations doing business in the U.S. and move the U.S. international tax regime closer to a territorial system on par with other developed countries.

Before the Act’s proposed reduction in U.S. corporate income tax rates from 35% to 20%, U.S. corporate income tax rates were significantly higher than the corporate tax rates in most other countries. Under current law, with certain exceptions, U.S. income taxes on profits realized by a foreign subsidiary are deferred until the profits are repatriated in the form of dividends to the U.S. parent. When a dividend distribution is made, the U.S. parent recognizes income and incurs a U.S. tax liability that can be offset by foreign income taxes paid or incurred by the foreign subsidiary itself, as well as any foreign income taxes withheld on the dividend. These factors, in conjunction, have long been thought to contribute to U.S. corporations shifting business activity to foreign countries (to reduce their immediate tax obligations) and cause the profits from this activity to be accumulated outside the U.S. indefinitely, rather than reinvested in U.S. business operations (to defer payment of U.S. tax).

The Act’s proposed reduction in the U.S. corporate tax rate will address part of this problem. The Act’s other changes to our international tax provisions are intended to address the issue of profits being kept in offshore corporations indefinitely. These changes are backstopped with provisions intended to reduce the shifting of profits offshore into tax haven jurisdictions. With that background, here is a brief summary of some of the more significant changes proposed by the Act as it pertains to US corporations with foreign income.

Move to territorial system and repeal current foreign tax credit system

The Act would implement a dividend exemption system on a foreign subsidiary’s earnings. Under the dividend exemption system, 100% of the foreign-source portion of dividends paid after 2017 by a foreign corporation to a U.S. corporate shareholder owning 10% or more of the foreign corporation would be exempt from U.S. income tax. The Act would remove the availability of tax credits for foreign taxes (both deemed paid taxes and withholding) with respect to any exempt dividend. Foreign tax credits would still be allowed for any Subpart F income (defined below) that is included in the income of the U.S. corporate shareholder on a current-year basis.

This change represents a dramatic shift in U.S. tax policy. If passed in its current form, the Act will require U.S.-based multinationals to reevaluate completely their international corporate structure to minimize their overall income tax obligations. Although the intended purpose of this change is to encourage business activity to remain in the U.S., it may provide an additional incentive for U.S.-based companies to shift some of their business offshore, since profits from this activity will not be subject to U.S. tax on repatriation. However, as discussed below, a further change that would be made by the Act is intended to penalize U.S. companies that shift high-profit activities to low-tax jurisdictions.

Implement deemed repatriation of earnings held offshore

The Act includes a transitional rule that would require certain U.S. corporate shareholders to include their pro rata shares of historical earnings and profits of a foreign subsidiary (i.e., accumulated earnings from 2017 and prior years) in their taxable income to the extent such earnings and profits have not been previously subject to U.S. tax. The portion of earnings and profits comprising cash or cash equivalents would be taxed at a rate of 12%, while earnings and profits invested in property would be taxed at a rate of 5%. At the election of the taxpayer, the tax may be paid over a period of up to eight years, in equal annual installments of 12.5% of the total tax liability due.

This change is intended to provide both a mechanism for transitioning from the historic tax structure to the territorial system and an incentive for U.S.-based corporations to repatriate their earnings to the U.S. This could present many planning opportunities for U.S.-based multinationals.

Modify certain rules pertaining to controlled foreign corporations (“CFCs”)

Generally, foreign subsidiaries of U.S. multinationals are classified as controlled foreign corporations (CFCs). Under current law, a U.S. parent is taxed on its CFC’s Subpart F income currently, even if such income is not distributed. As a general rule, Subpart F income is income that can easily be shifted from one company to another (e.g., sales between related companies). Thus, for example, the profits of a foreign subsidiary that involve the manufacture of goods overseas are not taxed under the Subpart F rules, but certain related party transactions, royalties, commissions, etc., are.

Despite the ostensible move toward a territorial system of taxation, many (indeed, most) of the Subpart F rules would remain. However, certain Subpart F rules have been either repealed or relaxed. For example, Section 956, which would impose an immediate tax when a CFC makes a loan to its U.S. parent or engages in some other transaction that is classified as a prohibited “investment in U.S. property,” has been repealed since the same funds could be repatriated tax-free through a dividend.

Create certain rules to prevent base erosion

The Act introduces several new provisions to prevent shifting of profits to related foreign corporations. One provision would require certain U.S. shareholders to be taxed on 50% of their “foreign high return amount.” Another provision imposes a 20% excise tax on payments (other than interest) made by a U.S. corporation to a related foreign corporation within an “international financial reporting group” that are deductible or includible in either cost of goods sold or the basis of a depreciable or amortizable asset. Both provisions exclude income that the related foreign corporation elects to treat as effectively connected with the conduct of a U.S. trade or business.

A “foreign high return amount” is defined as the excess of a U.S. shareholder’s aggregate net income over a return equal to the short-term applicable federal rate plus 7% on the U.S. shareholder’s aggregate adjusted basis in depreciable tangible property, adjusted downward for interest expense. An “international financial reporting group” is defined by the Act as a group of entities that: includes at least one foreign corporation engaged in a trade or business in the U.S. or at least one U.S. corporation and one foreign corporation; prepares consolidated financial statements; and has annual global gross receipts of more than $100 million. Although not expressly aimed at multinationals, the proposed limitations on the deductibility of interest may also affect intercompany loans that have been used to “strip” profits from U.S. corporations.

In certain circumstances, these rules could reduce or eliminate the effect of the otherwise otherwise-sweeping territorial- based taxes, including, for example, high-margin businesses such as technology-based businesses. If enacted, such businesses may need to reevaluate their multinational structure in light of the Act.

A full evaluation of the impact of these proposed changes will, of course, take time. There is no assurance that the Act will become law in its current form. It is likely that significant changes will be made at the Senate level. There will undoubtedly be a concerted effort by lobbyists to ameliorate the impact of changes that will adversely affect their clients. Additionally, the federal income tax rules will presumably result in changes in state income tax laws. Finally, some of these provisions could conflict with the U.S.’s obligations under various international tax treaties.

The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.

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