How The Tax Cut and Jobs Act Would Change International Business Taxation
November 7, 2017
The House Tax Cuts and Jobs Act released by the House of Representatives Ways and Means Committee has several provisions which affect the operations of multinational corporations. The central focus of the international portion of the bill is to introduce a territorial system for taxing corporate income. This includes the introduction of a participation exemption for foreign sources income along with a base erosion provision to prevent income shifting. It also includes transition rules to account for past deferred earnings.
Overview of Major International Rules in the Tax Cuts & Jobs Act
- Move to a territorial system through a 100 percent dividend deduction (Sec. 4001)
- Deemed repatriation of deferred foreign income (Sec. 4004)
- Base Erosion Rules
- Inclusion of foreign high returns (Sec. 4301)
- Limitation of interest deduction within a corporate network (Sec. 4302)
- Excise tax on domestic purchases from related foreign corporations (Sec. 4303)
- Limitation of treaty benefits for certain deductible payments (Sec. 4503)
Territorial tax systems only tax income where it is earned. To avoid taxing income earned in other countries, a territorial system removes income of foreign affiliates from the tax base of the parent corporation. Most countries with a territorial system provide a deduction for the two most common forms of income from an affiliate corporation: dividends and capital gains. These deductions are known as participation exemptions.
Section 4001 of the House Tax Cuts and Jobs Act provides a 100 percent deduction for dividends received from foreign sources. This is slightly more generous than most OECD countries with a dividend deduction regime, which often exempt only 95 percent of dividends. In addition, section 4002 removes the penalty on a foreign affiliate for using retained earnings to invest in U.S. property, which provides an alternative avenue to return earnings to the United States. Section 4003 adjusts the value of the subsidiary when calculating losses to avoid artificially high net operating losses. Although the House Tax Cuts and Jobs Act includes a dividend deduction, capital gains from the sale of an interest in a foreign corporation are still taxed.
To facilitate the transition from a worldwide to a territorial system, section 4004 forces corporations to repatriate and pay a reduced rate on deferred earnings. The provision specifies that earnings held as cash or cash equivalents are subject to a 12 percent rate while reinvested earnings are subject to a 5 percent rate. Corporations have eight years to pay the taxes on the deferred earnings, with a minimum of 12.5 percent paid per year. The split between cash and reinvested earnings is the greater of an evaluation on November 2, 2017, and December 31, 2017. S corporations are exempt from the deemed repatriation.
Four provisions in the House Tax Cuts and Jobs Act prevent the erosion of the corporate tax base from income shifting. Section 4301 creates a new test for including foreign-source income into a U.S. parent’s tax base. The provision requires that 50 percent of income from a foreign subsidiary above a normal return, defined as 7 percent plus inflation, on tangible, depreciable assets, must be included in the tax base of the U.S. parent. This inclusion test is done for each subsidiary independently and is not based on the country in which the subsidiary is located.
Since the normal return is based on tangible assets, income from intangibles, such as patents and trademarks, is entirely considered a high return. As such, 50 percent of intangible assets in a foreign subsidiary will be subject to the 20 percent U.S. corporate tax. This effectively forces U.S.-domiciled parent corporations to pay U.S. tax of up to 10 percent on all intellectual property in their corporate network. This could create a de facto lower rate on intellectual property held in low-tax countries (which could be termed a “patent cloud” rather than a “patent box.”)
Section 4302 strengthens the existing rules that limit the amount of interest a corporation can deduct. Known as thin capitalization rules, they prevent corporations from shifting income to related foreign corporations through oversized loans, where interest is deductible. The new rule limits the interest deductible to 110 percent of the earnings-weighted average of all interest expenses within the corporation’s larger global network, or international financial reporting group. All interest above the limit is carried forward for a maximum of five years. This rule is in addition to the interest limitation in section 3301 but is limited to international financial reporting groups with annual global receipts more than $100 million.
Section 4303 introduces a measure to reduce income shifting through transfer pricing – the prices that related corporations charge each other for goods and services. The provision introduces a 20 percent excise tax on all payments from a U.S. corporation, parent or subsidiary, to a related foreign corporation for deductible inputs, such as intermediate goods and depreciable capital assets. Interest payments and intercompany services are excluded from the excise tax.
The excise tax can be avoided by declaring the payments as Effectively Connected Income (ECI). In this case, the U.S. corporation includes a portion of the related foreign corporation’s income in the U.S. corporation’s taxable base. In addition, a portion of the foreign corporation’s expenses can be deducted from the U.S. corporation’s taxable income. As such, if the foreign corporation prices the transaction at cost for the related U.S. corporation, then the U.S. corporation should not pay any additional taxes, since the additional income from the transaction is offset by the deduction from the expenses.
Although the excise tax for the payment to foreign-related corporations is central to this provision, it is unlikely lawmakers intended the excise tax to be part of normal business activity. Instead, the excise tax could be the stick that incentivizes U.S. corporations to declare the transactions ECI. The result would be a disincentive to price transactions far above cost, to shift income from the United States to foreign jurisdictions.
Finally, section 4503 introduces a limitation to tax treaties involving payments that are deductible by the U.S. corporation. This provision gives regulators the option of denying the lower treaty withholding-tax rate on payments that are deductible, such as royalties or interest payments. Instead, these payments would face the statutory 30 percent withholding tax rate on payment from U.S. corporations to a foreign corporation. The provision allows parent corporations to always receive the treaty rate, regardless of regulators’ decisions. As such, the tax treaty limitation is effectively an anti-treaty shopping provision.
Overview of Other Sections
Section 4101 adjusts which type of income a foreign tax credit can apply. Foreign taxes, including withholding taxes, would only be credited toward income that falls under subpart F, income that must be included in the U.S. tax base even though it was earned overseas. Section 4102 changes how inventory is apportioned between U.S. and related foreign corporations.
Section 4201 adjusts rules for shipping income, which could fall under subpart F. Section 4202 repeals a portion of subpart F related to oil income. Section 4203 adjusts the threshold at which subpart F income must be filed for inflation. Section 4204 makes the look-thru rule permanent, which required corporations to file the assets and income of certain subsidiaries as their own. Section 4205 modifies the rules for determining whether a foreign corporation is effectively controlled by U.S. parties. Section 4206 eliminates the 30-day grace period under which controlled foreign corporation rules do not apply.
Sections 4401, 4402, and 4403 are all tax provisions that will help support U.S. territories. Section 4401 is a retroactive expansion of a deduction of 9 percent of qualified business activity or taxable income limited to 50 percent of W-2 wages in Puerto Rico. Section 4402 is an extension of the higher rebate for excise taxes paid on sales in the United States of rum from Puerto Rico and the Virgin Islands. Section 4403 is an extension of the economic development credit in American Samoa. These provisions are meant to inject cash into weather-battered and struggling U.S. territories.
Section 4501 changes the requirement for insurance companies to operate through a passive foreign investment company (PFIC). Insurance companies would face a stricter set of rules under which they can receive an exception for their PFICs. This includes strict limitations on losses and reserves.