House Ways and Means Committee Chairman Kevin Brady (R-TX) on November 2, 2017 released a 429-page tax reform bill called the “Tax Cuts and Jobs Act of 2017” (TCJA).

The TCJA will be the subject of the House Committee consideration this week, and Senate Finance Committee Chairman Orrin Hatch (R-UT) announced that he plans to release a Senate Republican version of a tax reform bill after the Ways and Means Committee completes its work.

Discussion

The following summary of the TCJA focuses on certain provisions intended to modernize U.S. international tax rules.

Proposed Territorial Tax System

Under the TCJA, the U.S. corporate tax rate would be reduced from 35% to 20% permanently, not temporarily as was earlier considered, and the U.S. taxation system would move to a territorial regime of taxing foreign earnings with anti-base erosion provisions targeting both U.S.-based and non-U.S.-based multinational companies.

Adopting a territorial tax system means that domestic income would be subject to current U.S. tax, while foreign branch income would be exempt from U.S. tax, and no foreign tax credit would be allowed with respect to that foreign source income.

The TCJA would exempt from U.S. tax 100% of certain qualified foreign-source dividends received by U.S. corporations from foreign subsidiaries in which the U.S. corporation owns at least a 10% interest, effective for distributions made after 2017.

Currently, anti-deferral rules tax as dividends certain investments in U.S. property by foreign subsidiaries.  For example, loans made by foreign subsidiaries to the U.S. parent may result in deemed dividend treatment, consequently resulting in U.S income recognition and a tax liability.  Under the TCJA, such investments in U.S. property would be exempt from U.S. tax for tax years of foreign corporations beginning after 2017.

The TCJA includes a limitation on losses with respect to 10% owned foreign corporations.  Only for determining loss on the sale of stock of a 10% owned foreign corporation, a U.S. parent would reduce its basis in the stock of the foreign corporation equal to the amount of any exempt dividend it received from that foreign corporation.

Transition Tax on Accumulated Foreign Earnings

The adoption of a territorial tax system includes a one-time transitional tax on accumulated foreign earnings.  Specifically, the tax would be imposed on a U.S. 10%-shareholder's pro rata share of the foreign corporation's post-1986 tax-deferred earnings, determined as of November 2, 2017, or December 31, 2017 (whichever is higher), at 12% for cash, cash equivalents, or certain other short-term assets, and 5% for illiquid assets (e.g., property, plant and equipment).

An affected U.S. shareholder with a 10%-or-greater stake in a foreign corporation with a post-1986 accumulated deficit would be able to offset the deficit against tax-deferred earnings of other foreign corporations. The U.S. shareholder could elect to pay the transitional tax over a period of up to eight years.

Anti-Base Erosion Rules

Under current law, companies owe the full 35% corporate tax rate on their worldwide earnings and have to pay it on any profits they bring back to the U.S., arguably encouraging profits to be left outside the U.S. The TCJA introduces new proposals to address these concerns.

“High Returns” Tax

The TCJA would impose current U.S. tax on 50% of a U.S. shareholder's aggregate net controlled foreign corporation (CFC) income in excess of high returns from tangible assets, summarized as follows:

• U.S. parent would be currently taxed on 100% of Subpart F income
• U.S. parent would be currently taxed on 50% of CFCs’ foreign “High Returns” income
  • “High Returns” income equals Foreign income (excluding Subpart F income) minus interest expense minus “Routine Return”
  • Routine Return equals adjusted basis of tangible assets multiplied by (7% plus the short-term federal rate)

Stated differently, foreign high returns would be the excess of the U.S. parent's foreign subsidiaries' aggregate net income over a routine return (7% plus the Federal short-term rate) on the CFCs’ aggregate adjusted bases in depreciable tangible property, less interest expense.  Foreign high returns would not include, among other things, income effectively connected with a U.S. trade or business and Subpart F income.

For purposes of these rules, a modified foreign tax credit would be available on High Returns income, allowing only 80% of the foreign taxes paid on the High Returns income as a foreign tax credit.

The provision would be effective for tax years of foreign corporations beginning after 2017 and for tax years of U.S. shareholders in which or with which such tax years of foreign subsidiaries end.

Excise Tax on Payments to Foreign Affiliates

With the intent to prevent shifting of profits to foreign affiliates, the TCJA also establishes a new tax on certain payments from domestic corporations to related foreign corporations. The TCJA provides that payments (other than interest) made by a U.S. corporation to a related foreign corporation that is deductible, includible in costs of goods sold, or includible in the basis of a depreciable or amortizable asset would be subject to a 20% excise tax, unless the related foreign corporation elected to treat the payments as income effectively connected with the conduct of a U.S. trade or business, making such payments taxable in the U.S. on a net basis.

The proposal targets companies based outside the U.S. and former U.S. companies that have carried out an inversion transaction to prevent them from loading up U.S. subsidiaries with deductions and from pushing profits to low-tax countries through payments such as royalties.

For example, European companies that sell foreign-made products into the U.S. market through local distribution units could be among those most affected.  Or, if a Mexican subsidiary of a car company sells a part to the U.S. subsidiary, the Mexican subsidiary would now be charged under the new rule. Such companies could end up paying tax on the transfers twice – first if they paid the excise tax in the United States and then in their home countries where they are taxed now.

The Senate tax plan is not expected to include an excise tax on imports by multinational companies, but there will be more information on this issue when the Senate Finance Committee version of the bill is released.

As drafted in the House bill, the provision would apply after December 31, 2018, only to payments from U.S. corporations to their foreign affiliates totaling at least $100 million annually.

Proposed Changes to Interest Expense Deduction

U.S. corporations with foreign affiliates are subject to a new limit on interest expense deductions.  A U.S. corporation’s interest expense is limited to 110% of such U.S. corporation’s share of the group's global earnings before interest, taxes, depreciation, and amortization (EBITDA).  Excess interest expense can be carried forward for 5 years, and there is a de minimis exception for groups with combined gross receipts of $100 million or less.  The provision would be effective for tax years beginning after 2017.

Changes Affecting the Foreign Tax Credit System

Repeal of Indirect Foreign Tax Credits

Under current U.S. rules and subject to certain limitations, a 10% U.S. corporate shareholder is eligible to credit against its U.S. tax liability foreign income taxes deemed paid with respect to dividend distributions from foreign subsidiaries (i.e., indirect foreign tax credits).

The TCJA would repeal the indirect foreign tax credit rules, providing that no foreign tax credit or deduction would be allowed for any taxes (including withholding taxes) paid or accrued with respect to any dividend to which the dividend exemption under the TCJA would apply.  A foreign tax credit would be allowed for any Subpart F income that is included in the income of the U.S. shareholder on a current year basis.

The provision would be effective for tax years of foreign corporations beginning after 2017 and for tax years of U.S. shareholders in which or with which such tax years of foreign subsidiaries end.

Inventory Sales Sourcing Rules Changed

Under current law, in determining the source of income for foreign tax credit purposes, up to 50% of the income from the sale of inventory property that is produced within the U.S. and sold outside the U.S. (or vice versa) may be treated as foreign-source income.

The TCJA provides that income from the sale of inventory property produced within and sold outside the U.S. (or vice versa) would be allocated and apportioned between sources within and outside the U.S. solely on the basis of the production activities with respect to the inventory.  The provision would be effective for tax years beginning after 2017.

Proposed Modifications to Subpart F Rules

The following are select modifications contained in the TCJA:

• Certain payments between affiliated CFCs that would otherwise be includable Subpart F income have benefited from temporary “look through” rules excluding such income from U.S. tax. The exclusion from U.S. income with respect to such payments of dividends, interest, rent, or royalties, for example, would be made permanent. 

• Under current law, a U.S. parent of a foreign subsidiary is subject to current U.S. tax on its pro rata share of the subsidiary's Subpart F income.  However, a de minimis rule states that if the gross amount of such income is less than the lesser of 5% of the foreign subsidiary's gross income or $1 million, then the U.S. parent is not subject to current U.S. tax on any of the income. The $1 million De Minimis Rule for foreign base company income would be adjusted for inflation under the TCJA.  The provision would be effective for tax years of foreign corporations beginning after 2017, and for tax years of U.S. shareholders in which or with which such tax years of foreign subsidiaries end.

• To tighten the Subpart F Rules, stock in foreign corporations held by a foreign shareholder of U.S. corporation would be treated as constructively owned by U.S. corporation, and the “30 day rule”, which requires a 30-day holding period to create a CFC, would be eliminated.  This modification would mean that a U.S. parent would be subject to current U.S. tax on the CFC’s Subpart F income even if the U.S. parent does not own stock in the CFC for an uninterrupted period of 30 days or more during the year. The provision would be effective for tax years of foreign corporations beginning after 2017, and for tax years of U.S. shareholders in which or with which such tax years of foreign subsidiaries end.

Planning Considerations

Now that the House Ways and Means Committee has issued its bill, and as indicated by Senator Hatch, the Senate Finance Committee can be expected to prepare draft legislation that will proceed to the floor in each chamber, and then the differences between the separate bills would be resolved in a House-Senate conference committee.

Companies should determine how the provisions in the TCJA will affect their taxes and their current ways of doing business. For example, analyzing how the anti-base erosion provisions would apply to their supply chains and capital structures, and what changes to operations would be beneficial if foreign earnings can be repatriated with no additional U.S. tax would help companies determine how to plan for these possible changes.

For additional information on this topic, please contact Javier Salinas, Managing Director of International Tax at [email protected] or (415) 288-6291, or another member of BPM LLP’s International Tax Services.