On November 9, 2017, the Senate Finance Committee released the details of its version of the tax reform plan entitled the Description of the Chairman's Mark of the “Tax Cuts and Jobs Act” (TCJA) (referred to herein as the “Senate Plan”).
The House tax reform bill, originally released on November 2, 2017, underwent two amendments before being approved by the Ways and Means Committee (the “House Bill”). See BPM’s previously-issued summary of the international tax provisions by clicking here. The references to the House Bill in the discussion below incorporate those amendments.
The House of Representatives voted on and passed the House Bill on November 16, 2017. The changes to the House Bill as passed bring the cost of the legislation down to a $1.4 trillion revenue loss, an amount within the agreed limits in the budget, in part by modifying the transition rules on the treatment of deferred foreign income.
The Senate Plan, by contrast, does not currently comply as written with what is known as the “Byrd Rule,” which prevents the Senate from passing tax and spending measures on simple majority votes if they increase budget deficits beyond 10 years. As discussed below, the Senate Plan provides for different treatment with respect to some of the international tax proposals contained in the House Bill, and includes some significant, novel proposals.
The Senate Plan is currently undergoing consideration in a “markup” process the week of November 13.
The following summary of the TCJA focuses on certain provisions of the international tax proposals, highlighting both the more significant, novel proposals in the Senate Plan and where the Senate Plan differs with those provisions of the House Bill.
Corporate Tax Rate
The House Bill provides that after 2017 there would be a 20% flat corporate tax rate and a 25% flat rate for personal service corporations.
The Senate Plan proposes that after 2018 there would be a 20% flat corporate tax rate and the special tax rate for personal service corporations would be eliminated.
Transition Tax on Accumulated Foreign Earnings
Deduction for Foreign-Source Portion of Dividends
The adoption of a territorial tax system proposed in the TCJA includes a one-time transitional tax on accumulated foreign earnings. The House Bill provides for a 100% deduction for the foreign-source portion of dividends received from certain foreign corporations in which a U.S. shareholder holds a 10% interest, subject to a six-month holding period, and no foreign tax credit would be permitted for foreign taxes paid or accrued with respect to a qualifying dividend.
The Senate Plan also includes the 100% deduction for the foreign-source portion of dividends received by 10% U.S. shareholders of certain foreign corporations, but the Senate Plan extends the holding period requirement to one year instead of six months. Likewise, under the Senate Plan, no foreign tax credit would be permitted for foreign taxes paid or accrued with respect to a qualifying dividend.
The above changes would be effective for tax years of foreign corporations beginning after December 31, 2017, and for tax years of U.S. shareholders in which or with which such tax years of foreign corporations end.
Deemed Dividend Treatment for Accumulated Foreign Earnings
With respect to accumulated foreign earnings, the House Bill imposes a tax 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 14% for cash, cash equivalents, or certain other short-term assets, and 7% for illiquid assets (e.g., property, plant and equipment).
Both the House Bill and Senate Plan propose that the U.S. shareholder could elect to pay the transitional tax over a period of up to eight years. However, the House Bill provides that such payments may be made in equal annual installments of 12.5% of the total tax liability due, whereas the Senate Plan proposes payments under the elective plan with the eight-year installment payments back-loaded (8% in the first five years, 15% in year six, 20% in year seven and 25% in year eight). Additionally, the Senate Plan proposes that accumulated foreign earnings held in cash or cash equivalents and in illiquid assets be deemed repatriated and taxed at 10% and 5%, respectively.
The Senate Plan includes provisions not included in the House Bill: the limitations period for assessment of tax on such mandatory inclusions would be extended to six years (instead of three), and it provides for a recapture rule imposing a 35% tax rate on mandatory inclusions of a U.S. shareholder that becomes an expatriated entity (under the section 7874 inversion rules) within 10 years of the Senate Plan’s enactment.
Changes Affecting the Foreign Tax Credit System
Repeal of Indirect Foreign Tax Credits
The House Bill 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 December 31, 2017, and for tax years of U.S. shareholders in which or with which such tax years of foreign subsidiaries end.
The Senate Plan provides for these same changes to the foreign tax credit system. Additionally, the Senate Plan provides for a separate foreign tax credit limitation basket for foreign branch income. Foreign branch income is the business profits of a U.S. person attributable to any qualified business units in one or more foreign countries. This provision would be effective for tax years beginning after Dec. 31, 2017.
Inventory Sales Sourcing Rules Changed
The House Bill 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 Senate Plan is consistent with these House Bill provisions. This proposed change would be effective for tax years beginning after December 2017.
Anti-Base Erosion Rules
Through anti-base erosion measures, Congress is proposing taxes meant to address activities of U.S. companies—especially pharmaceutical and technology businesses—that transfer intangible assets to low-tax countries outside the U.S. to reduce their overall tax bills.
“High Returns” Tax
The House Bill imposes current U.S. tax on 50% of a U.S. shareholder's aggregate net CFC income in excess of high returns from tangible assets. 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. This provision would effectively create a 10% tax on foreign subsidiaries with high profits. 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.
Tax on “Global Intangible Low-Tax Income”
To address the same issue, the Senate Plan proposes a new, 12.5% tax on the foreign income that U.S. companies generate from patents, copyrights and other intellectual property (IP). In other words, the Senate Plan would require that U.S. shareholders of CFCs be subject to current U.S. taxation at a 12.5% rate on “global intangible low-taxed income” (GILTI) similar to how Subpart F income is recognized.
Under the plan, the new tax would be applied to a company’s foreign income regardless of whether the IP is located in the U.S. or abroad. For example, a U.S. company selling pharmaceuticals in France would have the same 12.5% tax rate regardless of whether its patent is held in the U.S. or Ireland. The purpose is to encourage U.S. companies to keep their existing patents in the U.S. and move those abroad to the U.S. tax-free (from a U.S. tax perspective) to take advantage of the U.S. legal system and patent protection. This new tax on GILTI would be applicable in addition to the proposed, lower 20% corporate tax rate on all domestic profits.
Under a related provision, corporate U.S. shareholders generally would be entitled to a deduction equal to 37.5% of any GILTI plus other foreign-derived intangible income. Combined, these provisions amount to a 12.5% tax regime that would impose current taxation on the net income of a CFC that generally exceeds a routine rate of return on the CFC’s tangible depreciable business assets.
The Senate concept is similar, but not identical to, the “patent box” systems used by countries such as the U.K. to offer discounted tax rates on income that can readily be moved from one country to another.
This proposal would be effective for tax years of foreign corporations beginning after December 31, 2017, and for tax years of U.S. shareholders in which or with which such tax years of foreign corporations end.
Other noteworthy base erosion prevention measures in the Senate Plan include:
- An incentive to migrate IP to the United States. For certain distributions of IP held by a CFC on the date of enactment, the fair market value of the property on the date of the distribution would be treated as not exceeding the adjusted basis of the property immediately before the distribution. If the distribution is not a dividend, a U.S. shareholder's adjusted basis in the stock of the CFC with respect to which the distribution is made would be increased by the amount (if any) of the distribution that would, but for this proposal, be includible in gross income. Stated differently, this proposal eliminates the potential tax on distributing IP back to the United States, which may in some cases encourage relocation of intangibles back to the United States if there are no foreign tax consequences to such a distribution. The provision would apply to distributions made by the CFC before the last day of the third tax year of the CFC beginning after December 31, 2017.
- A tax on base erosion payments. The Senate Plan does not include the provision in the House Bill providing an excise tax on domestic corporations making payments to foreign affiliates, with an election by the foreign corporation to avoid the excise tax by paying U.S. corporate income tax. However, the Senate Plan has a provision intended to reach a similar result: the “base erosion minimum tax.” This base erosion minimum tax effectively requires a domestic corporation that makes deductible payments to a foreign affiliate to pay the higher of (a) a tax equal to 10% of its income without any deduction for such otherwise deductible payments to its foreign affiliate ("base erosion payments") and (b) its regular corporate tax liability (reduced only by the R&D tax credit).
The base erosion minimum tax applies to domestic corporations that have annual gross receipts in excess of $500 million (for the three prior tax years) and that has a "base erosion percentage" of 4% or higher for the taxable year. The base erosion percentage means, for any taxable year, the percentage determined by dividing the corporation’s base erosion tax benefits by the total deductions allowed with respect to the corporation. The tax would apply to base erosion payments paid or accrued in tax years beginning after December 31, 2017.
- A broader definition of “U.S. shareholder.” The Senate Plan proposed definition of “U.S. shareholder” would include a person who owns 10% or more of a foreign company’s stock by value (in addition to those who own 10% or more by vote, which is the test under current law) for the purposes of determining whether a foreign corporation is a CFC and for purposes of the various changes described above.This change would take effect for taxable years beginning before January 1, 2018.
- Hybrid payment rules. The Senate Plan would deny a deduction with respect to certain payments of interest or royalties between related parties where the recipient is not required to include the payment in income under the tax law of its country of residence, is allowed a deduction with respect to such amount, or is a “hybrid entity” (i.e., is treated as a pass-through entity for U.S. tax purposes but not for foreign tax purposes, or vice versa).
- Outbound transfers of IP rules. The Senate Plan confirms IRS authority providing that upon an outbound transfer of foreign goodwill or going concern value, a U.S. transferor would be subject to either current gain recognition or to a special rule that requires inclusion of deemed royalties following such transfer, even if the value of the transferred property was created exclusively through offshore activities. The Senate Plan likewise confirms the IRS’s authority to specify the method to be used to determine the value of the IP transferred.
Proposed Modifications to Subpart F Rules
Select modifications contained in the House Bill include:
- 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. The Senate Plan is consistent with these proposed changes.
- 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. The Senate Plan is consistent with these proposed changes.
- 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. The Senate Plan is consistent with these proposed changes.
- The House Bill would repeal rules on investments in U.S. property. By contrast, the Senate Plan includes a new proposal with respect to investments in U.S. property. The requirement in Subpart F that U.S. shareholders recognize income when earnings are repatriated in the form of increases in investment by a CFC in U.S. property (e.g., loans by a CFC to its U.S. shareholder) would be amended to provide an exception for domestic corporations that are U.S. shareholders in the CFC either directly or through a domestic partnership. The proposal is effective for taxable years of CFCs beginning after December 31, 2017, and for taxable years of U.S. shareholders in which or with which such taxable years of the foreign corporations end.
The Senate Plan does not currently comply with what is known as the “Byrd Rule,” which prevents the Senate from passing tax and spending measures on simple majority votes if they increase budget deficits beyond 10 years. In other words, the Senate would need 60 votes to pass the bill as currently drafted, and Republicans currently hold 52 Senate seats.
While provisions are being discussed and clarified in the markup process, companies should determine how the provisions in the TCJA will affect their taxes and their current ways of doing business. For example, by 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, companies would be in a better position to 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.
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