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International Provisions of the Tax Cuts and Jobs Act of 2017

On November 16, 2017 the US House of Representatives passed the Tax Cuts and Jobs Act (TCJA). The US Senate Finance Committee approved its own version of the bill that is now headed to the Senate floor. The House and Senate versions of the bill have some differences. Once the US Senate passes a bill, the House and Senate versions of the bill will be reconciled in Conference. Under the Budget reconciliation process the bill can be passed in the Senate by simple majority.

Both bills contain several provisions that affect international investments. This is a summary of the main international provisions being considered by Congress:

Participation Exemption and Repeal of 902

Unlike most industrialized countries, the United States taxes income of US companies distributed by foreign companies and provides a foreign tax credit to eliminate double taxation. The limitations on the foreign tax credit and the complexity of the rules has been regarded as an obstacle to the competitiveness of US companies doing business overseas. The TCJA establishes a territorial system where dividends from 10% owned foreign corporations are 100% exempt from corporate tax. If this proposal becomes law it will be, without a doubt, one of the most important transformational changes of the United States tax system.

The proposal establishes a “participation exemption” that is widely used by most European and other developed countries and replaces the indirect tax credit system under IRC Section 902 that is repealed. Under the TCJA, no foreign tax credit would be allowed for any foreign taxes (including withholding taxes) with respect to exempt dividends. There is a six-month holding period requirement for the participation exemption. Passive Foreign Investment Companies (PFICs) that are not Controlled Foreign Corporations (“CFCs”) are not covered by the new system.

Unlike other countries, the participation exemption does not consider any amount as non-deductible expenses and does not provide for a switch-over clause for low taxed income.

The Senate version of the bill has a similar provision but the participation exemption is subject to a one-year holding period and denies benefits for “hybrid dividends”. The anti-hybrid dividend rule echoes similar provisions adopted by other countries based on Action 2 (Hybrid Mismatch Arrangements) of the Organization for Economic Co-Operation and Development (OECD) BEPS[1] Project. Hybrid dividends are those received by a US 10% shareholder that create a deduction (or that carry another tax benefit) for the foreign company (e.g. deductible as interest for the foreign CFC). Also, under the Senate version of the bill, hybrid dividends between CFCs would be subpart F income.

Subpart F will be retained with some modifications and a mandatory repatriation tax will be imposed on earnings and profits currently held in foreign corporations. The bill also creates a minimum anti-base erosion tax on foreign income. These items are discussed below.

Tax on Accumulated Foreign Earnings

Deferred foreign income is subject to a mandatory repatriation tax. The tax rates are 14% for earnings held in cash and cash equivalents and 7% for all other earnings. Taxpayers may elect to pay the tax over eight years. Deferred foreign income includes all earnings for taxable years beginning before January 1, 2018. The calculation of the deferred foreign income is made taking into account the higher amount calculated as of November 2, 2017 and December 31, 2017.

The tax applies to US Shareholders[2] of CFCs and of 10/50 Corporations.

The Senate version of the bill imposes the same tax but rates of 10% and 5% respectively.

Inventory Sales Sourced Solely on Production

The sale of inventory is currently sourced based on rules under IRC Section 863 that take into account the place of production and of sale of the inventory. Under TCJA only production activities will be taken into account to determine the source of the income. For instance, sale of inventory in the United States but produced outside the United States will be foreign source income.

Subpart F

Under Section 951 of the IRC, subpart F inclusions require an uninterrupted 30-day ownership of the stock of the CFC. The TCJA eliminates this requirement. Hence, United States shareholders are required to include subpart F items in gross income if a foreign corporation is a CFC at any time during a taxable year.

The CFC-look through rules under IRC 954 (c) (6) will become permanent under the TCJA. This provision was originally enacted in 2006 and has been extended several times (once retroactively). It was scheduled to sunset in 2019. The provision provides that dividends, interest, rents, and royalties that one CFC receives from a related CFC are not treated as foreign personal holding company income and it has become a staple in international tax planning (usually in tandem with check-the-box election) for multi-national companies since it allows for intercompany transactions between CFCs without triggering subpart F.

Foreign base oil-related income is no longer subpart F under the TCJA. This means that processing, transporting, or distributing oil and gas in a foreign country other than the country where the oil or gas was extracted is no longer Foreign Base Company Income.

The de minimis exception threshold for Foreign Base Company Income will be subject to periodic inflation adjustment. Currently the de minimis threshold is 5% of gross income or $1 Million. This last amount will now be periodically adjusted for inflation.

Foreign Branches

Under the Senate version of the bill, foreign branch income will be allocated to a specific foreign tax credit basket (e.g. a separate basket for foreign tax credit purposes). The TCJA does not contain a similar provision.

Another change under the TCJA is that if a foreign branch incorporates in a foreign country by transferring substantially all its assets to a foreign corporation[3], an amount equivalent to the branch’s foreign loss must be included in gross income.

Global Minimum Tax

Some of the most important provisions in the TCJA are related to tax erosion including a new global minimum tax. The House version of TCJA includes a tax on “foreign high return amounts”. This provision eliminates deferral on certain earnings of US shareholders of CFCs. The provision requires these shareholders to include in gross income 50% of the foreign high return amount while the Senate version of the bill eliminates deferral on “global intangible low-taxed income” or “GILTI”. In this last case, the mechanism requires US shareholders to include in gross income the excess of the shareholder’s net CFC tested income over the shareholder’s net deemed tangible income return where tangible income is ten percent of the shareholder’s pro rata share of qualified business assets of each CFC.

Export Incentive

The Senate version of the TCJA also provides for a tax incentive that lowers tax on corporations to the extent that exports increase relative to domestic sales. The TCJA provides a tax subsidy contingent on exports not dissimilar to the provisions for Foreign Sales Corporations and the Extraterritorial Income Exclusion that Congress had to repeal after the World Trade Organization ruled them illegal export subsidies.

Anti-treaty Shopping

The House version of the TCJA does not include a provision from the original version of the bill that would have limited the application reduced rates under tax treaties with respect to deductible payments to related parties if the reduced rate would not have been granted in a direct payment to the foreign parent.

Interest Expense Limitation

The House version of the TCJA limits interest expense deduction for US corporations that are part of an international financial reporting group, to the corporation’s share of the group’s EBITDA while the Senate has proposed an interest expense limitation based on US corporation’s net interest and the debt-to-equity differential percentage.

Excise Tax on Payments to Foreign Persons

The House version of TCJA imposes a 20% excise tax on payments to non-resident related parties that are deductible, includable in cost of goods sold or the depreciation of assets. The tax is payable by the US corporation making the payment, not by the recipient of the income. The excise tax does not apply if the US corporation elects to treat the payment as Effectively Connected Income. The excise tax does not apply to interest.

The Senate version of the TCJA imposes tax on the Base Erosion Minimum Amount to corporations with gross receipts of at least $500 Million other than S Corporations, Regulated Investment Companies, and REITs. The Base Erosion Minimum Amount is determined by comparing modified taxable income with taxable income, a comparison that results in a difference due to the base erosion benefit from payments to foreign related parties.

If any of these provisions becomes law it will be recommendable to analyze if they are consistent with the international obligations of the US under tax treaties (including non-discrimination provisions) and other international agreements.

Repeal of IC-DISC Provisions

The Senate version of the TCJA will repeal the IC-DISC regime.

PFICs

Under current law, the test for PFIC includes a passive income test of 75% or more of gross income but passive income does not include income from the active conduct of an insurance business if the foreign corporation would be taxed as an insurance company if it were a US entity and it is predominantly engaged in an insurance business. The TCJA limits the exception to situations where the loss and loss expense adjustments and certain reserves represent more than 25% of the assets of the foreign corporation. The new test would limit the ability of foreign insurance companies to qualify for the exception from PFIC and affects companies with limited unpaid loss reserves. Also, the definition of reserves does not include unearned premiums.

Interest Expense Apportionment

The Senate bill proposed to limit interest expense apportionment to tax basis among the members of an affiliated group and would no longer allow interest expense apportionment based on fair market value. The fair market value alternative was meant to reflect economic reality of expanding businesses with new assets and different tax basis from pre-existing business. The House version of the bill does not have a similar provision.

Definition of Intangible Property

The definition of intangible property for transfer pricing purposes now explicitly includes workforce in place, goodwill, and going concern. The definition will also apply to outbound transfers of intangible property to foreign corporations in IRC 351 transactions.
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[1] Base Erosion and Profit Shifting.
[2] 10% or more of the combined voting power of all classes of stock owned directly or by attribution.
[3] As defined by IRC 367 (a)(3)(C).

This summary covers development known as of November 15, 2017.

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