The Tax Cuts & Jobs Act (TCJA) has been the law for just over two months and U.S. tax accountants are in "busy season" completing 2017 tax returns. Most of the provisions of the tax overhaul apply beginning with the 2018 tax year, but U.S. individuals and companies with foreign operations were affected immediately. There's still time to develop an appropriate strategy even if your 2018 tax planning didn't include these new provisions, but it should be done sooner rather than later as an additional tax bill may be due on April 17, 2018.
Below, we briefly discuss the TCJA provisions that are applicable to companies and individuals with foreign activities.
The New Participation Exemption System of Taxation
The TCJA significantly changes the way foreign operations are taxed. The new law essentially exempts U.S. corporations from paying U.S. tax on income earned outside the U.S. through controlled foreign corporations (CFC). Under the prior law, income earned outside of the U.S. by CFCs could be subject to U.S. income tax when the funds were repatriated. This effectively created an incentive for U.S. corporations to keep foreign-earned profits outside the U.S. Starting in 2018, these dividends from CFCs can be brought into the U.S. without being taxed. This changes the U.S.'s longstanding world-wide tax system to one closer to a territorial system.
Deemed Repatriation of Foreign Earnings
Under the new TCJA all previously untaxed foreign profits will be included on the company's 2017 tax return as "Subpart F income." The U.S. company is allowed a calculated deduction. The income will effectively be taxed at either 8% for profits where there is no cash position in the foreign company or 15.5% for profits where the foreign corporation has cash. Then, any available foreign tax credits can be applied. If foreign tax credits are insufficient to cover the tax, taxpayers can elect to pay the tax over eight years with the majority payable in the last couple of years. In addition to the eight-year election, there are certain mechanisms that could defer the tax longer or even eliminate it.
While the tax burden is not as significant as we initially thought it would be, the tax compliance reporting will be complicated. A new revision of Form 5471 will likely be required, along with a new withholding obligation related to sales of foreign companies. This change may delay the 2018 filing season because the reporting and related taxes will be on 2017 tax returns, and the IRS has had no time to make necessary updates. If you are an individual facing the 2017 repatriation tax, you should ask your tax advisor about elections to mitigate the tax amount.
Foreign Tax Credit
Prior law allowed taxpayers with deemed or actual dividends from foreign corporations to offset related income tax with taxes paid in the foreign jurisdiction. The foreign source income will no longer be taxed and the TCJA disallows much of the credit attributable to foreign source income. It also disallows the previously available alternative deduction of those foreign taxes. However, a taxpayer may offset some of the impact of the deemed repatriation of foreign earnings, as described above, using foreign tax credits.
Global Intangible Low-Taxed Income (GILTI)
Since dividends of foreign source income will now escape U.S. taxation, Congress recognized the potential for companies to move certain profits into foreign companies. To mitigate this risk, the TCJA introduced a new code section that taxes certain income earned by these CFCs if the income is attributable to intangible assets located in low-tax jurisdictions. GILTI seeks to tax the foreign income in the U.S. at half of the new corporate rate and allows as much as 80% of their foreign taxes paid to offset it. The spirit of this provision seems intended to prevent relocation of intangibles offshore, however the mechanics can make the tax applicable to any company, with or without intangibles, in certain situations.
Base Erosion Anti-Abuse Tax (BEAT)
In addition to Congress' crack-down on payments of U.S.-deductible expenses to a related party outside the U.S., they have created a new tax on large corporations with gross receipts of more than $500 million. This tax would be imposed in a similar fashion to the repealed AMT on corporations with base erosion payments that rise to a level that implies that profits are leaking offshore.
Sales of Partnership Interests by Nonresident Individuals and Foreign Corporations
Nonresident individuals and foreign corporations are generally taxed in the U.S. only on income that is effectively connected with a U.S. trade or business (ECI). Capital gains are typically not treated as ECI and therefore are taxed only in a taxpayer's home country. In 2017, the IRS lost a case in Tax Court (Grecian Magnesite v. Commissioner) in which the Court found in favor of the taxpayer who took the position that gains on sales of partnership interests are not subject to U.S. taxation based on the above principles. Going forward, the TCJA reverses the tax court's ruling and codifies the IRS' long-standing position, which taxes these capital gains as if the underlying assets of the business were sold. Thus, gains on sales of partnerships by foreign partners are taxed as if they were ECI instead of capital gains. There may be an opportunity to amend 2014-2016 tax returns to claim the Tax Court's 2017 position. Taxpayers may also be able to take the favorable case position during 2017 on sales prior to the effective date of TCJA.
More Changes May Still Lay Ahead
We think it is likely that, as the TCJA is applied, Congress will discover issues that necessitate a technical corrections bill in the future. For instance, currently, the tax code imposes a 30% withholding rate on certain types of income paid to foreign corporations if there is no specific treaty rate. It seems likely Congress would decrease this withholding rate to the new 21% corporate tax rate.
The tax advisors at Williams Benator & Libby will continue to monitor these and any legislative changes and share update with our clients and friends of the firm, as necessary. If you have any questions as you review or revise your tax strategy, we encourage you to contact your trusted WBL international tax advisors.
