On November 2, 2017, the House of Representatives released the Tax Cuts and Jobs Act (the “Bill”). The Bill includes a broad set of proposed changes to overhaul the current U.S. tax system, including rules on how foreign income and foreign persons would be taxed. The Bill’s key proposals relating to the taxation of foreign income and foreign persons are summarized below.
- Establishment of Participation Exemption System for Taxation of Foreign Income
Deduction for foreign-source portion of dividends received by domestic corporations from specified 10-percent owned foreign corporations (Section 4001 of the Bill).
Under the proposed exemption system, 100 percent of the foreign source portion of dividends distributed by a foreign subsidiary to a U.S. corporate shareholder that owns 10 percent or more of the voting stock of the foreign corporation would be exempt from U.S. taxation. No foreign tax credit or deduction would be permitted for any foreign taxes (including withholding taxes) paid or accrued with respect to any exempt dividend, and no deductions for expenses properly allocable to an exempt dividend (or stock that gives rise to exempt dividends) would be taken into account for purposes of determining the U.S. corporate shareholder’s foreign-source income. The Bill also includes a 6-month holding period requirement along with certain other ownership requirements for the U.S. corporate shareholder to claim the exemption. In addition, the exemption does not apply to dividends received from a passive foreign investment company (“PFIC,” as defined in IRC §1297) that is not a controlled foreign corporation (“CFC,” as defined in IRC §957(a)). This provision would be effective for distributions made after tax years ending after December 31, 2017.
Application of participation exemption to investments in United States property (Section 4002 of the Bill).
The Bill would repeal IRC §956 for U.S. corporate shareholders. IRC §956 would continue to apply to non-corporate taxpayers. This provision would be effective for tax years of foreign corporations beginning after December 31, 2017.
The Bill does not directly address situations where a CFC is owned by a U.S. shareholder that is a partnership with corporate partners but rather provides regulatory authority to the Department of Treasury and the Internal Revenue Service to address these types of situations.
Limitation on losses with respect to specified 10-Percent owned foreign corporations (Section 4003 of the Bill).
The Bill also provides that a U.S. parent would reduce the basis of its stock in a foreign subsidiary by the amount of any exempt dividends received by the U.S. parent from that foreign subsidiary solely for purposes of determining loss (but not the amount of any gain) on any sale or exchange of the foreign subsidiary stock by its U.S. parent. This provision would be effective for distributions made after December 31, 2017.
In addition, if a U.S. corporation transfers substantially all of the assets of a foreign branch (within the meaning of IRC §367(a)(3)(C)) to a specified 10-percent owned foreign corporation, i.e., any foreign corporation with respect to which any domestic corporation owns 10-percent, but does not include a PFIC that is not a CFC, the U.S. corporation would be required to include the amount of any post-2017 losses that were incurred by the branch, subject to certain limitations. Amounts included in gross income would be treated as derived from U.S. sources. This provision also includes coordination rules with IRC §367 and would be effective for transfers made after December 31, 2017.
Treatment of deferred foreign income upon transition to Participation exemption system of taxation (Section 4004 of the Bill).
The Bill also provides that U.S. shareholders owning at least 10 percent of a foreign subsidiary, generally, would include in income for the subsidiary’s last tax year beginning before January 1, 2018 the shareholder’s pro rata share of the net post-1986 historical earnings and profits (E&P) of the foreign subsidiary to the extent such E&P has not been previously subject to U.S. tax, determined as of November 2, 2017, or December 31, 2017 (whichever is higher). The net E&P would be determined by taking into account the U.S. shareholder’s proportionate share of any E&P deficits of foreign subsidiaries of the U.S. shareholder or members of the U.S. shareholder’s affiliated group. This transition tax would apply to all U.S. shareholders (as defined in IRC §951(b)) of a specified foreign corporation. For this purpose, a “specified foreign corporation” means (1) a CFC or (2) any foreign corporation in which a domestic corporation is a U.S. shareholder (determined without regard to the special attribution rules of IRC §958(b)(4)), other than a PFIC that is not a CFC.
The E&P would be classified as either E&P that has been retained in the form of cash or cash equivalents, or E&P that has been reinvested in the foreign subsidiary’s business (e.g., property, plant, and equipment). The portion of the E&P comprising of cash or cash equivalents would be taxed at a reduced rate of 12 percent, while any remaining E&P would be taxed at a reduced rate of five percent. Foreign tax credit carryforwards would be fully available, however, any foreign tax credits triggered by the deemed repatriation would be partially limited to offset the U.S. tax. No deduction would be permitted for any foreign taxes that would not be allowed as a foreign tax credit under this limitation.
At the election of the U.S. shareholder, the tax liability would be payable over a period of up to eight years, in equal annual installments of 12.5 percent of the total tax liability due.
If the U.S. shareholder is an S-corporation, S-corporation shareholders may elect to defer the payment of the transition tax until the S-corporation ceases to be an S-corporation, substantially all of the assets of the S-corporation are sold or liquidated, the S-corporation ceases to exist or conduct business, or stock in the S-corporation is transferred. Annual reporting of an S-corporation shareholder’s deferred net tax liability would however, be required.
The proposed exemption system does not appear to be a true territorial system in the sense that an exemption does not appear to be provided for income earned through a foreign branch or a foreign entity that is recognized as a partnership for U.S. tax purposes. In addition, the exemption system would not apply to non-corporate taxpayers. The transition tax on the other hand, would apply to all U.S. shareholders of specified foreign corporations (as defined above), with a limited deferral exception for S-corporation shareholders.
The proposed transition tax rates are also higher than what was previously proposed in the GOP Better Way for Tax Reform House Blueprint (the “Blueprint” included an 8.75 percent rate for cash and cash equivalents, a 3.5 percent rate otherwise).
The E&P determination dates for the transition tax (i.e., November 2, 2017, or December 31, 2017, whichever date has the higher E&P) may also prevent taxpayers from shifting or reducing E&P after November 2, 2017, to try to minimize the transition tax before the 2017 year end.
- Modification Related to Foreign Tax Credit System
Repeal of Section 902 Indirect Foreign Tax Credits; determination of section 960 credit on current year basis (Section 4101 of the Bill).
The Bill provides 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 discussed above would apply. An indirect foreign tax credit would still be allowed for any subpart F income that is included in the income of the U.S. shareholder on a current year basis, without regards to pools of foreign earnings kept abroad. This 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.
Source of income from sales of inventory determined solely on basis of production activities (Section 4102 of the Bill).
Under current rules, to determine source of income and calculate the foreign tax credit limitation, income from the sale of inventory produced (in whole or in part) by the taxpayer is sourced partially to the jurisdiction(s) where the inventory is produced and partially to the jurisdiction where title to the produced inventory passes from the taxpayer to the purchaser.
The Bill provides that income from the sale of inventory produced by the taxpayer within and sold outside the United States (or vice versa) would be allocated and apportioned between sources within and outside the United States solely on the basis of the production activities with respect to the inventory. This provision would be effective for tax years beginning after December 31, 2017.
- Modification of Subpart F Provisions
Repeal of inclusion based on withdrawal of previously excluded subpart F income from qualified investment (Section 4201 of the Bill) AND repeal of treatment of foreign base company oil related income as subpart F income (Section 4202 of the Bill).
Under current rules, U.S. shareholders of a CFC are required to currently include their allocable share of net subpart F income earned by the CFC even where no cash or property is actually distributed. Subpart F income includes foreign base company oil related income (as defined in IRC §954(g)). In addition, foreign shipping income earned between 1976 and 1986 was not subject to current U.S. tax under subpart F if the income was reinvested in certain qualified shipping investments. Under current law, such income becomes subject to current U.S. tax in a subsequent year to the extent that there is a net decrease in qualified shipping investments during that subsequent year.
Under the Bill, the imposition of current U.S. tax on previously excluded foreign shipping income of a foreign subsidiary if there is a net decrease in qualified shipping investments would be repealed. In addition, under the Bill, the imposition of current U.S. tax on foreign base company oil related income would be repealed.
Both provisions 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.
Inflation adjustment of de minimis exception for foreign base company income (Section 4203 of the Bill).
IRC §954(b)(2) provides a de minimis exception to subpart F income so that if the sum of foreign base company income and gross insurance income of a CFC for the taxable year is less than the lesser of five percent of the CFC’s gross income or $1 million, then none of the CFC’s gross income for the taxable year is treated as subpart F income.
Under the Bill, the $1 million threshold in the de minimis exception under IRC §954(b)(2) would be adjusted for inflation. This 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.
Look-thru rule for related controlled foreign corporations made permanent (Section 4204 of the Bill).
The Bill would make the look-thru rule of IRC §954(c)(6) permanent. This provision would be effective for tax years of foreign corporations beginning after December 31, 2019, and for tax years of U.S. shareholders in which or with which such tax years of foreign subsidiaries end.
Modification of stock attribution rules for determining status as a controlled foreign corporation (Section 4205 of the Bill).
For purposes of determining whether a U.S. person owns shares in a CFC and determining CFC status, IRC §958 looks at direct, indirect and constructive ownership. Under existing constructive ownership rules for purposes of determining CFC status, IRC §958(b)(4) turns off the constructive ownership rules in IRC §318(a)(3) so that a domestic partnership or estate is not treated as owning stock owned by its foreign partners or beneficiaries, a domestic trust is not treated as owning stock owned by its foreign beneficiaries and a domestic corporation is not treated as owning stock owned by its foreign shareholders. The constructive ownership rules in IRC §958(b) do not apply for purposes of determining the U.S. shareholders’ subpart F income.
The Bill would strike IRC §958(b)(4) so that the constructive ownership rules in IRC §318(a)(3) would apply to treat certain U.S. persons as owning stock owned by a related foreign person for purposes of determining CFC status. For example, under these new rules, a U.S. corporation would be treated as constructively owning stock held by its foreign shareholder if the foreign shareholder owned, directly or indirectly, 50 percent or more in the value of the stock of the domestic corporation. Subpart F income would appear to continue to be included by U.S. shareholders based on direct/indirect ownership and not constructive ownership. This 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.
Elimination of requirement that corporation must be controlled for 30 days before subpart F inclusions apply (Section 4206 of the Bill).
The Bill would remove the requirement in IRC §951(a)(1) that the foreign corporation be a CFC for an uninterrupted period of 30 days or more during the taxable year so that U.S. shareholders would be required to include their allocable share of income under IRC §951 if the foreign corporation was a CFC at any time during the taxable year. This 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 Bill’s proposals to simplify international tax rules including subpart F rules appears to have been scaled back from previous proposals. For example, the Blueprint proposed to eliminate the bulk of the subpart F rules and retain only the foreign personal holding company rules. The Bill on the other hand appears to retain foreign base company services income and foreign base company sales income as categories of subpart F income. In some respects, the Bill makes it more likely for certain entities to be treated as CFCs and in some instances, more likely for U.S. shareholders to have subpart F income. In addition, these proposed rules could potentially add additional compliance burdens.
- Prevention of Base Erosion
Current year inclusion by United States shareholders with foreign high returns (Section 4301 of the Bill).
To prevent base erosion, the Bill provides that a U.S. parent of one or more foreign subsidiaries would be subject to current U.S. tax on 50 percent of the U.S. parent’s foreign high returns. Foreign high returns would be measured as the excess of the U.S. parent’s foreign subsidiaries’ aggregate net income over a routine return (seven percent plus the Federal short-term rate) on the foreign subsidiaries’ aggregated adjusted bases in depreciable tangible property, adjusted downward for interest expense. Foreign high returns would not include income effectively connected with a U.S. trade or business, subpart F income, insurance and financing income that meets the requirements for the “active finance exception” from subpart F income under IRC §954(h), income from the disposition of commodities produced or extracted by the taxpayer, or certain related party payments. Like subpart F income, the U.S. parent would be taxed on foreign high returns each year, regardless of whether it left those earnings offshore or repatriated the earnings to the United States.
Foreign high returns would be treated similarly to currently taxed subpart F income for certain purposes of the Code, including for purposes of allowing an indirect foreign tax credit. The indirect foreign tax credits allowed for foreign taxes paid with respect to foreign high returns would be limited to 80 percent of the foreign taxes paid, would not be allowed against U.S. tax imposed on other foreign-source income (i.e., such foreign tax credits would only be allowed to offset U.S. tax on foreign high return inclusions), and would not be allowed to be carried back or forward to other tax years. This provision would be effective for tax years of foreign corporations beginning after December 31, 2017, and for the tax years of U.S. shareholders in which such tax years of foreign subsidiaries end.
Interest (Section 3301 of the Bill) AND Limitation on deduction of interest by domestic corporations which are members of an international financial reporting group (Section 4302 of the Bill).
Section 3301 was included in Title III – Business Tax Reform Subtitle D – Reform of Business-related Exclusions, Deductions, etc. section of the Bill. Section 3301 provides that every business, regardless of its form, would be subject to a disallowance of a deduction for net interest expense in excess of 30 percent of the business’s adjusted taxable income. The net interest expense disallowance would be determined at the tax filer level – for example, at the partnership level instead of the partner level. Adjusted taxable income is a business’s taxable income computed without regard to business interest expense, business interest income, net operating losses, and depreciation, amortization, and depletion. Any interest amounts disallowed under the provision would be carried forward to the succeeding five taxable years and would be an attribute of the business (as opposed to its owners). Special rules would apply to allow a pass-through entity’s unused interest limitation for the taxable year to be used by the pass-through entity’s owners and to ensure that net income from pass-through entities would not be double counted at the partner level. This provision would repeal existing interest deduction limitations in IRC §163(j) and would be effective for tax years beginning after December 31, 2017.
It should be noted that businesses with average gross receipts of $25 million or less would be exempt from the interest limitation rules described in Section 3301 of the Bill. This provision would be effective for tax years beginning after December 31, 2017. Additionally, Section 3301 would not apply to certain regulated public utilities and real property trades or businesses.
Section 4302 of the Bill includes additional interest deduction limitations applicable to certain taxpayers. The Bill provides that the deductible net interest expense of a U.S. corporation that is a member of an international financial reporting group would be limited to the extent the U.S. corporation’s share of the group’s global net interest expense exceeds 110 percent of the U.S. corporation’s share of the group’s global earnings before interest, taxes, depreciation, and amortization. This limitation would apply in addition to the general rules for disallowance of certain interest expense under Section 3301 of the Bill. Taxpayers would be disallowed interest deductions pursuant to whichever provision denies a greater amount of interest deductions. Any disallowed interest expense would be carried forward for up to five tax years, with carryforwards exhausted on a first in, first out basis. For this purpose, an international financial reporting group is a group of entities that (1) includes at least one foreign corporation engaged in a U.S. trade or business or at least one domestic corporation and one foreign corporation, (2) prepares consolidated financial statements, and (3) has average annual global gross receipts for the three reporting year period ending with such reporting year of more than $100 million. This provision would be effective for tax years beginning after December 31, 2017.
Excise tax on certain payments from domestic corporations to related foreign corporations; election to treat such payments as effectively connected income (Section 4303 of the Bill).
The Bill provides that payments (other than interest) made by a U.S. corporation to a related foreign corporation that are deductible, includible in costs of goods sold, or includible in the basis of a depreciable asset would be subject to a 20 percent 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. The excise tax would be paid by the U.S. corporation. Consequently, the foreign corporation’s net profits (or gross receipts if no election is made) with respect to those payments would be subject to full U.S. tax, eliminating the potential U.S. tax benefit otherwise achieved. Exceptions would apply for intercompany services which a U.S. company elects to pay for at cost (i.e., no markup) and certain commodities transactions. To determine the net taxable income that is deemed ECI, the foreign corporation’s deductions attributable to these payments would be determined by reference to the profit margins reported on the group’s consolidated financial statements for the relevant product line. No credit would be allowed for foreign taxes paid with respect to the profits subject to U.S. tax. Further, in the event no election is made, no deduction would be allowed for the U.S. corporation’s excise tax liability.
The Bill also includes proposed rules regarding the treatment of partnerships so that any specified amount paid, incurred, or received by a partnership which is a member of any international financial reporting group (and any amount treated as paid, incurred, or received by a partnership) shall be treated for purposes of these rules as amounts paid, incurred, or received, respectively, by each partner of such partnership in an amount equal to such partner’s distributive share of the item of income, gain, deduction, or loss to which such amounts relate.
This provision would apply only to international financial reporting groups where the average annual aggregate payment amount of such group for the three reporting year period ending with such reporting year exceeds $100 million. This provision would be effective for amounts paid or accrued after December 31, 2018.
- Provisions Related to Possessions of the United States
The Bill also includes provisions to extend (1) deductions with respect to income attributable to domestic production activities in Puerto Rico, (2) the temporary increase in limit on cover over of rum excise taxes to Puerto Rico and the Virgin Islands and (3) the American Samoa economic development credit. The proposal regarding the extension of deductions with respect to income attributable to domestic production activities in Puerto Rico would apply retroactively to tax years beginning after December 31, 2016 and before January 1, 2018. The proposal regarding the extension of the American Samoa economic development credit would have a retroactive applicability date and apply to taxable years beginning after December 31, 2016, and be extended to tax years beginning before January 1, 2023. The proposal regarding the extension of the temporary increase in limit on cover over of rum excise taxes to Puerto Rico and the Virgin Islands would apply to distilled spirits brought into the United States after December 31, 2016, and be extended to rum imported into the United States before January 1, 2023.
- Other International Reforms
Restriction on insurance business exception to passive foreign investment company rules (Section 4501 of the Bill).
The Bill provides that the PFIC exception for insurance companies would be amended to apply only if the foreign corporation would be taxed as an insurance company were it a U.S. corporation and if loss and loss adjustment expenses, unearned premiums, and certain reserves constitute more than 25 percent of the foreign corporation’s total assets (or 10 percent if the corporation is predominantly engaged in an insurance business and the reason for the percentage falling below 25 is solely due to temporary circumstances). This provision would be effective for tax years beginning after December 31, 2017.
Limitation on treaty benefits for certain deductible payments (Section 4502 of the Bill).
Section 4502, which would have limited treaty benefits for certain deductible payments, was stricken from the Bill by the Joint Committee on Taxation a day after the Bill was released.
 This Tax Alert was drafted on November 6, 2017.
 See IRC §§ 958(b)(4) and 318(a)(3) for details.
 See IRC §951(a).
 See Sections 4401 through 4403 of the Bill for additional details.
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