New Tax Law Enacts Changes for Foreign Income and Foreign Persons
The new Tax Cuts and Jobs Act (TCJA) contains many provisions affecting foreign income and business relationships with companies abroad.
Here are some of the key provisions of the law. (Unless otherwise noted, the reforms apply to years starting after December 31, 2017.)
Prereform. U.S. citizens, resident individuals, and domestic corporations generally were taxed on all income, whether earned in the U.S. or abroad. Foreign income earned by a foreign subsidiary of a U.S. corporation generally wasn’t subject to U.S. tax until the income was distributed as a dividend to the U.S. corporation.
New law. The system of taxing U.S. corporations on the foreign earnings of their foreign subsidiaries when the earnings are distributed has been replaced. These changes kick in for tax years of foreign corporations that begin after December 31, 2017, and for tax years of U.S. shareholders in which, or with which, such tax years of foreign corporations end.
The law provides for an exemption for certain foreign income. This exemption is referred to as a dividends received deduction (DRD). It’s a 100% deduction for the foreign-source portion of dividends received from specified 10%-owned foreign corporations.
The foreign-source portion bears the same ratio to the dividend as the undistributed foreign earnings of the foreign corporation bears to its total undistributed earnings. In this case, a specified 10%-owned foreign corporation generally is any foreign corporation other than a passive foreign investment company that isn’t also a controlled foreign corporation (CFC) of which any domestic corporation is a U.S. shareholder.
No foreign tax credit or deduction is allowed for taxes paid or accrued with respect to a dividend that qualifies for the DRD. The deduction isn’t allowed if the domestic corporation didn’t hold the stock in the foreign corporation for a certain length of time.
The provision eliminates the “lockout” effect, which encourages U.S. companies to avoid bringing their foreign earnings back into the U.S.
The DRD is available only to C corporations that aren’t regulated investment companies (RICs) or real estate investment trusts (REITs).
Specified 10%-Owned Foreign Corporation Sales or Transfers
Prereform. When a U.S. corporation sold or exchanged stock in a foreign subsidiary, any gain might be considered a dividend to the extent that the foreign corporation had earnings and profits (E&P) that hadn’t already been taxed by the United States. If foreign business was conducted through a branch of a U.S. corporation rather than a foreign subsidiary, the corporation owed U.S. taxes on the foreign earnings and deducted losses as though they accrued directly to the U.S. parent.
New law. For dividends received, a domestic corporate shareholder’s adjusted basis in the stock of a “specified 10%-owned foreign corporation” is reduced by an amount equal to the portion of any dividend received that wasn’t taxed because of allowable dividends, but only for the purpose of determining losses on sales and exchanges of the foreign corporation’s stock.
If a U.S. corporation transfers substantially all of the assets of a foreign branch to a foreign subsidiary, any transferred losses incurred by the foreign branch must generally be included in the parent’s gross income.
Deferred Foreign Income
Prereform. U.S. citizens, resident individuals, and domestic corporations generally were taxed on all income, regardless of where it was earned. Foreign income earned by a foreign subsidiary of a U.S. corporation generally wasn’t subject to tax in the United States until the income was distributed as a dividend to the corporation.
New law. U.S. shareholders owning at least 10% of a foreign subsidiary generally must include in income their pro rata share of the net post-1986 historical E&P of the subsidiary to the extent the E&P hasn’t been taxed in the United States. This relates to the subsidiary’s last tax year beginning before 2018. The portion of the E&P comprising cash or cash equivalents is taxed at a reduced rate of 15.5%; any remaining E&P is taxed at a reduced rate of 8%.
The shareholder may elect to pay the tax in installments over up to eight years in the following manner:
8% of the tax liability for each of the first five payments,
15% for the sixth installment,
20% for the seventh installment, and
25% for the eighth installment
S Corporations and REITs
Shareholders of S corporations may elect to maintain deferral on such income until the shareholder transfers its S corporation stock or the S corporation:
Changes its status,
Sells substantially all of its assets, or
Stops conducting business.
For REITs, post-1986 E&P is excluded from the gross income tests. In addition, REITs can elect to meet their distribution requirement of accumulated deferred foreign income under the same eight-year installment plan that applies to U.S. shareholders who elect for the installment plan to pay their net tax liability resulting from the mandatory inclusion of pre–effective-date undistributed CFC earnings.
Global Intangible Low-Taxed Income (GILTI)
Prereform. A U.S. person generally wasn’t subject to U.S. tax on foreign income earned by a foreign corporation in which it owned shares until that income was distributed as a dividend. Several antideferral regimes modified this general rule. One of these exceptions was certain types of income earned by CFCs that fell under the heading of Subpart F income.
New law. For tax years of foreign corporations that begin after December 31, 2017, and for tax years of U.S. shareholders in which or with which such tax years of foreign corporations end, a U.S. shareholder of any CFC must include in gross income the excess (if any) of the holder’s net CFC-tested income over the shareholder’s net deemed tangible income return; this excess is known as global intangible low-taxed income (GILTI). This must be done in a manner generally similar to inclusions of Subpart F income. The shareholder’s net deemed tangible income return is equal to 10% of the aggregate of the holder’s pro rata share of the qualified business asset investment of each CFC in which it owns stock.
GILTI is taxed at a 10% rate and doesn’t include effectively connected income, Subpart F income, foreign oil and gas income, or certain related-party payments.
Foreign tax credits are allowed for foreign income taxes paid with respect to GILTI, but they are limited to 80% of the foreign income taxes paid and can’t be carried back or forward.
Deduction for Foreign-Derived Intangible Income and GILTI
Prereform. U.S. persons were generally taxed on all income, whether derived in the U.S. or abroad. Foreign income earned through foreign corporations was generally subject to U.S. tax only when the income was distributed as a dividend.
New law. For tax years that begin after December 31, 2017, and before January 1, 2026, a domestic corporation may deduct an amount equal to the sum of:
37.5% of the foreign-derived intangible income (FDII) of the domestic corporation, plus
50% of the GILTI amount (if any) that’s included in the gross income of the domestic corporation.
FDII bears the same ratio to the corporation’s deemed intangible income as its foreign-derived deduction-eligible income bears to its domestic deduction-eligible income.
For tax years that begin after December 31, 2025, the allowed deduction will decrease to:
21.875% of the FDII of the domestic corporation, plus
37.5% of the GILTI amount included in the gross income of the domestic corporation.
Repeal of Foreign Base Company Oil-Related Income Rule
Prereform. Subpart F income includes foreign base company income (FBCI). Foreign base company oil-related income was included in the Subpart F income of U.S. shareholders as a category of FBCI.
New law. For tax years of foreign corporations that begin after December 31, 2017, and for tax years of U.S. shareholders in which or with which such tax years of foreign subsidiaries end, foreign base company oil-related income is eliminated from FBCI.
CFC Decreased Investments
Prereform. Foreign base company shipping income that was a qualified shipping investment wasn’t included in Subpart F income. The previously excluded income was then recaptured if and when it was subsequently withdrawn from the qualified shipping investment. Although the 1986 Tax Reform Act repealed the exclusion for qualified shipping investments, the recapture provision was retained.
New law. A U.S. shareholder in a CFC that invested previously excluded Subpart F income in qualified foreign base company shipping operations isn’t required to include as income a pro rata share of the previously excluded Subpart F income when the CFC decreases such investments. This applies to tax years of foreign corporations that begin after Dec. 31, 2017, and for tax years of U.S. shareholders in which or with which such tax years of foreign corporations end.
CFC Status Attribution Rules
Prereform. A U.S. parent of a CFC was subject to U.S. tax on its pro rata share of the CFC’s Subpart F income. A foreign subsidiary is a CFC if it is more than 50% owned by one or more U.S. persons, each of which owns at least 10% of the foreign unit. Constructive ownership rules applied in determining ownership for this purpose.
New law. Constructive ownership rules are amended for the last tax year of a foreign corporation that begins before January 1, 2018, for all subsequent tax years of a foreign corporation, and for the tax years of a U.S. shareholder in which or with which such tax years end. Certain stock of a foreign corporation owned by a foreign person is attributed to a related U.S. person for purposes of determining whether the related U.S. person is a U.S. shareholder of the foreign corporation and, thus, whether the foreign corporation is a CFC.
Broader Definition of U.S. Shareholder
Prereform. A U.S. shareholder for CFC purposes was a U.S. person who owned 10% or more of the total combined voting power of all classes of stock entitled to vote of the foreign corporation.
New law. The definition of U.S. shareholder is expanded to include any U.S. person who owns 10% or more of the total value of shares of all classes of stock of a foreign corporation. This applies to the last tax year of foreign corporations beginning before January 1, 2018, and for tax years of U.S. shareholders in which or with which such tax years of foreign corporations end.
30-Day Minimum Holding Period Eliminated
Prereform. A U.S. parent of a CFC was subject to U.S. tax on its pro rata share of the CFC’s Subpart F income, but only if the U.S. parent owned stock in the foreign subsidiary for an uninterrupted period of 30 days or more during the year.
New law. A U.S. parent is subject to current U.S. tax on the CFC’s Subpart F income even if the U.S. parent doesn’t meet the ownership requirement. This applies to tax years of foreign corporations that begin after December 31, 2017, and for tax years of U.S. shareholders in which or with which such tax years of foreign subsidiaries end.
Tax Reform Tackles Base Erosion and BEATS Down on Tax Abuse
The far-reaching legislation also contains stipulations on income shifting and foreign tax. Unless otherwise noted, the changes apply to years starting after December 31, 2017.
Base erosion refers to payments between a domestic corporation and related foreign parties that are deductible for U.S. tax purposes. While a withholding tax applies to many such payments, treaties frequently reduce the withholding tax and, at times, eliminate it. If a withholding tax doesn’t apply, deductible payments of interest, royalties, and management fees reduce the U.S. tax base.
Prereform. There was no minimum tax that had to be paid on certain deductible payments to a foreign affiliate.
New law. For base erosion payments paid or accrued, certain corporations with average annual gross receipts of at least $500 million must now pay a BEAT equal to the base erosion minimum tax for the tax year.
For any tax year beginning before January 1, 2026, the base erosion minimum tax is the excess of 10% of the modified taxable income of the taxpayer for the tax year,
1. Over an amount equal to the regular tax liability reduced (but not below zero) by the excess (if any) of credits, and
2. Over an amount that includes the general business credit allowed for the tax year allocable to the research credit.
For tax years beginning after December 31, 2025, the tax is 12.5% of the modified taxable income of the taxpayer for the tax year — over an amount equal to the regular tax liability of the taxpayer for the tax year.
In other words, the regular tax liability is reduced by an amount equal to all credits allowed, including the general business credit.
Members of affiliated groups that include a bank or securities dealer will pay the BEAT tax at an 11% rate, increasing to 13.5% after 2025.
“Modified taxable income” means the taxable income of the taxpayer. It is determined without regard to any base erosion tax benefit with respect to any base erosion payment, or the base erosion percentage of any net operating loss deduction allowed.
A “base erosion payment” generally means any amount paid or accrued by a taxpayer to a foreign person that is a related party to which a deduction is allowable. This includes any amount paid or accrued to the related party in relation to the taxpayer’s acquisition from the related party of property of a character subject to the allowance of depreciation (or amortization).
Excluded are any amounts paid or incurred for services that don’t contribute significantly to fundamental risks of business success or failure and are the total services cost with no markup.
There is also an exception for certain derivative payments made in the ordinary course of a trade or business.
Foreign Tax Credit System
The new law also makes modifications related to the foreign tax credit system:
Prereform. A U.S. corporation that owned at least 10% of the voting stock of a foreign corporation was allowed a deemed-paid credit for:
- Foreign income taxes paid by the foreign corporation that the U.S. corporation treated as having paid when the income on which the foreign tax was paid was distributed as a dividend, and
- Foreign taxes paid by the controlled foreign corporation on the portion of its earnings that the U.S. shareholder was required to include in income under Subpart F.
New law. No foreign tax credit or deduction is allowed for any taxes (including withholding taxes) paid or accrued with respect to any dividend to which the deduction for the foreign-source portion of dividends applies. This is for tax years of foreign corporations that begin after December 31, 2017, and for tax years of U.S. shareholders in which or with which such tax years of foreign subsidiaries end.
A foreign tax credit is allowed for any subpart F income that is included in the income of the U.S. shareholder on a current year basis.
Separate Basket for Foreign Branch Income
Prereform. The foreign tax credit limitation was calculated separately for two categories (or “baskets”) of income:
1. Passive, and
New law. Foreign branch income must be allocated to a specific foreign tax credit basket. “Foreign branch income” refers to the business profits of a U.S. person that are attributed to one or more qualified business units in one or more foreign countries.
Foreign Tax Credit Limitation
Prereform. For purposes of the limitation on the foreign tax credit, if a taxpayer sustained an overall domestic loss for any tax year, then, for each succeeding year, an amount of U.S.-source taxable income was recharacterized as foreign-source income if it was lower than:
1. The full amount of the loss to the extent not carried back to prior tax years, or
2. 50% of the taxpayer’s U.S.-source taxable income for that succeeding tax year.
New law. For any tax year of the taxpayer that begins after December 31, 2017, and before January 1, 2028, the taxpayer may, with respect to pre-2018 unused overall domestic losses, elect to substitute, for the above 50% amount, a percentage greater than 50% but not greater than 100%.
Limits on Income Shifting through Intangible Property Transfers
Prereform. A U.S. person that transferred intangible property to a foreign corporation in an otherwise nonrecognition transaction was generally treated as having sold the property in exchange for payments contingent on the property’s productivity, use or disposition. In these cases, the U.S. transferor included an amount in income each year, over the useful life of the property.
New law. The changes address recurring issues of definition and methodology that have arisen in controversies over transfers of intangible property that use the statutory definition of “intangible property.”
The definition is revised and the IRS authority to require certain valuation methods is confirmed. The basic approach of the existing transfer pricing rules with regard to income from intangible property remains unchanged. Workforce in place, goodwill (both foreign and domestic), and going concern value are intangible property, as is the residual category of “any similar item” the value of which isn’t attributable to tangible property or the services of an individual.
New Law Takes Aim at Sourcing Income and Dividends
Income from inventory produced in the U.S. and sold abroad is no longer eligible for split sourcing but must be fully U.S.-sourced.
That rule change is among the many modifications in the Tax Cuts and Jobs Act (TCJA). Unless otherwise noted, the changes mentioned in this article are for tax years beginning after December 31, 2017.
Sourcing Income from Sales of Inventory
Prereform. In determining the source of income for foreign tax credit purposes, up to 50% of the income from the sale of inventory property that was produced within the U.S. and sold outside the U.S. (or vice versa) could be treated as foreign-source income.
New law. Gains, profits and income from the sale or exchange of inventory property produced partly in and partly outside the U.S. must be allocated and apportioned on the basis of the location of production with respect to the property.
For example, income derived from the sale of inventory property to a foreign jurisdiction is sourced wholly within the U.S. if the property was produced entirely in the U.S., even if title passage occurred elsewhere. Likewise, income derived from inventory property sold in the U.S., but produced entirely in another country, is sourced in that country even if title passage occurs in the U.S. If the inventory property is produced partly in and partly outside the U.S., the income derived from its sale is sourced partly in the U.S.
Fair Market Value of Interest Expense Apportionment
Prereform. Taxpayers had to determine U.S.-source and foreign-source income for various purposes. The Internal Revenue Code provides rules for allocating interest, etc., for those purposes.
New law. For purposes of such determinations, members of a U.S.-affiliated group can’t allocate interest expense on the basis of the fair market value of assets. Instead, the members have to allocate interest expense based on the adjusted tax basis of assets.
Stock Compensation of Insiders in Expatriated Corporations
Prereform. An excise tax was imposed on the value of the specified stock compensation held by disqualified individuals if a corporation expatriated and gains on any stock in the expatriated corporation were recognized by any shareholder in the expatriation transaction. The excise tax was 15% of the value of the specified stock compensation.
New law. For corporations becoming expatriated after the reforms are enacted, the excise tax on stock compensation in an inversion is increased from 15% to 20%.
Deduction Denied for Certain Related-Party Payments
Prereform. No deduction was allowed for losses from sales or exchanges of property (except in corporate liquidations), directly or indirectly, between certain related persons. There was no explicit disallowance of a deduction for any disqualified related-party amount paid or accrued under a hybrid transaction or by, or to, a hybrid entity. A disqualified related-party amount is any interest or royalty paid or accrued to a related party to the extent that:
1. There is no corresponding inclusion to the related party under the tax law of the country of which such related party is a resident for tax purposes, or
New law. There’s no deduction for any disqualified related-party amount paid or accrued pursuant to a hybrid transaction or by, or to, a hybrid entity. In general, a hybrid transaction is one that involves payment of interest or royalties that aren’t treated as such by the country of residence of the foreign recipient. And, in general, a hybrid entity is an entity that is treated as fiscally transparent for federal income purposes but not for purposes of the tax law of the foreign country, or vice versa.
Surrogate Foreign Dividends
Prereform. Qualified dividend income was taxed at capital gains rates, rather than as ordinary income. Generally, qualified dividend income includes dividends received during the tax year from domestic corporations and qualified foreign corporations.
New law. Any dividend received by an individual shareholder from a corporation which is a surrogate foreign corporation (other than a foreign corporation that is treated as a domestic corporation), and which first became a foreign surrogate corporation after the date the reforms are enacted, isn’t entitled to the lower rates on qualified dividends.
Restriction on Insurance Business Exception to PFIC Rules
Prereform. U.S. shareholders of a passive foreign investment company (PFIC) were taxed on the PFIC’s earnings. An exception to this rule applied to certain income derived in the active conduct of an insurance business.
New law. The test based on whether a corporation is predominantly engaged in an insurance business is replaced with a test based on the corporation’s insurance liabilities. Under the provision, passive income for purposes of the PFIC rules doesn’t include income derived in the active conduct of an insurance business by a corporation:
1. Subject to tax if it were a domestic corporation, and
2. For which the applicable insurance liabilities constitute more than 25% of its total assets as reported on the company’s applicable financial statement for the last year ending with or within the taxable year.