Establishment of Participation Exemption System for Taxation of Foreign Income and Transition Tax
Under current law, a U.S. person generally is not subject to U.S. tax on foreign income earned by a foreign corporation in which it owns shares until that income was distributed to the U.S. person as a dividend.
The Tax Cuts and Jobs Act will replace the current-law system of taxing U.S. C-corporations on the foreign earnings of their foreign subsidiaries when these earnings are distributed with a dividend-exemption system.
The Act provides a 100% deduction for foreign-source portion of dividends received from “specified 10-percent owned foreign corporations” by U.S. C-corporate shareholders. 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. 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. This exemption does not apply to dividends received from a passive foreign investment company that is not a controlled foreign corporation.
This provision would be effective for distributions made after tax years ending after December 31, 2017. The Act also imposes a one-time transition tax on a U.S. 10% shareholder’s pro rata share of unremitted post-1986 accumulated foreign earnings. The portion of the unremitted post-1986 accumulated foreign earnings held in cash or cash equivalents is taxed at a reduced rate of 15.5% while the remaining accumulated foreign earnings are taxed at 8%. If the foreign corporation’s post-1986 tax deferred earnings is equal to the greater of earnings as of November 2, 2017 or December 31, 2017, the U.S. shareholder may elect to pay the mandatory tax over eight years or less (with a balloon payment schedule in the last three years). In the case of any S-corporation shareholder, the net tax liability may be deferred until the S-corporation changes its status, sells substantially all of its assets, ceases to conduct business, or the electing shareholder transfers its S corporation stock.
Somerset Observation: U.S. domestic C-corporations that own foreign corporations will see the benefit of the participation exemption. The transition tax would apply to all U.S. shareholders of specified foreign corporations with a limited deferral for S-corporation shareholders whereas the participation exemption only applies to U.S. C-corporations. Whether it makes sense for a flow-through entity or individual to form a U.S. C corporation to invest in a foreign corporation will depend on the industry and the type of income earned. For example, individuals and flow-through entities that invest in foreign corporations could be taxed at their capital gains marginal rate on foreign dividends received from a treaty country or at their ordinary marginal rate on foreign dividends received from a non-treaty country. The top marginal rates range from 20% on capital gains to 37% on ordinary income.
Modifications Related to Foreign Tax Credit System
Because of the participation exemption, the Act repeals indirect foreign tax credits. Indirect taxes are the foreign taxes paid by the foreign corporation. Rather than paying tax on the net dividend, corporations under current law could gross up their dividend by the foreign taxes and claim a tax credit on their U.S. return for these underlying taxes. Under the Act, 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 Act Sec. 4001 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.
Somerset Observation: The repeal of the indirect foreign tax simplifies the computations and is consistent with allowing the participation exemption.
Prevention of Base Erosion
Base erosion refers to payments between a domestic corporation and related foreign parties that are deductible for U.S. tax purposes. Generally, withholding payments are required unless reduced or eliminated under a treaty. If the withholding tax was eliminated altogether, the deductible payments reduce the U.S. base. Accordingly, under pre-Act law, there was no minimum tax required on these payments.
Under the Act, certain corporations are required to pay a minimum tax equal to the excess of 10% (5% for one tax year for base erosion payments paid or accrued in tax years beginning after December 31, 2017) of the modified taxable income over an amount equal to the regular tax liability reduced (but not below zero) by the excess (if any) of an adjusted amount of credits allowed.
Somerset Observation: A base erosion payment generally means any amount paid or accrued by a taxpayer to a foreign person that is a related party of the taxpayer and with respect to which a deduction is allowable, including an amount paid or accrued by the taxpayer to a foreign related party of depreciable or amortizable property. Generally we expect the related party will be a foreign owner of the U.S. Corporation. The 10% rate increases to 12.5% for taxable years beginning after December 31, 2025.
Global Intangible Low-Taxed Income
Under current law, a U.S. person generally was not subject to U.S. tax on foreign intangible income.
Under the Act, a U.S. holder of any controlled foreign corporation (CFC) would be subject to current U.S. taxation on its global intangible low-taxed income (GILTI). A U.S. shareholder’s GILTI inclusion equals the excess, if any, of (i) its aggregate pro rata shares of certain net items of its CFCs over (ii) 10% of its aggregate pro rata shares of its CFCs’ bases in certain tangible property. In the case of a domestic corporation, a deduction is allowed equal to the sum of: (A) 37.5% of the foreign-derived intangible income (FDII) of the domestic corporation for the tax year, plus (B) 50% of the GILTI amount (if any) which is included in the gross income of the domestic corporation. If any amount is includible in the gross income of a domestic corporation, such domestic corporation is allowed credit against its U.S. tax equal to 80% of certain foreign income taxes that are paid by CFCs and properly attributable to GILTI items.
Somerset Observation: This rule reduces the benefit of the participation exemption, likely impacting the high tech industries that collect royalty payments.
Change in Rule for Sourcing Income from Sales of Inventory
Under current law, in determining the source of income for foreign tax credit purposes, up to 50% of the income from the sale of inventory property that is produced within the U.S. and sold outside the U.S. (or vice versa) may be treated as foreign-source income.
For tax years that begin after Dec. 31, 2017, 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.
Somerset Observation: This rule works both ways: if income is included in the U.S. return that is produced outside the U.S. it is foreign source income. This rule eliminates one of the easier rules for U.S. corporations to utilize excess foreign tax credits.
Expansion of Definition of “U.S. Shareholder”
The Act expands the definition of “U.S. shareholder” to also 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.
Elimination of 30-Day Minimum Holding Period for CFC
Under current law, any U.S. shareholder of a CFC is subject to current U.S. tax on its pro rata share
of the CFC’s subpart F income, but only if the U.S. shareholder owns stock in the foreign corporation for an uninterrupted period of 30 days or more during the year.
Under the Act, a U.S. shareholder is subject to current U.S. tax on the CFC’s subpart F income even if the U.S. shareholder does not own stock in the CFC for an uninterrupted period of 30 days or more during the year.
Under current law, a taxpayer could reduce the tax rate on export profits from their top marginal rate (highest rate of 39.6%) to the top capital gain rate (highest rate of 20%) by forming an IC DISC.
Under the Act, the tax savings has been narrowed from the top marginal rate of 37% to the top capital gain rate of 20%.