The first step in Tax Reform was announced late last week. This is just a starting point in the process. There are some significant changes ahead but the initial changes announced are far from being finalized. The House Ways and Means committee is currently marking up the initial bill that is summarized below. The Senate will come out with its version later this week. We will compare the two plans to see what is similar in both plans which typically gives us a very good idea what will be in final legislation. It appears the legislation will be effective in 2018. So year end planning will be critical this year. Reach out to your Somerset advisor with any questions or concerns. Stay tuned as more updates will be forthcoming from us as the amendments to the legislation take place.
Establishment of Participation Exemption System for Taxation of Foreign Income
Deduction for foreign-source portion of dividends. The Act would replace the current-law system of taxing U.S. corporations on the foreign earnings of their foreign subsidiaries when these earnings are distributed with a dividend-exemption system.
Under the exemption system, 100% of the foreign-source portion of dividends paid by a foreign corporation to a U.S. corporate shareholder that owns 10% or more of the foreign corporation would be exempt from U.S. taxation. No foreign tax credit or deduction would be allowed for any foreign taxes (including withholding taxes) paid or accrued with respect to any exempt dividend.
The provision would be effective for distributions made after 2017.
The provision would eliminate the “lock-out” effect under current law, which encourages U.S. companies to avoid bringing their foreign earnings back into the U.S. (Act Sec. 4001)
Somerset Observation: The foreign dividend will be treated the same as a dividend from an 80% or more owned U.S. subsidiary. There will be an exclusion of 100% of the foreign dividend on the U.S. tax return. The participation exemption will replace the current foreign tax credit regime for U.S. corporations. The concept of the participation exemption is not new in international tax. The Netherlands has historically permitted participation exemptions to Dutch companies. This favorable tax treatment in the Netherlands has allowed profits to be moved freely between companies without a dividend tax. Under the U.S. current system of foreign tax credits, high tax rates in the foreign country shelter the income from additional U.S. tax. Whereas low or zero foreign tax rates (Bermuda, Bahamas, Cayman Islands, Singapore) result in additional U.S. tax on dividends paid from these countries.
Under the participation exemption, tax rates assessed on the foreign income are treated the same. Money earned in both high and low tax rate jurisdictions can be returned to the U.S. tax free. Due to the favorable tax result of no tax on foreign dividends, there are clawbacks to control stuffing profits in overseas subsidiaries. These clawbacks are described below. To qualify for the exemption, the underlying foreign earnings used to measure the dividend must be from an active business. Income from passive investments like stocks and bonds will not qualify for the participation exemption.
Repeal of Tax on Foreign Subsidiary Investments in U.S. Property
Under current law, undistributed earnings of a foreign subsidiary of a U.S. shareholder that are reinvested in U.S. property are subject to current U.S. tax. This rule prevents a U.S. corporate shareholder from avoiding U.S. tax on the distribution of earnings from a foreign subsidiary by instead reinvesting those earnings in U.S. property.
Somerset Observation: The old law prevented a U.S. controlled foreign corporation from using its untaxed foreign earnings to purchase real estate in Hilton Head South Carolina. Upon purchase of U.S. property, the U.S. shareholders were liable for a U.S. tax on the foreign earnings. Because the foreign earnings would no longer be taxable under the participation exemption proposal, a U.S. controlled foreign corporation can reinvest in U.S. property without triggering additional U.S. taxes.
Limitation on Losses with Respect to Foreign Subsidiaries
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 its foreign subsidiary – but only for purposes of determining the amount of a loss (and not the amount of any gain) on any sale or exchange of the foreign subsidiary. (Act Sec. 4003)
Somerset Observation: If the parent sells the foreign stock in a later year, exempt dividends will reduce the basis of the foreign stock and prevent a double deduction.
Treatment of Deferred Foreign Income upon Transition to the New Participation Exemption System—Deemed Repatriation
Under the Act, U.S. shareholders owning at least 10% of a foreign subsidiary generally would include in income for the subsidiary’s last tax year beginning before 2018 the shareholder’s pro rata share of the net post-’86 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.
The portion of the E&P comprising cash or cash equivalents would be taxed at a reduced rate of 12%, while any remaining E&P would be taxed at a reduced rate of 5%.
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% of the total tax liability due. (Act. Sec. 4004) .
Somerset Observation: For mature Fortune 500 corporations primarily in the tech and pharmaceutical industries with piles of cash and property overseas, their untaxed earnings residing overseas at the end of the fiscal year beginning before 2018 will be taxed at the rate of 12% or, if there is no cash left in the foreign company, 5%. These U.S. corporations can elect to pay the U.S. tax over a period of eight years. While prior earnings are subject to these rules, future earnings will be eligible for the participation exemption.
Modifications Related to Foreign Tax Credit System
Repeal of indirect foreign tax credits. 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.
The provision would be effective for tax years of foreign corporations beginning after 2017 and for tax years of U.S. shareholders in which or with which such tax years of foreign subsidiaries end. (Act Sec. 4101)
Somerset Observation: Under current law companies in high tax jurisdictions were able to repatriate profits tax free by claiming a credit against U.S. tax for foreign taxes paid on the earnings repatriated. The participation exemption eliminates the need to compute these indirect credits. The participation exemption could reduce state income taxes in a state where the indirect credit was not available or in a state that did not allow a deduction for foreign source dividends.
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.
Under the Act, income from the sale of inventory property produced within and sold outside the U.S. (or vice versa) would be allocated and apportioned between sources within and outside the U.S. solely on the basis of the production activities with respect to the inventory.
The provision would be effective for tax years beginning after 2017. (Act Sec. 4102)
Somerset Observation: The sourcing of inventory sales to a country outside the U.S. was used by companies to enhance their foreign tax credit by including 50% of their export profit as foreign source, even though no foreign jurisdiction assessed an income tax on the export profit. With the repeal of the foreign tax credits for most corporate taxpayers, this strategy may not be a critical source of zero taxed foreign source income to utilize foreign tax credits. If the property is produced in the U.S. , 0% instead of 50% of the export profit will be foreign source.
Prevention of Base Erosion
Current year inclusion by U.S. shareholders with foreign high returns. Under the Act, a U.S. parent of one or more foreign subsidiaries would be subject to current U.S. tax on 50% of the U.S. parent’s foreign high returns. Foreign high returns would be the excess of the U.S. parent’s foreign subsidiaries’ aggregate net income over a routine return (7% plus the Federal short-term rate) on the foreign subsidiaries’ aggregate adjusted bases in depreciable tangible property, adjusted downward for interest expense. Foreign high returns would not include, among other things, income effectively connected with a U.S. trade or business and subpart F income.
The provision would be effective for tax years of foreign corporations beginning after 2017 and for tax years of U.S. shareholders in which or with which such tax years of foreign subsidiaries end. (Act Sec. 4301)
Somerset Observation: This is one of two clawbacks to control the favorable participation exemption. Taxpayers would be required to compute a hypothetical excess foreign income and pay tax on the excess. These rules prevent stuffing foreign profits in the overseas subsidiary, especially in a country like Ireland where the tax rate is even lower than the proposed 20% U.S. tax rate. The return is measured, not by the return on the fair market value of the assets, but rather on the tax basis of the assets. The proposed clawback will increase recordkeeping of the earnings and the assets held in the overseas subsidiaries.
Limitation on Interest Deduction by Domestic Corporations with International Intercompany Debt
The deductible net interest expense of a U.S. corporation that is a member of an “international financial reporting group” would be limited under the Act to the extent the U.S. corporation’s share of the group’s global net interest expense exceeds 110% of the U.S. corporation’s share of the group’s global earnings before interest, taxes, depreciation, and amortization (EBITDA). An international financial reporting group is a group of entities that includes at least one foreign corporation engaged in a trade or business in the U.S. or at least one domestic corporation and one foreign corporation, prepares consolidated financial statements, and has annual global gross receipts of more than $100 million.
The provision would be effective for tax years beginning after 2017. (Act Sec. 4302)
Somerset Observation: Foreign owned companies may lose a portion of their interest deduction. Instead of just considering the debt on the books of the U.S. subsidiary, the numbers will be combined with the parent in a foreign country. This proposed rule will require that the global group analyze the U.S. Corporation’s share of global EBITDA to determine the U.S. portion of deductible interest expense. This proposal will increase the recordkeeping of the global group and require information to be shared among its members.
New Tax on Certain Payments from Domestic Corporations to Related Foreign Corporations
In order to prevent shifting of profits to foreign affiliates, the Act would provide 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 or amortizable asset would be subject to a 20% 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 provision would apply only to international financial reporting groups (as defined by Act Sec. 4302) with payments from U.S. corporations to their foreign affiliates totaling at least $100 million annually.
The provision would be effective for tax years beginning after 2018. (Act Sec. 4303)
Somerset Observation: The second clawback rule to prevent stuffing profits in a foreign corporation is a new excise tax of 20% on payments by a U.S. corporation to its foreign affiliate for a deductible item. This excise tax will be a disincentive to shift profits to the foreign affiliate from the U.S. by enhancing the income of the foreign subsidiary with related party payments. To avoid the assessment of the excise tax on the U.S. Corporation, the foreign affiliate can absorb the liability by filing a Form 1120 F and pay the 20% corporate income tax on its profits. The foreign affiliate liability will likely be less than the 20% excise tax. Transfer pricing rules are not going away. But this proposed rule has more bite than current transfer price rules.
Interest Charge Domestic International Sales Corporation
Change in tax rates, but no direct change to taxation of these special purpose export entities.
Somerset Observation: With the lowering of the individual rate on active pass through income from S corporations and partnerships from 39.6% to 25%, the tax rate arbitrage of charging a commission on a manufacturers export sales through an IC DISC has been reduced from 19.6% to 5%. For architects and engineers with revenue from projects outside the U.S. the tax advantage remains 19.6%.