How Trump’s Tax Reform Is Changing Tax Reporting Foreign Companies
Congress voted to enact one of the most sweeping U.S. tax reform bills on December 20, 2017. This bill is called the Tax Cuts and Jobs Act (TCJA) and will revamp the U.S. international tax system and reduce business taxes.
The intention of TCJA, according to proponents in Congress, is to boost U.S. businesses by making changes to how they are taxed. The legislation passed through Congress rapidly, but many of its ideas have been advanced by TCJA’s authors for over a decade. Important provisions of TCJA include a permanent reduction in the U.S. federal corporate income tax rate from 35% to 21%, reduced tax rates for many U.S. businesses that are organized as S corporations, limited liability companies (LLCs) and partnerships, the ability to expense the full cost of equipment bought through 2023, and many changes to the U.S.’s international tax rules.
The TCJA may well spur US M&A activity, by raising after-tax rates of return on investment in US companies. However, the new law’s impact on even routine corporate transactions can vary dramatically—for better or for worse—depending on precisely how those transactions are structured. The Act also has a disparate impact on differently situated businesses. In effect, the Act’s authors give:
U.S. Merger and Acquisition activity may increase due to TCJA through raising after-tax rates on investment in U.S. companies. However, even routine corporate transactions can be impacted by TCJA. These impacts can occur for better or for worse on routine transactions depending on precisely how those transactions are structured. Differently situated businesses can also have a disparate impact due to TCJA. TCJA authors give:
- Rate reductions and accelerated expenses to S companies with significant U.S. operations.
- Reduced tax rates of up to 15.5% to S multinationals. They will also receive a territorial system and will repatriate hundreds of billions of dollars.
- New anti-avoidance rules targeting historically accepted means of repatriating profits from the U.S. without material U.S. tax costs for non-U.S. multinationals with material U.S. operations.
U.S. Companies Investing Abroad
Territorial systems were not available for U.S. parent companies of multinational groups prior to TCJA. These territorial systems allow profits of non-U.S. subsidiaries earned overseas to be exempted from U.S. tax when those profits are repatriated to the United States. Contrary to approaches found in other major world economies, the U.S. taxed these profits at regular U.S. corporate rates even if they were repatriated back to the U.S. and gave entities credits for taxes paid overseas. The switch to a territorial system under TCJA does contain limits to ensure that most or all income of a U.S.-headed multinational group is taxed at least once, somewhere.
- Under TCJA U.S. corporations can deduct the full amount of any dividend paid to it by a non-U.S. company whom the U.S. corporation owns at least 10% of their shares. The deduction makes dividends exempt from U.S. corporate income tax.
- This benefit applies to dividends from any non-U.S. subsidiary where the U.S. corporation has a minimum of 10% interest in the non-U.S. subsidiary.
- To take advantage of the exemption, the U.S. corporation must hold its interest in the non-U.S. company for more than a year. If the company received dividends in the first year of the holding period, exemptions can apply as long as the U.S. corporation eventually holds those shares for over a year. Also, dividends paid on a hybrid instrument (equity for U.S. tax purposes, but debt for non-U.S. tax purposes) generally do not qualify for the exemption.
- TCJA makes it possible for a U.S. corporation to get the effect of a full or partial exemption. It does not, however, provide a specific exemption for a U.S. corporation’s gain from sales of shares in a 10% or more owned non-U.S. company.
- When 50% of the shares of a non-U.S. owned company are owned by large U.S. shareholders then the U.S. company must re-characterize a portion of its gain from a sale of shares of the non-U.S. company as dividends. In this case, the portion of the seller’s gain re-characterized as a dividend equals the seller’s pro rata share of any and all retained earnings of the non-U.S. company whose shares are being sold. Thus, if a non-U.S. entity has significant retained earnings and the U.S. parent sales shares of this entity, then a large part of the U.S. parent’s gains would be exempt from tax under the new rules if they were re-characterized as dividends.
- If a non-U.S. company sells a business in the form of an asset sale or similar transaction that would be treated as an asset sale for U.S. tax purposes, the U.S. parent would get an exemption from U.S. tax for all sale proceeds it received from the non-U.S. company distributing the proceeds to its U.S. parent. Balancing this U.S. tax advantage against any increase in non-U.S. tax costs that could arise due to the transaction structuring would be necessary to ensure the greatest benefit.
- A forced repatriation rule prevents territorial systems from allowing non-U.S. subsidiaries to pay dividends to their U.S. parent companies out of offshore earnings built up before 2018. Were this not the case, they could fully escape U.S. tax on those earnings. In lieu of this, Congress opted to impose a one-time U.S. tax on the above earnings at far lower rates than a U.S. parent would have paid before TCJA.
- TCJA requires U.S. shareholders that have at least a 10% interest in a non-U.S. company to include its share of the non-U.S. company’s earnings that have not been previously subject to U.S. tax in 2017. This rule applies to all 10% U.S. shareholders, including U.S. pass-through entities and U.S. individuals, though only a 10% U.S. corporate shareholder benefits from the new territorial system.
- 10% U.S. shareholders will be taxed at a 15.5% rate on non-U.S. corporation investments of its accumulated earnings in cash or cash equivalents. They will be taxed at an 8% rate on earnings that have been reinvested in non-U.S. property, plants and equipment through the non-U.S. corporation.
- When a 10% U.S. shareholder includes their offshore earnings in its income in 2017, their tax liability will be triggered. However, the U.S. shareholder can pay off this tax liability through payments over eight years. The payment schedule is as follows: 8% in each of the first five years after 2017; 15% in the sixth year; 20% in the seventh year; and 25% in the eighth year.
- Under TCJA, a U.S. parent company will have to immediately pay a U.S. income tax on a large part of profits earned by non-U.S. subsidiaries at a rate of 10.5%, increasing to 13.1% after 2025. These taxes must be paid in the year the profits were earned regardless of whether the profits are repatriated to the U.S. The only exception is when the non-U.S. subsidiary pays a material amount on non-U.S. income taxes on their profits.
- This regime applies to global intangible low-taxed income (GILTI) earned by a non-U.S. subsidiary with a U.S. parent. GILTI is the non-U.S. subsidiary’s earnings after being reduced by a formulaic amount representing the part of those earnings attributable to the non-U.S. subsidiary’s tangible depreciable assets such as machinery and equipment.
- The rate the U.S. parent must pay on its pro rata share of the non-U.S. subsidiary’s GILTI for U.S. income tax is 10.5% from 2018 to 2025. In 2026 and thereafter, the rate changes from 10.5% to 13.1%.
- A U.S. parent is allowed a credit against this U.S. income tax for 80% of the total of non-U.S. income taxes that the U.S. parent and its subsidiaries pay on their GILTI. The effect is that during the years where the parent is taxed at 10.5%, the U.S. parent will pay no U.S. income tax on its GILTI if the effective rate of non-U.S. tax imposed on such income is 13.1%. If the non-U.S. effective tax rate is under 13.1%, then the U.S. parent’s corporate group is liable to pay a combination of U.S. and non-U.S. taxes on the groups GILTI. The combined effective rates for these taxes will range between 10.5% to 13.1%. After the rate increase in 2026, the same principles apply although the combined effective rate changes range will be 13.1% to 16.4%.
- The GILTI rules apply to U.S. corporations where they are the parent of a non-U.S. corporation, and where a U.S. pass-through entity is the parent. The impact, however, is more severe for pass-through entities and U.S. individuals owning the non-U.S. subsidiary. This is due to these individuals not being eligible for the 80% tax credit addressed above.
- The TCJA does provide rate benefits for a U.S. corporation’s income that is derived directly from serving non-U.S. markets. This benefit is applicable to foreign derived intangible income (FDII) and is defined as all income a U.S. corporation derives from property sold, leased or licensed to any person that is not a U.S. person. The final rate is calculated after a reduction by a formulaic return on the tangible assets used in generating such income. From 2018 to 2025, a U.S. corporations tax rate on FDII will be 13.1% and the rate will increase to 16.4% in 2026 and will remain at that rate thereafter. This provision, along with GILTI rules incentivize U.S. multinationals to place more of their assets and operations serving overseas markets in the U.S. How strong this incentive proves to be, however, is still unclear.
Even though the new territorial system makes it attractive to invest in non-U.S. subsidiaries and JVs on balance, acquisition and investment opportunities could turn out more costly than anticipated where profits will be subject to low or no non-U.S. income taxes if there is no structuring to address new “GILTI” rules.
Non-US Companies Investing in the United States
The burdens of non-U.S. headed multinational corporate groups investing in the U.S. will increase due to multiple provisions under TCJA.
- A 10% minimum tax on any “base erosion tax benefits” derived from transactions with non-U.S. affiliates are applied to multinational corporate groups with large U.S. operations. The applicable rate is 5% instead of 10% for 2018, and it will jump to 12.5% after 2025.
- The rules only affect corporate groups where the U.S. operations generate a minimum of $500 million in average annual gross receipts. These U.S. companies must also have “base erosion tax benefits” accounting for 3% or more of the total deductions that they claim.
- Any deduction resulting from a payment by a U.S. company to a “related party” is a base erosion tax benefit. These payments can take the form of interest, royalties and services fees. A base erosion tax benefit can also come in the form of depreciation or amortization from an asset purchased from a related party. There are, however, exceptions applying to payments and related deductions under derivative contracts and routine services.
- The term “related party”, for the purposes above, includes a 25% owner of the applicable U.S. company, an individual that has over 50% ownership with the U.S. company or with a 25% owner of the company, or any other individual that is under common control with the U.S. company. There are also certain constructive ownership rules that apply related to the determination of whether an individual is a 24% owner and whether there is over 50% common ownership in the U.S. company.
- It appears the intention of the new 10% tax is to override any contrary provisions of existing U.S. tax treaties.
- This rule reaches many common transactions. For example, non-U.S. parents borrowing from capital markets or banks and then lending part or all of the proceeds to a U.S. subsidiary would experience a base erosion tax benefit on the interest on the intercompany loan.
- Banks and securities dealers are given special rules.
- TCJA no longer allows a U.S. company to receive a deduction for interest or royalty payments to a non-U.S. affiliate with over 50% common ownership with the U.S. company. This applies where the payment is not included in the income of the non-U.S. affiliate under tax laws of the country where the corporation resides, or if the affiliate is given a deduction to offset that income under such tax laws. This new rule diminishes the benefits from financing transactions through cross-border intergroups and then treating the transaction as a repo for non-U.S. tax purposes, but as debt for U.S. tax benefit purposes.
- Under TCJA, the controlled foreign corporations (CFC) rules, have been expanded where a non-U.S. parent owns both U.S. and non-U.S. subsidiaries. This provision will be effective starting in 2017 and will treat non-U.S. subsidiaries, which are sister companies to U.S. subsidiaries as CFCs.
- One result is the minimum requirement for U.S. subsidiaries, beginning in 2017 to make detailed filings on an annual basis with the IRS regarding activities of non-U.S. subsidiaries on their U.S. tax returns.
- If a U.S. subsidiary owns 10% or more of the shares of a non-U.S. sister company, the U.S. subsidiary must include its pro rata share of dividends, interest, royalties and other certain forms of income as income, if it is received from the non-U.S. sister company.
- Although Congressional commentary on TCJA indicates Congress had other intentions, a reading of TCJA shows that if a minority U.S. shareholder has ownership of 10% or more in a non-U.S. parent company that has at least one U.S. subsidiary, that shareholder could be subject to the CFC rules regarding all non-U.S. subsidiaries owned by the non-U.S. parent company. The U.S. shareholder would have to make detailed filings with the IRS and those subsidiaries. In addition, the shareholder in that case would be required to pay U.S. tax on its pro rata share of any relevant income received from any of those non-U.S. subsidiaries.
- The TCJA did nothing to alter any anti-inversion rules that were established by Congress and the Obama administration. These rules address cases where parties to cross-border merger and acquisition deals seek U.S. tax benefits by having a smaller non-U.S. entity acquire a larger U.S. merger partner in a share for share transaction. The TCJA in fact, imposes extra restrictions that are meant to make inversions even less attractive. TCJA wants to encourage U.S. companies to remain in the U.S. and will seek to penalize them if they leave the U.S. through inversions.
US Companies With Significant U.S. Operations
The biggest benefits under TCJA are given to U.S. companies investing in U.S. businesses.
- Corporate Income Tax Rate Reduction. The TCJA reduces the federal income tax to its lowest rate in almost 80 years. Although many of the cuts are temporary, the rate change from 35% to 21% is not set to expire at this time. The rate under TJCA is significantly lower than current tax rates in other countries and not much higher than others.
- Earnings From “Passthrough” Entities Deduction. Historically, U.S. taxpayers have paid tax on profits from closely held U.S. businesses at normal individual rates of up to 39.6%. While the business is not taxed itself, owners must pay the above rate. Under TCJA, such individuals will be provided a deduction that will effectually reduce their top rate of tax to 29.6% on the profits of income from pass-through entities.
- The income must be generated by business operations of entities in the U.S. to qualify for the deduction.
- Businesses must also meet payroll thresholds, and most service businesses will not be eligible for the deduction.
- Ordinary dividend income from real estate investment trusts (REITs) will also be subject to the 29.6% tax rate.
- Businesses can Expense 100% of the Cost of Newly Acquired Equipment. Under TJCA, most tangible property that has been or will be acquired between September 27, 2017 and January 1, 2023 can be fully expensed in the first year it is used in a trade or business. After January 1, 2023, tangible property acquired will be deductible up to 80% in the first year and 20% the year after. There is no special expensing available for the 2027 tax year and any subsequent years. Both new and used assets are covered under the new provision if it is the taxpayer’s first year of use.
- 30% Limit on Interest Deductions. The Act limits interest deductions to the sum of the U.S. entities business interest income for that taxable year, plus 30% of the adjusted taxable income for the company in that same tax year.
- Adjusted taxable income is computed as net income without regard to interest income or expense, depreciation and amortization. The tax years following, adjusted taxable income will take into account depreciation and amortization when calculated. for taxable years before January 1, 2022.
- Disallowed interest deductions can be carried forward to succeeding taxable year as business interest paid or accrued. There is no limit to how many years this carryforward is allowed.
- For debt issued prior to the enactment of TCJA, there is no grandfathering.
- Taxpayers can elect out of the 30% limit if they conduct a real property trade or business. However, they must claim depreciation deductions for real property over longer periods than would be available otherwise.
- To ensure the TCJA could be passed quickly, House Ways and Means Committee Chairman Kevin Brady stated, “a lot of good provisions got left on the cutting room floor”. We should expect more tax changes in future budgets, especially regarding the international tax code.
- Since this legislation passed without a vote from the Democratic Party, should they regain control of Congress, they could seek to alter the TCJA. However, previous experience shows it could be challenging to undo rate cuts or other benefits that are popular to U.S. businesses. The TCJA does also have some key elements in common with proposals brought forth by Democrats during the Obama administration.
- Many companies will want to set terms of their U.S. debt in such a manner that will allow them to optimize interest deductions due to the 30% limit. They can do this through U.S. acquisitions in the form of purchasing U.S. plants and equipment. Companies will also need to scrutinize their current and expected debt structure to ensure where they can find tax advantages.
- Structuring compensation and equity ownership arrangements for U.S. individuals working for “pass-through” entities along with international operations will need to be addressed due to the new complications emerging.
- The change to CFC rules, as well as new restrictions on debt financing and IP arrangements will force action from non-U.S. headed groups.
- TCJA together with BEPS and other initiatives creates a more complicated picture for U.S. parented and non-U.S. parented multinational groups in the future. These may cause such groups to move away from tax havens into corporate structures that maximize lightly taxed income in operating countries, one of which may be the United States. Time will tell.
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