Tax Reform: Businesses (Outbound) — Part 2
As I write this next article, the House has just approved the tax bill and it now heads to the Senate where many negotiations and changes are likely to befall the act as written. However, not as much or as extensive as the press on the left will have you believe nor as little as those on the right will state; but there will be changes.
So now on to the part that was in fact titled “Title IV – Taxation of Foreign Income and Foreign Persons.” As stated in the last post, this really is aimed at those large multinational corporations that have an apparent stack of gold held outside the US waiting to be brought back in to the country to generate economic growth. Although that’s far from the truth, this is a long held Republican policy that is relatively well supported in business communities in the US.
Do not doubt for one second that with these rules it really is a sweeping change of foreign taxation of “US Inc” and their overseas operations. This is essentially taking the US corporate taxation system from one of a tax credit system to an exclusion system; which I will explain in a little more detail below. For now I am going to concentrate on the main issues that I foresee our clients encountering that will case some ongoing issues that we would need to address.
Participation Exemption for Taxation of Foreign Income
Dividend Received Deduction (DRD) on 10% owned foreign corporations (section 4001)
- This is the big ticket item that as I mentioned above is here so that US parents of foreign subsidiaries of which they own a 10% or greater interest in are encouraged to repatriate those overseas profits back to the US by way of dividend. Previously, the dividend would have been includible in taxable revenue of the US corporation with the potential to reduce your US tax exposure by way of a foreign tax credit associated with the foreign dividend and/or profits. However, the proposed regulations would exclude the dividend income entirely, which is now a similar taxing regime to the majority of other foreign countries, in particular the UK. In doing this the US are hoping to increase cash investment in the US economy from all those overseas entities in which US corporations are perceived to be hoarding profits that have not been subject to US taxation.
- This rule applies to all dividends received once historical earning and profits (E&P) of the overseas entity has been reduced to zero. The dividends extracted on historical E&P will attract a tax rate of either 12% or 5% for cash or illiquid assets respectively.
Repeal of indirect FTCs and determination of section 960 credit on current year basis (section 4101)
- Now given that the new rules are introducing an exclusion based system on dividends, it’s logical for them to adjust and repeal the ability to obtain a foreign tax credit against the income the corporation is excluding.
Modification of Subpart F provisions (sections 4201 – 4206)
- Subpart F is a part of the code that applies solely to controlled foreign corporations (CFCs) being a foreign entity that is controlled by US person(s). The rules that apply to CFCs are too extensive for this article but if you are aware of CFCs and Subpart F, then you will likely have an awareness of how those rules work. What these reforms are doing are changing very specific parts of the code that in the main do not change the overriding effect of Subpart F.
- However one important part of the changes that have caused concern here at CLA and amongst the profession is a change to their attribution rules of who owns stock for Subpart F and CFC purposes. The rules appear to attribute stock ownership to a US corporation for all overseas entities that its own shareholder owns.
- To give you an example of how these rules will work without any adjustment:
- A UK entity has four wholly owned subsidiaries in the US, Germany, Ireland and Australia;
- Under current rules, there are no CFCs subject to Subpart F for the purposes of US taxation, therefore no additional reporting or US tax considerations are in point;
- Under the new rules, the IRS will attribute stock ownership and therefore CFC status to the German, Irish and Australian entities as if owned by the US entity itself;
- So the ultimate tax consequences of these new rules are that all parts of Subpart F can apply to these entities and therefore potentially penal US tax treatment could apply with regards to their operations and at the very least created even more compliance work to be undertaken and provided to the IRS even if no immediate tax consequences are in point.
- As I’m sure you have now deduced, this potentially brings three overseas entities with no direct connection with the US in to the US tax net. Other than having common ownership with the US entity, there should be no rhyme nor reason for the IRS to have jurisdiction over these entities. This is one part of the reforms I would dearly love to see removed, adjusted and at the very least explained in more detail as to what in particular they are looking to achieving with this rule change. It will cause even more compliance burden and therefore cost to our clients that is already cause for concern for them at present.
There are also new proposals for the implementation of a base erosion profit shifting (BEPS) regime whereby an excise tax of 20% on payments made to foreign affiliates is implemented. However, the rule will only apply to what are considered “international financial reporting groups” whose payments to foreign affiliates exceed $100m annually. Given the limitation of such a scenario on our client base, I have not elaborated further on these rules.
These rules are new, yet to be tested and yet to be voted on, so many more iterations are likely to be put forward. However, there is a strong expectation that a lot of these new rules will indeed come in to effect by the end of the year given the political need of this administration to claim a victory on tax reform and for them to push through the promise that was made on their campaign.
As many people have commented this new regime takes what was a ‘worldwide’ taxing system, to one that is akin to a ‘territorial’ based taxing system. However, this new territorial based system only seems to apply to corporations and/or businesses and I see no evidence yet that they are looking to move to a territorial based and residency based system for individuals.
Which leads me nicely to what will be our next article, hopefully before the first of the American holidays of the holiday season, Thanksgiving. I will look to outline the key aspects of these new reforms and how they will affect the individual taxpayers, with particular focus on those international aspects our clients encounter.
As ever, any questions or comments please feel free to get in touch and I’ll be sure to respond.