Territorial Tax Regime
Consistent with both the House bill and Senate bill, the Act will implement a territorial tax system intended to reduce the scope of income subject to U.S. tax for domestic corporate taxpayers. This is largely achieved via the application of a foreign dividend exemption (akin to a European participation exemption) whereby foreign-source dividends paid by a foreign corporation to a U.S. corporate shareholder would be fully deductible for U.S. tax purposes upon receipt, provided that (i) the U.S. corporate shareholder has owned 10% or more of the foreign corporation for at least one year, and (ii) the dividend is not tax deductible to the foreign corporation for local tax purposes. No foreign tax credit (or deduction for foreign taxes) would be generated in respect of foreign taxes paid or accrued with respect to such exempted dividends.
Transitioning from the U.S.'s current worldwide tax system to a territorial tax regime will significantly change the cash tax impact of repatriating offshore earnings. The tax benefits enjoyed by multinational taxpayers with offshore tax deferral structures could be minimized, and such taxpayers should consider the comparative benefits of restructuring in light of this significant change and the other provisions discussed here.
Mandatory Repatriation Pipeline
As part of the transition to a territorial tax system, all foreign earnings currently accumulated offshore by certain U.S. corporate taxpayers are mandatorily deemed repatriated to the United States at a reduced tax rate of 15.5% for cash earnings (up from 14.5% in the Senate bill) and 8% for earnings invested in non-cash assets, such as property, plant, and equipment (up from 7.5% from the Senate bill). This one-time "toll charge" would be imposed regardless of whether the earnings were physically transferred to the United States.
The amount of earnings subject to the toll charge is the greater of post-1986 through 2017 accumulated earnings and profits as of November 2, 2017 or December 31, 2017. This amount cannot be reduced by distributions during the 2017 taxable year, unless the distributions were made to another foreign corporation subject to the toll charge. Treasury has broad discretion to (i) avoid double counting of earnings subject to the toll charge, and (ii) limit abusive earnings planning by taxpayers attempting to avoid the toll charge.
A U.S. shareholder recognizing the deemed or actual repatriation may elect to pay the tax liability over an 8-year period, in annual installments of 8% of the toll charge for the first 5 years, 15% of the toll charge for the sixth year, 20% of the toll charge for the seventh year, and 25% of the toll charge for the eighth year.
The mandatory repatriation pipeline likely negates the tax deferral incentive for keeping previously accumulated foreign earnings outside of the United States. Based on whether there is a commercial or financial need to access such offshore cash, U.S. shareholders could perceive this toll charge as either a tax holiday opportunity or a punitive tax burden. In light of the Treasury's broad authority to adjust earnings subject to this mandatory tax, taxpayers who may be liable for the toll charge should closely consider their current earnings position.
Interest Expense Limitations
The Act imposes more restrictive limitations on the interest deductions that may be taken by U.S. corporate taxpayers. In particular, U.S. entities will only be allowed to deduct net business interest expense up to a defined limit effectively equal to 30% of EBITDA for tax years 2018 through 2021 and 30% of EBTI thereafter. This limitation would apply to interest expense incurred in connection with both related party and unrelated party debt. The interest expense must be related to a business, which includes that which is properly allocable to a trade or business and excludes certain activities, such as performing services as an employee, a real property trade or business, and regulated utilities. Small businesses with average annual gross receipts of less than $15 million will be exempt from these limitations, and any disallowed interest expense can be carried forward indefinitely.
The Act notably abandoned the worldwide debt cap rules that were proposed in the House bill and Senate bill, which would have disallowed a U.S. corporation's net interest expense to the extent it exceeded its share of the worldwide group's aggregate net interest expense.
The Act is more restrictive than current rules with respect to a U.S. corporation's ability to reduce its taxable earnings via interest expense deductions. Thus U.S. entities and multinational groups that implement debt-leveraged acquisitions and intercompany debt pushdown arrangements should evaluate how this reduced deductibility will impact their effective tax rates.
Controlled Foreign Corporations: GILTI and FDII
Each person who is a U.S. shareholder owning 10% or more (as measured by vote or value) of a controlled foreign corporation (CFC) must include in income the global intangible low-taxed income (GILTI) earned by the CFC. For a C corporation that is a U.S. shareholder of a CFC, the effective U.S. tax rate on GILTI is projected to be 10.5% through 2025, and 13.125% thereafter.
Each domestic corporation (including a domestic corporation that is a U.S. shareholder of a CFC) is eligible for a reduced effective tax rate, instead of the normal 21% corporate income tax rate, on its foreign-derived intangible income (FDII). For a domestic corporation (including a domestic corporation that is a U.S. shareholder of a CFC), the effective tax rate on its FDII is projected to be 13.125% each year through 2025, and 15.625% thereafter, according to an illustration in the Explanatory Statement, although the actual mathematical result would appear to be 16.40625% thereafter.
By imposing the new tax on the GILTI of foreign subsidiaries, and reducing the otherwise applicable tax on the FDII of domestic corporations, these provisions in tandem are designed to encourage domestic corporations to retain their intangible property onshore.
1. Current Inclusion of Global Intangible Low-Taxed Income for U.S. Shareholders of CFCs
The Act requires each person who is a U.S. shareholder of a CFC to include in gross income the GILTI of the CFC, in addition to phantom subpart F income that is already subject to inclusion under current law.
A deduction is available to a U.S. corporate shareholder of a CFC, of 50% of the GILTI for taxable years beginning after December 31, 2017 and before January 1, 2026, which is thereafter reduced to 37.5% for taxable years beginning after December 31, 2025. After taking into account the corporate income tax rate of 21% and this deduction, the resulting effective U.S. tax rate on GILTI is 10.5% each year through 2025, and 13.125% thereafter.
A foreign tax credit is also available to a U.S. corporate shareholder of a CFC up to 80% of the foreign taxes properly attributable to the CFC tested income (defined below), in a separate basket, without carryover.
The inclusion of GILTI applies to each person who is a U.S. shareholder. However, the deduction and the credit are available only to a C corporation that is a U.S. shareholder. It appears that a U.S. non corporate shareholder of a CFC must include all GILTI at its, his, or her tax rate without benefit of the deduction or the credit.
The GILTI is computed by starting with the CFC's net tested income (generally consisting of gross income other than income effectively connected with a U.S. trade or business, subpart F income, dividends from related persons, and foreign oil and gas extraction income), and then subtracting a 10% assumed rate of return on its qualified business asset investment (generally consisting of the CFC's average aggregate adjusted bases in specified tangible property used in its trade or business).
These provisions are effective for taxable years of foreign corporations beginning after December 31, 2017, and for taxable years of U.S. shareholders in which or with which such taxable years of foreign corporations end.
2. Deduction for Foreign Derived Intangible Income of U.S. Corporations; Deduction for GILTI of U.S. Corporate Shareholders of CFCs
The Act provides domestic corporations with a deduction resulting in reduced effective rates of U.S. tax on their FDII (defined as the portion of their intangible income, determined under a formula, derived from serving foreign markets). The Act also provides U.S. corporate shareholders of a CFC with a deduction for the GILTI earned by the CFC, as described above.
A domestic corporation, in taxable years beginning after December 31, 2017 and before January 1, 2026, is allowed a deduction of 37.5% of FDII, which is reduced to 21.875% of FDII for taxable years beginning after December 31, 2025. Taking into account the 21% corporate income tax rate, the domestic corporation's effective U.S. tax rate on FDII is 13.125% each year through 2025, and should be 16.40625% thereafter, although the illustration in the Explanatory Statement refers to 15.625% thereafter.
By comparison, as described above, a U.S. corporate shareholder of a CFC has a resulting effective U.S. tax rate on GILTI of 10.5% each year through 2025, and 13.125% thereafter. The Explanatory Statement to the Act notes that, because of the 80% foreign tax credit described above, the minimum foreign tax rate with respect to GILTI, at which no U.S. residual tax is owed by the U.S. corporate shareholder of a CFC, would be 13.125% through 2025; and foreign tax rates on GILTI between 10.5% and 13.125% through 2025 would result in total combined foreign and U.S. tax rates between 10.5% and 13.125%. It is not clear whether this math is correct.
These deductions for FDII and GILTI are available only to C corporations that are not RICs or REITs.
If the sum of a domestic corporation's FDII and GILTI amounts exceeds its taxable income determined without regard to this provision, then the FDII and GILTI for which a deduction is allowed are reduced. The reduction in FDII equals such excess multiplied by a ratio of the FDII divided by the sum of FDII and GITL. The reduction in GILTI is the remainder of such excess.
Base Erosion and Anti-Abuse Tax
The Act includes a new base erosion and anti-abuse tax (BEAT). The BEAT is substantially the same as the anti-base erosion provision contained in the Senate bill. It applies to domestic corporations (other than S corporations, RICs, and REITs) that are part of a group with at least $500 million of annual domestic gross receipts (measured over a rolling three-year period) and have a "base erosion percentage" over a predetermined threshold (generally 3%). Broadly speaking, base erosion percentage is (i) the aggregate of a taxpayer's base eroding payments (nearly all deductible payments or payments made to acquire depreciable or amortizable property) to foreign related persons, divided by (ii) the aggregate allowable deductions for the taxable year, subject to certain exclusions.
For affected taxpayers, incremental tax liability under the BEAT for a particular taxable year is equal to the excess of (i) 10% (5% for 2018) of the taxpayer's "modified taxable income" (MTI) over (ii) the taxpayer's regular federal income tax liability for the taxable year, reduced by certain tax credits. MTI is a taxpayer's taxable income, adjusted by adding back base eroding payments made to foreign related parties (including the portion of any NOL carryback or carryover that comprises such payments). Subject to a narrow exception, base eroding payments do not include payments that are includable in cost of goods sold. Other notable exclusions include payments for certain services that are provided at cost, payments subject to U.S. withholding tax under Chapter 3 of the Code, and payments with respect to certain derivatives.
Banks and registered securities dealers are subject to a modified version of these rules that casts a wider net by applying a lower base erosion percentage and a higher MTI rate.
For taxable years beginning after 2025, the MTI rate used to calculate the incremental tax will increase from 10% to 12.5%, and regular income tax liability will be reduced by all credits (rather than just certain credits, as mentioned above). These changes make it more likely, in any given case, that there will be an excess of MTI over regular tax liability (and, thus, incremental tax imposed under the BEAT).
The BEAT affects both U.S.-parented and foreign-parented multinational companies and implicates most intercompany payments. Notably, because cost of goods sold is generally not included in base eroding payments, purchases of inventory from foreign affiliates typically would not push a taxpayer into a taxable position under the BEAT. The provision of services by foreign affiliates at cost should be similarly benign. However, there are ambiguities as to the scope of the exclusion for services provided at cost and uncertainties about how it will work in practice. Affected companies will need to undertake detailed modeling to determine the impact of the BEAT on their effective tax rates, and regulatory guidance will be critical in addressing the statutory ambiguities.
In addition to the complexity and ambiguity of the BEAT itself, it is accompanied by expanded Form 5472 reporting requirements and increased penalties for non-compliance (increasing from $10,000 to $25,000 for taxable years beginning after December 31, 2017).