The U.S. House of Representatives unveiled the details of their tax reform framework in a 429-page bill dubbed as the “Tax Cuts and Jobs Act” last Thursday.
As anticipated, this initial bid to sell tax reform ideas to the public contains some provisions consistent with the concepts introduced in the previous framework. However, there are a few surprises that are quite novel and perplexing even to the minds of seasoned tax professionals, where its implementation remains unclear.
Many tax experts think that the provisions involving international transactions are the most controversial with serious and far-reaching repercussions on multinational enterprises. What follows is an analysis of the international tax aspects of the bill and comments on how it could potentially affect international business.
The bill has 20 provisions related to international taxation but only a handful are seen to have significant impact on businesses. Other than the 20% income tax rate reduction for corporations, the major proposals for the international system include: (1) implementing a territorial tax system; (2) imposing a transition tax on accumulated foreign earnings; (3) a new anti-deferral provision; (4) limitations on interest expense deduction; and (5) new excise tax on importations and payments to foreign corporations.
Here are the significant changes to the international tax system:
Borrowing ideas from the Europeans, the bill introduces the so-called Participation Exemption system for taxation of foreign income. Under this system, the current rule on taxing US corporations on the foreign earnings of their foreign subsidiaries where these earnings are distributed would be replaced with a dividend-exemption system. Therefore, there is a 100% exemption for foreign-source dividends – the bill would exempt 100% of the foreign-source portion of dividends received by a US corporation from a foreign corporation in which the US corporation owns at least a 10% stake. It is worth noting that the bill does not extend similar exemption to foreign branches nor to capital gains.
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. Furthermore, 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 US corporate shareholder’s foreign-source income.
The idea behind this provision is to allow US multinational enterprises (MNEs) to compete on a more level playing field against foreign MNEs by eliminating another layer of taxation which foreign MNEs are not liable to, according to the drafters. This says that earnings generated outside the US are outside US taxing jurisdiction. While this may be a sound attempt at territoriality (concept of taxation), it is interesting to note that this is the only provision in the entire bill promoting this idea. The rest of the bill is a continuation of the US’s word-wide taxation concept or the nationality-based rule of taxation.
The bill proposes a mandatory toll charge on tax-deferred foreign earnings. A one-time transitional tax would be imposed on US 10%-shareholder’s pro-rata share of the foreign corporation’s net post-1986 tax-deferred earnings to the extent that such earnings have not been previously subject to US tax determined as of November 2, 2017 or December 31, 2017 (whichever is higher).
The rate will be 12% (in the case of accumulated earnings held in cash, cash equivalents or certain other short-term assets) or 5% (in the case of accumulated earnings invested in illiquid assets such as property, plant and equipment). The net E&P would be determined by taking into account the US shareholder’s proportionate share of any E&P deficits of foreign subsidiaries of the US shareholders or member of the US shareholder’s affiliated group. Meaning, foreign corporations with a post-1986 accumulated deficit would be able to offset the deficit against tax-deferred earnings of other foreign corporations. The US shareholder could elect to pay the transitional tax over a period of up to eight years.
The idea behind this provision of deeming unrepatriated earnings as repatriated is to eliminate the tax advantage of keeping these earnings outside the US.
The bill attempts to expand the anti-deferral rules under Subpart F by imposing a 50 percent tax on US parent’s Foreign High Returns (FHR). FHR is a new term which means the aggregate net Controlled Foreign Corporation (CFC) income (excluding income from commodities, subpart F income, active finance income qualifying under Section 954(h) and 954(i), insurance income and certain related-party payments) in excess of extraordinary returns from tangible assets.
FHR would not include income effectively connected with a US trade or business, subpart F income, insurance and financing income that meets the requirements for the active financing exemption (AFE) from subpart F income under current law, income from the disposition of commodities produced or extracted by the taxpayer, or certain related-party payments. This proposed rule imposes tax on FHR each year, just like the subpart F rules, regardless of whether the earnings are left offshore or repatriated to the US.
This appears to be a form of a minimum tax on excess return based on some formula. It is still unclear how this will be implemented.
The new proposed rules on interest expense deduction will impact international business with the introduction of multiple limitations through revisions to current Section 163(j) and new Section 163(n).
Section 163(j) would be revised and expanded to limit the deduction for net interest expense of all businesses. The limitation would apply to net interest expense that exceeds 30% of adjusted taxable income (ATI).
The new Section 163(n) limits the deduction for net interest expense of domestic corporations that are part of an international financial reporting group. The deduction for net interest expense of a US corporation is limited to 110% of the corporation’s share of the group’s net interest expense. To determine the limitation, the US corporation’s EBITDA is compared to the worldwide EBITDA of the group. These provisions modify other provision of the tax codes such as NOL. Note that US companies subject to the limitation of the two provisions must choose the one that disallows the greater amount of interest deduction.
Interest disallowed under either provision may be carried forward up to five years using the first-in, first-out basis. The provision is limited to groups with average annual gross receipts in excess of $100 million over three-year period.
The bill introduces a new excise tax on payments made to foreign related parties. A 20% excise tax is imposed on all deductible payments except interest paid to a related foreign company. Covered payments are those that are deductible, includible in cost of goods sold, or includible in the basis of a depreciable or amortizable asset unless the related foreign company elected to treat those payments as effectively connected income (ECI) and thus taxable in the US.
If the ECI election were made to treat the payments as taxable in the US, the income would be taxed on a net basis. This provision would apply only to international reporting groups with payments from US corporations to their foreign affiliates totaling at least $100 million annually. This provision will take effect after 2018. So, there is a grace period provided.
Under this rule, it appears that payments (to the related foreign party) for royalties, services and even amounts paid for goods or assets that are depreciable or amortizable are subject to tax. This indeed sounds burdensome, however it is interesting to note that the concept introduced in this particular provision seems a variant of the now-abandoned destination-based cash flow tax that was earlier floated around by the House GOPs. Ultimately, this features a border adjustment tax. We will see if this will pass under WTO scrutiny.
While only a few provisions on international tax have significant impact, the proponents of the bill seem to have come up with proposals worth debating in the name of simplifying the internal revenue code and providing tax breaks to both individuals and businesses.
The tax reform bill purports to simplify the tax code and provide respite to businesses, in particular. However, in its current form, it is far from simplifying the code as new concepts are introduced which yet add another layer to the already complex internal revenue code. Moreover, instead of giving breaks to businesses, the bill in fact imposes a net additional tax burden to MNEs upwards of $60 billion over a 10-year period based on the scoring by the Joint committee on Taxation.
The provisions discussed above are merely proposals which in the coming days, and perhaps, months will be debated, modified and even withdrawn altogether. Let the discussion begin and see what happens.
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