U.S. Tax Cuts and Jobs Act Becomes Law
On 22 December, United States President Trump signed into law an amended version of the so-called conference agreement to the Tax Cuts and Jobs Act (H.R. 1, TCJA), a massive tax reform bill that lowers business and individual tax rates, modernizes U.S. international tax rules, and provides the most significant overhaul of the U.S. tax code in more than 30 years.
One highlight of the TCJA is that it replaces the current graduated corporate rate structure with a flat 21 percent rate, effective in 2018 and fully repeals the corporate alternative minimum tax (AMT). It also permits items that are amortized under current law to be fully expensed in the year placed in service through 2022, with a phase-out of that benefit thereafter. On the offset side, it imposes new limits on the deduction for net business interest, repeals the section 199 manufacturing deduction and the deduction for state and local lobbying expenses, and disallows like-kind exchanges other than for real property.
Additionally, the TCJA moves the U.S. from a worldwide tax system to a participation exemption system by giving corporations a 100 percent dividends received deduction for dividends distributed by a controlled foreign corporation (CFC). To transition to that new system, the measure imposes a one-time deemed repatriation tax, payable over eight years, on unremitted earnings and profits at a rate of 8 percent for illiquid assets and 15.5 percent for cash and cash equivalents. The conference agreement generally follows the Senate-passed structure in establishing new base erosion prevention provisions, with modifications. It does not adopt proposals in the House and Senate bills that would have made permanent the look-through rules for CFCs under section 954(c)(6); nor does it include a proposed new section 163(n) that would have placed a further limit on interest deductions of multinational corporations by measuring U.S. interest expense and equity against the similar ratios for the worldwide group.
Other highlights include:
Multinationals having a particular interest in intangible property holdings will take note of the new provision for global intangible low-taxed income (GILTI). Under the provision, a U.S. shareholder is required to include in gross income the amount of its GILTI. However, the U.S. shareholder is allowed a deduction equal to 50 percent of the GILTI and the amount treated as a dividend by reason of the U.S. shareholder claiming a foreign tax credit as a result of the inclusion of the GILTI amount in income. GILTI is the excess of the shareholder’s net tested income over the deemed tangible income return, which is defined as the excess of 10 percent of the shareholder’s basis in tangible property used to produce tested income less the amount of interest expense allocated to net tested income. Tested income for this purpose is the gross income of the corporation determined without regard to the following exceptions: (1) the corporation’s effectively connected income under section 952(b); (2) any gross income taken into account in determining the corporation’s subpart F income; (3) any gross income excluded from foreign base company income or insurance income by reason of the high-tax exception under section 954(b)(4); (4) any dividend received from a related person (as defined in section 954(d)(3)); and (5) any foreign oil and gas extraction income and foreign oil related income, over deductions (including taxes) properly allocable to such gross income under rules similar to the rules of section 954(b)(5). The amount of GILTI included by a U.S. shareholder is allocated across all of such shareholder’s CFCs, based on each CFC’s proportionate share of tested income. In addition, the shareholder can claim a foreign tax credit for 80 percent of the taxes paid or accrued with respect to the tested income of each CFC from which the shareholder has an inclusion.
From a practical perspective, the effect of the GILTI provision is to subject a U.S. shareholder to tax (at a reduced rate in the case of U.S. corporations) on its CFCs’ combined net income above a routine equity return on tangible depreciable business assets that is not otherwise subject to U.S. tax or to foreign tax at a minimum rate or is not otherwise specifically excluded.
In addition to the immediate inclusion of GILTI, the new law allows a domestic corporation a deduction for 37.5 percent of the foreign-derived intangible income and a 50 percent deduction of the GILTI. These deductions are reduced to 21.875 percent and 37.5 percent, respectively, in taxable years beginning after December 31, 2025. Foreign-derived intangible income is an amount equal to the corporation’s deemed intangible income multiplied by an amount equal to the corporation’s foreign-derived deduction-eligible income over its total deduction-eligible income. Deduction-eligible income is the gross income of the corporation determined without regard to: (1) the subpart F income of the corporation under section 951; (2) the GILTI of the corporation; (3) financial services income; (4) any dividend received from a CFC with respect to which the corporation is a U.S. shareholder; (5) any domestic oil and gas income of the corporation; and (6) any foreign branch income (as defined in section 904(d)(2)(J)) of the corporation, over the deductions (including taxes) properly allocable to such gross income.
Deemed intangible income is the excess of a corporation’s deduction eligible income over 10 percent of the basis in its tangible depreciable property used to produce deduction-eligible income. Foreign-derived deduction eligible income means with respect to a taxpayer for its taxable year, any deduction-eligible income of the taxpayer that is derived in connection with (1) property that is sold by the taxpayer to any person who is not a U.S. person and that the taxpayer establishes to the satisfaction of the Secretary is for a foreign use or (2) services provided by the taxpayer that the taxpayer establishes to the satisfaction of the Secretary are provided to any person, or with respect to property, not located within the United States. For this purpose, the terms sold, sells, and sale include any lease, license, exchange, or other disposition of property.
Practically, FDII is intended to represent a domestic corporation’s income in excess of a routine return, determined on a formulaic basis, that is derived from serving foreign markets. When the deductions for FDII and GILTI are combined with the tax imposed under the GILTI provision, the effect is to subject domestic corporations to tax at a reduced rate on net income in excess of a routine return derived in connection with sales to, or services performed for, foreign customers, whether that income is earned by the corporation or its CFCs. It should also be noted that the FDII and GILTI deductions are not available for individuals, RICs, REITs, or S corporations.
If a U.S.-parented group holds its IP offshore, any returns from exploiting that IP will be taxed at a rate of at least 10.5 percent (and potentially higher considering foreign tax and the ability to receive a foreign tax credit for only 80 percent of foreign taxes). If the same group holds its IP in the United States, the 37.5-percent FDII deduction for sales and services income provided to unrelated foreign persons, effectively provides an ETR of at least 13.125 percent on returns to the same IP. The small rate differential (ignoring potential foreign tax) significantly decreases the advantage under current law of holding IP offshore. It should be noted however that the law as signed by the President did not include a provision that would have temporarily incentivized the onshoring of IP by providing for the nontaxable transfer of IP from CFCs to U.S. shareholders. As such, U.S. multinational may still be likely to maintain existing offshore IP in existing offshore IP holding structures.
The legislation represents the most historic tax reform enacted since the Tax Reform Act of 1986. The professionals at Align will remain fully engaged as the Treasury Department and the IRS begin the regulatory process to implement the legislation and we welcome the opportunity to work with clients in navigating this crucial path.
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