The Senate’s version of the Tax Cuts and Jobs Act (TCJA) was passed on December 2 by a vote of 51 to 49 and makes fairly consistent fundamental changes to the tax treatment of US manufacturing companies with operations abroad, as compared to the House version. The Senate version, however, appears to add additional complexity and sophistication on the international tax provisions.
Importantly, both the House and Senate need to come together to pass final legislation in identical form before it can be signed into law by the president, including agreement as to effective dates of the various aspects of the tax reform.
Similar to the House’s approach, the Senate’s approach to tax reform includes the switch of the US tax system to a hybrid territorial regime that would provide a 100-percent dividends received deduction on future foreign source dividends and replace the US’s existing worldwide tax system, under which US corporations’ earnings and profits (E&P) are deferred until distributed or deemed repatriated under the US subpart F or passive income regime. This shift to a territorial regime will require US multinationals to repatriate the estimated $2.6 trillion of foreign earnings held overseas.
But while the new territorial system is very different from the old worldwide system, there are aspects of the worldwide system woven into the Senate bill, just as in the House bill. Overall, there appears to be a hybrid approach to territoriality, as we have seen with other countries.
We’ve laid out some ways the TCJA will impact our manufacturing clients with foreign subsidiaries. That said, here are some key elements of the bill, some of which are positive for our manufacturing clients and some of which are negative or neutral:
Tax on mandatory deemed repatriation, with bifurcated rates. To shift to a new tax regime, US corporations will have to do a level set. The Senate bill requires that a US multinational with 10 percent-owned foreign subsidiaries must generally include its subsidiaries’ post-86 net E&P (through 2017 for calendar year taxpayers) into income. The portion of the E&P that is cash or cash equivalents is taxed at a 14.49 percent rate (14 percent in the House bill), while non-cash assets are taxed at a rate of 7.49 percent (seven percent in the House bill). The taxes can be paid over an eight-year period, but the timing of payments differ in that the House bill provides for payment in eight equal installments; the Senate bill back-ends the payment of the tax. S corporations are also subject to the repatriation tax with the net amount flowing up to the shareholders; however, deferral of this mandatory deemed repatriation is available to S corporations in certain instances.
100-percent deduction for foreign-sourced dividends. After 2017, both the Senate and House bills replace the current worldwide system where a C corporation is not taxed on subsidiaries’ foreign earnings until those are distributed (deemed or actual). Instead, both bills introduce a dividend exemption system. It is noted, however, that the participation exemption is not available to a C corporation for the sale of foreign stock. For S corporations and partnerships, the ability to benefit from the dividend exemption system is not available, which is a negative element of the proposed tax reform. There is, however, a 23-percent deduction for qualified pass-through business.
Modifications to the US subpart F and foreign tax credit regimes. US subpart F limits the deferral of US taxation of certain passive income earned outside the United States by controlled foreign corporations. The House bill introduced a new subpart F provision around high-margin income, such as earnings from intellectual property, which would be taxed at a 10-percent rate (50 percent of income taxed at 20-percent rate) less a foreign tax credit for 80 percent of foreign income taxes regardless of whether or not that income is distributed to the US multinational.
The Senate bill introduces a new subpart F provision around “global intangible low-taxed income” (or GILTI), and offers a 50 percent deduction for such income and the ability to offset any US tax with an 80 percent foreign tax credit. This expansion of the existing US subpart F rules is likely to be viewed as unfavorable to those who have high margin/low taxed income streams in their foreign operations, as it is a reversion back to a worldwide tax regime approach.
Further, the Senate bill permits a 37.5 percent deduction for “foreign derived intangible income” which will encourage taxpayers to situate intellectual property in the United States. On the foreign tax credit front, there will be separate baskets added for the House’s high-margin income, as well as baskets for the Senate’s GILTI income noted above and foreign branch income – the separate basketing minimizes a taxpayer’s ability to mix high and low taxed income for purposes of calculating foreign tax credit limitations. These modifications to Subpart F will increase the compliance burden on US multinationals.
Preventing erosion of the US tax base through interest expense limitations and taxes on certain related party payments. While the TCJA aims to shift to the territorial tax regime by generally taxing income where it is earned, there is a focus on maintaining the US corporate tax base as well. Both the House and Senate versions of tax reform include the US tax base preservation mechanism around limiting net interest expense. The House version looks to EBITDA for limitation purposes, while the Senate version looks to a “debt-to-equity differential percentage.” Additionally, the House bill focuses on large taxpayers in this regard and the Senate bill does not differentiate as to the size of a taxpayer. Both bills, however, aim to apply the rules without regard to whether or not a taxpayer is foreign-owned, as is the case under the current section 163(j) earnings stripping rules.
Another US tax base preservation measure under the TCJA relates to certain excise (House version) or add-on minimum taxes (Senate version) for US multinationals that make significant related party payments to foreign affiliates. These measures are perceived to be broad in nature. Given the strong resistance to the House Blueprint’s border adjustment tax from the summer of 2016, there could be modifications to these anti-base erosion measures during Conference Committee.
Interest charge domestic international sales corporation (IC-DISC) may go untouched. Earlier versions of the Senate bill repealed the IC-DISC provisions, which allow for certain export incentives for domestic goods sold outside of the US based on tax rate differentials. The Senate bill passed on December 2nd adopted a provision to restore IC-DISC provisions, which effectively does not repeal or modify existing IC DISC provisions.
As noted, US tax reform is a fast-moving process: the 1986 tax reform bill was years in the making—the TCJA is compressed into mere months. The final tax reform bill will require agreement as to the differences noted above—we anticipate that each taxpayer will face unique opportunities and challenges once the final legislation is passed into law. We encourage clients to talk with us about the opportunities and challenges they face under the new system.
Lynette Stolarzyk is Principal, Midwest Region International Tax Leader, at global advisory firm Baker Tilly.