Until enactment of the new tax law, the United States had the highest corporate tax rate among countries who are members of the Organization for Economic Cooperation and Development. Due to this high tax rate, US corporations frequently kept foreign-generated earnings overseas because they generally remained untaxed until repatriated to the US. By setting-up foreign corporations to operate its foreign businesses, a US corporation typically could defer tax on the foreign earnings until the foreign corporation paid dividends to the US corporate shareholder. There were, however, certain anti-deferral tax regimes under the old law that were designed to tax currently foreign passive income and certain highly mobile forms of foreign-sourced income generated by a foreign corporation, even if the foreign earnings were not distributed as dividends to the US corporate shareholder.
Besides having one of the highest marginal tax rates, the US imposed a tax system that taxed worldwide earnings of a US person, including repatriated foreign sourced earnings of a foreign subsidiary corporation distributed as a dividend to the US parent corporation. The US attempted to mitigate this broad scope of taxation, as well as dual taxation, by implementing a complicated foreign tax credit system. This worldwide system of taxation was in stark contrast to most other countries, which imposed a territorial system of taxation under which the countries taxed corporate earnings sourced inside the countries, but did not tax repatriated business earnings of foreign corporations sourced outside of those countries.
This territorial system of taxation encourages corporations to repatriate their foreign earnings back to the home country because no further tax is imposed. To encourage this practice by US corporations, the new tax law has introduced a partial territorial tax system under which foreign-sourced earnings of a foreign subsidiary will, in in many cases, not be subject to US tax when repatriated as a dividend. We emphasize the “partial” nature of the new US territorial system because the new tax law does not disturb the continuing application of the anti-deferral rules found under the prior law that currently taxes a 10% US corporate shareholder (defined to include any US shareholder that owns at least 10% of a foreign corporation, by vote or by value) on its proportionate share of (i) Subpart F income (i.e., the passive income and highly mobile sales and services income) attributable to a controlled foreign corporation (CFC) and (ii) earnings of a CFC that the CFC invests in “US property.”
Congress hopes that the combination of the lower corporate tax rate and the imposition of this “partial” territorial system of taxation will spur US corporations to re-think where they conduct their business operations and encourage them to repatriate foreign earnings for use and investment inside the US.
100% Deduction for Foreign-source Portion of Dividend
- A 10% US corporate shareholder is allowed a 100% dividend received deduction for the foreign sourced portion of dividends received from the foreign corporation.
- A US corporate shareholder who owns less than 10% of a foreign corporation is not eligible to take a 100% deduction for any dividend amount received from the foreign corporation.
- A non-corporate shareholder is not eligible for the 100% dividend received deduction.
- No foreign tax credit (FTC) or deduction is allowed for any foreign taxes paid or accrued by the 10% US corporate shareholder (or foreign corporation taxes deemed paid or accrued) with respect to a dividend that qualifies for the 100% deduction. For FTC purposes, the amount of the dividend eligible for the 100% deduction has to be excluded from the numerator and denominator of the fraction used to compute the foreign tax credit limitation.
- The 10% US corporate shareholder is not eligible for the 100% deduction for any dividend on any share of foreign corporation stock that is not held for at least one year during the period extending 365 days before or after the date on which the share becomes ex-dividend.
- The 100% deduction is not available for a dividend from a foreign corporation that is a personal foreign investment company (PFIC) that is not a controlled foreign corporation. A PFIC is a foreign corporation in which 75 percent or more of its gross income for the tax year consists of passive income, or 50 percent or more of its assets consists of those that produce, or are held for the production of, passive income.
- The 100% deduction is not available for certain hybrid dividends (i.e., an amount received from a CFC for which a 100% deduction would otherwise be allowed and for which the CFC received a deduction (or other tax benefit) with respect to any income, war profits, or excess profits taxes imposed by any foreign country or US possession), and instead those hybrid dividends will be treated as Subpart F income and currently taxed to the US corporate shareholder under the Subpart F tax regime. Moreover, no foreign tax credit or deduction will be available for foreign taxes paid or deemed paid on any hybrid dividend taxed as Subpart F income.
- The foreign source portion of any dividend from the foreign corporation to the 10% US corporate shareholder is the amount that bears the same ratio to the dividend as (i) the undistributed foreign-sourced earnings of the foreign corporation bears to (ii) the total undistributed earnings (foreign and US) of that foreign corporation.
- “Undistributed earnings” is defined as the amount of earnings and profits of the foreign corporation as of the end of its tax year in which the dividend is made without diminution for any dividends made by the foreign corporation during the same tax year.
- Foreign-sourced dividends are dividends not attributable to (i) income of the foreign corporation effectively connected with a US trade or business or (ii) dividends received by the foreign corporation from a domestic corporation (whether directly or indirectly through a wholly owned foreign corporation), at least 80% of the stock (vote and value) of which is owned by the foreign corporation (directly or indirectly through the wholly owned foreign corporation).
- What defines a dividend for purposes of the 100% dividend received deduction is broadly construed. For example, if a 10% US corporate shareholder indirectly owns stock of a foreign corporation through a partnership and would qualify for the 100% deduction with respect to dividends from the foreign corporation if it owned the stock directly, it would be eligible to take the 100% deduction with respect to its distributive share of the partnership’s dividend.
Sales or Transfers Involving Specified 10-Percent Owned Foreign Corporations
- Amounts received by a 10% US corporate shareholder upon the sale or exchange of stock in a foreign corporation held for at least one year and which are treated as dividends (since the proceeds represent accrued deferred foreign earnings attributable to the period during which the selling US corporate shareholder owned the foreign corporation’s stock at a time when the foreign corporation was a CFC) also will be treated as dividends for purposes of the US corporate shareholder being able to have those proceeds (to the extent that are attributable to foreign sourced earnings) subject to the 100% dividend received deduction.
- For purposes of determining the loss arising from a US corporate shareholder’s disposition of stock of a foreign corporation, the stock basis of the foreign corporation will be reduced (but not below zero) by the amount of the 100% deduction utilized by the US corporate shareholder for the dividend paid or accrued on such foreign stock. This is meant to avoid a perceived double tax benefit of excluding the dividend income by means of the 100% deduction, and getting a second benefit by using a high basis to compute a loss for the dividend-related shares that are disposed of in a taxable transfer.
- Where a controlled foreign corporation (CFC) owned by a US corporate shareholder sells the stock of a lower-tier CFC, the foreign-source portion of the amount treated as a dividend will be Subpart F income to the US corporate shareholder of the selling CFC; however, such income will be eligible for the 100% dividend received deduction.
- If a US corporation operates a foreign branch that generates losses that it uses to reduce its US income tax liability, and then transfers substantially all of the assets of the foreign branch to a foreign corporation in which it owns at least a 10% equity interest in vote or value, the US corporation will be required, subject to certain limitations, to recapture and include in income the amount of foreign “transferred losses.” Transferred losses of the foreign branch is the amount equal to the excess of:
- the losses incurred by the foreign branch of the US corporation after December 31, 2017, and before the transfer, for which a loss deduction was applied against taxable income of the US corporation over
- the sum of (A) any taxable income earned by the foreign branch in tax years after that in which the loss is incurred and through the close of the tax year of the transfer, and (B) a certain amount of gain computed under the loss recapture rules arising out of the disposition/transfer of those assets from the foreign branch to the foreign corporation.
Any amounts included in gross income under the foreign branch loss recapture rules are treated as derived from sources within the United States for foreign tax credit purposes.
- Generally, if a US corporation transfers property to a foreign corporation in connection with a corporate organization, reorganization, and liquidation, the foreign corporation is not treated as a corporation and the otherwise tax-free transfer rules for reorganizations and liquidations involving US corporations are inapplicable, causing the transfer to be a taxable exchange. There are a number of exceptions to the general gain recognition rule on outbound transfers of property, one of which was a transfer of property to be used by a foreign corporation in an active trade or business outside of the United States (known as the “active trade or business exception”). The active trade or business exception has been repealed by the new tax law, effective for outbound transfers of property by a US corporation to a foreign corporation occurring after December 31, 2017.
Transition Tax on Deferred Foreign Earnings
- A transition tax is generally imposed on accumulated deferred foreign earnings, without requiring an actual distribution, upon the transition to the new partial territorial system that utilizes the 100% dividend received deduction. Under the transition rule, for the last tax year beginning before January 1, 2018, all 10% US shareholders of a CFC or other foreign corporation (other than a PFIC that is not a CFC) that is owned by at least one 10% US corporate shareholder must include in income as Subpart F income such shareholder’s pro rata share of the accumulated post-1986 foreign earnings of the foreign corporation as of November 2, 2017, or December 31, 2017, whichever amount is greater (mandatory income inclusion). A portion of the mandatory income inclusion is deductible. The deduction amount depends upon whether the deferred earnings are held in cash or other assets. The deduction results in a reduced rate of tax of 15.5% for the included deferred foreign income held in liquid form and 8% for the remaining deferred foreign income. A corresponding portion of the foreign tax credit is disallowed. The transition tax can be paid in installments over an eight-year period. Special rules are provided for US shareholders that are REITs or that become expatriated entities after December 22, 2017.
- For purposes of computing the post-1986 earnings and profits (E&P) that is subject to the transition tax, the amount does not take into account any E&P that was accumulated during the period when the foreign corporation was not owned by at least one 10% US corporate shareholder. However, post-1986 earnings and profits are taken into account for purposes of the transition tax even if such E&P was generated in periods during which the US shareholder did not own stock of the foreign corporation.
- If a 10% US corporate shareholder is an S corporation and it is the subject of this transition tax, each shareholder of the S corporation may elect to defer payment of the transition tax until the occurrence of a “triggering event.”
- A triggering event is the earliest to occur of (i) the S corporation ceasing to be an S corporation, (ii) a liquidation or sale of substantially all of the assets of the S corporation and (iii) a transfer of stock of the S corporation by the shareholder of the S corporation (including a transfer on account of death of the shareholder), unless the transferee enters into an agreement with the IRS under which it assumes the liability for the transition tax that is being deferred. If a shareholder elects to defer the transition tax, the S corporation and electing S corporation shareholder will be jointly and severally liable for the transition tax.
- Upon the occurrence of a triggering event, each S corporation shareholder may pay its proportionate share of the transition tax in installments over eight years unless the triggering event is a liquidation or sale of substantially all of the assets of the S corporation. In that case, each shareholder may pay the transition tax over eight years only with the consent of the IRS.
- Unlike shareholders of an S corporation, partners of US partnerships that own at least 10% of the vote or value of a foreign corporation whose E&P becomes the subject of the transition tax are not eligible to elect the deferral of the transition tax.
Global Intangible Low-Taxed Income (GILTI)
- GILTI is a new category of Subpart F income that imposes a current tax on 10% US shareholders (corporations and non-corporations) of a CFC attributable to the CFC’s intellectual and intangible property that the CFC licenses to its affiliates and others. A 10% US shareholder’s GILTI for the tax year equals the amount (if any) by which its “net CFC tested income” for the year exceeds its “net deemed tangible income return” for the year.
- To determine its “net CFC tested income,” a 10% US shareholder first calculates the “tested income” of each of its CFCs. Tested income is the CFC’s gross income, excluding its: effectively connected income; Subpart F income; income with respect to which the CFC elects the high tax exception to Subpart F; related party dividends; insurance income and; foreign oil and gas extraction income, less any allocable deductions. Effectively, GILTI only includes income attributable to its intellectual property and other intangible assets. If the allocable deductions attributable to the intangible property exceed the CFC’s gross income, the CFC has a “tested loss.” The 10% US shareholder’s “net CFC tested income” is the amount by which the aggregate “tested income” of all of its CFCs exceeds the aggregate “tested loss” of all its CFCs. If the 10% US shareholder does not wholly own the CFCs, the amount of its “net CFC tested income” is proportionate to its interest in the “tested income” and “tested loss” of the CFCs.
- The 10% US shareholder’s “net deemed tangible income return” is the aggregate of the amount by which 10 percent of each CFC’s “qualified business asset investment,” (QBAI) exceeds the amount of the CFC’s excess interest expense, if any, that the CFC’s “tested income” calculation reflects. A CFC’s QBAI for a tax year is the CFC’s aggregate adjusted basis in depreciable tangible property used (i) in the CFC’s trade or business and (ii) for the production of “tested income,” as determined by averaging the property’s basis on the four quarter ends of the year. As with “net CFC tested income,” a 10% US shareholder’s “net deemed tangible income return” takes into account only its proportionate share of the QBAI of the CFCs. Once a 10% US shareholder’s gross GILTI is calculated, it is entitled to deduct 50% of that amount to arrive at its net GILTI. Based on the 21% corporate tax rate, the 10% US corporate shareholder’s GILTI is subject to an effective US tax rate of 10.5%. For tax years beginning in 2026, the GILTI deduction decreases to 37.5%, resulting in an effective rate of 13.125%.
A US corporation (other than S corporations, REITs and RICs) with average annual gross receipts of at least $500 million over the past three tax years and with deductions attributable to outbound payments exceeding a specified percentage of the corporation’s overall deductions are required to pay a minimum tax equal to the greater of its regular tax liability or 10% of its “modified taxable income.” A US corporation generally computes its “modified taxable income” by adding back to taxable income any deduction for a payment made to a related foreign entity.
Other Miscellaneous Provisions Affecting International Taxation
- The Subpart F regime is intended to assure that highly mobile foreign-sourced income attributable to passive activities, as well as to sales of products or services, is not manipulated by the US corporate shareholder and its foreign affiliated corporations so as to be taxed only in a low tax rate jurisdiction. Under the Subpart F rules, US shareholders of a controlled foreign corporation (CFC) are currently taxed on their pro rata shares of the CFC’s Subpart F income without regard to whether the income is distributed to the shareholders; however, the same US shareholders may exclude from income the actual distributions of the CFC’s earnings and profits that were previously included in its income under the Subpart F rules. A CFC is a foreign corporation in which one or more “US shareholders” own more than 50% of the vote or value of the foreign corporation. Under the new tax law:
- A “US shareholder” is an individual or corporation who owns at least 10 percent of the total combined voting power of all classes of stock entitled to vote or at least 10 percent of the total value of all classes of stock of the foreign corporation.
- The requirement that a foreign corporation must be a CFC for an uninterrupted period of 30 days or more before a US shareholder is required to include amounts in gross income under Subpart F is eliminated. Now, Subpart F income inclusion by a US shareholder is required if the foreign corporation is a CFC at any time during the tax year.
- The deemed-paid foreign tax credit is repealed due to the implementation of the 100% dividend received deduction under the new tax law. The credit was allowed under the old tax law for income tax paid with respect to dividends received by a US corporation that owned 10 percent or more of the voting stock of a foreign corporation. Now that a US corporations gets the benefit of the 100% deduction for the foreign sourced portion of dividends received from the foreign corporation, Congress believed that allowing a credit attributable to income not taxed in the US would be an unwarranted double tax benefit.
- US taxpayers are taxed on their worldwide income, but to avoid US and foreign tax on the same foreign source income, they are allowed a foreign tax credit (FTC) for foreign income taxes paid or accrued. The FTC is limited, however, so that the available credit does not exceed the amount of US taxes that would be imposed on the same foreign source income. Without this limitation the result would be an eroding US tax base and a reduction of US tax on US source income. Thus, if foreign taxes exceed the US tax that would be due on the same foreign source income, the excess foreign taxes cannot be credited. Instead, the excess foreign taxes may be carried back one year and forward 10 years as FTCs.
- In mathematical terms, the FTC limitation is computed by multiplying a US taxpayer’s total US tax liability (before the foreign tax credit) for the tax year by the ratio of the taxpayer’s foreign source taxable income to worldwide taxable income. However, this is not the end of the analysis. FTCs could be unfairly used if low tax and high tax foreign source income were blended within a single FTC credit limitation. That is, on a conceptual basis, if all income and credits were combined in a single basket, a taxpayer could take the unused excess FTC limitation derived from low tax foreign income to absorb the excess FTCs on high foreign tax income. This concept is known as cross-crediting.
- To remedy the possible manipulation of the FTC by cross-crediting, the prior law imposed a separate two basket system- a “passive category income” basket targeted at low tax foreign income and a “general category income” basket targeted at high tax foreign income. Passive category income includes dividends, interest, rents, royalties, and annuities as well as dividends from a domestic international sales corporation (DISC) or a former DISC and distributions from a former foreign sales corporation. General category income is all types of income other than passive category income.
Under this two basket system the foreign tax credit limitation must be calculated separately for each basket of foreign source income. The separate foreign tax credit limitations prevent the averaging of high foreign income taxes on income such as active business with low-taxed income such as passive income. Cross-crediting within the same category of income is permitted, meaning that high and low tax income and credits from all countries within the same category are combined, but the overall combined FTC limit on each separate income basket may not be higher than the applicable US tax rate.
- The new tax law has introduced a third FTC limitation basket for foreign branch income. Foreign branch income means the business income of a US corporation that is attributable to one or more qualified business units (QBUs) in one or more foreign countries. A QBU is defined as any separate and clearly identified unit of a trade or business of a taxpayer that maintains separate books and records. The law directs that the IRS promulgate regulations to determine the amount of business income attributable to a QBU. The effect of this new basket is to prevent combining the foreign source income of the branch with the general category income so that excess FTCs attributable to high tax branch income cannot be accessed by combining lower tax income found in the general category income basket. This new basket also means that carrybacks and carryforwards of excess foreign tax credits in the foreign branch company basket will be allowed only to the extent of the excess limitation in the basket. The foreign branch company basket does not apply to income of the foreign branch that is passive category income.
- The new tax law has introduced a fourth new FTC limitation basket for GILTI income. Generally, a 10% US shareholder of a CFC that has a GILTI inclusion is entitled to a “deemed paid” FTC equal to 80% of the foreign incomes taxes paid by the CFC that are deemed attributable to the CFC’s income derived from its intellectual and other intangible property. However, if a taxpayer does not have sufficient foreign source income in a given year to use the GILTI FTC, any foreign taxes attributable to GILTI for that year in excess of its FTC limitation will be permanently lost, because the related FTCs cannot be carried back or carried forward.
Sourcing of Inventory Sales
Income from cross-border sales of inventory is sourced on the basis of the production activities. Sourcing of the income will not be based on title passage. If inventory is produced partially inside and outside of the US, the sourcing of the sale (US versus foreign) will be allocated and apportioned between US and foreign sources solely on the basis of the production activities with respect to the property. If the inventory is produced entirely in the US, the income from the sale of the property will be US source income. If the inventory is produced entirely in another country, the income from the sale of the property will be foreign source income.