How Tax Reform Has Impacted Foreign Operations
Most U.S. corporations conduct their foreign business operations through foreign subsidiaries. When a foreign subsidiary is owned more than 50 percent by U.S. shareholders, it’s considered a controlled foreign corporation (CFC).
If a U.S. corporation controls a foreign corporation in a low-tax jurisdiction, it may be motivated to shift profits into the low-tax foreign country in which the CFC is located in an effort to defer U.S. taxes on such income. A complex set of provisions, referred to as Subpart F, are aimed at curbing such behavior.
The Tax Cuts and Jobs Act expanded the reach of Subpart F, and added new anti-abuse provisions that target “base erosion and profiting shifting.” As a result, U.S. corporations conducting their foreign operations through CFC’s are facing a myriad of new tax implications.
- The Expansion of Subpart F. The definition of a U.S. shareholder has been expanded to include U.S. persons that own 10% or more of the value of the foreign corporation’s stock. Under prior law, only U.S. persons that owned 10% or more of the voting stock met the definition of a U.S. shareholder.
Thus, a U.S. person who owns stock in a foreign corporation with 5% of the votes and 10% of the value will now qualify as a U.S. shareholder. As noted above, U.S. shareholders of a CFC are subject to the complex anti-abuse provisions of Subpart F.
The ownership tests under Subpart F have also been modified so that stock owned directly, indirectly, and constructively, is taken into account.
- The New Tax on Global Intangible Low-Taxed Income. After determining a CFC’s Subpart F income, U.S. shareholders will have to determine if they are subject to tax on the CFC’s global intangible low-taxed income (GILTI).
The new tax imposes a minimum tax on certain low-taxed income and is reduced by a special deduction. For 2018, the deduction amount is 50% of GILTI. The taxpayer is also allowed to take a foreign tax credit up to 80%.
The taxpayer’s ability to take the special deduction and a partial foreign tax credit means only income subject to an effective tax rate less than 13.125% should result in a GILTI inclusion.
For example, if the CFC has $100 of GILTI, it will get a $50 GILTI deduction. The $50 of net income will be subject to the U.S. tax rate of 21% for a total tax of $10.50. If the foreign tax rate is $15, the CFC will get a $12 foreign tax credit (80% of $15). Thus, the U.S. tax liability after applying the credit is $0.
- Dividend Exemption/Transition Tax. The new law allows U.S. shareholders to take a 100-percent dividend received deduction for foreign-source dividends received from a CFC, as long as such income is not considered Subpart F, GILTI, or an investment in U.S. property under section 956.
The transition to a dividend exemption system also requires U.S. shareholders to pay a one-time tax on the CFC’s previously untaxed foreign earnings (i.e., foreign earnings that have been parked offshore benefiting from deferral).
The CFC’s untaxed earnings are divided into two groups—1) cash/cash equivalents, and 2) all other earnings. Cash, and cash equivalents, are subject to a 15.5% tax rate, and all other earnings are subject to a rate of 8%.
The earnings are included in the income of a U.S. shareholder on the last day of the taxable year of the foreign corporation that began before January 1, 2018. U.S. shareholders can elect to pay the transition tax in eight installments over eight years, pursuant to a specified schedule.
- The Base Erosion and Anti-Abuse Tax. A new minimum tax on U.S. corporations making deductible payments to related foreign persons is another aspect of the tax law changes.
The base erosion and anti-abuse tax (BEAT) amount is computed as 10 percent of modified taxable income (5 percent for years beginning in 2018 and 12.5 percent for years beginning in 2026 or later). If the BEAT amount is greater than the regular corporate tax liability for the year, U.S. corporations have to pay the excess amount as the minimum tax.
Modified taxable income is calculated without the allowance of deductions for amounts paid or accrued to related foreign persons. A related foreign person can include a CFC, and deductible payments to a CFC are added back in calculating a taxpayer’s modified taxable income (even if such amounts are included in the taxpayer’s income as Subpart F or GILTI).
- Foreign Derived Intangible Income Deduction. This new deduction encourages U.S. companies to keep their intangible assets in the United States instead of moving them to low-taxed controlled foreign corporations.
Foreign-derived intangible income (FDII) is income from exporting products tied to intangible assets held in the United States. Under this provision, U.S. corporations can get a deduction for a portion of their FDII, which results in an effective U.S. tax rate of 13.125% on such income.
The deduction amount is 37.5 percent for years beginning before 2026 and is available only to C Corporations that are not RICs or REITs.
As you can see, U.S. shareholders conducting their foreign operations through a CFC have to be cognizant of the growing tax implications under Subpart F, as well as new provisions, like the BEAT, that could require the restructuring of payments to foreign affiliates. These new tax law changes will have a considerable impact on U.S. persons investing and doing business abroad.
Tara Fisher has been practicing international tax for over 15 years. Her professional background includes working for the U.S. Congress Joint Committee on Taxation, the national tax practice of PricewaterhouseCoopers, the University of Pittsburgh, and American University in Washington D.C.