In the year ahead, 91 percent of tax executives say implementing tax code changes will be their primary tax issue, according to the BDO 2018 Tax Outlook Survey.
FEI Daily spoke with Joe Calianno, Tax Partner and International Technical Tax Practice Leader, National Tax Office at BDO about base erosion provisions in the Tax Cuts and Jobs Act (TCJA) and repatriation.
FEI Daily: Has the U.S. moved to a true territorial tax system in your opinion?
Joe Calianno: It is somewhat of a misnomer to say that the U.S. has moved to a true territorial tax system. It is true that, as part of the TCJA, Congress included a new provision (Section 245A) that provides a 100 percent dividend received deduction (DRD) when certain domestic C corporations receive dividends from their foreign subsidiaries (assuming certain conditions are satisfied to qualify for the 100 percent DRD). This provision provides a significant benefit to certain domestic C corporations.
However, the benefit is limited in that the provision only applies to certain domestic C corporations. For example, this provision would not apply if an individual receives a dividend from one of his foreign subsidiaries. Further, other income earned abroad by U.S. persons, or income earned through a foreign branch or foreign partnership, or dividend income that does not qualify for the 100 percent DRD under Section 245A, generally is required to be included in income and would be subject to tax in the U.S. Additionally, the TCJA generally retained the controlled foreign corporation (CFC) anti-deferral rules, which require U.S. persons who are ‘U.S. shareholders’ of CFCs - as defined in the Internal Revenue Code- to include in their income their pro rata share of the CFC’s earnings attributable to certain types of income earned by such CFCs. For example, certain passive or related party type of income which constitute ‘subpart F income’ under the CFC anti-deferral rules.
In fact, Congress expanded the CFC anti-deferral rules in several ways, making those rules more likely to apply. For instance, Congress added a new CFC anti-deferral rule (Section 951A) that makes it more likely that ‘U.S. shareholders’ of CFCs will be required to include an even larger amount of their CFCs’ earnings in income under the anti-deferral rules. It is commonly called GILTI because it requires ‘U.S. shareholders’ of CFCs to include in their income their pro rata share of their ‘global intangible low taxed income.’ This provision generally was enacted to address the situation where CFCs were generating high returns primarily through foreign IP, with little or no tangible, depreciable business assets but, in reality, can have a much broader reach given the complicated mechanical formula for determining this amount. Thus, as a result of the expansion of the CFC anti-deferral rules, it is quite possible that ‘U.S. shareholders’ of CFCs may be required to include greater amounts in their income under the CFC anti-deferral rules.
However, it’s worth noting that the TCJA did provide some benefits to certain domestic C corporations when it comes to determining their income. In addition to the 100 percent DRD under Section 245A and the reduced corporate tax rate, the TCJA provides special deductions under Section 250 for certain domestic C corporations that earn ‘foreign-derived intangible income’ and have ‘GILTI’ inclusions under the CFC anti-deferral rules. These deductions can mitigate the amounts that must be included in income by such domestic C corporations. Also, the TCJA permits a domestic C corporation to claim a reduced foreign tax credit relating to its GILTI inclusion under the CFC anti-deferral rules (however, there are several limitations relating to the credit). The impact of GILTI on ‘U.S. shareholders’ of CFCs that are not domestic C corporations can be much more burdensome.
FEI Daily: We know there were certain base erosion provisions in the TCJA. At a high level, can you describe some of these provisions?
Calianno: The Tax Cuts and Jobs Act (TCJA) has several new provisions designed to curtail base erosion. Given the high U.S. corporate tax rate before tax reform (one of the highest statutory rates of industrialized nations), U.S. taxpayers (especially U.S. multinationals) historically have put a premium on ways of reducing their overall U.S. effective tax rate in order to remain competitive in the global marketplace. These reductions often took the form of deductible payments to related parties (often foreign-related parties). Even though the top corporate rate has been dramatically reduced as a result of tax reform, Congress nevertheless believed that it was necessary to limit base erosion techniques. As a result, Congress added several provisions designed to curtail or limit the benefit of certain base erosion payments as part of tax reform.
For instance, Congress introduced a new provision (a new Section 163(j)) designed to limit business interest deductions. Subject to certain exceptions, the amount allowed as a deduction for any taxable year for business interest under new Section 163(j) is limited to the sum of the business interest income of such taxpayer for such taxable year, 30 percent of the adjusted taxable income of such taxpayer for such taxable year, and the floor plan financing interest of such taxpayer for such taxable year.
Several operating rules must be considered in applying this new provision, such as a rule permitting a carryforward of disallowed interest.
Additionally, there is another provision that provides for a limitation on the ability to take a deduction relating to certain royalties or interest paid or accrued to related parties. More specifically, new Section 267A can deny a deduction for certain related party interest and royalty amounts when paid or accrued pursuant to a certain hybrid transaction, or by, or to, hybrid entities when certain conditions are satisfied. At a very high level, this provision is designed to deny a deduction in situations where one party to the transaction would otherwise receive a deduction for a payment, but the related party recipient is not required to include such amount in income under the tax law of the country where the related party is a resident for tax purposes. Several special rules are included in the application of this provision, and there is broad regulatory authority to expand the scope of the transactions covered by this. We have seen this type of provision on the global front as part of the Organisation for Economic Co-operation and Development (OECD)’s attempt to curb base erosion and profit shifting (BEPS)—OECD’s BEPS Action 2 is somewhat similar.
Moreover, there’s another provision added by tax reform that’s designed to address base erosion payments, commonly referred to the base erosion and anti-abuse (BEAT) tax. This tax requires certain corporations to pay an additional corporate tax in situations where they make certain ‘base erosion payments’ to foreign-related parties and certain thresholds and conditions are satisfied (a very complicated formula is used for determining the additional corporate level tax). This additional tax generally applies to a corporate taxpayer (other than a RIC, REIT, or S corporation) with average annual gross receipts of at least $500 million (three-year testing period) and a ‘base erosion percentage’ of 3 percent or more for the tax year. Several special rules are included in determining whether this threshold is satisfied, including certain group aggregation rules and a modification of base erosion percentage if a bank or registered securities dealer is part of the group.
The new provision provides detailed rules on what does and doesn’t constitute a base erosion payment for purposes of applying this test. In any event, corporations that make certain deductible payments to a foreign-related party, or purchase depreciable or amortizable property from a foreign-related party, will need to evaluate this new provision. First, whether the threshold is met for the application of the provision, and, second, if such threshold is met, what the corresponding additional corporate tax may be.
These provisions can have a significant impact on taxpayers. We have been working closely with our clients to determine the applicability of these provisions as it relates to transactions or structures they currently have in place, and, in some instances, quantifying the impact of these provisions or modifying certain transactions or structures to address these new provisions.
It is likely that we will see more guidance from the IRS and Treasury on the application of these provisions in the near future.
FEI Daily: What are companies doing to address these new international provisions?
Calianno: As a starting point, many companies are assessing the impact of all the international tax changes as they relate to their transactions and structure. There is a lot of modeling surrounding tax reform. As I mentioned earlier, there are several new provisions addressing base erosion. Companies are determining which of these provisions may directly impact them and, if they do, trying to quantify the impact. In some instances, a company may restructure a transaction if one of the new provisions would impact the transaction (e.g., if a company had a transaction where a royalty deduction is denied because of new Section 267A, the company may seek to restructure the arrangement so that the transaction will be outside the scope of the provision). The companies that will be impacted by the new CFC anti-deferral GILTI provision are modeling out the impact it may have from a tax, accounting, and financial statement perspective.
All these changes, as well as the other international tax changes, will need to be considered on the planning side of transactions as well. For instance, Congress repealed a provision previously in the Internal Revenue Code that, as a result of its repeal, makes it costlier to incorporate a foreign branch (the repeal of the foreign active trade or business exception to gain recognition under Section 367(a)).
In addition, many companies are also debating whether to have their foreign earnings repatriated back to the U.S. As a result of the transition tax (also called the repatriation tax), many companies will have earnings in their foreign subsidiaries that will have already been taxed in the U.S. Generally speaking, those earnings can be repatriated back to the U.S. without additional U.S. tax, assuming that the foreign subsidiaries have the cash available to distribute. However, you always need to consider other issues relating to such a distribution, such as any foreign withholding tax that may be imposed on such a distribution. Whether a U.S. company will repatriate the previously taxed earnings of their foreign subsidiaries will vary depending on their plans and needs, domestically and abroad.