Effective January 1, 2018, the Tax Cuts and Jobs Act of 2017 was passed by the Senate and signed into law in the tax reform bill signed by President Trump. Major components of the bill include the reduction of individual and corporate tax rates, limitations on interest expense for businesses, and a change from a worldwide tax system to a hybrid territorial tax system that, in summary, would only tax income in the country it is earned. With all these changes comes new taxes and rules that many individual and companies need to plan around to ensure maximum tax savings.
Tax reform will have an impact to all United States taxpayers including foreign investors who earn income in the United States – many inbound companies will need to consider changing different tax strategies which have worked for years.
Tax Rate Reduction
United States has always been known to have one of the highest corporate tax rates of 35% – as part of the Tax Cuts and Jobs Act, the corporate tax rate is reduced to 21%. Due to the previously high tax rate in the US, foreign-owned US corporations have always found it favorable to keep the income low in the US. This could be done in ways such as deductible interest or royalty payments to the foreign parent.
With the tax rate in the United States dropping to 21%, it may not be beneficial to leverage the US corporation with debt as a way to lower the income with interest expense. For foreign parents headquartered in a country which now has a higher tax rate than this US, this tax planning strategy may no longer be beneficial.
Interest Expense Limitation
The Tax Cuts and Jobs Acts also brought forth an amendment to Section 163(j) which limits interest expense deduction to 30% of the taxpayer’s earnings before interest, taxes, depreciation, and amortization (EBIDTA). The change to Section 163(j) limits this deduction on all ‘business interest’, regardless of form.
Interest expense has been a large deduction item for foreign-owned US companies which finance their operations by related party debt. Many companies will need to analyze their structure for capital and make changes to minimize the limitation. The disallowed interest expense can be carried forward with an indefinitely.
Repatriation Toll Tax
The Tax Cuts and Jobs Act imposes a mandatory tax on repatriation known as the toll charge. Before the tax reform, earnings and profits of a controlled foreign corporation (CFC) were taxed when repatriated or deemed repatriated under the Subpart F rules. For this reason, much of the cash of US corporation was trapped overseas with lower taxing jurisdictions.
As part of the transition into a territorial tax system, the toll charge will tax 15.5% for cash and 8% for illiquid assets of all previously untaxed foreign earning and profits. This tax will be due regardless if the actual cash is brought back to the US or not. This impacts US inbound corporations with a ‘sandwich structure’ -where a non-US corporation owns a US corporation which owns a non-US corporation (CFC). The US corporation of these structures will be taxed with the toll charge regardless of making any actual distributions.
Although the toll charge can be an additional tax that the corporation incurs, it allows the cash to be brought back to the US under this lower tax rate of 15.5% or 8%.
Base erosion and anti-abuse tax
The base erosion and anti-abuse tax (BEAT) is a minimum tax which targets base erosion by imposing a minimum tax on corporations with (1) a 3-year average gross receipts of at least $500 million and (2) who make base eroding payments to related foreign person for 3% or more of their certain deductible expenses. The BEAT is effective for certain payments of base eroding starting after tax year 2017.
The BEAT is a 10% minimum tax (5% in 2018) on significant base-eroding payments. Base eroding payments are generally any amount paid to a related party to that is deductible or used to acquire property which is subject to additional depreciation or amortization deductions. US companies that make deductible payments for intercompany debt, services from non-US affiliates or royalty payments to non-US owned intellectual property may be subject to BEAT.
This will be a significant tax on many inbound corporations which benefited from base eroding deductions on their US taxes. Many companies will need to re-evaluate their structures and where to locate intellectual property which makes the most sense for business and tax purposes.
Before tax reform, a CFC could only exist if a non-US entity was under a US entity. With the new stock attribution rules, if a non-US parent owns a non-US entity and a US entity, the US entity will need to report the brother/sister relationship as a CFC. This will not cause any Subpart F inclusion for brother/sister entities which still only applies to direct or indirect ownership of the CFC.
Originally this created additional reporting issues since a Form 5471 is needed to be filed for every CFC of a US entity. However, the IRS recently released guidance that this new CFC relationship is not subject to a Form 5471 filing, which similar to the Subpart F rules, only applies to direct or indirect ownership.
The Tax Cuts and Jobs Act has changed a lot of planning structures which have been used by foreign-owned US companies for years. Although there are some negative impacts such has the interest expense limitation and additional repatriation tax for foreign-owned US corporation with underlying CFC’s – the tax reform is meant to encourage companies to reinvest in the United States. Additional deductions such as full expensing of qualified property allows many inbound investors to invest additional capital in the US and benefit on tax savings of a full deduction.
The recent tax reform included many changes to the way foreign earnings and payments to foreign affiliates are taxed. Consult with an international tax specialist at Brunoro Law to discuss adapting your international structures and investments with the Tax Reform.
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