Buckle Your Seat Belts – Major Changes to International Taxation Currently Pending in Congress.

By Stephen A. Beck on November 27, 2017

 

As of the date of this article, the U.S. Congress is considering two different legislative proposals that would cause significant changes to the U.S. income taxation of international business activities and investments. The U.S. House of Representatives passed on November 16, 2017, H.R. 1, the “Tax Cuts and Jobs Act” (the “House Proposal”) while the Senate Finance Committee passed on that same date its own proposal (the “Senate Proposal”). The Senate and House proposals are generally consistent regarding the nature of the changes that would be made to the U.S. income tax laws affecting international transactions, but there are subtle differences that will need to be resolved as the legislative process moves forward to achieve passage of final legislation.

This article does not attempt to summarize every change to the U.S. international tax laws that would result under the pending House and Senate proposals. Rather, this article summarizes five categories of international tax reforms under the pending proposals that would be broadly applicable and thus are important to monitor as the legislative process advances.

In addition, this article does not discuss every nuance or detail relating to the pending proposals discussed herein. Instead, this article is intended to provide a high level overview of the pending proposals so that readers will be alerted and can look further into the proposals potentially impacting them.

I.  100% Deduction for Foreign-Source Dividends.

Under current law, U.S. citizens, U.S. resident individuals, and U.S. corporations are subject to U.S. tax on their worldwide income as that income is earned. In contrast, a U.S. shareholder of a foreign corporation can generally benefit from deferral of U.S. income tax on that foreign corporation’s income until the year in which that income is distributed to that shareholder.

        A.  The House Proposal.

The House Proposal would provide a 100% deduction for the foreign-source portion of a dividend received by a U.S. corporate shareholder from a “specified 10% owned foreign corporation.” See House Proposal, §4001(a). To be eligible for the 100% deduction, the shareholder receiving the dividend must be a domestic corporation that is a “U.S. shareholder” (i.e., it must own at least 10% of the voting stock) of the distributing foreign corporation. See id. A “specified 10% owned foreign corporation” is basically any foreign corporation owned by a corporate “U.S. shareholder,” but that term does not include a foreign corporation that is a “passive foreign investment company” (a “PFIC”) and not a “controlled foreign corporation” (a “CFC”). See id. The deduction of the foreign-source portion of the dividend is not allowed unless (i) the corporate U.S. shareholder has owned stock of the foreign corporation for at least 180 days and (ii) that foreign corporation has retained its status as a “specified 10% owned foreign corporation” throughout that period. See id., §4001(b).

The House Proposal would also amend the foreign tax credit limitation under I.R.C. §904 with the basic effect that the corporate U.S. shareholder would not be entitled to claim any foreign tax credit for any foreign income tax paid in connection with the foreign-source portion of a dividend received by the “specified 10% owned foreign corporation.” See id., §4001(d). Thus, if the corporate U.S. shareholder is not subject to U.S. income tax on the foreign-source portion of the dividend from the foreign corporation, that U.S. shareholder also cannot reduce its U.S. income tax liability by the amount of any foreign income tax paid on that foreign-source portion of that dividend.

The 100% deduction would be effective for distributions made after December 31, 2017. See id., §4001(f). The limitation of foreign tax credit relating to foreign-source dividends would be effective for deductions with respect to tax years ending after December 31, 2017. See id.

        B.  The Senate Proposal.

The Senate Proposal also provides for a 100% deduction of the foreign-source portion of a dividend received by a corporate U.S. shareholder from a “specified 10% owned foreign corporation” in substantially the same manner as the House Proposal. See Joint Committee on Taxation’s Description of the Senate Finance Committee Chairman’s Mark of the “Tax Cuts and Jobs Act” (the “JCT Report”), p. 218. There are, however, two notable differences.

First, under the Senate Proposal, the deduction of the foreign-source portion of the dividend is not allowed unless (i) the corporate U.S. shareholder has owned stock of the foreign corporation for at least 365 days and (ii) that foreign corporation has retained its status as a “specified 10% owned foreign corporation” throughout that period. See id., p. 219.

Second, the Senate Proposal would not permit the 100% deduction in connection with a “hybrid dividend,” which is an amount received from a CFC for which (i) a deduction would otherwise be allowed under the Senate Proposal and (ii) the “specified 10% owned foreign corporation” received a deduction or other tax benefit from taxes imposed by a foreign country. See id.

The 100% deduction would be effective for taxable years of foreign corporations beginning after December 31, 2017 and for taxable years of U.S. shareholders in which or with which such taxable years of the foreign corporations end. See id.

II.  Deemed Repatriation at Reduced Tax Rates, with Electable Deferral.

        A.  The House Proposal.


The House Proposal would essentially provide for the deemed repatriation by certain foreign corporations of their deferred foreign income to their U.S. shareholders. More specifically, the House Proposal would generally require U.S. shareholders to pay tax on their pro rata share of foreign earnings accumulated within foreign corporations to the extent those foreign earnings had not previously been subject to U.S. income tax. See House Proposal, §4004.

This provision would apply to a U.S. shareholder of a “deferred foreign income corporation,” which is basically any CFC and any other foreign corporation in which a least one domestic corporation is a U.S. shareholder, except that a PFIC that is not a CFC cannot be a “deferred foreign income corporation.” See id. The “deferred foreign income corporation’s” post-1986 foreign-source earnings that had not previously been taxed under Subpart F would be required to be treated as Subpart F income in the last taxable year of the “deferred foreign income corporation” beginning before January 1, 2018. See id. Thus, for that tax year, the U.S. shareholder would be required to report and pay U.S. income tax on its pro rata share of that Subpart F income attributable to the previously untaxed foreign-source earnings.

The U.S. shareholder, however, could elect to pay its resulting U.S. income tax liability in connection with the previously deferred foreign-source earnings over an eight-year period in equal annual installments. See id. In addition, the U.S. shareholder would be entitled to a deduction in an amount sufficient to result in the U.S. shareholder paying a fourteen percent (14%) tax rate on the accumulated foreign earnings held in cash or cash equivalents or a seven percent (7%) tax rate on the accumulated foreign earnings held in other less-liquid assets. See id. The U.S. shareholder would not be entitled to any foreign tax credit for any foreign income tax paid in connection with the portion of the foreign-source earnings that is deductible for U.S. income tax purposes. See id.

        B.  Senate Proposal.


The Senate Proposal is generally consistent with the House Proposal, except that the Senate Proposal would permit the U.S. shareholder to a greater deduction so that the tax rate applying to the accumulated foreign earnings held in cash and noncash assets would be ten percent (10%) and five percent (5%), respectively. See JCT Report, p. 223. In addition, a six-year statute of limitation on assessment would apply in connection with the U.S. shareholder’s obligation to report and pay tax on the accumulated foreign earnings. See id., p. 224. The Senate Proposal would also allow the U.S. shareholder to elect to pay the income tax on the accumulated foreign earnings over eight installments, but the Senate Proposal would provide the added benefit of lesser payments in earlier years and increased payment amounts in the later years of the installment term. See id.

The Senate Proposal also discourages future expatriation of U.S. shareholders. It provides that, if a U.S. shareholder becomes an expatriated entity (i.e., transfers substantially all of its assets to a foreign corporation) within ten years of the date of enactment of the Senate Proposal as legislation, then that U.S. shareholder (i) will not be entitled to any deduction in connection with the accumulated foreign earnings taxed under this provision and (ii) will be subject to a thirty-five percent (35%) tax rate on the full amount of the accumulated foreign earnings that the U.S. shareholder was required to report under this provision. See id., p. 226.

III.  Repeal of Indirect Foreign Tax Credit.

Under current law, a domestic corporate shareholder that owns at least ten percent (10%) of the voting stock of a foreign corporation is eligible to claim a foreign tax credit for the foreign tax paid by that foreign corporation in connection with earnings that were distributed to the domestic corporate shareholder by that foreign corporation. See I.R.C. §902. This ability of a domestic corporate shareholder to report a foreign tax credit in connection with foreign income tax paid by the foreign corporation is commonly referred to as the “indirect foreign tax credit.”

        A.  The House Proposal.

The House Proposal would repeal the indirect foreign tax credit for tax years beginning after December 31, 2017. See House Proposal, §4101(a). The House Proposal, however, would still permit a domestic corporate shareholder of a CFC to claim a foreign tax credit in connection with foreign income tax paid by the CFC with regard to income that the domestic corporate shareholder was required to report as income under Subpart F. See id., §4101(b).

        B.  The Senate Proposal.

With regard to the House Proposal provisions described above, the Senate Proposal contains equivalent provisions. See JCT Report, p. 240. The Senate Proposal also includes other modifications to the foreign tax credit, such as the creation of a separate foreign tax credit limitation basket for foreign branch income. See id., p. 241.

IV.  Modification of CFC Classification Standards.

The House and Senate Proposals would make changes to the current law standards governing U.S. Shareholders of a CFC, as summarized below.

        A.  The Thirty-Day Control Requirement for CFC Status.

Under current law, a U.S. shareholder is not required to report and pay tax on Subpart F income unless the foreign corporation is a CFC for an uninterrupted period of thirty days or more during the tax year. See I.R.C. §951(a)(1). In order to be a CFC, more than fifty percent (50%) of the vote or value of the CFC’s stock must be owned by U.S. shareholders. See I.R.C. §957(a). Thus, under current law, a U.S. shareholder is not required to report and pay tax on Subpart F income unless more than fifty percent (50%) of the vote and value of the foreign corporation’s stock is owned by U.S. shareholders for an uninterrupted period of at least thirty days during the tax year.

            1.  House Proposal.

The House Proposal would eliminate the thirty-day requirement so that a U.S. shareholder would be required to report and pay tax on Subpart F income of a foreign corporation as long as more than fifty percent (50%) of that foreign corporation’s stock was owned by U.S. shareholders at any time during the tax year. See House Proposal, §4206. This provision would be effective for tax years of foreign corporations beginning after December 31, 2017 and for tax years of U.S. shareholders with or within which those tax years of the foreign corporations end. See id.

            2.  Senate Proposal.

The Senate Proposal would also eliminate the thirty-day requirement in the same manner as the House Proposal.

        B.  The U.S. Shareholder Definition.

Under current law, a “U.S. shareholder” is defined as a U.S. person who owns ten percent (10%) or more of the total combined voting power of all classes of stock entitled to vote of the foreign corporation. See I.R.C. §951(b).

            1.  The House Proposal.

The House Proposal does not make any change to the definition of a “U.S. shareholder.”

            2.  The Senate Proposal.

The Senate Proposal would expand the definition of a “U.S. shareholder” so that it would also apply to a U.S. person who owns at least ten percent (10%) of the value of the foreign corporation’s stock. See JCT Report, p. 233.

        C.  Stock Ownership Attribution From Foreign Persons.

Under current law, certain constructive ownership rules are used to attribute stock ownership to related persons for purposes of determining whether a U.S. person is a U.S. shareholder and whether a foreign corporation is a CFC. See I.R.C. §958(b). Under the current constructive ownership rules, a domestic corporation cannot be attributed stock ownership from its foreign shareholder. See I.R.C. §958(b)(4).

            1.  The House Proposal.

The House Proposal would allow a domestic corporation to have constructive ownership of stock owned by its foreign shareholder for purposes of determining whether that domestic corporation is a U.S. shareholder of a CFC. See House Proposal, §4205. This provision would apply to tax years of foreign corporations beginning after December 31, 2017 and to tax years of U.S. shareholders with which or within which those taxable years of the foreign corporations end. See id.

            2.  The Senate Proposal.

The Senate Proposal would also allow a domestic corporation to have constructive ownership of stock owned by its foreign shareholder. See JCT Report, p. 233. The Senate Proposal specifies, however, that the domestic corporation would not be attributed stock owned by its foreign shareholder for the purpose of determining the domestic corporation’s pro rata share of the Subpart F income of the CFC. See id. The effective date for this provision is the same under the Senate Proposal as under the House Proposal. See id.

V.  Modification of Subpart F Income Standards.

The House and Senate proposals would make several changes with regard to the existing standards under Subpart F of the Internal Revenue Code, which govern the situations in which a U.S. shareholder must report and pay U.S. income tax as certain types of foreign-source income are earned by the foreign corporation. The existing standards that would be revised under the House and Senate Proposals are summarized below.

        A.  Foreign Base Company Oil Related Income.

Under current law, “foreign base company oil related income” is a sub-category of Subpart F income. See I.R.C. §954(g). Thus, a U.S. shareholder of a CFC must pay U.S. income tax on its pro rata share of the “foreign base company oil related income” as it is earned by the CFC, regardless of whether that income is distributed from the CFC to the U.S. shareholder. See I.R.C. §951(a).

“Foreign base company oil related income” is defined by cross-referencing the definition of “foreign oil related income” under I.R.C. §907(c)(2) and (3). See I.R.C. §954(g). “Foreign oil related income” is basically income from oil and gas “downstream” activities, including the processing, transportation, distribution or sales of minerals or their primary products. See I.R.C. §907(c)(2), (3). “Foreign oil related income,” however, does not include income from the extraction of minerals from oil or gas wells. See I.R.C. §907(c)(1).

            1.  The House Proposal.

Under the House Proposal, “foreign base company oil related income” would be repealed as a category of Subpart F income. See House Proposal, §4202. As a result, a CFC could generally derive income from “downstream” foreign-source oil and gas activities, such as processing, refining, transporting or reselling the oil and gas, without causing the U.S. shareholder of the CFC to be immediately subject to tax on that oil related income. Instead, that foreign-source oil and gas related income generally would not be subject to tax in the U.S. until that income is distributed to the U.S. shareholder. This provision would apply to tax years of foreign corporations beginning after December 31, 2017 and tax years of U.S. shareholders in which or with which such tax years of the foreign corporations end. See id.

            2.  The Senate Proposal.

Like the House Proposal, the Senate Proposal would also repeal “foreign base company oil related income” as a category of Subpart F income. See JCT Report, p. 232.

        B.  The “Look-Through” Rule.

Under current law, a special “look-through” rule provides that certain passive income, such as dividends, interest, rents and royalties, received by one foreign subsidiary from a related foreign subsidiary generally is not includible in the taxable income of the U.S. shareholder of a CFC, provided that the income was not already subject to current U.S. tax or effectively connected with the conduct of a U.S. trade or business. See I.R.C. §954(c)(6)(A). Under current law, however, this special “look-through” rule is set to expire for tax years beginning on or after January 1, 2020. See I.R.C. §954(c)(6)(C).

            1.  The House Proposal.

The House Proposal would make the “look-through” rule permanent so that it would no longer expire for tax years beginning on or after January 1, 2020. See House Proposal, §4204.

            2.  The Senate Proposal.

The Senate Proposal would also make the “look-through” rule permanent. See JCT Report, p. 234.

        C.  The De Minimis Exception From Subpart F.

Under current law, if the amount of Subpart F income of a CFC is less than the lesser of: (i) five percent (5%) of the CFC’s total gross income; or (ii) $1 million, then the U.S. shareholders of that CFC are not required to include any Subpart F income in their taxable income in connection with that CFC. See I.R.C. §954(b)(3).

            1.  The House Proposal.

The House Proposal would apply an inflation adjustment to the $1 million threshold of the de minimis exception from Subpart F. See House Proposal, §4203. This change would apply to tax years of CFCs beginning after December 31, 2017 and to tax years of U.S. shareholders in which or with which those CFC tax years end. See id.

            2.  The Senate Proposal.

The Senate Proposal is consistent with the House Proposal with regard to the de minimis exception from Subpart F.

        D.  CFC Investment in U.S. Property.

Under current law, if a CFC uses its earnings to make investments in U.S. property, those U.S. investments may result in the U.S. shareholders reporting and paying tax under Subpart F. See I.R.C. §951(a)(1)(B); I.R.C. §956.

            1.  The House Proposal.

The House Proposal would amend I.R.C. §956 so that it does not require U.S. income taxation of a U.S. shareholder that is a corporation. See House Proposal, §4002. This change would apply to taxable years of foreign corporations beginning after December 31, 2017. See id.

            2.  The Senate Proposal.

The Senate Proposal would amend I.R.C. §956 so that it does not require a U.S. shareholder to recognize income from a CFC’s investment of its earnings in U.S. property if that U.S. shareholder is a corporation that owns the CFC either directly or through a domestic partnership. See JCT Report, p. 234. The Senate Proposal would be effect for taxable years of foreign corporations beginning after December 31, 2017 and to taxable years of U.S. shareholders in which or with which those taxable years of foreign corporations end. See id.

If anyone has any questions regarding the above-summarized provisions of the House Proposal or Senate Proposal or how those provisions may impact particular international business investments or activities, please contact
Stephen A. Beck by phone at 214-749-2401 or by email.

     





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