The House of Representatives’ tax reform bill, the Tax Cuts and Jobs Act (TCJA), makes fundamental changes to the tax treatment of U.S. manufacturing companies with operations abroad. The House’s changes to the tax code are complex and sophisticated. We are now in the process of digesting the Senate’s tax bill text as well its amendments.
The first overhaul of the tax code in more than 30 years switches the U.S. tax system to a territorial regime that would provide a 100 percent dividends received deduction on future foreign source dividends and replace today’s worldwide system, under which U.S. corporations are not taxed on the earnings & profits (E&P) of their foreign subsidiaries until those earnings are distributed or where the earnings run afoul of the U.S. subpart F or passive income regime, i.e. “Deferral”. This shift to a territorial regime will require U.S. multinationals to repatriate the estimated $2.6 trillion held overseas, i.e., Repatriation Tax.
But while the new territorial system is very different from the old, there are aspects of the worldwide system woven into the House bill.
We’ve laid out some ways the TCJA will impact our manufacturing clients with foreign subsidiaries. However, keep in mind the tax bill is a fast-moving target and key steps still remain: the House and Senate versions of the bills will have to go through multiple dialogues and reconciliations; and it must be signed into law.
That said, here are some key elements of the bill, some of which are positive for our manufacturing clients and some of which are negative or neutral:
Tax on mandatory deemed repatriation, with bifurcated rates: To shift to a new tax regime, U.S. corporations will have to do a level set. The House bill requires that a U.S. multinational with 10 percent-owned foreign subsidiaries include its subsidiaries’ post-86 E&P (through 2017) into income. The portion of the E&P that is cash or cash equivalents is taxed at a 14 percent rate, while non-cash assets are taxed at a rate of 7 percent. The taxes can be paid over an eight-year period. S corporations are also subject to the repatriation tax with the net amount flowing up to the shareholders; however, deferral of this mandatory deemed repatriation is available to S corporations in certain instances such as ceasing to be an S corporation, selling its stock or assets, or ceasing to conduct business; the deferral aspect is a positive element of the House’s proposed tax reform.
100 percent deduction for foreign-sourced dividends: After 2017, the bill replaces the current system where a C corporation is not taxed on subsidiaries’ foreign earnings until those are distributed (deemed or actual). Instead, the bill introduces a dividend exemption system. For S corporations and partnerships, the ability to benefit from the dividend exemption system is not available, which is a negative element of the proposed tax reform.
Modifications to the U.S. subpart F regime: U.S. subpart F limits the deferral of U.S. taxation of certain passive income earned outside the United States by controlled foreign corporations. Under the TCJA, subpart F will now be used to prevent erosions of the U.S. tax base (i.e., base erosion). The House bill introduces new section 951A whereby high-margin income, such as earnings from intellectual property, will be taxed at a 10 percent rate (50 percent of income taxed at 20 percent rate) less a foreign tax credit for 80 percent of foreign income taxes regardless of whether or not that income is distributed to the U.S. multinational. This expansion of the existing U.S. subpart F rules is likely to be viewed as unfavorable to those who have high margin income streams in their foreign operations, as it is a reversion back to a worldwide tax regime approach.
Preventing erosion of the US tax base through (i) interest expense limitations and (ii) excise tax on certain related party payments: While the TCJA aims to shift to the territorial tax regime, generally taxing income where it is earned, there is a focus on maintaining the U.S. corporate tax base as well. One such U.S. tax base preservation mechanism is to limit net interest expense. Section 163(n) is designed to preserve the U.S. tax base by restricting how much net interest expense a foreign corporation or related party can deduct on its U.S. tax return to no more than 110 percent of the U.S. company’s income as it relates to the entire group or 30 percent of its adjusted taxable income per section 163(j).
Another U.S. tax base preservation measure under the TCJA relates to a U.S. multinational making deductible payments to a foreign subsidiary (such as payments for inventory or materials). The payments are subject to an excise tax on the gross amount of the payment equal to the highest rate in effect under section 11 (which is currently 20 percent) unless the foreign subsidiary chooses to opt-in to the U.S. tax code by electing into the effectively connected income regime. Note that this excise tax is only for multinational taxpayers with $100 million or more of such related party payments. The excise tax is a negative element of the House bill that will effect U.S. multinational groups that import parts or manufacture products from affiliates outside the U.S.
As noted, U.S. tax reform is a fast-moving process: the 1986 tax reform bill was years in the making — the TCJA is compressing that work into weeks. The final tax reform bill may be very different from the current one — and each taxpayer will face unique opportunities and challenges. We encourage clients to talk with us about the opportunities and challenges they face under the new system.