Transition Tax and Notice Foreign Tax Credits BEAT Interactions

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1 Transition Tax and Notice Foreign Tax Credits BEAT Interactions Steve Blore Greg Kernek Deloitte Tax LLP May 11, 2018

2 Transition Tax and Anti-Avoidance Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

3 Transition Tax: The concept and example What happens Subpart F increased by USP s pro rata share of deferred foreign earnings Based on greater of 11/2 or 12/31 E&P balance per DFIC Inclusion reduced by EDFC deficit balance as of 11/2 Deduction allowed to achieve a 15.5% ETR on earnings to the extent of its aggregate foreign cash position (AFCP), and an 8% ETR on earnings in excess of the AFCP. AFCP is measured as of last day of all DFICs/EDFCs tax years beginning before January 1, 2018, or the average of each such DFICs/EDICs last two years ending before November 2, 2017, whichever is higher Foreign tax credit is reduced in proportion to the deduction (based on 2017 corporate tax rates) Considerations What happens to the taxes associated with DFIC s PTI? See later slide! What happens to EDFC s deficit? What about fiscal year end entities? USP DFIC 11/2 E&P: 90 12/31 E&P: 100 Taxes: (a) PTI: (b)(4)(A) PTI: 75 Taxes: 30 Cash Balances 12/31/17: 15 12/31/16: 5 12/31/15: 15 Inclusion: 25 (100 75) 78 Gross up: 10 (25/100 * 40) Deduction: (19.5) (25+10)*.557 Net TI: 15.5 US tax at 35%: 5.4 (5.4/35 = 15.5%) Less FTC: 4.4 (10*.557) Total Tax: 1 EDFC 11/2 E&P: <75> 12/31 E&P: <90> Taxes: 20 Cash Balances 12/31/17: /31/16: 0 12/31/15: 10 5 AFCP 12/31/17: 25 12/31/16: 12/31/15: 15 Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

4 Transition Tax: General rules and considerations Section 965 Transition Tax Last taxable year of a specified foreign corporation (SFC) beginning before January 1, 2018 ( inclusion year ) Subpart F income increased by SFC s accumulated post-1986 deferred foreign income as of November 2 or December 31 ( section 965(a) earnings amount ), whichever is greater SFC: any foreign corporation that is a CFC or has at least one US corporate shareholder, except that it excludes PFICs that are not also CFCs Any US shareholder of an SFC generally has a section 951 inclusion of its pro rata share of its untaxed deferred E&P as subpart F income ( section 965 inclusion ). The section 965 inclusion is reduced by US shareholder s pro rata share of certain SFC deficits A portion of the section 965 inclusion is deductible under section 965(c), resulting in reduced effective rate of tax. The deduction rate depends on US shareholder s pro rata share of SFC cash assets Effective corporate rates of 15.5% (to extent of US shareholder s aggregate foreign cash position or AFCP ) 8% (remainder) (deduction rate based on the highest rate of tax applicable to corporations in the taxable year of inclusion, even if the US shareholder is an individual) FTC for deemed-paid taxes disallowed for the applicable percentage of taxes paid or accrued with respect to any amount for which a deduction is allowed under section 965: [0.771 * ( 965 inclusion AFCP)/ 965 inclusion] + [0.557 * AFCP/ 965 inclusion] Full 35% tax imposed if US company inverts within ten years after enactment Notes and observations Election to pay in increasing installments over eight years Additional timing accommodations relating to S-corps and REITs Appears generally to apply to individuals as well as corporations, so long as there is one corporate US shareholder (direct or indirect) Guidance provided under Notices and Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

5 Notice Anti-Avoidance Rule Treasury and the IRS intend to issue regulations under 965(c)(3)(F) and (o) providing that a transaction will be disregarded for purposes of determining a US shareholder s 965 tax liability if each of the following conditions is satisfied: Transaction occurs (in whole or in part) on or after November 2, 2017 Transaction is undertaken with a principal purpose of reducing the 965 tax liability of such US shareholder, and Such transaction would reduce the 965 tax liability of such US shareholder. A transaction reduces the 965 tax liability of a US shareholder if it does any of the following: Reduces a 965(a) inclusion amount Reduces the US shareholder s aggregate foreign cash position, or Increase the amount of foreign income taxes of any specified foreign corporation ( SFC ) deemed paid by such US shareholder under 960 as a result of an inclusion under 951(a) by reason of 965. For purposes of the anti-abuse rule, a domestic owner of a domestic passthrough entity is also treated as a US shareholder. Transfer includes any (1) disposition, (2) exchange, (3) contribution, (4) distribution, (5) issuance, (6) redemption, (7) recapitalization, or (8) loan, and includes indirect transfers (e.g., a transfer of a partnership interest is a transfer of the partnership s assets). Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

6 Transition Tax Notice , 3.04(a)(iv) Example Internal Group Transaction FP On 1/2/18, USP sells all of the stock of FS to FP in exchange for cash, in a transaction that is recharacterized as a dividend eligible for the 245A dividends-received deduction pursuant to 1248(j). On 1/3/18, FS makes a distribution with respect to the stock transferred to FP. USP 12/31 TYE FS 11/30 TYE Under Notice , 3.04(a)(iv), the transfer of the stock of FS is a pro rata share transaction because such transfer is to a person related to USP, and the transfer would, without regard to the antiavoidance rule, reduce USP s pro rata share of FS s 965(a) earnings amount. Because USP and FP are also members of an affiliated group within the meaning of 3.04(a)(iv), the transfer of the stock of FS is also an internal group transaction and is treated per se as being undertaken with a principal purpose of reducing the 965 tax liability of USP. Accordingly, the transfer will be disregarded for purposes of determining USP s 965 tax liability with the result that, among other things, USP s pro rata share of FS s 965(a) earnings amount is determined as if USP owned (within the meaning of 958(a)) 100 percent of the stock of FS on the last day of FS s inclusion year and no other person received a distribution with respect to such stock during such year. Copyright 2018 Deloitte Development LLC. All rights reserved. International Tax Reform Notice

7 Notice Anti-Avoidance Rule: Presumed and Per se * Relatedness is determined under 267(b) and 707(b), immediately before or after the transaction Description Definition Tax Avoidance Presumed Exceptions Per se Tax Avoidance Exceptions 3.04(a)(ii) Cash Reduction Transaction Transfer that would reduce the aggregate foreign cash position of SFC s US shareholder Transaction is a (i) (ii) Transfer of cash, A/R, or cash equivalent assets (see 965(c)(3)(B)(iii)) by an SFC to SFC s US shareholder or person related* to SFC s US shareholder Assumption by SFC of A/P of its US shareholder or person related* to SFC s US shareholder - Transaction occurring in the ordinary course of business - Rebuttable if facts and circumstances clearly establish transaction was not undertaken with a principal purpose of tax avoidance Specified distribution: distribution by an SFC to its US shareholder or a person related* to SFC s US shareholder, if (i) there was a plan or intent for distributee to transfer (directly/indirectly) 965(c)(3)(B) assets to any SFC or (ii) distribution is non-pro-rata to a related* foreign person Distribution by an SFC to its US shareholder treated as per se NOT undertaken with a principal purpose of tax avoidance 3.04(a)(iii) E&P Reduction Transaction Transaction that would reduce accumulated post-86 deferred foreign income or post-86 undistributed earnings Transaction between an SFC and (i) (ii) (iii) SFC s US shareholder Another SFC of the SFC s US shareholder Any person related* to SFC s US shareholder - Transaction occurring in the ordinary course of business - Rebuttable if facts and circumstances clearly establish transaction was not undertaken with a principal purpose of tax avoidance Specified transaction: (i) (ii) (iii) Complete liquidation of SFC under 331 Sale/disposition of stock by SFC Distribution by SFC that reduces its E&P under 312(a)(3) None. 3.04(a)(iv) Pro Rata Share Transaction Transfer of SFC s stock to SFC s US shareholder or a person related* to its US shareholder Transfer would (i) (ii) (iii) Reduce US shareholder s pro rata share of 965(a) amount Increase US shareholder s pro rata share of a specified E&P deficit Reduction to US shareholder s pro rata share of cash position Disregard of certain accounting method changes and entity classification elections - Rebuttable if facts and circumstances clearly establish transaction was not undertaken with a principal purpose of tax avoidance Internal group transaction: pro rata share transaction if transferor and transferee are members of an affiliated group** in which the US shareholder is a member **affiliated group as defined in 1504(a), ignoring 1504(b), and with a special rule for 80%-owned partnerships None. 3.04(b) Accounting Method Changes and Entity Classification Elections - Change in method of accounting for an SFC s taxable year that ends in 2017 or 2018 that would otherwise reduce US shareholder s 965 tax liability - Entity classification election that would reduce the 965 tax liability of any US shareholder Reduction in 965 tax liability (i) (ii) (iii) Reduces 965(a) inclusion amount Reduces aggregate foreign cash position Increases the amount of foreign income taxes of any SFC deemed paid by such US shareholder under 960 as a result of an Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11, inclusion under 951(a) by reason of 965 Exception: Original Form 3115 requesting the change was filed before 11/2/17 Exception: Entity classification election filed before 11/2/17 Rule applies regardless of whether the change is made with a principal purpose of reducing the 965 tax liability of a US shareholder

8 Treatment of E&P in future years Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

9 Transition tax Treatment of E&P in future years Deferred Foreign Income Corporations ( DFIC ) 965(b)(4)(A) 965(b)(4)(A) provides that if a 965(a) inclusion from a DFIC is reduced by the US shareholder s aggregate E&P deficit, the reduction amount becomes PTI beginning in the year of the inclusion. Taxes not deemed paid with 965(a) inclusion may be creditable when PTI is distributed. See new 960(b) and (c) and old 960(a)(3) and (b). Cf. CCA (March 1, 2002). E&P Deficit Foreign Corporation ( EDFC ) 965(b)(4)(B) 965(b)(4)(B) provides that a US shareholder s pro rata share of E&P of an EDFC is increased by the amount of the EDFC s deficit that reduced 965(a) inclusions from one or more DFICs. The increase occurs beginning in the year of the inclusion and, for purposes of 952, is attributable to the same activity as the deficit. Some uncertainty as to the meaning of US shareholder s pro rata share language. Presumably calls for an adjustment to EDFC s post-1986 undistributed earnings while they still matter, but these are not typically based on US shareholders shares of the foreign corporation s earnings. Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

10 Transition tax Accessing remaining taxes in DFIC: 965(b)(4)(A) Base case USP s 965 inclusion from DFIC is reduced to zero by deficit in EDFC, and 100 E&P in DFIC becomes PTI in taxes remain in DFIC Enhancement Distribute DFIC earnings. When PTI in DFIC is distributed, USP may be deemed to have paid 30 taxes in DFIC which are properly allocable to 100 PTI under new 960(b) / old 960(a)(3). Presumably deemed-paid taxes are general basket, assuming underlying earnings would have been general-basket earnings if distributed Note: 78 gross-up applies to deemed paid taxes Considerations Whether USP is able to claim FTC for deemed paid taxes depends on its FTC limitation. 960(c) may provide additional 904 limitation in year PTI is distributed Note: If deemed paid, taxes apparently not haircut because taxes are not paid or accrued with respect to an amount for which a deduction is allowed under / PTI 30 taxes USP 12/31 DFIC EDFC 12/31 E&P: 100 Taxes: 30 E&P: <100> Assumes consistent level of E&P at all relevant testing dates Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

11 Foreign Tax credits Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

12 Foreign Tax credits Modifications to Existing FTC Rules: 902 and 904(c), (d), and (g) 902 is repealed for taxable years beginning after December 31, 2017, which means that a pooling approach to computing deemed paid taxes is gone. 904(c) carryover periods for excess FTCs generally still apply, but no carryover is allowed for excess credits arising from GILTI inclusions 904(d) is amended to add two new separate baskets GILTI basket (includes income described in 951A other than passive income) Branch income basket (includes income from foreign branches other than passive income) 904(g) now provides an election to accelerate recapture of overall domestic loss (ODL) accounts Limited to ODLs attributable to pre-effective date years (including the inclusion year) Provision expires December 31, 2027 Absent IRS guidance, OFL and ODL accounts in general or passive baskets are not recaptured out of/recharacterized as GILTI or branch basket income Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

13 Foreign Tax credits Modifications to Existing FTC Rules: 960 Revised 960(a) would allow a deemed paid credit on subpart F inclusions computed on an annual basis Only taxes properly attributable to an item of income included under 951(a) are creditable Citing Treas. Reg , the JCT report states [i]t is anticipated that the Secretary would provide regulations with rules for allocating taxes similar to rules in place for purposes of determining the allocation of taxes to specific foreign tax credit baskets Treas. Reg does not use the term properly attributable but states that taxes are related to income if the income is included in the base on which the tax is imposed New 960(d) would provide special, limited deemed paid credit for taxes properly attributable to GILTI inclusions. The income and credits (as previously noted) would be included in a separate basket, and no excess credit carryovers would be allowed Revised 960(b) modifies a rule previously in 960(a)(3), allowing deemed paid credits for foreign taxes associated with PTI distributions Unlike under current law, additional taxes paid on PTI distributions are subject to 78 gross-up Current law 960(b) is re-designated 960(c) and continues to potentially provide additional limitation in the year PTI is distributed to allow a corporation to claim additional foreign taxes imposed on PTI distributions as credits Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

14 Foreign Tax credits 960(b) Taxes imposed on PTI 12/31 USP DFIC EDFC 12/31 E&P: 100 Taxes: 20 12/31 E&P: (77.50) Taxes: 0 Subpart F income of a deferred foreign income corporation (as otherwise determined under section 952) will be increased by the greater of accumulated post-1986 deferred foreign income of such corporation determined at two fixed testing dates, November 2, 2017 and December 31, 2017 Under 965(g), FTC for deemed-paid taxes generally are disallowed at the same rate as the portion of the 965 inclusion that is deductible When PTI is distributed, 960(b) provides that the recipient shall be deemed to have paid so much of such foreign corporation s foreign income taxes as are properly attributable to the PTI distributed Scenario USP has a 965 inclusion of from DFIC on 12/31/17 and computes 4.50 pre-haircut deemed-paid taxes [22.50/100 * 20]. The inclusion becomes PTI of DFIC under (b)(4)(A) converts the amount not included by reason of an allocable deficit (77.50) into additional DFIC PTI As of December 31, 2017 and after its 965(a) inclusion, DFIC has 100 PTI and taxes, and EDFC has 0 E&P and taxes In 2018, DFIC distributes 100 PTI to USP 960(b) apparently allows deemed paid taxes on PTI distribution USP includes taxes in income under 78 The better view is is not haircut because not attributable to the 965 inclusion * Assume E&P is consistent at each relevant testing date Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

15 Section 904(d)(1)(A): The GILTI Basket Tested Income and Tested Foreign Income Taxes Under section 960(d)(1), if any amount is includible in the gross income of a domestic corporation under section 951A, such corporation is deemed to have paid foreign income taxes equal to 80 percent of (A) such domestic corporation's inclusion percentage [GILTI/tested income], multiplied by (B) the aggregate tested foreign income taxes paid or accrued by controlled foreign corporations. USP GILTI 70 Section 960(d)(3) defines "tested foreign income taxes" as the foreign income taxes paid or accrued by the CFC which are properly attributable to the tested income [and not GILTI income] of such foreign corporation taken into account by such domestic corporation under section 951A. CFC1 CFC2 ISSUES: What happens to tested income that is not GILTI and tested taxes that are not deemed paid? CONCLUSIONS: Tested Income: Tested income taken into account in computing deemed paid taxes does not come up to USP and thus remains in CFC and available for distribution as a dividend or section 956 inclusion. Taxes: Taxes subject to 20% haircut disappear, consistent with legislative history which suggests no intent to preserve the tested foreign taxes subject to the 20% haircut. Taxes not deemed paid because inclusion percentage is less than 100% remain available to be deemed paid in a future year with a section 956 inclusion, i.e., taxes don t come up to USP. Tested Income (30) Tested Income 100 Tested Foreign Income Taxes 25 CFC2 Section 960(d) = 80% x 70/100 x 25 = 14 deemed paid credit Inclusion percentage: 70% What happens to the 11 of remaining taxes? 1) 20% x 70% x 25 = 3.5 permanently lost 2) (1 70%) x 25 = 7.5 available at CFC1 as future deemed paid credits Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

16 Section 904(d)(1)(A): The GILTI Basket Overview/Look-Through Section 904(d) has been amended to add a separate basket for GILTI (includes income described in section 951A other than passive category income and branch income). Section 904(c) carryover periods for excess FTCs generally still apply, but no carryover is allowed for excess credits arising from GILTI inclusions. Section 904(d)(3) Look-through rules Characterize dividends, interest, rents, royalties received by a U.S. shareholder from a CFC as general limitation income unless properly assigned to another separate limitation category based on CFC s earnings. For example, rents and royalties received or accrued by a U.S. shareholder from its CFC are characterized based on category to which CFC s corresponding expense relates. A CFC has tested income but the GILTI basket exists only at the U.S. shareholder level. Thus, interest, rent, and royalty payments from a CFC to its U.S. shareholder MLTN are characterized under the default rule as general limitation income. Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

17 Section 904(d)(1)(A): The GILTI Basket Section 78 Under section 78, the additional amount included in gross income is treated as a dividend for all purposes (except sections 245 and 245A). Section 904(d)(3)(G) provides an exception for a section 78 gross-up on a section 951(a)(1)(A) inclusion, treating it as an additional subpart F inclusion for purposes of applying the look-through rules. There is no analogous exception for a section 78 gross-up on a section 951A inclusion. Thus, the section 78 gross-up on a section 951A inclusion is included in gross income as a dividend, which by definition is not GILTI but is taxable because section 245A does not apply. USP CFC Tested Income 100 Tested Foreign Income Taxes 20 Look-through does not apply so dividend defaults to general limitation category. Taxes attributable to the section 78 gross-up We believe it is acceptable to treat the section 960(d) deemed paid taxes as entirely in the GILTI basket. Tested Income (net of 250) Section 78 net of 250) Section 960(d) FTC Limit Excess Limit (Credit) However, it is also reasonable to pro rate section 960(d) deemed paid taxes between GILTI and general baskets. See Treas. Reg (a)(1)(ii). GILTI basket or (5.50) or (2.30) General Limitation or (1.1) Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

18 Section 904(d)(1)(A): The GILTI Basket Exclusion of Passive Category Income and Branch Income Section 904(d)(1)(A) defines the GILTI basket as including any amount included in gross income under section 951A, but excluding passive category income and branch income. Given that there is no GILTI basket at the CFC level, tested income and losses of all CFCs are first aggregated at the U.S. shareholder level. Once the total GILTI inclusion amount is determined at the U.S. level, it is prorated among CFCs with positive tested income. If tested income or loss includes passive category income, guidance is needed on when that income should be excluded from the GILTI calculation. Nearly all passive income/loss at CFC level likely is currently included under subpart F or an expense allocable to subpart F income, and thus would not be a tested income/loss. If tested income, in an unusual case, included passive income, apparently passive income would be included in GILTI and then moved to passive basket. Unclear whether passive income would move before or after section 250. If tested income, in an unusual case, included passive losses, apparently loss would reduce GILTI. Unclear whether any adjustment would be required at U.S. level. Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

19 The Branch Basket Section 904(d)(1)(B) & (2)(J) Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

20 Section 904(d)(2)(J): The Branch Basket General Rule The Act creates a new foreign branch income basket under section 904(d)(1)(B), defined under section 904(d)(2)(J). Foreign branch income means the business profits of a U.S. person which are attributable to one or more qualified business units ( QBUs ) (as defined in section 989(a)) in one or more foreign countries. Foreign branch income does not include passive category income. The amount of business profits attributable to a QBU shall be determined under rules established by the Secretary. In short, for income to be included in the branch basket you need: (1) business profits (2) of a U.S. person (3) attributable to (4) a QBU (5) in a foreign country. Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

21 Section 904(d)(2)(J): The Branch Basket Business Profits Assumes gross income less deductions (i.e., net concept). Gross income and deductions must be regarded for U.S. federal income tax purposes. Presumes a trade or business. Consider a per se QBU with no trade or business. Presumes profits are derived from the conduct of a trade or business. Consider whether interest and royalties booked at the branch are per se business profits. Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

22 Section 904(d)(2)(J): The Branch Basket Attributable to For income, consider three approaches under existing authorities: Booking method: Treas. Reg (a)-1(d)(3) ( The principles of (b) shall apply in determining whether an asset, liability, or item of income or expense is reflected on the books of a qualified business unit (and therefore is attributable to such unit). ) and Treas. Reg (d)-5(c)(3) ( Except to the extent provided in paragraph (c)(4) of this section, the domestic owner's items of income, gain, deduction, and loss are attributable to the extent they are reflected on the books and records of the hybrid entity or transparent entity, as applicable, as adjusted to conform to U.S. tax principles. ). ECI/DCL branch method: Income is attributable to a U.S. trade or business or foreign branch separate unit under the section 864 regulations. See also Treas. Reg (d)-5(c)(2). Note that the U.S. Model Technical Explanation of Article 7 (Business Profits) notes that the treaty concept of income attributable to a PE and the ECI concept under section 864(c) are analogous but somewhat different. PE method: In the treaty context, the business profits attributable to a PE are the profits it would have earned if it were a separate and independent enterprise engaged in the same or similar activities under the same or similar conditions. For expenses, look to Treas. Reg through -17. See Treas. Reg T(f)(1)(ii). Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

23 Section 904(d)(2)(J): The Branch Basket QBU and in One or More Foreign Countries QBU Section 989(a) definition of a QBU as any separate and clearly identified unit of a trade or business of a taxpayer which maintains separate books and records applies. Arguably, the per se QBUs described in Prop. Reg (a)-1 would qualify as QBUs for this purpose (but may not have attributable business profits and thus may not earn branch income). In one or more foreign countries Consider place of organization and/or principal place of business. Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

24 Section 904(d)(2)(J): The Branch Basket Attribution of USP Profits to Branch USP USP Disregarded payment for contributing to widget manufacture DRE Payment for third party services contributing to widget manufacture 3 rd Party Disregarded income from purchase of manufactured widget DRE Income for purchase of widget 3 rd Party Scenario: USP manufactures widgets through its DRE and pays DRE an arm s length price for manufacturing services. DRE contracts with a third party to contribute to the manufacture of the widgets. USP sells the finished widgets (income from sale to 3 rd party not depicted). Assume DRE is a QBU. Considerations What income and deduction are attributable to DRE? Should DRE be attributed a portion of the income earned by USP? Consider the source of the income. Scenario: DRE purchases widgets manufactured by USP at an arm s length price. DRE sells the widget to an unrelated third party at a mark up over purchase price. Assume DRE is a QBU. Assume sale to foreign party for foreign use. Considerations What income and deduction are attributable to DRE? Is income paid to DRE foreign branch income and, therefore, not DEI for purposes of FDII? See section 250(b)(3)(A)(i). Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

25 Section 904(d)(2)(J): The Branch Basket Payments to Branches from CFCs USP USP USS DRE 10% 90% Royalty / interest CFC Royalty / interest Foreign P/S CFC Scenario CFC pays a royalty to DRE. Assume DRE is a QBU and payment qualifies as business profits under section 904(d)(2)(J)(i). Considerations Is the payment foreign branch income or does look through apply? For royalties, consider where the IP is booked. Scenario CFC pays a royalty to Foreign P/S. Assume P/S is a QBU and payment qualifies as business profits under section 904(d)(2)(J)(i). Considerations Is the payment foreign branch income or does look-through apply? Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

26 Interest Expense Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

27 Interest Expense Apportionment Valuation and Characterization of CFC Stock The value of a U.S. shareholder s investment in CFCs equals its tax basis in its stock in a first-tier CFC (excluding section 961 basis), increased or decreased by accumulated E&P (including PTI) of the first-tier CFC and any lower-tier CFCs (pro rated if less than 100% ownership). See Treas. Reg T(c)(2)(i)(B). After valuing CFC stock, the stock must be characterized as an asset generating income in one or more separate limitation categories using the same method the CFC uses to apportion interest expense (tax book value (TBV) or modified gross income (MGI)). Treas. Reg T(c)(3)(i). The TBV method characterizes stock based on a tax book value of the assets owned by the CFC (and lower-tier CFCs) during the taxable year under Treas. Reg T(g)(3) as if the CFC were a U.S. corporation. The MGI method characterizes the stock based on the gross income (net of interest expense) of the controlled foreign corporation and each lower-tier corporation in each separate category. Treas. Reg T(g)(3) provides as the general rule that assets are characterized according to the source and type of the income that they generate, have generated, or may reasonably be expected to generate. If an asset generates income in more than one category (a multiple category asset), however, the regulation does not look to the types of income in each category that the asset has or may be expected to generate. Instead, multiple category assets are characterized based on the assets current year income yield. The value of each asset is then prorated among the relevant groupings of income according to their respective proportions of gross income. Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

28 Interest Expense Apportionment Section 904(b)(4) Section 904(b)(4) provides: A domestic corporation that receives a dividend eligible for the 100% DRD under section 245A must allocate and apportion expenses to the exempt income, and those expenses then are disregarded in computing the FTC limitation. In addition, expenses allocable and apportionable to stock, a dividend on which would qualify for the 100% DRD, are disregarded except to the extent earnings with respect to the stock are included under section 951(a)(1) or section 951A(a). The Conference Report states: For purposes of computing the section 904(a) foreign tax credit limitation, a domestic corporation... must compute its foreign-source taxable income (and entire taxable income) by disregarding the foreign-source portion of any dividend received from that foreign corporation for which the DRD is taken, and any deductions properly allocable or apportioned to that foreign-source portion or the stock with respect to which it is paid. Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

29 Interest Expense Apportionment Impact of Exempt Income and Assets - Section 864(e)(3) Section 864(e)(3): For purposes of allocating and apportioning any deductible expense, any tax-exempt asset (and any income from such an asset) shall not be taken into account. A similar rule shall apply in the case of the portion of any dividend (other than a qualifying dividend as defined in section 243(b)) equal to the deduction allowable under section 243 or 245(a) with respect to such dividend and in the case of a like portion of any stock the dividends on which would be so deductible and would not be qualifying dividends (as so defined). In the Senate version of TCJA, section 245A was proposed to be added to section 864(e)(3). However, this proposed addition of section 245A was not included in the final version of the bill (instead section 904(b)(4) was enacted). Treas. Reg T(d)(2)(i) provides that exempt income and exempt assets are not taken into account in apportioning deductions to gross income. An exempt asset means any asset, the income from which is, in whole or part, exempt, excluded, or eliminated for federal tax purposes. Exempt income includes dividends deductible under section 245(a) [U.S.-source dividends from a 10%-owned foreign corporation]. Treas. Reg T(d)(2)(ii)(B) further provides that for purposes of apportioning deductions using an asset method, assets would not include that portion of stock equal to the portion of dividends paid thereon that would be deductible under... section 245(a). Consider conference report language with respect to new section 250 (deduction for GILTI and FDII) treating the deduction as an exemption from taxable income. Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

30 Interest Expense Apportionment GILTI Example MGI Method, Base Case (No QBAI or Tested Losses) TBV 1,000 U.S. Assets U.S. Gross income 2,000 USP Interest expense 500 CFC TBV 850 Tested Income 300 QBAI 0 ASSUMPTIONS: USP apportions interest expense using TBV method; CFC apportions interest using MGI USP has 300 GILTI inclusion, 150 of which is deducted under section 250. CFC stock is a GILTI generating asset even though there is no GILTI basket at the CFC level. The CFC stock may be treated as a multiple category asset. Thus stock may be characterized under Treas. Reg T(c)(3) and T(g)(3) based on its current year income yield % (300/300) of 850 TBV assigned to GILTI = 850 USP s 500 of interest expense is apportioned accordingly: to U.S.-source 500 * 1000/ to GILTI 500 * 850/1850 Thus, USP has 1, of U.S. source income and (79.7) [(300 * 50% section 250) 229.7] of GILTI. Considerations Under MGI, CFC stock is characterized based on gross, rather than net, income, but GILTI/tested income is a net amount Effect (if any) of section 864(e)(3) with respect to CFC stock Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

31 Interest Expense Apportionment GILTI Example MGI Method, CFC has QBAI TBV 1,000 U.S. Assets U.S. Gross income 2,000 USP Interest expense 500 CFC TBV 850 Tested Income 300 QBAI 1,500 ASSUMPTIONS: USP apportions interest expense using TBV method; CFC apportions interest using MGI Analysis USP has 150 GILTI inclusion (300 tested income less 10% * 1500 QBAI), 75 of which is deducted under section 250. CFC stock is a GILTI generating asset even though there is no GILTI basket at the CFC level. The CFC stock may be treated as a multiple category asset. Thus stock may be characterized under Treas. Reg T(c)(3) and T(g)(3) based on its current year income yield: - The portion of CFC s income reduced by QBAI may be treated as follows: o o o Characterize as general or passive at CFC level. Treat as exempt under section 904(b)(4) because when distributed all untaxed earnings likely would qualify for the section 245A DRD. Treat all tested income as deemed included by U.S. shareholder. If not included under section 951A, tested income treated as a dividend eligible for section 245A DRD and thus exempt under section 904(b)(4). Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

32 Interest Expense Apportionment GILTI Example MGI Method, CFC has QBAI (Continued) TBV 1,000 U.S. Assets U.S. Gross income 2,000 USP Interest expense 500 CFC TBV 850 Tested Income 300 QBAI 1,500 ASSUMPTIONS: USP apportions interest expense using TBV method; CFC apportions interest using MGI Analysis (Cont.) Accordingly, the CFC stock may be characterized as follows: - 50% (150/300) of 850 TBV assigned to GILTI = % (150/300) of 850 TBV assigned to general, passive, OR DRD/exempt because of QBAI = 425. Considerations Under MGI, CFC stock is characterized based on gross, rather than net, income, but GILTI/tested income is a net amount Effect (if any) of section 864(e)(3) with respect to CFC stock Consider whether CFC must pay a dividend eligible for the section 245A DRD in order for section 904(b)(4)(B)(ii) to apply Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

33 Interest Expense Apportionment Interaction of Section 904(b)(4) and the DRD Holdco Base Case BANK U.S. Assets Interest expense 300 USP TBV 200 TBV 400 Distribution 150 Distribution 100 CFC1 CFC2 PTI 100 ECI Foreign Branch ECI 50 Absent the section 245(a) distribution, interest expense would be allocated 100 to U.S. source income (300*(200/600)) and 200 to foreign source income (300*(400/600)). However, as a result of the application of section 864(e)(3) and Treas. Reg T(d)(2)(ii), the TBV of the CFC stock should be 140. As a result, interest expense should be allocated 176 to U.S. source income (300*(200/340)) and 124 to foreign source income (300*(140/340)). 65% of the stock is exempt per section 864(e)(3) and Treas. Reg T(d)(2)(ii); these rules look to the deduction allowable under sections 243 and 245(a). Considerations Affiliation under section 864(e)(5), if more than 50% of CFC s income is ECI. However, as a result of the distribution from CFC2, only 33% of CFC1 s gross income is ECI and section 959(b) excludes the 100 from CFC1 s E&P. 100 of the distribution to USP is not treated as a dividend. Section 959(d). ASSUMPTIONS: USP apportions interest expense using TBV method; no 245A; no GILTI Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

34 Interest Expense Apportionment Interaction of Section 904(b)(4) and the DRD Holdco BANK U.S. Assets Interest expense 300 USP TBV 200 TBV 400 Distribution 200 Distribution 100 PTI 50 (c)(3) CFC1 CFC2 ECI Foreign Branch ECI 50 USP receives 50 of dividend income eligible for section 245A. Section 864(e)(3) and Treas. Reg T(d)(2)(ii) apply; the TBV of the CFC stock should be 270 (50% of dividends paid qualify for 65% deduction [400-(50%*400*65%)]). Section 904(b)(4) applies. USP s 300 of interest expense is apportioned accordingly: 128 to U.S.-source income 300 * 200/ to DRD/exempt income 300 * 270/470 0 to foreign source income PTI 100 ASSUMPTIONS: USP apportions interest expense using TBV method; no GILTI Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

35 Interest Expense Apportionment Interaction of Section 904(b)(4) and the DRD Holdco BANK U.S. Assets Interest expense 300 USP TBV 200 TBV 400 Distribution 200 Distribution 100 PTI 50 (c)(3) CFC1 CFC2 Tested Income 75 QBAI 0 ECI Foreign Branch ECI 50 USP has 75 GILTI inclusion, 37.5 of which is deducted under section 250. USP receives 50 of dividend income eligible for section 245A. Section 864(e)(3) and Treas. Reg T(d)(2)(ii) apply; the TBV of the CFC stock should be 270. Section 904(b)(4) applies. USP s 300 of interest expense is apportioned accordingly: 128 to U.S.-source income 300 * 200/ to foreign source income 300 * 270/470 * 75/ to DRD/exempt income 300 * 270/470 * 50/125 PTI 100 Tested Income 0 QBAI 0 ASSUMPTIONS: USP apportions interest expense using TBV method Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

36 Base Erosion Anti-abuse Tax ( BEAT ) Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

37 Base Erosion Anti-abuse Tax (BEAT) Overview Element US Tax Applicable taxpayer Taxable base Safe harbor Foreign Tax credit Observations BEAT Applicable taxpayer pays Base Erosion Minimum Tax Amount (BEMTA) if 10% of its modified taxable income (5% for taxable years beginning in 2018) exceeds Its regular tax liability (reduced by credits other than (1) section 41(a) research credits and (2) a portion of applicable section 38 credits equal to 80% of applicable section 38 credits or the BEMTA determined without such credits) Corporations (excluding RICs, REITs, and S corps) Modified taxable income Taxable income determined without regard to Base erosion tax benefits with respect to base erosion payments o Amounts paid or accrued to a foreign related party (generally, 25% relatedness ), including in connection with the acquisition of depreciable/amortizable property o Amounts constituting a reduction in gross receipts paid or accrued to a related surrogate foreign corporation or a foreign member of the surrogate foreign corporation s expanded affiliated group (applies to 60-80% inversions post-11/9/17) o Excludes Base erosion payments taxed at 30% under sections 871 or 881 No-markup services, if certain requirements in section 482 met Certain qualified derivatives Base erosion percentage of any NOL Three-year average annual gross receipts (including those of related domestic corps and ECI of foreign corps) of $500 million or less Base erosion percentage (ratio of base erosion tax benefits to all deductions excluding deductions allowable under sections 172, 245A, and 250, and deductions with respect to certain at-cost service payments and qualified derivative payments excepted from BEAT) of less than 3% (2% for banks ) for the taxable year N/A Interaction with GILTI and ECI under section 882 could give rise to double US-taxed payments Financial transactions could qualify as base erosion payments to the extent such transactions fail to qualify for the qualified derivatives exception If taxpayer s regular tax liability is reduced more than 50% by credits or if taxpayer s taxable income is reduced more than 50% by base erosion payments, BEAT may impose additional tax COGS not included in base erosion payments Application to taxpayers with large NOLs Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

38 Tax on base erosion payments The Senate proposal imposes a minimum tax equal to the Base Erosion Minimum Tax Amount ( BEMTA ) of an applicable taxpayer for a taxable year Applicable taxpayer s BEMTA = 10%* X Modified taxable income Regular tax liability less tax credits (excluding section 41(a) research credits and a portion of applicable section 38 credits) An applicable taxpayer is generally any corporation other than a REIT, RIC, or S corporation An applicable taxpayer only includes corporations that have average annual gross receipts greater than $500 million for the previous three taxable years (taking into account related US corporations gross receipts, and in the case of a foreign taxpayer, gross receipts attributable to ECI) 3% Safe Harbor: There exists a safe harbor for corporations that have a base erosion percentage of less than 3% for the taxable year. The safe harbor is 2% for banks Modified taxable income ( MTI") The applicable taxpayer s Chapter 1 taxable income in a taxable year determined without regard to a base erosion tax benefit (a deduction allowed in the taxable year with respect to a base erosion payment) A base erosion tax benefit does not include deductions attributable to base erosion payments that are taxed under sections 871 or 881 and withheld upon under sections 1441 or If such payments are subject to a reduced rate of tax, this exclusion only applies to the proportion of such reduction * 5% for taxable years beginning in 2018 Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

39 Tax on base erosion payments (cont d) Modified taxable income (cont d) Modified taxable income also includes a percentage of NOLs equal to the NOL s base erosion percentage defined on the next slide) A base erosion payment is defined broadly to include any amount paid or accrued by a taxpayer to a related foreign person with respect to which a deduction is allowable A base erosion payment also includes a payment to a related foreign person in connection with the acquisition of property subject to depreciation or amortization deductions and a payment that reduces a taxpayer s gross receipts made to related surrogate foreign corporations defined in section 7874(a)(2) or a foreign member of a related surrogate foreign corporation s EAG A taxpayer s base erosion percentage is equal to the ratio of The taxpayer s aggregate deductions with respect to base eroding payments, over The taxpayer s total amount of Chapter 1 deductions (including deductions with respect to base erosion payments) other than deductions allowed under section 172 (NOLs), section 245A (relating to the Act s 100% DRD), section 250, 1 and those deductions relating to the exception from the BEAT for at-cost service payments and qualified derivatives Regular tax liability ( RTL ) is given the same meaning as in section 26(b), and is generally defined as a taxpayer s tax liability under Chapter 1, excluding certain excise and US source taxes (e.g., gross basis tax on FDAP income under sections 871 and 882 and branch profits tax under section 884) 1 It is assumed that section 250 provides the new deduction for foreign-derived intangible income Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

40 BEAT general example US Foreign Foreign Contract Mfr. Legal title passage $100 Goods Related party payment Third-party payment Services USCo CFC1 CFC2 $200 $300 Services US Customers Meets sub con assume 10% ETR $80 Royalty Base erosion tax benefit: $200 3% Safe harbor: Does not qualify BEAT USCo base erosion percentage: 90.9% $200/$220 =.909 or 90.9% BEMTA = Modified taxable income * 10% (regular tax liability ( RTL ) non- R&E credits) MTI: $280 $ 300 Gross income $ 20 Deductions (without regard to any base erosion tax benefit) $ 280 RTL: $16 $ 300 Gross income $ 220 Deductions X $ 80 21% Corporate rate $ 16.8 Residual US Tax $280 * 10% = $ 28 Less RTL = $ 16.8 BEMTA = $ 11.2 * For purposes of the BEAT computation, assume that (1) USCo has $20 of other deductible costs with third parties (2) USCo qualifies as an Applicable Taxpayer; and (3) The $200 payment for services by USCo is a payment for which a deduction is allowed in the taxable year Key takeaways Total US tax of $28 If CFC1 is not subject to sufficient tax, the base erosion payment could also be subject to GILTI Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

41 Cost sharing arrangements Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

42 Cost sharing arrangements: R&D expenditures $1.5 Billion payment for contract R&D USP and CFC1 are participants in a cost-sharing arrangement that meets the requirements of Treas. Reg Pursuant to the arrangement, the participants are required to share in intangible develop costs (IDCs) with respect to future developed IP in proportion to each participant s reasonably anticipated benefits (RABs) USP $0.5 Billion payment for contract R&D Third-Party or US Related- Party R&D Services Each participant must also make payments to each other (CST Payments) such that their IDC share is in proportion to their respective RAB share CST payment of $1 billion CFC1 CFC2 Generally, a CST Payment made from an applicable taxpayer to a related foreign party as reimbursement for CFC1 s Contract R&D costs paid to foreign parties would give rise to a deduction in the US on account of services performed in a foreign jurisdiction USP and CFC1 s RABs are shared 50% to each participant Before modification, USP bears $2 billion of contract R&D expenditures, $0.5 billion of which are paid to CFC2, a foreign related person. The payment to CFC2 gives rise to a base erosion tax payment and base erosion tax benefit Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

43 Cost sharing arrangements: R&D expenditures (cont d) CST Payment of $0.5 Billion USP $1.5 Billion Payment for Contract R&D Third Party or US Related Party R&D Services Treas. Reg (j)(3)(i) provides that CST payments generally will be considered the payor s costs of developing intangibles at the location where such development is conducted and that [e]ach cost sharing payment received by a payee will be treated as coming pro rata from payments made by all payors and will be applied pro rata against the deductions for the taxable year that the payee is allowed in connection with the IDCs Arguably, contract R&D payments may be modified to cost share participants to minimize BEAT payments under Treas. Reg (j)(3)(i) and Treas. Reg (j)(3)(iii), Example 1 CFC1 CFC2 For example, consider having CFC1 make a $0.5 billion dollar payment for contract R&D services to CFC2 instead $0.5 Billion Payment for Contract R&D The change would eliminate a large base erosion payment from USP and CFC2 Note also that, generally, a CST payment made from an applicable taxpayer to a related foreign party as reimbursement for contract R&D costs paid to foreign parties would give rise to a deduction in the United States Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

44 Interaction with GILTI inclusion Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,

45 BEAT and GILTI interaction Services Legal title passage USP CFC1 Related party payment Third-party payment $100 $120 Good Third-Party Customers Foreign Rate: % QBAI: $0 *For purposes of the BEAT computation, assume that (1) USCo has no deductible costs with third parties (2) No applicable credits besides 901 credits (3) USCo qualifies as an Applicable Taxpayer (4) The $100 payment for services by USCo is a deductible payment for which a deduction is allowed under 162 in the taxable year USCo Net CFC tested income: $100 - $ = $ GILTI: $ $0 QBAI = $ Deemed paid taxes: 80% x $ = $ gross-up: 100% x $ = $ GILTI Base Erosion Tax Benefit: $100 3% Safe harbor: Does not qualify (USCo Base Erosion Percentage: 100% ($100/$100)) BEMTA = Modified Taxable Income ( MTI ) 10% (Regular Tax Liability ( RTL ) non-r&e credits) MTI: $170 $120 Income from sales of good $100 GILTI $ deduction $170 RTL: $14.7 $120 Income from sales of good $100 GILTI $ deduction $ deduction $ 70 X 21% Corporate rate $ 14.7 Key takeaways Residual US Tax GILTI inclusion less 50% deduction: 50% x ($ $13.125) = $50 US Tax before FTC: 21% x $50 = $10.5 FTC: $10.5 Residual US Tax on GILTI: $0 BEAT Residual US Tax $170 10% = $17 Less (RTL - Non-R&E credits) = ($14.7 $10.5) = $4.2 BEMTA = $12.8 The FTC that reduces the US tax on GILTI on the other hand increases BEMTA Copyright 2018 Deloitte Development LLC. All rights reserved. Houston TEI - May 11,