Comprehensive Reform of the U.S. International Tax System The NY State Bar Association Tax Section Annual Meeting

Transcription

1 Comprehensive Reform of the U.S. International Tax System The NY State Bar Association Tax Section Annual Meeting Chair: Kathleen L. Ferrell, Davis Polk & Wardwell LLP Michael J. Caballero, Covington & Burling LLP Peter Connors, Orrick, Herrington & Sutcliffe LLP Danielle Rolfes, KPMG LLP Andrew R. Walker, Milbank, Tweed, Hadley & McCloy LLP January 23, 2018

2 Agenda Introduction General overview of new international tax regime as enacted in the TCJA Discussion of participation exemption, transition tax (including recent guidance), and interactions with existing law New minimum tax provisions on CFC income deemed to be derived from intangibles, and preferential taxation of foreign-derived intangible income (GILTI/FDII) New anti-base erosion rules (BEAT) Discussion of the role of FTCs in the New International Tax Regime 2

3 Quasi-Territorial System New 245A introduces a participation exemption for domestic corporate shareholders Applies to foreign source portion of dividends and capital gain (to the extent capital gain would otherwise be treated as 1248 dividends) Requirements: Holding period (365 days in a 731 day period) 10% of vote or value (incorporating the new definition of U.S. shareholder) Scope Does not apply to PFICs with respect to the shareholder Does not apply to hybrid dividends No foreign tax credit (direct or indirect) is available Observations: As will be discussed further, application of 959/961 and GILTI makes the deduction under 245A somewhat redundant for existing multinationals Deemed repatriation will create large PTI accounts, so that the actual distributions will seldom be taxable dividends without regard to the participation exemption Virtually all income, other than the net deemed tangible income return, will be currently included Does not apply to deemed dividends resulting from 956 inclusions 3

4 Transition Tax General Deemed repatriation of accumulated post- 86 deferred foreign income Applies to 10% U.S. shareholders (corporate and individuals) of: CFCs, and companies i.e., there must be at least one 10% U.S. shareholder that is a domestic corporation A U.S. partnership can be a U.S. shareholder Operates through a subpart F inclusion Deferred foreign income is based on the greater of the aggregate post- 86 accumulated foreign earnings and profits as of November 2, 2017 or December 31, 2017 Deficits can be used to reduce the inclusion 10% U.S. shareholder determination is by vote or value 958(b)(4) repealed so that downward attribution applies to test for CFC status Causes transition tax to apply in a number of unexpected situations 4

5 Change to Constructive Ownership 100% U.S. Sub Foreign Parent 5% Foreign Subsidiary 95% FP owns 95% of a foreign subsidiary and 100% of a domestic corporation (U.S. Sub) U.S. Sub owns the balance (5%) of the foreign subsidiary Foreign subsidiary is treated as a CFC and a specified foreign corporation (SFC) U.S. Sub is treated as a U.S. shareholder U.S. Sub would include the post-1986 deferred income of the SFC but only to the extent of its direct (5%) ownership in the SFC 5

6 Transition Tax Repatriation Rate The repatriation tax rate is achieved through a deduction that is the same for both individuals and corporations. This is the amount necessary to result in a 15.5-percent rate of tax on cash or cash equivalents, and 8-percent rate of tax on all other earnings Corporations: For both taxable year 2017 and 2018, the tax rate with respect to the cash portion is 15.5% Reflecting a deduction of 55.7% for 2017 and a deduction of 26.2% for 2018 For both taxable year 2017 and 2018, the tax rate with respect to the non-cash portion is 8% Reflecting a deduction of 77.14% for 2017 and a deduction of 61.9% for 2018 Individuals: For taxable year 2017 (assuming that the individual maximum tax rate is 39.6%): The tax rate with respect to the cash portion is 17.5% (reflecting a deduction of 55.7%) The tax rate with respect to the non-cash portion is 9.05% (reflecting a deduction of 77.14%) For taxable year 2018 (assuming that the individual maximum tax rate is 37%): The tax rate with respect to the cash portion is 27.31% (reflecting a deduction of 26.2%) The tax rate with respect to the non-cash portion is 14.1% (reflecting a deduction of 61.9%) Individuals may wish to make the 962 election to obtain benefit of indirect credits and reduced rate on repatriation 6

7 Transition Tax What is cash? Cash and foreign currency held by the foreign corporation The net accounts receivable of the foreign corporation; plus The fair market value of the following assets held by the foreign corporation: personal property which is (i) actively traded and (ii) for which there is an established financial market commercial paper, certificates of deposit, the securities of the Federal government and any state or foreign government any obligation with a term of less than one year any asset which the Secretary of the Treasury identifies as being economically equivalent to any asset described above No guidance as of yet Cash is based on the greater of the cash position at the last day of the last taxable year beginning before January 1, 2018, or the average of the cash position at the last day of each of the two taxable years ending immediately before November 2,

8 IRS Notice IRS Notice (December 29, 2017) announces that IRS intends to issue regulations in the following areas: Determination of aggregate foreign cash position Determination of cash position with respect to (a) allocation between multiple inclusion years, (b) treatment of related-party transactions, and (c) treatment of derivatives and hedging transactions Determination of accumulated post 86 deferred foreign income Determination of deferred E&P with respect to (a) adjustments to account for certain amounts paid or incurred between 11/2/2017 and 12/31/2017, (b) distributions to SFCs, (c) SFCs with non-u.s. shareholders Basis adjustments with respect to amounts treated as Subpart F income under 965 The IRS intends to issue regulations under 965(o) to provide appropriate basis adjustments in order to carry out the provisions of 965 Treatment of consolidated groups for purposes of 965, and Determination of foreign currency gain or loss under 986(c) (relating to PTI) 8

9 IRS Notice IRS Notice (January 19, 2018) announces that IRS intends to issue regulations in the following areas: Confirming that an SFC can t be both a DFIC and E&P Deficit Corporation PTI will count as earnings for purposes of determining a foreign corporation s deficit corporation status (surprising result) but won t go into the calculation of the 965 earnings amount. Confirming that hovering deficits reduce E&P Providing that demand notes will be treated as cash Fixing the 961 issue for lower-tier DFICs Providing rules regarding currency translations for E&P and cash Providing relief from certain aspects of the implications of the change in constructive ownership rules (primarily, the reporting rules) 9

10 Previously Taxed Income Ordering Rules of 959(c) (c)(1) 956 Inclusions (c)(2) Subpart F income (c)(3) Non-PTI What is the effect of 965 on PTI? There will be a lot of it and there will be pressure to repatriate it 986(c), which may trigger foreign currency gain on PTI remittances, may be a significant issue given the length of time it will take to absorb all PTI 10

11 Global Intangible Low-Taxed Income (GILTI) New 951A will, in effect, impose a foreign minimum tax on a U.S. shareholder s allocable share of the GILTI of CFCs The calculation of GILTI is based on a formula that exempts from inclusion a deemed return on depreciable tangible assets, and deems the remaining income (subject to certain exclusions) to be intangible income that is subject to current U.S. taxation Net tested income : generally the aggregate net income of all CFCs of a U.S. shareholder other than (i) ECI, (ii) subpart F income, (iii) high-taxed income, (iv) dividends from related persons, and (v) certain foreign oil and gas income Net deemed tangible income return : an amount equal to 10% of the tax basis of the depreciable tangible assets of each CFC the net income of which is taken into account in net tested income (QBAI) minus net interest expense taken into account in net tested income Tax basis for purposes of GILTI (as well as FDII) maintained following the alternative method of depreciation GILTI = Net tested income Net deemed tangible income return Application of GILTI plus existing subpart F/ 956 effectively taxes most foreign income, other than net deemed tangible income return, on a current basis 11

12 GILTI (Cont d) A U.S. shareholder that is a C corporation will be entitled to a tax credit for 80% of the foreign taxes paid by its CFCs deemed attributable to the GILTI amount GILTI tax credits are segregated into a separate foreign tax credit basket with no carryforward or carryback available for any excess credits A deduction is allowed for a portion of a corporate U.S. shareholder s GILTI The deduction is available only to C corporations, while GILTI is required to be included by all U.S. shareholders For taxable years , the deduction is equal to 50% of GILTI (resulting in a minimum effective rate of 10.5%) For taxable years after 2025, the deduction is reduced to 37.5% of GILTI (resulting in a minimum effective rate of %) The amount of the GILTI deduction may be reduced if the sum of the U.S. shareholder s FDII and GILTI exceeds its taxable income 12

13 GILTI Observations Reduction of the net interest expense taken into account in net tested income from net deemed tangible income return This effectively allocates 100% of the interest in the residual income category to QBAI rather than a pro rata share What is the policy rationale? Even if the rationale is to provide exemption only for presumptive normal return to equity capital not debt, why is all of the net interest taken into account in determining net tested CFC income a reduction to net deemed tangible income return? Retention of 956 for corporate taxpayers Trap for the unwary? Tension between Subpart F (generally a CFC by CFC concept with narrow exceptions like chain deficit rules) and GILTI (an aggregation of offshore income from CFCs then re-allocated to specific CFCs) 13

14 GILTI Observations (Cont d) GILTI application to non-corporate taxpayers Non-corporate 10% shareholders of CFC must include GILTI, but generally are not entitled to the associated deduction which is available only to domestic corporations This regime may convert what would have been deferred income into current income This regime may also, in certain cases, convert what could have been low-taxed qualified dividend income when repatriated into fully taxed income Individuals will not benefit from the 80% deemed paid credit for taxes attributable to CFC tested income under the TCJA/ 902/ 960 For taxpayers, other than domestic C corporations, this is more like a not quite taxed on worldwide income currently regime than a territorial regime The Act also does not list 1411 (3.8% medicare tax on net investment income) in specific provisions where GILTI is intended to be treated in the same manner as Subpart F income Insofar as dividends would have been subject ultimately to the tax, however, presumably the IRS may apply the same regime 14

15 GILTI Observations (Cont d) Application with respect to U.S. 10% shareholders that are S corporations Can you argue as a domestic corporation the GILTI deduction may be claimed at S corporation level? Compare 1363(b) taxable income computed in the same manner as an individual and 1366(a), (b) with Rath, 101 T.C. 196 (1993) Application with respect to 10% U.S. shareholders that are RICs 15

16 GILTI and Allows individual 10% shareholders to elect to be taxed as a domestic corporation on Subpart F income (tax is equal to the tax that would have been imposed under 11 and 55 if received by a domestic corporation ) actual distributions from CFC also taxable to extent dividend exceeds U.S. income tax paid on Subpart F Can claim 960 deemed paid credit Act s reference to 962 and legislative history suggest 962 is intended to be available Intended to allow the GILTI deduction or just the deemed paid credit for foreign taxes paid by CFC in the new GILTI basket? See Treas. Reg (b)(i) taxable income as used in 11 shall mean the sum of amounts included in shareholder s gross income under 951(a) plus 78 amount No reduction for any deduction of such shareholder? How does individual AMT interact with a 962 election? 962 not available for partnerships or S corporations although individual partner/s corporation shareholder that is herself a 10% shareholder may claim it 16

17 GILTI and Foreign Tax Credits Section 902 is repealed Section 960 revised to provide a factually based test of deemed paid credits attributable to the income Foreign tax credits are haircut to only 80%, but gross-up is 100% of FTCs Section 904(c) allows no carryovers of excess credits for GILTI taxes No carryforward of excess credits No carryback to take advantage of excess limitation Excess credits an immediate accounting hit? Computation of credit under section 960(d) is U.S.-shareholder-by-U.S.-shareholder Possible guidance to compute this on a consolidated basis similar to the approach in Notice on section 965? Section 904(d) imposes a separate foreign tax credit limitation for GILTI Basket computation should be group-wide under existing Treas. Reg Expense Allocation to GILTI Increases the effective tax rate if the taxpayer s GILTI is high-taxed Operation is unclear regarding how to treat GILTI assets 17

18 Tax Rate Impact of the 80% Haircut / 100% Gross Up As noted, GILTI imposes an 80% limit on the creditability of the foreign taxes that are deemed paid by the U.S. Shareholder The effect of the haircut is to impose residual U.S. tax even when the foreign rate exceeds the U.S. rate (up to %) Expense allocation means that the worldwide ETR is actually higher Foreign tax rate 0% 5% 10% % 15% 20% Residual U.S. Tax Rate 10.5% 6.5% 2.5% 0% 0% 0% TOTAL Global Tax Burden 10.5% 11.5% 12.5% % 15% 20% The policy rationale for the 80% haircut (and mismatched gross-up) has not been articulated At odds with history the FTC has been a dollar for dollar credit since it was enacted as part of the Revenue Act of 1918, almost 100 years ago Same approach was proposed in the Obama Administration tax reform proposal (28% corporate rate, 19% foreign rate with a 85% FTC) 18

19 GILTI Foreign Tax Credit Rules The Haircuts The complex interactions of the GILTI structure result in several haircuts of a taxpayer s FTCs First, any FTCs related to the exempt portion of the CFC s tested income because of the deemed return to QBAI are not creditable (which is appropriate) Next, any tested income that is reduced by the netting of tested losses limits available credits based on the U.S. shareholder s inclusion percentage The inclusion percentage is the ratio of the U.S. shareholder s GILTI to the gross tested income of its CFCs, before reduction for tested losses Any FTCs of a tested loss company are not creditable Finally, the credits that are included under section 960(b) are reduced by 20% (only 80% are creditable) Section 78 gross-up is still 100% of the foreign taxes deemed paid And then there is the FTC limitation, expense allocation, all with no carryovers 19

20 GILTI Planning the Impact of Tested Loss CFCs CFC1 CFC2 USP Tested income 800 (400) Foreign taxes QBAI 0 0 Deemed TIR 0 0 Net CFC tested income 400 Deemed TIR 0 GILTI 400 Allocation of GILTI to CFCs Deemed paid taxes % Haircut on Taxes 80 0 U.S. Parent CFC1 CFC2 800 Tested income 200 Foreign taxes 0 QBAI (400) Tested loss 100 Foreign taxes 0 QBAI 20

21 GILTI Planning the Impact of Tested Loss CFCs CFC1 + CFC2 USP Tested income 400 Foreign taxes 300 QBAI 0 Deemed TIR 0 Net CFC tested income 400 Deemed TIR 0 GILTI 400 Allocation of GILTI to CFCs 400 Deemed paid taxes % Haircut on Taxes 240 Same GILTI, 160 more FTCs U.S. Parent CFC1 CFC2 800 Tested income 200 Foreign taxes 0 QBAI (400) Tested loss 100 Foreign taxes 0 QBAI 21

22 Foreign-Derived Intangible Income (FDII) A deduction is allowed for a portion of a U.S. corporation s net income (other than GILTI and certain other income) that exceeds a deemed 10% rate of return on the U.S. corporation s tangible depreciable business assets and that is attributable to certain sales of property to foreign persons or to the provision of certain services to any person, or with respect to any property, located outside the United States For taxable years , the deduction is equal to 37.5% of FDII (resulting in an effective rate of %) For taxable years after 2025, the deduction is reduced to % of FDII (resulting in an effective rate of %) The amount of the FDII deduction may be reduced if the sum of the U.S. shareholder s FDII and GILTI exceeds its taxable income 22

23 FDII Observations FDII Effective rate is still higher than GILTI so effected taxpayers are not neutral as to whether intangiblerelated income is generated directly rather than offshore through CFCs May not survive World Trade Organization (WTO) challenges as an export subsidy, so could be a temporary regime Does not necessarily track 861 source rules (e.g., services performed within the United States for benefit of person located outside the United States) and will require elaborate regulation to prevent abuse when customers/clients are themselves multi-national Outbound regime for domestic MNCs after GILTI/FDII The outbound regime is quasi-territorial system only while the GILTI deduction rate for C corporations keeps effective tax rates substantially lower than regular corporate rate (21%) In the future Congress can make the regime more or less territorial by toggling the deduction percentage Also not pure territoriality in the sense that domestic corporations still have the option to structure high-taxed foreign income through pass-through entities 23

24 Base Erosion Anti-Abuse Tax (BEAT) New 59A establishes a base erosion minimum tax regime, intended to apply to large U.S. companies that reduce their U.S. tax liability by making deductible payments (e.g., interest and royalties) to related entities Applies to corporate taxpayers (other than RICs, REITs and C corporations) that have average annual gross receipts of at least $500 million for the three-year period prior to the current year and have a base erosion percentage of 3% (or 2% for financial group members) Base erosion percentage generally determined by dividing deductions taken for base erosion payments to related foreign persons by the aggregate deductions allowable to the U.S. corporation (excluding NOL carrybacks and carryforwards and certain other items) Applicable base erosion tax rate is generally 5% for tax years beginning in 2018, 10% for tax years beginning after December 31, 2018, but before January 1, 2026, and 12.5% for tax years beginning on or after January 1, 2026 Banks and registered securities dealers and their affiliates subject to higher base erosion tax rate by 1% 24

25 BEAT (Cont d) BEAT is equal to the applicable base erosion tax rate multiplied by the excess of the corporation's modified taxable income over its regular tax liability for the year (reduced by certain tax credits) Modified taxable income is taxable income calculated without regard to: Base erosion tax benefits, which are deductions determined by reference to base erosion payments, and The base erosion percentage of any NOL allowed under section 172 for the taxable year Base erosion payments generally are amounts paid or accrued to a related foreign person for which a deduction is allowable, including: Acquisitions of depreciable or amortizable property Certain reinsurance premiums COGS, for companies that inverted after Nov 9, 2017 Exceptions Amounts paid for services that are eligible for the services cost method under section 482, determined without regard to the business judgment rule Qualified derivative payments 25

26 BEAT Observations No carryforward mechanism to even out tax liability over time; BEAT is a permanent increase to tax Effectively a two-tier threshold Is there an Applicable Taxpayer ($500 million revenue + BE% test) Definition of Applicable Taxpayer: Is aggregation rule too good to be true? Whether BEAT liability exceeds regular tax liability reduced by certain credits Credits, such as FTCs, increase BEAT liability; Effectively a permanent disallowance Treatment of consolidated groups? Treatment of partnerships? No exception for payments made to U.S. branches Treatment of payments subject to a reduced w/h rate under a treaty Applicable BE% for NOLs 26

27 BEAT Observations (Cont d) Beware of netting! When is it appropriate to treat a payment as a reduction of gross receipts versus as a deduction? Significance of transfer pricing methodology versus contractual arrangement Scope of COGS Penalty for booking revenue in the U.S. for global customers to the extent offsetting deductible payments are made to related foreign persons that perform services Scope of exception for services eligible for the services cost method Markups Beware of other eligibility requirements Scope of exception for qualified derivative payments, including prohibition on embedded services, interest, or royalties 27

28 Why the Foreign Tax Credit matters 2013 U.S. Corporation Returns with a Foreign Tax Credit -- Form 1118 (dollar amounts in thousands of dollars) Number of returns U.S. income tax before credits Foreign tax credit claimed General business credit U.S. income tax after credits FTCs as a % of Pre-credit US income tax All industries 6, ,389, ,285,306 20,586, ,172, % Mining 200 7,875,675 4,456,496 84,094 3,156, % Construction , ,795 11, , % Manufacturing 1, ,059,429 68,627,970 6,737,715 66,513, % Wholesale and retail trade ,526,740 7,023,586 2,100,829 35,278, % Transportation and warehousing 131 6,522, ,505 92,784 5,946, % Information ,337,365 7,843,595 1,524,802 18,960, % Finance, insurance, real estate, and rental and leasing 1,089 39,946,532 6,447,763 1,823,225 31,063, % Services 1,984 59,059,009 23,232,468 8,173,099 27,415, % All other industries ,210 15,128 38, , % * Source: IRS, Statistics of Income Division, Corporation Foreign Tax Credit Study, September

29 Foreign Foreign Tax Tax Credit Credit Changes Changes Under Under the the TCJA Act Taxpayers likely will have constraints on their ability to use FTCs under the new system Reduced capacity resulting from the reduced corporate tax rate More income in the system as all foreign income is on the return, but 21% on general basket income, or 40% reduction in capacity Effectively 13% on GILTI, or 63% reduction in capacity In other words, high taxed income no longer needs to be very high taxed Subdivision of the general basket income from one to three baskets Old basket for general income New basket for branch income New basket for GILTI Reduced capacity in the general basket General basket is effectively limited to subpart F income and most active income will be in GILTI Repeal of section 863(b) export source rule Specific interest allocation rules No FMV Method impact on self-created intangibles The wait continues Conference Bill did not include acceleration of WWF of interest expense 29

30 Foreign Changes Tax to Credit the Foreign Changes Tax Under Credit the Limitation TCJA Open Issues Significant issues exist requiring guidance Taxpayers are accruing income as we speak Interest allocation is an average of a taxpayer s basis at the beginning and end of the year, so: Bad news half of the computation is already fixed Good news, 11 months to plan before the other half is fixed Section 904(d)(3) look-through treatment on interest and royalties from a CFC? Dividends are either PTI from subpart F income or GILTI, or exempt under section 245A Treatment of interest and royalties not clear under the statute Self-help solutions Characterization rules for expense allocation purposes Treatment of GILTI income and assets for expense allocation purposes Treatment of section 245A income for expense allocation purposes Application of section 960(b), which increase a taxpayer s FTC limitation upon the distribution of PTI to GILTI inclusions Presumably should be treated like other distributions of subpart F income 30