This month, the U.S. House of Representatives and Senate both released proposed laws looking to dramatically reform taxation in America. On November 16, the House passed the Tax Cuts and Jobs Act (the "Act") and the Senate Finance Committee (SFC) voted on and approved the Chairman's Mark of The Tax Cuts and Jobs Act. The Senate bill now goes to a floor vote. Both bills share the same name. This article is an overview of a number of the provisions in both that touch upon international taxation.
Shift to Territorial Tax System
Currently, the U.S. is one of the few countries that taxes the global earnings of its constituents. Levies owed on international activities are postponed until the monies are repatriated to the U.S., however, so it is estimated that over $3 trillion in foreign earnings and profits (E&P) reside overseas within foreign subsidiaries, yet to be taxed. While all agree companies do need cash locally to sustain regular operations, some feel that much of the unremitted earnings have not been repatriated back to the U.S. due entirely to the potential taxes owed.
The House bill looks to change the way foreign earnings are taxed and addresses the matter of payments to companies in foreign countries. In looking to make the U.S. a competitive place to do business, the tax rate for corporations is proposed to decrease from 35% to 20%, a rate that would only apply to U.S. domestic earnings. For U.S. corporate shareholders that own at least 10% of a foreign subsidiary, 100% of foreign-source dividends received will be exempt from U.S. taxation. This, in effect, changes taxation to a more local, territorial one. To address any historical E&P not yet taxed, a one-time 'deemed repatriation' tax will be levied. For E&P held in cash and cash-equivalents, the rate is 14%, with non-cash earnings taxed at 7%. Both rates were increased during the amendment process. Companies will have the option to spread payments equally over an eight-year period.
The Senate bill will also reduce the corporate rate to 20%, but delay its implementation for one year, starting in 2019 for budgetary reasons. Like the House bill, 100% of foreign-source dividends received will be exempt from U.S. taxation for U.S. corporate shareholders that own at least 10% of a foreign subsidiary. For E&P held in cash and cash-equivalents, the rate on the deemed repatriation of accumulated foreign earnings is 10%, while non-cash earnings will be taxed at 5%. Both plans allow for some foreign tax credits to potentially offset any taxes triggered by the 'deemed repatriation.
Taxing Foreign-Related Activities
With the movement toward a more territorially-focused tax system and exemption from taxes on foreign dividends received from subsidiaries, the House did include a tax on "foreign high returns." One measure designed to prevent 'base erosion' to countries with lower tax rates. Specifically, a U.S.-based parent corporation of a foreign subsidiary will be charged a tax on the excess of the aggregate net income of all subsidiaries over an established routine return on their adjusted basis in depreciable property. The return is currently set as 7% plus the Federal short-term rate. This is to address foreign subsidiaries whose assets are either fully used up or may only be comprised of intangibles that may have questionably high profits in comparison to the other related entities in countries with higher tax rates.
Another measure to prevent 'base erosion' through 'earnings stripping' is a new, 20% excise tax on certain outgoing payments from a U.S. company to a related foreign company. Currently, certain transfers (including royalties, cost of goods sold, and depreciable or amortizable assets) made by a U.S. company to a foreign subsidiary or parent corporation are fully deductible as a business expense. These payments will now be subject to a 20% excise tax. An amendment added November 9 will allow for a portion of foreign tax credits (80% of what has been paid or accrued) to be used against the excise tax. Interest payments will not be subject to the tax, but rather a limitation based on certain earnings calculations. An amendment was added to exempt businesses with average gross receipts under $25 million.
The 20% rate is equal to the proposed corporate tax rate in the U.S. and would, therefore, discourage any aggressive tax-saving strategies to move monies elsewhere. Companies will have the option to avoid the 20% excise tax by electing to treat the payments received as income effectively connected to a U.S. trade or business (ECI). In the latter case, the foreign company would then need to file a U.S. tax return and pay taxes on the net income the same as any domestic corporation. The goal is to stop a U.S. company from paying hypothetically inflated "management or similar fees" to a related company in a lower taxed jurisdiction.
The Senate bill has proposed similar, yet different measures. The focus is more on overseas activities than the movement of funds from U.S. companies to related ones abroad. To address overseas sales from U.S. companies, a 'base-erosion and anti-abuse tax' will be created. It will essentially be a 10% tax on 'global intangible low-taxed income' (GILTI), with a complex formula establishing the amount to be taxed based on certain 'qualified business asset investments' (QBAI). While calculated differently than the House's tax on "foreign high returns," the ideas are similar. There will also be a new 12.5% tax on foreign income derived from intangibles (patents, copyrights, intellectual property, etc.). Similar to the House Bill, interest payments made to related foreign companies will also be limited, based on a calculation related to earnings. Unlike the House bill, the SFC mark up has no exemption for smaller businesses. The Senate bill also repeals the popular Code rules for domestic international sales corporations, known as DISCs and IC-DISCs.
Anti-Treaty Shopping Measure
To discourage an aggressive practice known as "treaty shopping," the House has proposed limiting certain tax treaty benefits when the only apparent reason for the transaction is to avoid taxation. There is currently a 30% withholding tax when a U.S. company sends monies to another overseas. In many cases, the U.S. has a tax treaty with the country in which the recipient is located where the withholding rate is either lowered or eliminated. Treaty shopping occurs when Company A is looking to move money from a subsidiary, Company B. If the funds were to directly go to Company A, the local tax treaty would not allow a favorable rate. To sidestep this, Company A directs Company B to instead move money to Company C, located in a different country with a favorable tax treaty with the country of Company A. Company A can then obtain the money from Company C and avoid having to pay the withholding tax it otherwise would have incurred. The House bill would disallow any treaty benefits on the withholding tax unless the parent company would otherwise be able to receive that benefit by directly receiving the funds. This proposal is in line with the OECD's BEPS plan Action 6.
The Senate plan does not contain a specific anti-treaty shopping measure.
What Comes Next
Last week the House passed their version of the tax bill. The Senate Finance Committee approved its mark up last week with a number of amendments made. They intend to schedule a floor vote after Thanksgiving. ' In the Senate's bill that passed the SFC a number of tax rates have provisions to increase after a decade in order to comply with certain budgetary restraints.
Once both bills pass, they will go before a special committee comprised of members of both the House and Senate to reconcile any differences before later heading to the president for his signature.
Please return to the Our Thoughts On…Tax Reform blog for updates as they become available