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Linda Pfatteicher, Jeremy Cape, Mitch Thompson and Matthew Cutts Squire Patton Boggs
Linda Pfatteicher, Jeremy Cape, Mitch Thompson and Matthew Cutts are Partners, Tax Strategy & Benefits, Squire Patton Boggs
The long-awaited U.S. tax reform certainly has given taxpayers plenty to ponder and analyze. Two key provisions affecting U.S. multinationals have been referred to as the “carrot and stick” approach—GILTI and FDII.
An important, overarching change to U.S. international tax as a part of tax reform is the move to a more “territorial” tax system. Prior to this change all the global income of U.S. based multinationals could eventually be taxed in the U.S. when ultimately repatriated to the U.S., if not sooner as a result of that system's anti-deferral regimes. After tax reform, inbound dividends to the U.S. from 10 percent owned foreign subsidiaries, including controlled foreign corporations (“CFCs”), will generally not be subject to tax in the U.S. by means of a dividends received deduction.
GILTI is intended to discourage erosion of the U.S. base by moving or keeping valuable intangibles and their related income outside of the U.S. tax net and bringing it home tax free. Importantly, however, GILTI's reach is not limited to earnings on intangible assets and will cause current U.S. tax on certain higher than routine returns on assets that are earned in lower tax countries. This is an important exception to the territoriality approach described above.
New Internal Revenue Code (“IRC”) Section 951A provides that a U.S. shareholder of a CFC must include on a current basis certain types of high-return “GILTI” income. GILTI is afforded a 50 percent deduction resulting in a nominal rate on GILTI of 10.5 percent. As explained in the Joint Explanatory Statement of the Committee of Conference (“Conference Report”), GILTI is determined at the U.S. shareholder level as follows:
The Conference Report provides that although GILTI inclusions are not Subpart F income they generally will be treated in a manner similar to Subpart F for other purposes of the IRC. For example, the amount is treated as a deemed dividend and will be treated as previously taxed income if a cash dividend is later made from the relevant CFC.
The new rules allow an indirect foreign tax credit (“FTC”) with respect to GILTI but that credit is limited to 80 percent and there is a separate GILTI foreign tax credit basket with no FTC carryforward or carryback allowed, meaning foreign taxes paid on income in other categories cannot be aggregated with GILTI and its corresponding foreign taxes.
There are many still unanswered questions about application of GILTI including whether it will be calculated at the specific U.S. shareholder level, jointly among a consolidated group or sub-group, and how GILTI losses, income, and FTCs might be netted or not netted.
The GILTI provisions are effective for taxable years of foreign corporations beginning after December 31, 2017. Prior to 2026, the minimum foreign tax that will result in no inclusion of income under GILTI after application of the 80 percent FTC is 13.125 percent, increasing to 16.406 percent in 2026.
In order to encourage U.S. companies to export services and products related to intangible income that is owned in the U.S., a new deduction for such income was included in tax reform for income generated by relevant sales to non-U.S. customers. Like GILTI and despite its name, this special deduction is available to certain high-return export business activities in a similar manner to other countries' “patent boxes.”
As described below, IRC Section 250 provides a deduction for a portion of the following FDII:
The GILTI and FDII provisions work together to provide an overall deductible amount to U.S. taxpayers selling outside the U.S. by taking into account the “bad” income—high-return non-U.S. income—and the “good income”—high-return U.S. income. Once the FDII and GILTI amounts are determined, a corporate taxpayer may calculate a deduction equal to 37.5 percent of FDII plus 50 percent of GILTI. For taxable years beginning after December 31, 2025, these rates are reduced to 21.875 percent and 37.5 percent, respectively.
After application of the deductions, the effective tax rates are as follows:
Due to the Republicans' strong desire to pass tax legislation in 2017, Congress pushed extremely quickly to draft the text for tax reform. As a result, there is significant work needed to correct provisions that were enacted with insufficient detail or that may be inconsistent with existing provisions.
Although there is broad consensus that the Senate will at some point pass a technical corrections package to address these issues, the timing of such legislation remains unclear. In order to be treated as a “technical correction,” the change will require consensus between the Joint Committee of Taxation, U.S. Treasury Department, Senate Finance Committee (Majority and Minority) and the House Ways and Means Committee (Majority and Minority). If agreement is reached among these six, the resulting legislation would then require the Senate to deliver 60 votes in order to pass the technical corrections package. This passage may be difficult to achieve in an environment where Senate Democrats believe the tax reform became law without their input and created bad policy by favoring tax breaks for corporations over individuals. As a result, since Senate Democrats currently seem unwilling to “fix” a law they did not support, the timing of any technical corrections becoming law is uncertain.
In the interim, we expect to continue seeing the U.S. Treasury Department issue regulations and notices to provide clarity on how the new provisions should be applied in order for taxpayers to have greater certainty when filing their tax returns.
U.S. multinationals are already in the process of analyzing their supply chains to determine whether restructuring will be beneficial. While the new corporate tax rate of 21 percent is substantially lower than the prior 35 percent , in many cases this is still not low enough to drive a company to change its supply chain. This is because many U.S. companies with intangible property holding companies are able to achieve an overall effective rate lower than 21 percent with their current structure. In contrast, others have publicly stated that tax reform is providing a real incentive to bring manufacturing jobs back to the U.S. Whether this is simply a marketing technique or will actually happen remains to be seen. Certainly though, the hope is that U.S. tax reform will encourage more investment in the U.S. and create more jobs for Americans. The question is how successful this strategy will be when inbound investment seems to be discouraged by many provisions, such as the Base Erosion and Anti-Abuse Tax (“BEAT”). In addition, President Trump again recently brought up the idea of a border adjustment tax to penalize imports. In reaction to this protectionist approach by the U.S., the World Trade Organization appears prepared to challenge any provisions they believe are harmful to free trade, and they, along with several European finance ministers, have already expressed their displeasure with the FDII provisions.
It seems that U.S. tax reform will have an impact on tax regimes around the world. The way in which any particular government will respond to this reform, however, depends on a number of items. Here is a non-exhaustive list of four key factors.
One, to what extent does the non-U.S. tax regime in question have a corporate tax rate that now looks high by comparison? Prior to the U.S. changes, corporate tax rates in the mid to high 20s did not look completely out of kilter, given that the largest economy in the world had a 35 percent tax rate. Now, suddenly, those economies appear exposed. Australia, for example, has a headline rate of 30 percent, which it intends to reduce to 25 percent by 2026/2027, but which may come under pressure sooner than that. Countries like the U.K., which has gradually reduced its corporation tax rate from 28 percent to 19 percent since 2010, and which will reduce the rate to 17 percent in 2020, suddenly look less remarkable than they did in the past. In all likelihood, there will be some downward pressure on corporate tax rates across the globe; any jurisdiction that was looking to increase corporate tax rates (and there were not many) will find it difficult to do so.
Two, to what extent do U.S. businesses respond to the recent U.S. changes, particularly GILTI and FDII, by bringing back jobs and functions to the U.S., or creating jobs and functions in the U.S. rather than in another jurisdiction? It is not clear whether they will—the introduction of a territorial system has tended to result in offshoring in other jurisdictions that have done so; and some features of GILTI, in particular, may incentivize U.S. businesses actually to locate more tangibles outside the U.S. If the response of a significant number of businesses is to move a significant number of jobs and/or functions to the U.S., other jurisdictions may look to respond by creating a number of targeted incentives, such as R&D credits and patent boxes, to discourage such repatriation. If a jurisdiction considers that the battle has been lost, it may seek to impose a significant repatriation tax in response.
Three, to what extent does the introduction of a territorial system in the U.S. encourage more aggressive tax avoidance outside the U.S. by U.S. businesses? If dividends received from overseas are exempt from U.S. tax, any tax saving outside the U.S. should be absolute, subject to U.S. anti-avoidance provisions.
Four, to what extent does U.S. tax reform provide an opportunity to jurisdictions to adapt their tax systems to provide a symbiotic relationship with the U.S. tax regime? Many jurisdictions, especially those with tax haven characteristics, are nervous about the impact of BEPS and are looking for a role in the international tax space. The complexity of U.S. tax reform should provide opportunities for jurisdictions looking to make themselves attractive from a tax point of view to U.S. businesses and thus raise revenues, although extreme care will need to be taken by policymakers to ensure that they do not incur the wrath of the international tax community for indulging in so-called unfair tax competition.
Only time will tell whether the U.S. tax reform of 2017 will result in the desired effect of stimulating the U.S. economy and it will also take time to see all the impacts it may have on the rest of the world. While we wait, companies will continue to identify ways to maximize their returns in this new environment, and policymakers outside the U.S. will consider their responses.
Linda Pfatteicher, Jeremy Cape, Mitch Thompson and Matthew Cutts are Partners, Tax Strategy & Benefits, Squire Patton Boggs
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