TAX REFORM HAS OFFICIALLY ARRIVED – WHAT DOES IT MEAN FOR U.S. EXPATS? (PART II – BUSINESS TAXATION)
Last week, we started our review of the newly-enacted Tax Cuts and Jobs Act (“TCJA”), focusing on the personal taxation provisions. This week, we focus on the business taxation provisions that we believe will most significantly affect U.S. expats with overseas businesses.
We do want to note upfront that while almost all of the TCJA provisions are effective beginning with the 2018 tax year (or sometimes in a later year), there are a few foreign business taxation provisions that already became effective with respect to the 2017 tax year.
Perhaps most importantly for this tax season, a so-called “transition tax” is imposed on certain U.S. shareholders, as detailed below, with respect to the accumulated and previously untaxed earnings and profits generated by certain 10%-held foreign corporations through the 2017 tax year (or more technically speaking, through the last tax year beginning before the TCJA enactment date of December 22, 2017). Yes, we realize that’s a lot to absorb all at once, so we provide a user-friendlier description of the transition tax further down below in this blog.
For ease of understanding, we’ve broken down the TCJA provisions, into: (i) those that apply more generally to businesses, and (ii) those that apply more specifically to U.S. expats with businesses operating overseas.
GENERAL BUSINESS PROVISIONS
(1) CORPORATE TAX RATE REDUCED DRAMATICALLY
In one of the more dramatic changes to the U.S. tax system under the TCJA, the U.S. federal corporate tax rate is reduced to a flat rate of 21 percent.
(2) AMT FOR CORPORATIONS ELIMINATED
While the alternative minimum tax (AMT) is retained and modified for individuals, it is eliminated for corporations.
(3) MODIFICATION OF NOL DEDUCTION
The two-year carryback of net operating losses (“NOLs”) and accompanying carryback provisions are repealed under the TCJA. The deduction can now be carried forward indefinitely, but is limited to 80% of taxable income.
(4) NEW LIMITATION FOR INTEREST DEDUCTIONS
The TCJA completely rewrites 163(j), which acted to limit the deductibility of interest by a thinly capitalized corporation where the interest is paid to a related payee that is totally or partially exempt from U.S. tax on the distribution.
The new Section 163(j) limits the deductibility of interest expenses of any business entity (whether or not in corporate form) paid to anyone (not just related parties) to 30 percent of “adjusted taxable income” (defined similarly to “EBITDA” by adding back to taxable income interest, any NOL or pass-thru business deduction, and (until 2022 only) depreciation). Interest in excess of 30 percent is carried forward indefinitely. The new rule does not apply to: (1) taxpayers with average annual gross receipts for the three-year period ending with the prior tax year that do not exceed $25 million; and (2) real property trades or businesses that elect out of the limitation.
(5) NEW DEDUCTION FOR PASS-THRU INCOME
Individuals, trusts, and estates may be eligible for a 20% deduction on so-called “qualified business income” earned through a sole proprietorship (including a wholly-owned disregarded LLC), partnership, or S corporation. The 20% deduction is subject to a number of complex rules, including limitations based on taxpayer wages that phase in at certain taxable income thresholds ($315,000 for married individuals filing jointly and $157,500 for other individuals). The type of income eligible for the deduction is generally U.S. trade or business income, so the deduction is not relevant for expats with income from a foreign trade or business.
(6) STRICTER QUALIFICATION FOR LIKE-KIND EXCHANGES
The TCJA makes two significant changes to the rule allowing for the deferral of realized gain on like-kind exchanges. First, the rule is modified to allow for like-kind exchanges only with respect to real property that is not held primarily for sale. Second, real property located in the United States and real property located outside the United States are no longer considered property of a like kind.
FOREIGN BUSINESS PROVISIONS
(1) ESTABLISHMENT OF “PARTICIPATION EXEMPTION” SYSTEM FOR TAXATION OF FOREIGN INCOME
In another of the more dramatic changes to the U.S. tax system, the TCJA provides for a complete exemption for active foreign income (or non-Subpart F income) earned by certain U.S. corporate taxpayers via a foreign subsidiary. The exemption is provided for by means of a 100% dividends received deduction (“DRD”) for the foreign-source portion of dividends received from a “specified 10-percent owned foreign corporation” by domestic corporations that are U.S. 10% shareholders of those foreign corporations. This new rule is intended to encourage companies to repatriate their active income to invest in the U.S. economy.
While this new taxation regime doesn’t negate other important foreign income regimes such as the CFC or PFIC regimes (which continue to apply to passive-type income, such as dividends and interest, earned by foreign corporations), it does have a significant ripple effect on a number of other rules relating to the taxation of foreign income. For instance, foreign tax credits are not allowed for taxes paid or accrued with respect to a dividend that qualifies for the new DRD. Also, as an example, in the case of a sale by a domestic corporation of stock in a foreign corporation held for one year or more, any amount received by the domestic corporation which is treated as a dividend under Code Sec. 1248 of the Code, is treated as a dividend for purposes of applying the DRD.
(2) ONE-TIME TRANSITION TAX ON DEFERRED FOREIGN INCOME
As mentioned above, for expats who utilize a foreign corporation to operate their businesses overseas, there is one feature of the TCJA that already comes into play this filing season (i.e. it’s applicable to the 2017 tax year) for both U.S. corporate and non-corporate shareholders (including individuals).
Under revised Internal Revenue Section 965, as part of the transition to the participation exemption system described above, the TCJA uses the mechanics under Subpart F to impose on U.S. shareholders owning at least 10% of a foreign subsidiary a one-time mandatory “transition tax” on the undistributed, non-previously taxed post-1986 foreign earnings and profits (“E&P”) of a “specified foreign corporation.” A specified foreign corporation is defined as (i) any CFC, and (ii) any foreign corporation with respect to which one or more domestic corporations is a 10% United States shareholder. The portion of the E&P comprising cash or cash equivalents is taxed at the rate of 15.5%, while any remaining E&P is taxed at the rate of 8%. These rates can be higher in the case of individual U.S. shareholders and in the case of CFCs that have a fiscal (non-calendar) year end.
Section 965 specifies, importantly, that the transition tax applies to the greater of the accumulated post-1986 deferred foreign income (essentially the previously untaxed earnings and profits) of the foreign corporation determined as of November 2, 2017 or as of December 31, 2017. In order to prevent pre-transition tax avoidance planning, the section adds that E&P is determined by essentially ignoring dividends distributed during the 2017 taxable year (other than dividends distributed to another specified foreign corporation).
Also, importantly, Section 965 does not distinguish U.S. corporate shareholders from other U.S. shareholders, so the transition tax potentially applies to any U.S. person (including an individual) owning at least 10% of a foreign subsidiary. This aspect of the transition tax seems to us at odds with the new participation exemption system which applies solely to U.S. corporate shareholders, but as the House Bill specifies: “In contrast to the participation exemption deduction available only to domestic corporations that are U.S. shareholders under subpart F, the transition rule applies to all U.S. shareholders of a specified foreign corporation.”
Other aspects of Section 965 that could potentially ease the pain of the transition tax include the following:
- U.S. shareholders can elect to pay the transition tax over a period of up to eight years.
- In the case of foreign corporations held via an S corporation, U.S. shareholders can elect to maintain deferral on the deferred foreign income.
- Deferred earnings of a U.S. shareholder are reduced (but not below zero) by the shareholder’s share of deficits from other specified foreign corporations.
- The transition tax does not apply to previously-taxed earnings and profits.
- The portion of earnings subject to the transition tax does not include E&P that were accumulated by a foreign company prior to attaining its status as a specified foreign corporation.
We do want to emphasize that our description of the transition tax in this blog is only a high-level summary – we’ve spared you many of the intricate details that come with applying the tax properly. We will follow up in the coming weeks with a blog devoted exclusively to analyzing the impact of the transition tax.
(3) CURRENT YEAR INCLUSION OF GLOBAL INTANGIBLE LOW-TAXED INCOME
Starting with the 2018 tax year, a U.S. shareholder of any CFC will have to include in gross income the CFC’s global intangible low-taxed income (“GILTI”) in a manner generally similar to inclusions of Subpart F income as described above. In general, GILTI is computed as the income of the CFC (aggregated for all the CFCs owned by the U.S. shareholder) that is in excess of a 10% return on certain tangible property of the CFC. GILTI does not include income effectively connected with a U.S. trade or business, Subpart F income, Subpart F income qualifying for the high-tax exception, or certain related party payments.
A U.S. corporate (non-individual) shareholder is entitled to a 50% deduction to offset GILTI income plus an 80% foreign tax credit for the foreign tax paid at the CFC level (a so-called “indirect” credit). As a result, the corporate shareholder will be taxed at a maximum 10.5% rate (50% x 21% corporate tax rate), and there will be no additional tax if the GILTI was subject to foreign tax of at least 13.125%.
A U.S. individual, on the other hand, will be taxed at the ordinary tax rate on such GILTI income (37% will be the top rate starting with the 2018 tax year) with no 50% deduction and no foreign tax credit for the foreign tax paid at the CFC level. For this reason, an individual U.S. shareholder who holds at least 10% of the CFC should consider making a so-called “962 election” to be taxed as a corporation on the GILTI income (i.e., taxed at the 21% corporate rate with the 80% indirect foreign tax credit and 50% deduction). Such an election can have complex and varied tax consequences, and a tax advisor should be consulted to fully understand its merits.
It should be noted that the TCJA is still pending regulations which will help clarify the nuances of the GILTI provisions. The above represents our current best understanding based on the statutory language and accompanying legislative history.
(4) CHANGES TO THE CONTROLLED FOREIGN CORPORATION (CFC) RULES
The TCJA also makes a number of changes to the CFC rules, including:
- Elimination of the 30-day minimum holding period for shareholders of a CFC to be subject to the Subpart F inclusion rules.
- Expansion of the definition of “U.S. shareholder” for CFC purposes to include any U.S. person who owns 10% or more of the total value of shares in the foreign corporation (prior to this change, the CFC rules looked only to the percentage of voting interests).
- Amendment to the constructive ownership rules so that certain stock of a foreign corporation owned by a foreign person is attributed to a related U.S. entity for purposes of determining whether the related U.S. entity is a U.S. shareholder of the foreign corporation (which can determine whether the foreign corporation is a CFC). This change begins with the last tax year of the foreign corporation beginning before January 1, 2018.
We also note that the change to the U.S. corporate tax rate could dramatically affect the extent to which the Subpart F rules are applied to CFCs. As CFC owners know well, a U.S. 10% shareholder of a CFC is required to include currently in income the Subpart F (generally passive) income of such CFC. However, Subpart F inclusions are generally not required for any item of income received by a CFC if such income was subject to an effective rate of income tax imposed by a foreign country greater than 90 percent of the maximum rate of the corporate tax rate (the so-called “high-tax exception”). Under the new 21% corporate rate regime, when income of CFC is subject to tax at an effective rate greater than 18.9% in its foreign country, the Subpart F inclusion rule should seemingly not be triggered.
OTHER CHANGES FOR BUSINESSES
For the sake of completeness, the following are some of the other changes for businesses under the TCJA that are perhaps less relevant for most of our expat clients, but are still noteworthy:
- A 3-year holding period requirement is required in order for so-called “carried interest” (a partnership interest received in connection with the performance of services) of individuals to be taxed as long-term capital gain rather than ordinary income
- The additional first-year depreciation deduction is extended and modified (increasing the 50 percent allowance to 100 percent for property acquired and placed in service after September 27, 2017, and before January 1, 2023)
- The amount allowed to be expensed under section 179 is increased from $500,000 to $1 million
- Recovery period for certain real property is shortened
- For domestic corporations, the dividends received deduction is reduced for a less than 80%-owned corporation
- New base erosion anti-abuse taxes (BEAT) for certain corporations with average annual gross receipts of at least $500 million
SUMMARY CHART OF TAX REFORMS IN TCJA (BUSINESS TAXATION)
As a quick reference guide, here is a summary of the tax reforms in the TCJA that are of particular significance for U.S. expats operating businesses:
|TAX ISSUE||PREVIOUS LAW||NEW LAW UNDER TCJA|
|Corporate Tax Rate||Graduated rates up to a maximum rate of 35%||Flat rate of 21%|
|Alternative Minimum Tax||Imposed on corporations||Repealed for corporations|
|NOL Deduction||Carried back 2 years and carried forward 20 years||No carryback but carried forward indefinitely subject to exceptions|
|No percentage limitation||Deduction limited to 80% of taxable income|
|Limitation on Interest Deduction (163(j))||Limits the deductibility of interest expenses paid by U.S. corporations to foreign related parties to 50 percent of adjusted taxable income (ATI, or cash flow) on an annual basis (unless they have a debt to equity ratio below 1:5 to 1)||Limits the deductibility of interest expenses of any business entity (whether or not in corporate form) paid to anyone (not just related parties) to 30 percent of ATI|
|Does not apply to: (1) taxpayers with average annual gross receipts that do not exceed $25 million; and (2) real property businesses that elect out|
|Deduction For Pass-Thru Income||Individuals pay tax at ordinary income tax rates on trade or business income earned via pass-thru entities (LLC, S corp, or sole proprietorship) with no deduction||Individuals earning pass-thru income from a U.S. trade or business eligible for 20% deduction, subject to certain limitations|
|Like-Kind Exchanges||No gain or loss recognized (i.e., tax deferral) on exchange of a wide range of property for property of a like kind||Like-kind exchange treatment limited to real property that is not held primary for sale|
|U.S. real property and non-U.S. real property are no longer considered property of a like kind|
|Taxation of U.S. Shareholder’s Foreign Income||U.S. persons subject to taxation on worldwide income but foreign active income earned via a foreign subsidiary only taxed when repatriated||U.S. corporations essentially not subject to tax on foreign active income generated via a 10%-owned foreign subsidiary (because of a of a dividends received deduction upon repatriation) unless the GILTI rules apply|
|U.S. individuals are also subject to the GILTI provisions|
|Transition Tax on Deferred Foreign Income||N/A||Mechanics under Subpart F used to impose on U.S. shareholders owning at least 10% of a foreign subsidiary a one-time mandatory “transition tax” on the undistributed, non-previously taxed E&P of such foreign corporation|
|Transition tax rate is 15.5% for cash or cash equivalents and 8% for other E&P (rate may be higher for individuals)|
Due to the complexity of many provisions in the TCJA, we expect that we’ll be writing a number of additional blogs that will delve into the specifics of the provisions described above. For the latest news and in-depth coverage of the tax reform provisions, including further analysis of accompanying regulations and IRS publications, stay tuned throughout the year!