Foreign income provisions in the Tax Cuts and Jobs Act

By Sally P. Schreiber, J.D.

The draft Tax Cuts and Jobs Act, H.R. 1, released by the House Ways and Means Committee last week, makes many important changes to the tax treatment of U.S. corporations that own foreign corporations. The biggest changes are a repatriation provision that requires U.S. corporations to recognize deferred income from foreign subsidiaries' earnings and profits (E&P) over an eight-year period and a corresponding provision exempting from U.S. tax dividends that U.S. corporations receive from foreign subsidiaries.

100% deduction for foreign-source dividends received by U.S. corporate owners

The bill would replace the current system under which U.S. corporations are not taxed on the foreign earnings of their foreign subsidiaries until they are distributed as a dividend to the U.S. corporation. Instead, the bill would add a new section to the Code, Sec. 245A, which provides for a dividend exemption system. Under the provision, 100% of the foreign-source portion of any dividend received from a specified 10%-owned foreign corporation by a domestic corporation that is a U.S. shareholder of that foreign corporation would be exempt from U.S. taxation.

A specified 10%-owned foreign corporation is broadly defined to mean "any foreign corporation with respect to which any domestic corporation is a United States shareholder," excluding passive foreign investment companies, unless they are controlled foreign corporations (CFCs) (Sec. 245A(b), as proposed in Section 4001(a) of H.R. 1).

The foreign-source portion of the dividend is defined in Sec. 245A(c) as any dividend in an amount that bears the same ratio to the dividend as the post-1986 undistributed foreign earnings of the specified 10%-owned foreign corporation bear to the total post-1986 undistributed earnings of that foreign corporation.

This provision, which would be effective for distributions made after 2017 is designed to eliminate the "lock-out" effect that encourages U.S. companies not to bring earnings back to the United States.

The bill would also repeal Sec. 902, the indirect foreign tax credit provision, and amend Sec. 960 to coordinate with the bill's dividends-received provision. Thus, no foreign tax credit or deduction would be allowed for any taxes (including withholding taxes) paid or accrued with respect to any dividend to which the dividend exemption of the bill would apply. However, a foreign tax credit would be allowed for any Subpart F income that is included in the income of the U.S. shareholder on a current-year basis, without regard to pools of foreign earnings kept abroad.

Deemed repatriation provision

The bill would amend Sec. 956 to provide that U.S. shareholders owning at least 10% of a foreign subsidiary will include in income for the subsidiary's last tax year beginning before 2018 the shareholder's pro rata share of the net post-1986 historical E&P of the foreign subsidiary to the extent that E&P have not been previously subject to U.S. tax, determined as of Nov. 2, 2017, or Dec. 31, 2017 (whichever is higher).

The portion of E&P attributable to cash or cash equivalents would be taxed at a 12% rate; the remainder (E&P that have been reinvested in the foreign subsidiary's business (e.g., property, plant, and equipment)) would be taxed at a 5% rate. U.S. shareholders can elect to pay the tax liability over eight years in equal annual installments of 12.5% of the total tax due.

This provision eliminates the need for U.S. companies to track E&P accumulated by their foreign subsidiaries before the dividend exemption system was adopted. The election to pay the tax over eight years permits companies time to compute what they owe and repatriate money to pay the liability.

Elimination of U.S. tax on reinvestments in U.S. property 

Under current law, a foreign subsidiary's undistributed earnings that are reinvested in U.S. property are subject to current U.S. tax. The bill would amend Sec. 956(a) to eliminate this tax on reinvestments in the United States for tax years of foreign corporations beginning after Dec. 31, 2017. This provision would remove a disincentive from reinvesting foreign earnings in the United States. Because the law also provides a 100% exemption for the foreign-source portion of dividends from the foreign subsidiary of a U.S. corporate shareholder, no U.S. tax will be imposed whether a U.S. parent corporation reinvests its foreign subsidiary's earnings in U.S. property or elects to distribute them.

Limitation on loss deductions for 10%-owned foreign corporations

In a companion provision to the deduction for foreign-source dividends, the bill would amend Sec. 961 and add a new Sec. 91 to require a U.S. parent to reduce the basis of its stock in a foreign subsidiary by the amount of any exempt dividends received by the U.S. parent from its foreign subsidiary, but only for determining loss, not gain. The provision also requires a U.S. corporation that transfers substantially all of the assets of a foreign branch to a foreign subsidiary to include in the U.S. corporation's income the amount of any post-2017 losses that were incurred by the branch. The provisions would be effective for distributions or transfers made after 2017.

Income from production activities sourced 

The bill would amend Sec. 863(b) to provide that income from the sale of inventory property produced within and sold outside the United States (or vice versa) is allocated solely on the basis of the production activities with respect to the property.

Changes to Subpart F rules 

The bill would repeal the foreign shipping income and foreign base company oil-related income rules. Both rules required inclusion in income, for foreign shipping income in a year in which there is a decrease in investment in qualified shipping investments, and, for foreign base company oil-related income, in the current year, regardless of whether the income is distributed. The rules would be repealed for tax years beginning after 2017.

The bill would also add an inflation adjustment to the de minimis exception to the foreign base company income rules. Under the subpart F rules, a U.S. parent of a foreign subsidiary is subject to current U.S. tax on its pro rata share of the subsidiary's Subpart F income, regardless of whether the income is distributed to the U.S. parent. The de minimis rule states that if the gross amount of the income is less than the lesser of 5% of the foreign subsidiary's gross income or $1 million, the U.S. parent is not subject to current U.S. tax. The bill would adjust the $1 million for inflation after 2017.

The bill would also make the Sec. 954(c)(6) lookthrough rule permanent for tax years after 2019. The lookthrough rule provides that the passive income one foreign subsidiary receives from a related foreign subsidiary generally is not includible in the taxable income of the U.S. parent, provided that the income is not subject to current U.S. tax or effectively connected with a U.S. trade or business. The lookthrough rules are currently scheduled to expire after 2019.

Under the bill, a U.S. corporation would be treated as constructively owning stock held by its foreign shareholder for purposes of determining CFC status, which generally requires 50% stock ownership. The bill would also eliminate the requirements that a U.S. parent corporation must control a foreign subsidiary for 30 days before Subpart F inclusions apply.

Base erosion provisions

Under the bill, a U.S. parent of one or more foreign subsidiaries would be subject to current U.S. tax on 50% of the U.S. parent's foreign high returns—the excess of the U.S. parent's foreign subsidiaries' aggregate net income over a routine return (7 percentage points plus the federal short-term rate) on the foreign subsidiaries' aggregate adjusted bases in depreciable tangible property, adjusted downward for interest expense. Foreign high returns would not include income effectively connected with a U.S. trade or business, Subpart F income, and certain other income.

The deductible net interest expense of a U.S. corporation that is a member of an international financial reporting group would be limited to the extent the U.S. corporation's share of the group's global net interest expense exceeds 110% of the U.S. corporation's share of the group's global earnings before interest, taxes, depreciation, and amortization (EBITDA).

Payments (other than interest) made by a U.S. corporation to a foreign corporation within the same international financial reporting group that are deductible, includible in costs of goods sold, or includible in the basis of a depreciable or amortizable asset would be subject to a 20% excise tax, unless the related foreign corporation elected to treat the payments as income effectively connected with the conduct of a U.S. trade or business. Consequently, the foreign corporation's net profits (or gross receipts if no election is made) with respect to those payments would be subject to full U.S. tax, eliminating the potential U.S. tax benefit otherwise achieved.

For these purposes, an international financial reporting group is any group of entities that prepares consolidated financial statements if the average "annual aggregate payment" amount for the group for the three-year period ending in the reporting year exceeds $100 million. The annual aggregate payment amount means the aggregate of the specified amounts made by U.S. members of the group to foreign members of the group during the reporting year.

Sally P. Schreiber (Sally.Schreiber@aicpa-cima.com) is a JofA senior editor.

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