International Tax Reform: Adoption of Territorial System and GILTI Tax

The recently enacted 2017 tax act (originally called the Tax Cuts and Jobs Act – “Tax Reform Act”) contains sweeping changes to US international tax rules that will affect international  businesses and cross border investments.   A review of how to take advantage of these new rules can reap significant benefits or avoid tax pitfalls, as discussed below.

New Territorial Tax System

The Tax Reform Act adopts a new territorial system of taxation (also known as a participation exemption system), which may eliminate or reduce US income taxes on income earned outside the US by US C corporations (“C corps”).  If a C corp owns 10% or more of a foreign corporation that pays a dividend, then the C corp receives a 100% dividends received deduction (“DRD”) for the foreign source portion of the dividend, which will eliminate or reduce the US tax imposed on the dividend.  This DRD is only available for C corps and not for S corporations or individuals.

A DRD will not apply if the foreign corporation is a passive foreign investment company (“PFIC”) unless the foreign corporation is also a controlled foreign corporation (“CFC”) as discussed below.  A PFIC is a foreign company whose income predominantly comes from passive investments (such as marketable securities).

The new territorial system does not apply to income earned by a C corp from a foreign branch.  Income from a foreign branch is subject to US tax, although if foreign tax is imposed on that income, then a foreign tax credit may reduce or eliminate US tax.  As a result, businesses that operate as C corps may want to incorporate their foreign branches to eliminate US tax on branch income.

This system also can reduce the taxable gain realized when a C corp (but not an S corporation or an individual) sells the stock of a foreign corporation.  If the C corp owns the stock of a foreign corporation for one year or more, pre-2017 law recharacterizes any amount realized by the C corp on the sale as a deemed dividend to the extent of the accumulated earnings and profits of the foreign corporation.  The Tax Reform Act provides that such deemed dividend is eligible for the participation exemption system and thus, is not subject to tax.  As a result, a US C corp can eliminate part or all of the taxable gain on the sale of stock of a foreign subsidiary.

New Global Intangible Low-Taxed Income (“GILTI”) Tax

While labeled a tax on intangible income, the GILTI tax is actually a current tax imposed on US shareholders of CFCs on their share of any income earned by the CFC that exceeds a 10% return on investment.  A CFC is any foreign corporation if US shareholders own more than 50% of its stock; for this purpose, a US shareholder is any US person who owns 10% or more of the voting stock or value of the stock of the foreign corporation.  If a CFC has certain types of passive income known as Subpart F income, then US shareholders must include in their income their share of the Subpart F income even though no dividend is paid to them.

The Tax Reform Act provides that a US shareholder of any CFC must include in gross income, for a taxable year, its GILTI in a manner generally similar to the inclusion of Subpart F income.  GILTI means the excess of the shareholder’s net CFC tested income over the shareholder’s net deemed tangible income return in that CFC.  The shareholder’s net deemed tangible income return is an amount equal to the excess of 10% of the aggregate of the shareholder’s pro rata share of the qualified business asset investment (“QBAI”) in that CFC over certain interest expense of each CFC with respect to which it is a US shareholder.  The QBAI is essentially a book value concept since it is based on the tax basis of the CFC’s assets and not their fair market value.  As a result, the 10% threshold can easily be exceeded.

US shareholders who are C corps are given special tax benefits that can eliminate the GILTI tax.  First, under the new law, a C corp can deduct 50% of the GILTI inclusion amount, which reduces the potential corporate tax from 21% to 10.5%.  Second, for any amount of GILTI included in the gross income of a C corp, the C corp would be deemed to have paid foreign income taxes equal to 80% of the foreign taxes paid by the CFC with respect to such income.  If the CFC pays foreign taxes of 13.125% or more, then this special foreign tax credit will eliminate any GILTI tax.  Individuals and S corporations get no similar treatment and pay full US tax on any GILTI inclusion amount.

Conclusion

US taxpayers should carefully review the structure of their foreign entities with their advisors to determine if the new territorial tax system may apply to them, and whether any foreign corporations may qualify as CFCs, which will subject their US shareholders to the new GILTI tax as well as numerous other rules affecting CFC shareholders.  Since the Tax Reform Act limits the benefits of the new territorial tax system to C corps and also only allows C corps benefits to eliminate the GILTI tax, US taxpayers should consider owning foreign stock in a C corp.  Individuals who own foreign corporate stock may want to transfer such stock to C corps; S corporations owning foreign corporate stock also may want to restructure to take advantage of these new rules.  While this task may not be simple, the tax benefits may significant.