US international tax law: The Year of the Regulations

This year most of the regulations implementing and interpreting the Tax Cuts and Jobs Act (TCJA or Tax Reform Act ) statutory changes were issued in proposed or final form. The regulations are complicated and add to an already complex landscape. The impact of thousands of pages of regulations on new and existing international structures have to be quickly and carefully analysed. Each set of regulations has its own effective date rules. The intricacies of effective dates adds to the complexity of analysing the interplay of various regulations. It has become clear that tax reform was not a simplification of the US international tax laws.

International Tax Changes

The TCJA made significant changes to the way US multinationals' foreign profits are taxed. While initially the Tax Reform Act was publicised and seen as a change to a territorial tax system, due to the inclusion of a participation-based exception in the new US Internal Revenue Code section 245A, it has become clear that this is not the case. The TCJA really retains a worldwide tax system with foreign subsidiaries' earnings subject to a US minimum tax.

One-time mandatory repatriation transition tax

One of the TCJA provisions that had an immediate impact on offshore foreign earnings was the amendment of section 965, providing a one-time mandatory repatriation transition tax. The transition tax was implemented as a significant revenue raiser that would help offset the loss in revenue from the reduction in the corporate tax rate from 35% to 21%. It was intended to transition the US tax system to a 'territorial' tax system with tax-free repatriation of foreign profits under section 245A, which is generally limited to amounts that would not have otherwise been taxed in the United States as subpart F income or GILTI. The transition tax generally resulted in a one-time immediate tax on previously deferred offshore earnings of US taxpayers, creating significant previously taxed earnings and profits (PTEP).

Most taxpayers elected to pay the transition tax amounts in eight installments. Certain transactions, including the sale of assets of the US taxpayer, can trigger an acceleration of these installments and, thus, an immediate inclusion of the section 965 liability. However, an agreement can be entered into to allow for the continuation of the installment payment treatment. The regulations provided specific information and representations that a transfer agreement must contain, including a statement that the transferee agrees to assume the transferor's liability for any unpaid installment payments. As a result, it is important to carefully review the regulations and identify situations when a section 965 liability may be triggered, such as a liability of a target prior to a merger, so an agreement can be timely entered into to avoid an immediate lump-sum inclusion.

Public comments requested clarification from Treasury and the IRS regarding whether an underpayment of an installment would constitute an acceleration event under § 965(h)(3) or would result in the proration under § 965(h)(4). The proposed regulations provide that if a person is assessed a deficiency they timely file a return increasing the amount of their § 965(h) net tax liability above the amount taken into account in the payment of the first installment, or they file an amended return increasing the amount of their § 965(h) net tax liability, the deficiency or additional amount will be prorated among the installments under § 965(h)(4). This proration rule does not apply if the deficiency or additional liability is due to negligence, intentional disregard of rules and regulations or fraud with intent to evade tax.

GILTI

The tax on Global Intangible Low Tax Income (GILTI) in the new § 951A made significant changes to the way US multinational's ongoing foreign profits are taxed. GILTI is a newly defined category of foreign income added to the taxable income of US shareholders of controlled foreign corporations (CFCs) each year. GILTI prevents tax deferral and generally prevents retaining low taxed profits offshore.

The US shareholder is required to include in its income the CFC's GILTI income that exceeds a certain return on tangible assets. GILTI is subject to an effective tax rate of 10.5%, with an allowance for foreign tax credits, although the foreign tax credit rules have become complicated under proposed Treasury regulations. The included income, or tested income, is treated similar to subpart F income and is deemed to be currently distributed to a CFC's 10 percent US shareholders.

As a result of the one-time mandatory repatriation and GILTI, generally much of a CFC's income is currently included by a US corporate holder either as subpart F or GILTI generating PTEP, with little, if any, being subject to the dividends received deduction under section 245A unless the CFC has a high amount of foreign tangible assets.

The GILTI regulations provide extensive anti-abuse rules with rebuttable presumptions and per se rules that have drawn a lot of negative commentary, in particular the per se rule for property held for less than a 12-month period. The anti-abuse rules also prevent transfers of property from one CFC to another in order to obtain a stepped-up basis in order to reduce GILTI.

FDII

Foreign derived intangible income (FDII) is a tax incentive that applies generally to foreign sources income earned by a domestic US corporation from selling property to a foreign person for foreign use, or from providing services to persons located outside of the United States or with respect to property located outside of the United States. This incentive is limited by the domestic corporation's taxable income.

The proposed FDII regulations provide guidance for determining the amount of the § 250 deduction allowed. The deduction under § 250 is intended to reduce the effective rate of US income tax on FDII in order to help neutralise the role that tax considerations play when a domestic corporation chooses the location of intangible income attributable to foreign market activity.

The proposed Treasury regulations also provide that FDII can only be taken advantage of if certain documentation requirements are satisfied. Some of the documentation requirements in the regulations are burdensome and may require requesting information from, or amendments to, contracts with foreign purchasers or service recipients.

BEAT

To discourage related party "base-erosion payments", a new section 59A was enacted and operates similar to an alternative minimum tax on US corporations that have average annual gross receipts of at least $500 million during the preceding three tax years and have a "base erosion percentage", or generally the percentage of its deductions that are "base erosion payments", of at least 3% during the current year. This base-erosion and anti-abuse tax (BEAT) largely applies with respect to "base erosion payments" at a rate of 5% for 2018 and 10% starting in 2019.

The BEAT threshold is important. The BEAT rules only apply for taxpayers over the threshold. If the taxpayer can keep its base erosion percentage below that amount, the BEAT rules are turned "off".

Generally, related party base erosion payments increase the base erosion percentage. Base erosion payments most commonly include payments (for example interest, royalties and services) that are made to a foreign related party, generally determined with 25% ownership overlap, for which the taxpayer can take a current deduction. US companies acting as a shared service provider, or that have sales commissions, can create BEAT issues as well.

The proposed BEAT regulations were surprising and define "purchase" in a very broad manner to include deemed stock payments for property in otherwise tax-free transactions, such as a section 351 capital contribution by a shareholder who owns 100% of the foreign corporation and in a section 368 tax-free reorganisation. As a result, deductions for amortisation or depreciation allowable to a taxpayer from these types of transactions with foreign related parties are also base erosion payments.

The proposed BEAT regulations also provide helpful guidance that clarified that the Service Cost Method (SCM) exception is available under BEAT even if there is a markup, but that the portion of any payment that exceeds the total cost of services is not eligible for the SCM exception and is a base erosion payment. The proposed regulations do not require separate accounts to bifurcate the cost and markup components of services charges.

The BEAT regulations provide anti-abuse rules which can recharacterise certain transactions that have a principal purpose of avoiding § 59A.

Conclusion

The international tax landscape after the TCJA changed dramatically and it continues to change with the continued release of proposed and final Treasury regulations almost on a weekly basis. The regulations provide important new rules and interpretations and can be critical to understanding whether and how tax reform might impact or update a multinational corporation's tax analysis.