The 2018 Tax Cuts and Jobs Act (TCJA) brought several changes to how U.S. shareholders are taxed on earnings from a foreign corporation. These provisions were enacted to move us away from worldwide tax system to a modified territorial tax system.
Previously, earnings from foreign corporations were not taxable in the U.S. until the foreign corporation repatriated its earnings through dividend distributions with the exception of Subpart F income from Controlled Foreign Corporations (CFC’s). The new rules under the TCJA only apply to CFC’s .
Controlled Foreign Corporations
A CFC is defined as a foreign corporation in which U.S. persons own more than 50% of the combined voting power or the total value of stock. For the 50% test, only U.S. persons owning 10% of the stock or more are considered. Ownership is determined by direct, indirect or constructive ownership. A U.S. person is defined as a U.S. citizen or resident, domestic partnership, corporation, estate or trust.
- A U.S. person owns 50% and 6 other unrelated U.S. persons each own 8.33% – not a CFC
- A U.S. person owns 50%, but unrelated foreign persons own the other 50% – not a CFC
- A U.S. person owns 51%, but foreign persons own the other 49% – yes, CFC
- U.S. person A owns 50%, U.S. person B owns 50% – yes, CFC
The stock attribution rules are complex, so it is important to first analyze the ownership structure.
U.S. shareholders of CFC’s are now required to pay a transition tax in order to make the switch to the new regime. Since the earnings have not been previously taxed, the transition tax rules require that the tax is calculated on post 1986 earnings and profits as of December 31 2017. The calculations can be complex. But, essentially, the IRS gives you 8 years to pay the tax while transitioning to the new system.
Global Intangible Low-Taxed Income
There is also a new provision called Global Intangible Low-Taxed Income (GILTI). This is essentially a tax on a residual income. It’s calculated by excluding income that is taxed under other provisions in order to avoid double tax. For example, you exclude gross income included in determining Subpart F income or dividends from related persons. In calculating GILTI, you get a 10 percent discount on qualified business asset investments. So, if you have property used for the production of income in the foreign company, you get to reduce your GILTI. However, the benefit is reduced by the interest expense of any CFC.
A domestic corporation is allowed to deduct 50 percent of the GILTI income plus the amount treated as a dividend in calculating foreign tax. Because of this deduction, the effective rate ends up being about 10.5 percent. GILTI tax can further reduced by foreign tax credits.
Individuals are ineligible for the 50 percent GILTI deduction and cannot take the foreign tax credit. Additionally, the maximum tax rate for individual taxpayers is 37 percent, while the maximum corporate rate is 21 percent. This is when an old provision in the code can become your best friend, Section 962. This section allows the individual to compute tax on subpart F inclusions as he or she were a domestic corporation.
Finally, another thing to consider in the new provision is the “participation exemption” which provides a 100 percent dividend received deduction to any domestic corporation who owns a CFC. Some holding period requirements apply. Once again, individuals aren’t eligible for the participation exemption.
The new provisions increase the complexity of cross-border transactions. Every situation should be analyzed carefully before determining a plan of action. It is important to analyze your situation NOW in order to determine how you will be affected and then develop a proper plan.