The Tax Cuts and Jobs Act (TCJA) has ushered in a new era of international taxation, transforming the rules that govern the global economic landscape. Designed to enhance the competitiveness of U.S. companies on the global stage and attract increased investment to the United States, the TCJA is a multifaceted reform. While it primarily focuses on bolstering the global standing of U.S. entities, the legislation also endeavors to address concerns related to base erosion and profit shifting through the introduction of new anti-abuse rules. Let's delve into the major alterations that have unfolded for U.S. multinational entities.
Adoption of a Territorial Tax System
A cornerstone of the TCJA is the adoption of a territorial tax system. This seismic shift is embodied in the establishment of a participation exemption system for the taxation of foreign source income. Under this system, a 100-percent 'dividends received deduction' (DRD) is permitted for foreign-source dividends received by domestic corporations.
However, to qualify for the DRD, a domestic corporation must meet specific criteria, including classification as a U.S. shareholder and ensuring the foreign corporation in question is not a passive foreign investment company (PFIC). The legislation employs safeguards to prevent abuse; for instance, the DRD is unavailable for dividends received from a controlled foreign corporation (CFC) if the dividend is a hybrid dividend that conferred a deduction or other tax benefit in a foreign country.
Furthermore, the provision imposes a holding period requirement and applies to distributions made after December 31, 2017. This holding period mandates that a domestic corporation cannot claim a DRD if the shares are held for 365 days or less during the 731-day period beginning one year before the shares become ex-dividend with respect to the dividend.
Another critical component of the TCJA is the introduction of a transition tax targeting accumulated post-1986 deferred foreign income of specified foreign corporations. For the last taxable year commencing before January 1, 2018, any U.S. shareholder of a specified foreign corporation is required to include in income their pro-rata share of this deferred foreign income.
This provision aims to tax foreign source income currently held offshore. The tax rates on foreign earnings are bifurcated – 15.5 percent for cash and cash equivalents, and 8 percent for all other earnings. Notably, U.S. shareholders can opt for installment payments over an eight-year period. The installment plan spans the first five years at 8 percent of net tax liability, followed by 15 percent in the sixth year, 20 percent in the seventh year, and the remaining 25 percent in the eighth year.
Reduced Rates on Foreign-Derived Intangible Income and Global Intangible Low-Taxed Income
The TCJA introduces a new section (section 250) to the Internal Revenue Code, offering domestic corporations reduced U.S. tax rates on foreign-derived intangible income and global intangible low-taxed income.
For taxable years between December 31, 2017, and January 1, 2019, the effective tax rate on foreign-derived intangible income is 21.875 percent, while the effective tax rate on global intangible low-taxed income is 17.5 percent. Subsequently, for taxable years between December 31, 2018, and January 1, 2026, the effective rates drop to 12.5 percent and 10 percent, respectively. From December 31, 2025, onwards, the effective rates settle at 15.625 percent for foreign-derived intangible income and 12.5 percent for global intangible low-taxed income.
The TCJA introduces a spectrum of other modifications and provisions:
- Modifications to the Foreign Tax Credit System: This involves the repeal of the section 902 indirect foreign tax credit, the repeal of section 863(b) source rules, and the creation of a new foreign tax credit basket for foreign branch income.
- Modifications to the Subpart F Provisions: Key alterations include the repeal of foreign base company rules for shipping and oil-related income, modifications to stock attribution rules for determining CFC status, elimination of the 30-day control requirement before Subpart F inclusions apply, and the inclusion of global intangible low-taxed income similar to Subpart F inclusions.
- New Provisions Targeting Base Erosion and Profit Shifting: The TCJA takes a stand against abusive practices with the imposition of a base erosion minimum tax, revisions to definitions, and the requirement of specific valuation methods. Additionally, the legislation denies a deduction for certain related party payments tied to a hybrid transaction or hybrid entity and disallows reduced tax rates on dividends received from expatriated entities.
These anti-abuse rules align with the recommendations of the Organization for Economic Cooperation and Development (OECD) BEPS project and the Model Tax Treaty released by the U.S. Treasury Department in 2016. The latter mandates meeting specific base erosion tests before an entity qualifies for treaty benefits.
The Tax Cuts and Jobs Act has engineered a paradigm shift in international taxation. While aiming to fortify the competitive position of U.S. entities globally, it also addresses concerns related to base erosion and profit shifting through a comprehensive set of provisions. As the global tax landscape evolves, businesses and tax professionals navigate this intricate terrain, adapting to the new norms set by the TCJA.