International Taxation Matters: Potential Impact and Planning Points
Almost three years removed from the enactment of the Tax Cut and Jobs Act (TCJA), the IRS has continued to issue additional notices and regulations as part of its effort to provide clarity to taxpayers uncertain of the ramifications of new international statutory provisions. Mid-way through 2020, the IRS released final regulations concerning the provisions impacting U.S. multinational companies and cross-border transactions. Following is a brief discussion of these rules and their potential tax impact, as well as planning points to consider in 2020 and future years.
GLOBAL INTANGIBLE LOW-TAXED INCOME (“GILTI”)
Under the GILTI provisions established by the TCJA, U.S. taxpayers that are shareholders of controlled foreign corporations, or CFC’s, are required to make a current income inclusion on their share of a CFC’s undistributed foreign earned income that is ultimately treated as GILTI income. The GILTI inclusion amount, which is essentially equal to the foreign income earned by the CFC in excess of 10% of that foreign corporation’s depreciable tangible property, was designed to deter the offshoring of intellectual property (IP) and other valuable intangible assets, as well as to discourage the accumulation of offshore earnings in low-tax jurisdictions.
Domestic corporations are currently allowed a deduction of 50% of their GILTI inclusion and can additionally claim a foreign tax credit of up to 80 percent of foreign income taxes paid or accrued on GILTI inclusions, subject to certain foreign tax credit limitation rules. The GILTI high-tax exception, initially proposed in June 2019, has since been finalized and may provide relief to taxpayers conducting business in foreign high-tax jurisdictions in future tax years. Under the exception, income subject to tax in a foreign country at a rate greater than 18.9 percent would be excluded from GILTI at the election of the taxpayer. Because electing to apply the GILTI high tax exception may affect a number of other items included on a taxpayer’s return, including the application of foreign tax credits, the allocation of foreign business expenses, and the 163(j) interest deduction limitation, taxpayers considering making the election are recommended to have a financial analysis conducted in order to determine the exception’s potential tax impact.
Additionally, while non-corporate taxpayers would not typically be eligible for the foreign tax credit limitation or the 50% GILTI deduction, final regulations released in 2020 have established that individual taxpayers electing under section 962 to be treated as a U.S. C-Corporation can avail themselves of both of these methods of mitigating the effects of the GILTI inclusion.
FOREIGN-DERIVED INTANGIBLE INCOME (“FDII”)
Also introduced under the TCJA, section 250 allows a U.S. C-Corporation that provides services and makes sales to foreign customers located outside of the U.S. the ability to take a deduction on foreign-derived intangible income (“FDII”). The FDII deduction, which was intended to encourage C-Corporations to export goods and services outside of the U.S., essentially reduces the effective tax rate imposed on qualifying income to 13.125% of the normal federal statutory rate of 21%. However, in order to take advantage of the FDII provision, taxpayers were previously required to comply with stringent documentation rules to establish that their foreign sourced income was eligible for the FDII deduction. Heeding taxpayer complaints that its previous documentation requirements were unduly burdensome, the IRS released final regulations in 2020 that significantly relaxed the documentation rules such that specific documentation was no longer required for most forms of transactions. Instead, the final regulations grant taxpayers more flexibility in the means by which they substantiate that their services or sales transactions are: (1) to foreign persons and (2) are going to be consumed abroad. Because the applicability provisions of the 2020 final regulations clarify that taxpayers may choose to adopt them for tax years beginning on or after January 1, 2018, companies that previously could not take advantage of the FDII deduction due to the strict documentation rules required under the proposed regulations should consider filing amended returns adopting the final regulations, so that they can benefit from its comparatively less-stringent evidential standards.
BASE EROSION AND ANTI-ABUSE TAX (“BEAT”) – FINAL REGULATIONS
On December 22, 2017, the TCJA codified IRC section 59A (i.e., the base erosion and anti-abuse tax), which applied a tax on large (i.e., $500 million or more average gross revenue over the last 3 years) multinational corporations that shift profits abroad through related party transactions that create U.S. deductible payments to low-tax foreign countries.
On September 1, 2020, the IRS issued final regulations under section 59A, which provided clarity, flexibility and guidance on the application of BEAT.
OTHER NOTABLE PROVISIONS
2020 also brought forth final and proposed regulations regarding some open questions relating to both the determination of controlled foreign corporation (“CFC”) status under certain tax code provisions and the ability for the U.S. to tax income related to the sale of interests in partnerships engaged in a U.S. trade or business.
Section 864(c)(8), which was originally introduced under the TCJA, essentially provides that gain or loss derived from a foreign partner on the sale or exchange of a partnership interest in a partnership engaged in a U.S. trade or business is treated as effectively connected income and is subject to federal income tax in the U.S. While proposed regulations on the provision issued in 2018 had previously left taxpayers with some uncertainty as to the treatment of a foreign partner’s sale or exchange of partnership interest, the final regulations, released in September 2020, clarify that a foreign partner’s distributive share of a deemed gain or loss from the sale of his or her partnership interest would not include amounts otherwise excluded from the foreign partner’s gross income or which are exempt from U.S. federal income tax.
With respect to the determination of CFC status under certain tax code provisions, the IRS has also released guidance clarifying questions raised by the TCJA’s repeal of a stock attribution rule preventing the downward attribution of stock from a foreign person to a U.S. person. By increasing the number of U.S. persons considered to be shareholders of a corporation, the repeal of this provision, when taken into account with certain other constructive ownership provisions of the tax code, significantly increased the number of foreign corporations treated as CFCs. Final regulations released by the IRS in September 2020 provide relief to affected taxpayers in the form of safe harbor provisions, penalty relief, and various modifications to statute intended to narrow the definition of CFCs to be more consistent with its previous definition. While proposed regulations have been issued as part of an attempt to provide further guidance as to the ramifications of the repeal, and should be finalized in the upcoming year, taxpayers should be aware that not all of the new provisions are beneficial – as not treating a foreign corporation as a CFC could, in some cases, actually hurt the taxpayer’s ultimate tax positions. As a result, taxpayers are recommended to have a financial analysis conducted in order to determine the full impact of these updated provisions.