International Taxation Matters: Potential Impact and Planning Points

Now four years removed from the enactment of the Tax Cut and Jobs Act (“TCJA”), one year removed from the Coronavirus Aid, Relief, and Economic Security Act (“CARES”), and months away from finalization of the Biden administration’s General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals (“Green Book”), the IRS continues to issue notices and regulations as part of its effort to provide clarity to taxpayers uncertain of the ramifications of new international statutory provisions.

GLOBAL INTANGIBLE LOW-TAXED INCOME (“GILTI”)

Under the TCJA, the IRS established the GILTI tax regime to (1) disallow deferral of income generated by controlled foreign corporations (“CFC”); (2) deter the offshoring of intellectual property (“IP”) and other valuable intangible assets; and (3) discourage the accumulation of offshore earnings in low-tax jurisdictions. U.S. taxpayers regarded as U.S. shareholders (i.e., U.S. taxpayers that hold more than 10% vote or value of a CFC) are subject to immediate U.S. taxation on their share of a CFC’s undistributed foreign earnings characterized as GILTI inclusion amount. A CFC’s GILTI inclusion amount is the entity’s current year earnings reduced by 10% of its depreciable tangible property (i.e., deemed tangible income return on qualified business asset investment (“QBAI”)).

Domestic corporations regarded as U.S. shareholders of a CFC may take a deduction of 50% on their GILTI inclusion (i.e., IRC §250 deduction), and can additionally claim a foreign tax credit (“FTC”) of up to 80% for the CFC’s foreign income taxes paid or accrued on the GILTI inclusion amount, subject to certain FTC limitation. Individual U.S. shareholders must make an IRC §962 election to receive the same benefits as the previously mentioned domestic corporation U.S. shareholders.

On June 20, 2020, the IRS issued final regulations permitting U.S. taxpayers to make a GILTI high-tax exception (“HTE”) election, which provides U.S. income tax relief to CFCs conducting business in foreign jurisdictions with a corporate income tax rate greater than 18.9%. Making a HTE election may cause changes to a taxpayer’s U.S. income tax return, including the application of FTC, the allocation of foreign business expenses, and the IRC §163(j) interest deduction limitation. Therefore, a financial analysis is recommended prior to a HTE election to determine the HTE exception’s potential tax impact.

On September 13, 2021, the House Ways and Means Committee provided an update to the Biden Administration’s Green Book tax proposal issued on May 28, 2021. The following change to the GILTI provisions was proposed:

1. Compute GILTI on a country-by-country basis;
2. Reduce the deemed tangible income return on QBAI from 10% to 5%;
3. Allow for carryover of country-specific net tested losses;
4. Allow a 5-year carryforward of GILTI excess FTCs;
5. Reduce the IRC §250 deduction from 50% to 37.5%;
6. Include in net operating loss IRC §250 deduction that exceeds taxable income; and
7. Increase the FTC inclusion from 80% to 95%.

Taxpayers should note that it is currently uncertain whether the Ways and Means proposals will ultimately be enacted into law, and if so, whether the enacted legislation will remain in a form substantially similar to that currently outlined above.

FOREIGN-DERIVED INTANGIBLE INCOME (“FDII”)

Under the TCJA, the IRS established IRC §250, which 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 an annual 37.5% deduction of its 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., reduces the U.S. effective tax rate imposed on qualifying income from the 21% statutory corporate income tax rate to 13.125% for tax years 2018 through 2025 and 16.406% for years thereafter. The FDII deduction applies to income in excess of a 10% return on tangible assets, earned by a domestic corporation from the performance of services or sales, leases or licenses of property to non-U.S. persons for foreign use.

In order to take advantage of the FDII provisions, 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 transaction. 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) will 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 under the final regulations, so that they can benefit from the comparatively less-stringent evidential standards.

The Ways and Means proposal issued on September 13, 2021, provided the following changes to the FDII provisions:

1. Reduce the IRC §250 FDII deduction from 37.5% to 21.875%, resulting in a reduction of the proposed effective tax rate from 13.125% [(1-37.5%) X 21%] at 21% corporate tax rates to 20.7% [(1-21.875%) X 26.5%] at proposed 26.5% corporate tax rates; and
2. Net operating loss will include IRC §250 FDII deduction that exceeds taxable income.

Taxpayers should note that it is currently uncertain whether the Ways and Means proposals will ultimately be enacted into law, and if so, whether the enacted legislation will remain in a form substantially similar to that currently outlined above.

FOREIGN TAX CREDITS (“FTC”)

Current law states a taxpayer may claim a credit (or deduction) for foreign income taxes imposed by foreign countries or U.S. possessions. The FTC must not exceed the foreign taxes paid multiplied by the fraction of the taxpayer’s income sourced outside the U.S. over the taxpayer’s total taxable income from sources outside and inside the U.S. If any portion of the foreign taxes paid is not used as a credit due to the limitation, the foreign taxes paid may be carried back to the previous tax year and forward to a maximum of 10 years.

The Ways and Means proposal released on September 13, 2021, would make major changes to the FTC calculation if enacted into law. Under this proposal, the FTC must be determined on a country-by-country basis, and each item of income and loss must be specifically categorized on the U.S. taxpayer’s income tax return. In terms of GILTI, only deductions directly allocable to GILTI income are included in the calculation. Other significant changes include (1) the repeal of the foreign branch income basket, (2) the inability for dual capacity taxpayers to take a credit, (3) the disallowance of the foreign tax paid carryback, and (4) the change of the foreign tax carryforward maximum from 10 years to 5 years.

BUSINESS INTEREST LIMITATION

The TCJA introduced the business interest limitation under IRC §163(j), which was later amended under the CARES act. Under current law, IRC §163(j) limits the interest deduction to the sum of (1) interest income, (2) 50% of the entity’s adjusted taxable income (30% for partnerships), and (3) the floor plan financing interest expense (interest paid for the financing of motor vehicles in inventory for sale). The interest limitation is determined at the entity level.

The Ways and Means proposal provides changes to IRC §163(j) and creates IRC §163(n). If the proposal is approved, IRC §163(j) would be determined at the partner/shareholder level rather than the entity level. IRC §163(n) would limit the interest deduction of domestic corporations that are members in an international financial reporting group. A domestic corporation will calculate its allocable share of the group’s net interest expense by dividing the domestic corporation’s earnings before interest, taxes, depreciation, and amortization (“EBITDA”) by the group’s EBITDA and multiplying that fraction by the group’s net interest expense. The domestic corporation’s net income expense must not exceed 110% of the domestic corporation’s allocable share of the group’s net interest expense. Therefore, the maximum amount of interest that may be deducted by a domestic corporation, which is a member in an international financial reporting group, is 110% multiplied by the domestic corporation’s allocable share of the group’s net interest expense.

The newly proposed IRC §163(n) applies only to domestic corporations whose average excess interest expense over interest income exceeds $12 million over a three-year period. In addition, the limitation does not apply to any S-corporations, real estate investment trusts, regulated investment companies, or corporations that meet the small businesses exemption under IRC §163(j)(3). The proposal would allow for a carryforward of up to 5 years for business interest that is limited by IRC §163(j) or 163(n). The interest carryforward would be used in a first-in, first-out basis.

OTHER NOTABLE UPDATES

Though first established under the TCJA in 2017, the final Base Erosion and Anti-Abuse Tax (“BEAT”) regulations were released on September 1, 2020. These regulations provided clarity to taxpayers regarding the application of the tax, which is imposed 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. Among other changes, the September 2021 Ways and Means proposal raises the rate imposed under the BEAT regime to 10% in 2022, 12.5% in 2024, and 15% in 2026, thereby furthering the Biden Administration’s goal of discouraging the use of foreign tax havens. The Ways and Means draft modifications of the BEAT, however, stops short of the repeal previously outlined by the Biden Administration under its Stopping Harmful Inversions and Ending Low-Tax Developments (SHIELD) regime, and it remains to be seen whether further attempts will be made to bring the current BEAT even further in line with the SHIELD framework promulgated under the Biden Administration’s “Green Book.”

In an attempt to further dissuade multinational taxpayers from acquiring foreign companies and shifting their headquarters out of the U.S. (to avoid paying U.S. taxes), the Biden Administration released proposals in the Green Book to reduce the ownership threshold percentage at which foreign corporations are treated as domestic corporations for U.S. income tax purposes. In addition to effectively reducing the previous 80% ownership threshold to 50%, the anti-inversion proposals also expand the tests used to determine whether an inversion transaction has occurred. The Green Book proposal indicates that an inversion transaction would be deemed to occur if (1) immediately prior to the acquisition, the fair market value of the domestic entity is greater than the fair market value of the foreign acquiring corporation; (2) after the acquisition, the expanded affiliated group is primarily managed and controlled in the United States; and (3) the expanded affiliated group does not conduct substantial business activities in the country where the foreign acquiring corporation is organized. However, taxpayers should note that it is currently uncertain whether the anti-inversion proposals will ultimately be enacted into law, and if so, whether the enacted legislation will remain in a form substantially similar to that currently outlined in the Green Book.