International Operations—Prior Tax Law

Prior to the enactment of TCJA in 2017, the United States imposed income tax on the worldwide income of U.S. corporations. In a worldwide system of taxation, the IRS taxed all income earned both at home and abroad, while double taxation was mitigated by foreign tax credits. In order to avoid double taxation (foreign countries will also impose an income tax), the tax code provides a credit for income taxes paid to foreign countries. The credit was limited to the amount that the company would have owed the IRS on the foreign income if it was U.S. income. Taxpayers may pay residual tax on foreign income if the foreign tax rate is less than the domestic tax rate. The tax system while more characteristic of a worldwide nature was a hybrid system with components of both worldwide and territorial systems. Under prior law, U.S. taxes were not due on active foreign business income until it was repatriated to the U.S. parent company. As a result, U.S. companies generally held income generated from overseas business in foreign countries. The rules concerning taxation of foreign income are referred to as Subpart F of the tax code. This tax deferral did not apply to certain types of income, termed tainted income that includes passive income such as dividends, interest and royalties from one controlled foreign corporation (CFC) to another.

Tax regulations, effective in 1997, made it easier for U.S. corporations to change the tax classification of domestic and foreign entities. As a result, corporations could elect to be treated for tax purposes as a pass-through or a corporate entity. This election and the rules thereunder are called Check the Box. The Check the Box rules created additional tax planning strategies for multinationals. This is because a multinational could elect to treat a foreign corporation as a pass-through for U.S. tax purposes, while the foreign country might treat it as a corporation. This strategy and the foreign entities are called hybrid tax planning and hybrid entities. One method of using a hybrid entity involved a multinational with intellectual property. A multinational might check the box on a foreign affiliate making a royalty payment pursuant to a plan to limit U.S. tax on royalty payments under Subpart F.

Using pass-through entities (check-the-box) are often-times part of of a multinational’s tax strategy, along with transfer pricing policies, planning to access benefits of income tax treaties, and local country planning. The U.S. has tax treaties with 66 foreign countries that serve to reduce companies’ exposure to double taxation. Transfer pricing involves prices that related parties charge each other for goods and services.

International Operations—Current Tax Law

With the enactment of the TCJA in 2017, the U.S. international tax system remains a hybrid system, but has shifted from a mostly worldwide system to a more territorial system. In general, U.S. based multinationals now pay income taxes on U.S. earnings only and not on their worldwide earnings. This is accomplished by use of a foreign dividends exemption. In a territorial system of taxation, a jurisdiction imposes tax only on income earned in their home country. There is no home country tax on income earned in foreign jurisdictions. The territorial system usually allows a participation exemption such as a dividends received deduction for foreign dividends. The previous provisions in the Tax Code that allowed multinationals to keep foreign earnings (cash, etc.) offshore and thereby defer U.S. taxes have been changed. The TCJA enacted a system with a participation exemption (dividends received deduction) that allows foreign-source earnings of a foreign corporation to be repatriated to a corporate U.S. shareholder without U.S. tax. A foreign tax credit or deduction is not allowed for foreign taxes paid or accrued by the foreign corporation on earnings for which a dividends received deduction is allowed.

The dividends received deduction system could cause multinationals to allocate income to foreign corporations located in low-tax jurisdictions. With that in mind, the TCJA imposed a tax (effectively a minimum tax on some income—GILTI) on certain income, specifically income from intellectual property such as copyrights, licenses, patents and trademarks in order to prevent foreign corporations from using tax planning to avoid taxation. The planning would involve multinationals placing intangible assets in low tax countries with the result that income from intangibles would evade taxation. In order to avoid a negative impact on the competitiveness of U.S. multinationals due to the taxation of intangible income, the TCJA provides a 50% deduction for corporate U.S. shareholders of foreign companies with respect to certain intangible income. A new tax, Base Erosion and Anti-Abuse Tax (known as BEAT), under TCJA applies to large multinationals who might use planning to evade U.S. tax. It serves as a minimum tax centered around payments for foreign corporations engaged in U.S. trade or business and domestic corporations. Also, the corporate tax rate was reduced from 35% to 21%. Now that we have a more territorial system, the IRS collects more tax sooner on large sums of foreign income since foreign income is now taxed as earned and not later when repatriated. The U.S. also enjoys revenue gains from the minimum tax on foreign income (GILTI and BEAT). Also, it should be noted that a 21% tax rate is closer to the current corporate tax rates in foreign countries.

Bowman Law Firm, Gene M Bowman, Tax Attorney in Huntsville, Alabama