2018 Tax Reform: The Impact of the New Base Erosion Provisions on Multinational Companies; Questions for IP Structures
On December 22, 2017, President Trump signed into law the Tax Cuts and Jobs Act (the "Act"). The Act fundamentally overhauls the taxation of individuals, corporations, partnerships, and other multinational enterprises ("MNEs") investing in foreign entities under the existing Internal Revenue Code of 1986, as amended (the "IRC").
One of the key changes resulting from the Act is a decrease in the corporate tax rate from a top rate of 35% to a flat 21% rate effective January 1, 2018. This reduction in the corporate tax rate makes the United States’ rate significantly more competitive in the global landscape. The reduction in the corporate tax rate alone is expected to change incentives for MNEs such that it is less attractive to move intangible assets offshore, in turn encouraging repatriation/growth of income associated with intangible assets in the United States.
Furthermore, the Act broadens the definition of intangible assets and imposes base erosion provisions for both U.S. and foreign MNEs. To combat profit shifting on passive and mobile income, there are provisions to impose a tax on U.S. MNEs with respect to their global intangible low-taxed income ("GILTI") as well as a deduction for their foreign-derived intangible income ("FDII"). Furthermore, foreign based MNEs with U.S. subsidiaries can be levied with a "Base Erosion Anti-Abuse Tax" (the "BEAT").
The Definition of Intangible Property Under Section 936(h)(3)(B) is Broadened
The Act changes the definition of intangible property ("IP") in Section 936(h)(3)(B) to include workforce in place, goodwill (foreign and domestic), and going concern value. The residual category of "any similar item," which has value not attributable to property or services, is now defined as IP. The broadened definition also removes the flush language, "which has substantial value independent of the services of any individual," at the end of the subparagraph to clarify that the source or value is not relevant to whether property is within the scope of the Section 936(h)(3)(B) definition.
The provision further clarifies the IRS's authority to specify the method used when valuing IP in outbound transfers and intercompany pricing. First, for transfers of multiple IPs, aggregate-basis valuation would be permitted if that approach would result in a more reliable valuation than an asset-by-asset valuation. Second, the Act codifies the realistic alternative principle, the idea that a taxpayer would only enter into a certain transaction if none of the realistic alternatives are economically preferable.
This broadened definition of IP impacts the taxable income streams associated with such IP and casts a broader net on what is considered non-routine income not attributable to property or services. This will impact IP valuation methodologies and has a broader impact on international tax and transfer pricing considerations.
The expansion of the definition of intangibles will also impact companies converting branches into foreign corporations to take advantage of certain features of the Act, such as the participation exemption. This in turn will trigger adverse consequences under IRC section 367 which imposes taxation on the outbound transfer of property by a U.S. person to a controlled foreign corporation (“CFC”) in what would otherwise be a nontaxable exchange. Additionally, for foreign branches there are recapture rules that need to be considered.
In addition to expanding the definition of IP, the Act also implements the following base erosion provisions, effectively imposing a minimum tax on MNEs: GILTI, FDII, and the BEAT.
Global Intangible Low-Taxed Income and Foreign Developed Intangible Income
The Act adds to the IRC new Section 951A, which requires a U.S. shareholder of a CFC to include in income, as a deemed dividend, the global intangible low-taxed income ("GILTI") of the CFC. After factoring in a deduction that a domestic corporation will be entitled to claim with respect to such income inclusion, a domestic corporation will be subject to U.S. tax on GILTI at an effective rate of 10.5% (that is, 50% of the U.S. corporate tax rate of 21%). For purposes of this rule, GILTI is defined as the excess of a controlled foreign corporation's ("CFC's") aggregated net "tested income" over its "net deemed tangible income return" (i.e., routine return), which is defined as 10% of the aggregate of the shareholder’s pro rata share of its CFC’s bases in tangible property used to produce “tested income” over the amount of interest expense taken into account. The interest expense only reduces the CFC’s routine return if the interest income attributable to such expense is not otherwise taken into account in determining such shareholder’s net CFC tested income.
In contrast to the definition of GILTI stands the definition of FDII. A domestic corporation's FDII is the portion of its intangible income, determined on a formulaic basis, that is derived from serving foreign markets. In effect, the GILTI provision imposes a minimum tax on certain foreign income and discourages income-shifting incentives, whereas the deduction for FDII provides a benefit counterbalancing the additional tax effect due to GILTI income.
The GILTI tax will be incurred at the new 21% corporate tax rate after a 50% deduction (the deduction is reduced to 37.5% in 2026) is applied. U.S. corporate shareholders with GILTI inclusions will be permitted a foreign tax credit ("FTC") equal to 80% of their ratable share of foreign taxes deemed paid attributable to net CFC tested income. As such, the FTC only applies to domestic corporations and will essentially eliminate the tax on GILTI if there are sufficient foreign taxes.
The new Section 250 permits a domestic corporation the ability to claim a deduction for an amount equal to 37.5% of its FDII. This deduction is reduced to 21.875% for tax years beginning after December 31, 2025.
The deductions for FDII and GILTI are only available to C corporations that are not regulated investment companies ("RICs") or real estate investment trust ("REITs"). The deduction for GILTI applies to the amount treated as a dividend received by a domestic corporation under Section 78 that is attributable to the corporation's GILTI amount under new Section 951A.
Much of the legislation contained within the Act aims to increase domestic production, and the FDII provision provides an incentive for domestic corporations earning intangible income in the U.S. To this end, for purposes of computing its FDII, a domestic corporation's qualified business asset investment ("QBAI") is the average of the aggregate of its adjusted bases, determined as of the close of each quarter of the taxable year, in specified tangible property used in its trade or business and of a type with respect to which a deduction is allowable under Section 167. The adjusted basis in any property must be determined using the alternative depreciation system under Section 168(g), notwithstanding any provision of law which is enacted after the date of enactment of this provision (unless such later enacted law specifically and directly amends this provision's definition).
The FDII of any domestic corporation is the amount which bears the same ratio to the corporation's deemed intangible income as its foreign-derived deduction eligible income bears to its deduction eligible income. In other words, a domestic corporation's FDII is its deemed intangible income multiplied by the percentage of its deduction eligible income that is foreign derived.
Deduction eligible income means, with respect to any domestic corporation, the excess (if any) of the gross income of the corporation—determined without regard to certain exceptions to deduction eligible income—over deductions (including taxes) properly allocable to such gross income (referred to in this document as "deduction eligible gross income").
The exceptions to deduction eligible income are: (1) the subpart F income of the corporation determined under Section 951; (2) the GILTI of the corporation; (3) any financial services income (as defined in Section 904(d)(2)(D)) of the corporation; (4) any dividend received from a CFC with respect to which the corporation is a U.S. shareholder; (5) any domestic oil and gas extraction income of the corporation; and (6) any foreign branch income (as defined in Section 904(d)(2)(J)) of the corporation.
Assuming no interest expense in Example 1, a U.S. MNE with subsidiaries in four foreign jurisdictions is able to avoid the inclusion of GILTI income because the asset bases in Foreign 2 and Foreign 3 allow for "non-routine returns" in Foreign 1 and Foreign 4 to be sheltered.
As illustrated in Example 1, the determination of QBAI is crucial, and aggregation for purposes of computing GILTI helps to take advantage of different levels of assets bases in the CFCs. This rather formulaic approach, and the reliance on QBAI to compute a net deemed tangible income return, will most certainly invite much international debate and discussion since it deviates from a more qualitative approach to determine substance relating to tangible and intangible assets.
Assume similarly to Example 1, a US MNE with subsidiaries in four foreign jurisdictions. Also assume, no interest expense, no other limitations are applicable, and assume that all income earned by the US parent is with GILTI and FDII. Then the below illustrates an example on how the "net tax due" can be computed taking into account the GILTI and FDII with a FTC:
In Example 2, one should note that both the FDII deduction of 37.5% and the GILTI deduction of 50% have been applied. In addition, any deemed paid FTC with respect to entities that are "high taxed" can be used to offset other income in the current year. Excess credits cannot be carried forward or back, so excess FTCs are lost.
As such, the base erosion provisions of the Act may result in many companies simply deciding to onshore their intangibles. If they can do so at full value and get an amortization deduction at a lower rate, it may prove more attractive than deferral under the new regime. Recognizing this, these provisions provide that on-shored intangibles will have a carryover tax basis. Thus, if an intangible is self-created by the offshore corporation, it will come back to the U.S. with a zero basis
Base Erosion Anti-Abuse Tax
Another significant anti-base erosion provision in the Act is the BEAT. The BEAT imposes a minimum tax on certain deductible payments such as royalties and management fees made to a foreign affiliate. The amendments made to the section on base erosion payments, as defined in the Act, apply to such payments paid or accrued in taxable years beginning after December 31, 2017.
The Act requires "applicable taxpayers" to pay the excess of 10% of "modified taxable income" for a taxable year over an amount equal to its regular corporate tax liability for that year reduced by certain credits including the "base erosion minimum tax amount". The percentage tax rate is 5% for 2018 and 12.5% for taxable years beginning after December 31, 2025.
"Modified taxable income" is computed by adding back the base erosion tax benefit derived from a base erosion payment. A base erosion payment includes, among other items, any amount paid or accrued by an applicable taxpayer to a foreign related person that is deductible to the payor and any reinsurance premium paid to a foreign related person. Cost of goods sold is not considered a base erosion payment.
An "applicable taxpayer" is defined as a corporation with average annual gross receipts for the three-taxable-year period ending with the preceding taxable year of at least $500 million with a "base erosion percentage" of at least 3% (where the "base erosion percentage" is defined as the aggregate amount of base erosion tax benefits for the taxable year divided by the aggregate amount of deductions for such year). Furthermore, gross receipts of foreign persons not having effectively connected income are excluded from this computation.
A "foreign person" is related to the "applicable taxpayer" if either (i) it owns 25% or more of the taxpayer, (ii) it is related to the taxpayer or any 25% owner of the taxpayer under Section 267 (related to loss disallowance rules applicable to transactions between related parties) or Section 707 (related to transactions between partners and partnerships) or (iii) it is related to the taxpayer under the transfer pricing rules of Section 482.
Assume for purposes of this example a foreign MNE with subsidiaries abroad and in the United States. In particular, there is a consolidated U.S. group, a U.S. sub and a U.S. branch under the foreign parent company:
Example 3, illustrates and example where BEAT would not apply because the gross receipts test is not met.
Attractiveness of Domestic Corporations as an IP Holding Company
The Act largely removes the ability for MNEs to benefit from lower tax jurisdictions abroad due to its base erosion measures and the lower corporate tax rate. The lower tax rate of 21% combined with the revised transfer pricing policies provides a strong incentive for companies to both retain operations and IP in the U.S., and repatriate offshore operations and IP back to the United States. The Act also introduces a claw back provision for "valuable corporate assets" including IP. This means that there will be a minimum tax on foreign earnings derived from IP held abroad.
Under a 21% corporate tax rate, and as a result of the deduction for FDII and GILTI, the effective tax rate on FDII is 13.125% and the effective U.S. tax rate on GILTI (with respect to domestic corporations) is 10.5% for taxable years beginning after December 31, 2017, and before January 1, 2026. Since only a portion (80%) of FTCs are allowed to offset U.S. tax on GILTI, the minimum foreign tax rate, with respect to GILTI, at which no U.S. residual tax is owed by a domestic corporation is 13.125%.
If the foreign tax rate on GILTI is 0%, then the U.S. residual tax rate on GILTI is 10.5%. Therefore, as foreign tax rates on GILTI range between 0% and 13.125%, the total combined foreign and U.S. tax rate on GILTI ranges between 10.5% and 13.125%. At foreign tax rates greater than or equal to 13.125%, there is no residual U.S. tax owed on GILTI, so that the combined foreign and U.S. tax rate on GILTI equals the foreign tax rate.
For domestic corporations in taxable years beginning after December 31, 2025, the effective tax rate on FDII is 16.406% and the effective U.S. tax rate on GILTI is 13.125%. The minimum foreign tax rate, with respect to GILTI, at which no U.S. residual tax is owed is 16.406%.
The reform effectively imposes a foreign minimum tax on U.S. shareholders of CFCs to the extent the CFC is treated as having earned high net income. The treatment of high returns from foreign IP will be considered only a modest return. Each CFC is required to include 50% of the foreign high return amount in its income for the current taxable year. This provision would discourage companies from shifting IP and the resulting profits abroad.
MNEs with significant IP holdings are facing a new tax reality that could present substantial tax savings if they are retaining or repatriating offshored IP back to the United States. As indicated above, the anti-base erosion provisions are less punitive for C corporations who can utilize additional deductions not available to individuals and other forms of incorporation. This means, evaluating early the impact of these provisions and assessing alternative IP structures, will allow MNEs to be ready to comply with the new rules and take advantage of tax planning strategies impacting their effective tax rate. The international response to these changes in U.S. tax law will likely result in other countries following in quick order to counter with amendments to their tax laws to stay competitive and responsive to these recent developments.