The New Participation Exemption System for Taxation of Foreign Income Under the Tax Cuts and Jobs Act
The participation exemption system will transition the U.S. into a quasi-territorial system effectively replacing the current foreign tax credit system. Under the exemption system, 100% of the foreign-source portion of dividends paid by a foreign corporation to a U.S. corporate shareholder that owns 10% or more of the foreign corporation would be exempt from U.S. taxation.
I. Participation Exemption System
The Tax Cuts and Jobs Act (the “Act”) adds a new Section 245A that would allow a 100% deduction for the foreign-source portion of dividends received by a domestic corporation from a "specified 10%-owned foreign corporation."
A specified 10%-owned foreign corporation is a foreign corporation where the U.S. shareholder (defined in Section 951(b)) is a domestic corporation. The 100% dividend received deduction is available only to domestic C corporations that are neither real estate investment trusts nor regulated investment companies. Thus, domestic partnerships, S corporations and individuals are not considered eligible U.S. shareholders.
Dividends from passive foreign investment companies do not qualify for the 100% dividend received deduction (“DRD”), and a DRD is not available for any hybrid dividend. A hybrid dividend is generally defined as an amount received from a controlled foreign corporation (“CFC”) for which the foreign corporation received a deduction or other tax benefit related to taxes imposed by a foreign country.
The Act allows certain deemed dividends under Section 1248 to qualify for a 100% DRD. Specifically, if a domestic corporation has gain from the sale or exchange of stock of a foreign corporation that it has held for at least one year, any amount that is treated as a dividend under Section 1248 would be eligible for the 100% DRD. Subpart F income is not eligible for a DRD.
Under the participation exemption system, if a U.S. shareholder that is a domestic corporation has received a dividend from a foreign corporation that is allowed a 100% DRD, solely for the purposes of determining the domestic corporation’s loss on the sale of stock of the foreign corporation, the domestic corporation reduces its basis in the stock of the foreign corporation by an amount equal to the 100% DRD.
Where a U.S. corporation transfers substantially all of the assets of a foreign branch to a foreign subsidiary, the U.S. corporation must include in income the amount of post-2017 (year of enactment) losses realized by the branch.
II. Effective Date
The 100% deduction for the foreign source portion of dividends would apply to the distributions made after December 31, 2017.
III. Calculation of the Foreign Source Portion of a Dividend
The foreign-source portion of a dividend would be equal to the same proportion of the dividend as the foreign corporation’s foreign earnings bears to its total undistributed earnings. A foreign corporation’s undistributed foreign earnings would consist of all undistributed earnings except for income effectively connected with the conduct of a trade or business in the United States and dividend income received from an 80%-owned domestic corporation. Total undistributed earnings include all earnings without reduction for any dividends distributed during the tax year.
IV. Foreign Tax Credit Implications
Under the participation exemption system, an FTC or deduction would not be allowed for foreign taxes, including withholding taxes, paid or accrued with respect to any dividend benefiting from the 100% deduction.
Further, for purposes of the FTC limitation under Section 904(a), the foreign-source income would be determined without regard to both the foreign-source portion of any dividend received from such foreign corporation and deductions for expenses properly allocable to an exempt dividend.
FTCs will be available to offset current tax on deemed dividend inclusions pursuant to the subpart F provisions and the new tax on global intangible low-taxed income provisions (“GILTI”). The FTC available to offset GILTI income will be limited.
V. Holding Period Requirement
A domestic corporation would not be permitted a 100% DRD with respect to a dividend paid on any share of stock that is held for 365 days or less during the 731-day period beginning on the date that is 365 days before the date on which the dividend is paid. Further, the foreign corporation must qualify as a specified 10% foreign corporation and the domestic corporation must qualify as a 10% shareholder at all times during the applicable period.