The Tax Cuts and Jobs Act – Select Changes and Introduction of New Concepts
Basic Application of Subpart F Rules
Generally, under the subpart F rules, the earnings and profits of a controlled foreign corporation (“CFC”) continue to be deferred until repatriated unless a subpart F anti-deferral provision applies. The Tax Cuts and Jobs Act (the “Act”) has modified the subpart F and the underlying CFC regime. The following provides an overview of a number of those changes.
Modification of the definition of U.S. Shareholder
Under prior law, the definition of a U.S. Shareholder was limited to a U.S. person who own 10% or more of the total combined voting power of all classes of stock entitled to vote. The Act expands the definition of a “U.S. Shareholder” to include any U.S. person who owns 10% or more of the total value of shares of all classes of stock of a foreign corporation. This provision will likely result in more U.S. persons being classified as U.S. Shareholders. The provision is effective for taxable years of foreign corporations beginning after December 31, 2017, and for the taxable years of U.S. Shareholders ending with or within such taxable years.
Modification of stock attribution rules for determining CFC status
The new legislation amended § 958(b)(4) so that certain stock of a foreign corporation owned by a foreign person is attributed to a related U.S. person for purposes of determining whether the related person would be considered a U.S. Shareholder and whether, in turn, a foreign corporation is a CFC. The provision is retroactively effective beginning with the last taxable year of foreign corporations beginning before January 1, 2018, and all subsequent years of such foreign corporations and for taxable years of U.S. Shareholders in which, or with which, such taxable years of foreign corporation end.
For calendar-year taxpayers, this provision is effective for 2017.
Elimination of the 30-day control requirement for Subpart F
Under prior law, a foreign corporation must be controlled for an uninterrupted period of 30 days before subpart F inclusions are potentially applicable. The new law eliminates the 30-day requirement and therefore may capture more shareholders within the subpart F regime. The provision would be effective for taxable years of foreign corporations beginning after December 31, 2017, and for the taxable years of U.S. Shareholders ending with or within such taxable years.
Look-through rule for related foreign corporations
The new law ultimately did not make permanent the § 954(c)(6) look-through rules scheduled to expire for tax years beginning after January 1, 2020. Under this temporary provision, dividends, interest, royalties and rents received or accrued from a CFC that is considered a related person are not considered subpart F income to the extent such amounts are attributable to income of the related person which is neither subpart F income, nor income which is effectively connected with a U.S. trade or business.
Foreign Base Company Shipping Income
The Act repeals § 955. As a result, a U.S. Shareholder in a CFC that invested its previously excluded subpart F income in qualified foreign base company shipping operations is no longer required to include in income a pro rata share of the previously excluded subpart F income when the CFC decreases such investments in its shipping operations.
Foreign Base Company Oil Related Income
Under old law foreign base company oil related income is a category of subpart F income. The new law eliminates foreign base company oil related income as subpart F income.
Section 956 Remains
Section 956 has not been repealed. Therefore a CFC shareholder should continue to be mindful of any potential deemed income inclusion when the CFC’s earnings and profits are reinvested in the U.S.
Global Intangible Low Taxed Income – New Type of Imputed Income
A new concept called global intangible low taxed income (“GILTI”) has been introduced with the new law. The income inclusion under the GILTI provisions is similar to an income inclusion under Subpart F. Under this new regime, a U.S. Shareholder will be taxed on its pro-rata share of a CFC’s GILTI. GILTI can impact not only companies that use high-value intangibles, but other types of companies (e.g., service companies). This is because the new provision is based on a calculation, unlike the existing subpart F income regime which generally characterizes certain categories of income as foreign-base company income.
GILTI does not replace the existing subpart F income provisions. To the extent that income is subject to subpart F, it is deducted from the income subject to GILTI.
Although GILTI inclusions do not technically constitute subpart F income, GILTI inclusions are generally treated similarly to subpart F inclusions under a number of related provisions. It is anticipated that the Secretary may provide rules for coordinating the GILTI inclusion with other subpart F provisions.
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. The deduction is only available to domestic corporations. Further analysis is required to determine planning opportunities for non-corporate taxpayers. U.S. corporate shareholders with GILTI inclusions will be permitted a foreign tax credit equal to 80% of its ratable share of foreign taxes deemed paid attributable to net CFC tested income (but the § 78 gross up will be based on 100% of the foreign tax paid and the gross up is included in GILTI).
Deemed-Paid Credit = 80% × GILTI/Aggregate Tested Income × Aggregate Tested Foreign Income Tax
A U.S. Shareholder’s GILTI for any tax year is calculated as the excess of:
- the shareholder’s net CFC tested income for the tax year over
- the shareholder’s net deemed tangible income return for the tax year.
GILTI = Net CFC Tested Income – [(10% × QBAI) – Interest Expense]
The net CFC tested income is the excess of:
- the aggregate of the shareholder's pro rata share of the tested income of each CFC with respect to which the shareholder is a U.S. Shareholder for the tax year of the U.S. Shareholder (determined for each tax year of the CFC which ends in or with that tax year of the U.S. Shareholder) over
- the aggregate of the shareholder's pro rata share of the tested loss of each CFC with respect to which the shareholder is a U.S. Shareholder for the tax year of the U.S. Shareholder (determined for each tax year of the CFC which ends in or with that tax year of the U.S. Shareholder.
Net CFC Tested Income = Sum of CFC Tested Income − Sum of CFC Tested Loss
The net deemed tangible income return is (1) 10% of the aggregate of the shareholder's pro rata share of the qualified business asset investment (“QBAI”) of each CFC with respect to which the shareholder is a U.S. Shareholder for the tax year (determined for each tax year of each CFC which ends in or with the tax year of the U.S. Shareholder), over (2) the amount of interest expense taken into account under § 951A(c)(2)(A)(ii) in determining the shareholder's net CFC tested income for the tax year to the extent the interest income attributable to the expense is not taken into account in determining the shareholder's net CFC tested income. The QBAI of a CFC is the quarterly average of the U.S. Shareholder’s pro rata share of the aggregate tangible depreciable asset basis.
Importantly, certain types of income are excluded from the GILTI calculation including: any item of income described in § 952(b); any gross income taken into account in determining the subpart F income of the corporation (such as § 956); and any dividend received from a related person.
Sale of Partnership Interest (Grecian Magnesite Reversed)
Under the Act, gain from the sale or exchange of a partnership interest is treated as effectively connected income (“ECI”) to the extent the partnership is engaged in a U.S. trade or business and the foreign partner would have had ECI and the partnership sold all of its assets in a taxable sale at fair market value and allocated the gain or loss to the foreign partner in the same manner as non-separately stated income and loss (i.e., generally the partner’s distributive share).
Revenue Ruling 91-32 held that the gain realized by a foreign partner on disposing of its interest in a U.S. partnership should be analyzed asset by asset, and that, to the extent the assets of the partnership would give rise to effectively connected income if sold by the entity, the departing partner’s pro rata share of such gain should be treated as effectively connected income. The Tax Court in Grecian Magnesite had invalidated Rev. Rul. 91-32.
Effective for transactions after November 27, 2017 (the date was originally set to be December 31, 2017), the legislation overrides the holding in Grecian Magnesite and imposes a 10% withholding tax on the amount realized on the sale or exchange of an interest in a partnership (that is engaged in a U.S. trade or business), unless the transferor certifies that it is not a nonresident alien individual or foreign corporation. If the transferee fails to withhold the correct amount, the partnership is required to deduct and withhold from distributions to the transferee partner an amount equal to the amount the transferee failed to withhold. The Act imposes a withholding tax on disposition occurring after January 1, 2018.
There are a number of issues that will have to be considered, including:
- Treatment of sales prior to November 27, 2017 for installment notes.
- How does a partnership know that a non-resident has sold a partnership interest?
- It appears that the rule does not apply to U.S. tax-exempt investors in partnerships.
- Often non-residents invest through multiple levels of partnerships offshore. In this case, how would a U.S. partnership ever know that an interest in the partnership has been sold?
- It is important to note that although the Tax Court invalidated Revenue Ruling 91-32, a non-resident individual or foreign corporation that sells an interest in a partnership (or LLC taxed as a partnership) was and will continue to be subject to U.S. tax on gain attributable to U.S. real property interests under § 897(g). This has always been the law.
Increased Return Penalties
The Act increases the penalties for failing to timely file Form 5742, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business, from $10,000 per form to $25,000 per form.
Foreign Derived Intangible Income
The Act adds new § 250 which permits a domestic corporation to claim a deduction for an amount equal to 37.5% of its foreign-derived intangible income (“FDII”). This deduction is reduced to 21.875% for tax years beginning after December 31, 2025.
The FDII of any domestic corporation is the amount which bears the same ratio to the “deemed intangible income” of the corporation as:
- the foreign-derived deduction eligible income of the corporation, bears to
- the deduction eligible income of the corporation.
The deemed intangible income is the excess (if any) of:
- the deduction eligible income of the domestic corporation, over
- the deemed tangible income return of the corporation.
The concept of “deemed tangible income return” is essentially a metric focused on a corporation’s return on depreciable assets. The ultimate focus is on the extent foreign derived intangible income exceeds a 10% return on its U.S. depreciable assets.
Foreign-derived deduction-eligible income is, with respect to any taxpayer for any tax year, any deduction eligible income of the taxpayer which is derived in connection with:
- property which is sold by the taxpayer to any person who is not a U.S. person, and which the taxpayer establishes to IRS's satisfaction is for a foreign use, or
- services provided by the taxpayer which the taxpayer establishes to IRS's satisfaction are provided to any person, or with respect to property, not located within the U.S. (Code Sec. 250(b)(4)).