On May 25 White House Director of Legislative Affairs Marc Short said the Trump administration is working with Congress to draft a second phase of tax cuts and hopes to release a legislative package before the end of the summer. According to Short, this phase is “focused on the individual side.”
That announcement followed earlier interviews with House Ways and Means Committee Chair Kevin Brady, R-Texas, in which he said Congress is working on round 2 of tax reform and could release a bill before November. He said he hopes the next tax package will include making permanent some business provisions enacted in temporary form in the Tax Cuts and Jobs Act (P.L. 115-97), streamlining education tax incentives, and changing the rules for retirement savings.
Most observers are skeptical that “Tax Reform 2.0” will be passed in 2018. And even if a second tax bill does make it through Congress this year, changes to the international provisions of the code aren’t a priority. Still, it’s worthwhile to ask what Congress could do to fix some of the damage to the international tax system caused by the TCJA.
Deadweight Provisions
TCJA proponents touted the bill as a transition to a territorial system, accomplished via new section 245A, which provides 10 percent U.S. corporate shareholders of foreign corporations with a 100 percent dividends received deduction if a holding period requirement is met and the dividend isn’t paid on a hybrid instrument. However, the U.S. system retains more aspects of a worldwide system than a territorial one because new section 951A subjects U.S. shareholders of controlled foreign corporations to immediate U.S. tax on much of the earnings of those CFCs. Also, the participation exemption applies only to dividends and not to foreign earnings generated by a branch or the sale of a foreign corporation’s stock (other than that portion of gain attributable to the company’s earnings and profits).
Even so, making dividends from foreign corporations tax free to U.S. corporate shareholders renders moot many older provisions enacted to ensure that U.S. shareholders can’t access the earnings of foreign corporations without paying the full U.S. tax that would otherwise have been due on a dividend. The first step in bringing some coherence to the new system is cleaning out the deadweight provisions of the old.
Section 956 is the most problematic of the provisions originally intended as antiabuse rules to ensure the full taxation of foreign earnings at the U.S. shareholder level — none of which still serve that purpose. The section 956 rule treats as dividends amounts loaned up to shareholders. When dividends from foreign companies were taxable to U.S. shareholders, section 956 prevented shareholders from avoiding the general rule that dividends would be taxable at the full U.S. rate when repatriating the funds via a loan.
That antiabuse rule makes no sense if dividends aren’t taxable when repatriated; to the contrary, the rule now functions almost exclusively as a planning tool for taxpayers to access foreign tax credits. It’s precisely that type of planning that Congress was trying to shut down by creating two new income baskets in section 904(d)(1)(A) and (B) and by precluding the carryforward and carryback of FTCs attributable to global intangible low-taxed income.
When dividends are tax free under section 245A, they carry no FTCs with them. Foreign taxes paid by foreign corporations can now be accessed by their U.S. shareholders only under section 960 via a subpart F income inclusion, a section 951A inclusion, or a section 956 inclusion. Under the first two options, foreign taxes associated with CFC earnings are creditable to taxpayers generally only in the year those earnings are generated. As a result, section 956 is the only viable option for taxpayers to access foreign taxes that aren’t creditable in the year paid. That creates many planning opportunities that wouldn’t otherwise exist. Section 956 makes the repeal of section 902 somewhat elective: Low-taxed earnings can be brought up tax free under section 245A, but high-taxed earnings can be repatriated with a 100 percent FTC under section 960, using a section 956 loan.
But section 956 isn’t all good news for taxpayers: It adds more complexity to an already complicated system. For example, the ordering of section 956 inclusions and where GILTI inclusions fall in that order are unclear. For taxpayers who aren’t well advised, section 956 is a trap, taxing foreign earnings that would otherwise have been tax free under section 245A.
Both the House and Senate versions of the TCJA would have repealed section 956, but the final version didn’t do so, possibly because repeal was scored as a revenue loser. But now that the original purpose of section 956 as a backstop to the dividend inclusion regime has disappeared, repeal might be scored as a revenue raiser, which could make it an easy choice for revenue-strapped lawmakers.
Other provisions that no longer make sense in a system that exempts foreign-source dividends from tax include sections 367(b) and 1248(f). Section 367(b) regulations are intended to ensure that in an inbound liquidation or tax-free reorganization among U.S.-owned foreign corporations, amounts that would otherwise have been taxable on payment of a dividend or sale of stock remain taxable as a dividend. (Prior analysis: Tax Notes Int’l , Apr. 23, 2018, p. 517.) Section 1248(f) ensures that the foreign earnings of U.S.-owned foreign corporations can’t escape future U.S. tax using a section 355 transaction. Those rules have been made obsolete by section 245A, which would consider an actual dividend of those profits tax free anyway.
Overkill Provisions
Other code sections retain some rationale but have found their purpose much diminished. They include section 909, enacted in 2010 in response to planning that allowed separation of creditable foreign taxes from associated foreign income in cases involving hybrid arrangements. Under that section, a U.S. person can claim an FTC only when she takes the related income into account for U.S. tax purposes. Section 909 might still have relevance: The check-the-box rules allow for some hybrid planning involving first-tier entities. But a taxpayer’s ability to take advantage of splitting arrangements has been sharply curtailed, calling into question the need for such a complex provision.
Section 901(m), also enacted in 2010, was meant to limit FTC planning as well. The provision operates to partially deny a U.S. taxpayer’s ability to claim FTCs when U.S. and foreign tax rules provide for different tax bases. But because section 951A will result in the annual inclusion of most CFC earnings in U.S. taxable income, and because section 902 has been repealed, there’s limited ability to hype foreign taxes paid by CFCs. As discussed, one of the few ways to claim foreign taxes not included annually with subpart F income and section 951A income is section 956. If section 956 is repealed, there should be little justification for keeping section 901(m).
The GILTI Problem
Both taxpayers and government officials have been struggling to interpret new section 951A, which imposes current taxation on U.S. shareholder inclusions of a CFC’s GILTI. The provision is in subpart F of the code but is different enough that the regulations applicable to subpart F inclusions can’t easily be applied to it.
Other aspects of the GILTI calculation are also problematic, and Treasury and the IRS have been trying to decide how they can address them within the limits of their statutory authority. (Prior analysis: Tax Notes , May 21, 2018, p. 1097. Related analysis: p. 1408.) Congress could make it much easier by enacting statutory changes.
Expense Allocation
One of the biggest problems arises because the FTC limitation must be applied separately for GILTI, which means that taxes attributable to GILTI can’t be credited against income allocated to other baskets (such as subpart F or foreign branch income) and vice versa. Meanwhile, section 904(b)(5), combined with the more general rules of section 862, seems to require allocating to the GILTI basket properly attributable U.S. shareholder expenses that generate GILTI. That means that any U.S. shareholder with shareholder-level expenses will likely be paying an effective rate on GILTI over 13.125 percent even for high-taxed CFCs, in an apparent contradiction with the legislative history and the title of the code provision (see discussion in a New York State Bar Association Tax Section report).
Congress could make the tax rate on GILTI more in line with the example in the legislative history (and limit the U.S. tax rate on that income to 13.125 percent) by amending section 904(b)(5) so that at least some U.S. shareholder expenses aren’t allocable to income in the GILTI basket.
Carrybacks, Carryforwards, and Losses
The expense allocation problem is particularly acute because the TCJA amended section 904(c) to eliminate taxpayers’ ability to carry back and forward FTCs attributable to GILTI inclusions. It’s the expense allocation rule combined with the limitation on carryovers that’s increasing many taxpayers’ effective tax rates on their foreign earnings over the expected 13.125 percent. An alternative to fixing the expense allocation rule is to repeal the restriction on carryforwards and carrybacks in section 904(c).
Section 904(f) was designed to keep taxpayers from cross-crediting in multiple years when a foreign loss offset U.S. earned income in one year, or from netting in different baskets allowing for higher foreign tax creditability in subsequent years. Those rules are less necessary if there’s no carryforward or -back of GILTI credits, which now will presumably constitute most of the FTCs being claimed by U.S. shareholders.
If Congress decides to keep the elimination of the FTC carryover for GILTI credits, it should consider amending or repealing section 904(f).
Consolidated Returns
Unlike inclusions of subpart F income, which are calculated per entity, the GILTI inclusion requires calculation at the shareholder level, with a deduction applied to the amount resulting from netting the income of positive tested-income CFCs against the losses of CFCs with net tested losses (minus the amount of qualified business asset investment, also a shareholder-level calculation). The netting required at the shareholder level has given rise to many questions, traps, and planning opportunities for U.S. consolidated groups.
Section 1502 gives Treasury wide latitude to write consolidated return regulations so that the tax liability of any affiliated group can be clearly returned, determined, computed, assessed, collected, and adjusted, but not avoided. Congress could make everything easier by indicating that the GILTI calculation is to be done at the consolidated group level.
Previously Taxed Income
GILTI is a shareholder-level calculation, but once the GILTI amount has been calculated, the amount included must be reallocated down to each CFC. That downward allocation is needed to determine the previously taxed income amounts for each CFC (section 959). Amounts distributed from a foreign corporation are considered to come out of previously taxed earnings first. Unlike distributions of untaxed earnings that don’t come with an FTC, amounts distributed as previously taxed earnings may allow shareholders to claim withholding tax credits under section 960(c).
If GILTI isn’t treated as section 959 previously taxed income, that minimizes the complexities and compliance burdens associated with its calculation. And taxpayers might still be able to credit foreign withholding taxes attributable to GILTI inclusions just by including them in the GILTI basket.
Individuals
It’s unclear whether the far more favorable treatment for corporate shareholders of foreign companies compared with individual shareholders, evident in many changes made by the TCJA, was deliberate. That different treatment results from several factors:
both individual and corporate shareholders must include GILTI in income;
only corporate shareholders are entitled to the GILTI FTC;
only corporate shareholders are entitled to the section 250 deduction associated with GILTI inclusions;
individual shareholders aren’t entitled to the 100 percent dividends received deduction; and
individual shareholders aren’t entitled to any exemption on the sale of foreign corporate stock under section 1248.
Subjecting individual shareholders of foreign corporations to harsher tax treatment than corporate shareholders seems to contradict the claims that many Republican leaders made regarding the TCJA’s goal of helping small businesses grow. One of the most important steps in the growth trajectory of many businesses is to expand overseas. Providing major advantages to purely domestic business owners with the section 199A deduction and to corporate multinationals as described would hinder, not encourage, the global growth of small business.
To counter that result, Congress should consider expanding the deductions available to corporate shareholders for foreign dividends and GILTI inclusions to individual shareholders.
Sale of CFC Stock
When Congress enacted section 1248 in 1962, it was with the clear recognition that unless there was parity between the treatment of foreign earnings while a U.S. shareholder held foreign stock and on its sale, planning opportunities could cause business distortions and inefficient decision-making. But that distinction no longer makes much sense. If Congress is concerned about losing U.S. corporate residents, extending the participation exemption to sales of corporate stock — as most other territorial systems do — would seem wise.
BEAT
New section 59A provides for an alternative minimum tax to be imposed on a modified tax base when base-eroding payments to related parties exceed a threshold. The title of the provision and statements made at congressional hearings suggest that congressional intent in enacting the BEAT was to target foreign-owned multinational groups that were stripping out the U.S. tax base. As enacted, however, section 59A imposes a harsh penalty on U.S.-parented multinationals that have CFCs with tested income includable as GILTI, because amounts added back to the modified tax base are still includable in GILTI or subpart F, potentially resulting in double taxation. The BEAT is also doubly problematic for U.S.-parented multinationals because its computation of the modified base doesn’t allow for an offset by most credits, including FTCs, and because it’s unclear how it interacts with the section 163(j) limitation.
Potential fixes could provide that amounts includable to a U.S. shareholder under sections 951A or 951(a) aren’t considered base-eroding payments. Other measures that could address the double penalty for U.S. multinationals would be to permit FTCs to offset BEAT liability.
Foreign-Derived Intangible Income
One goal of the TCJA was to encourage U.S. taxpayers to keep in the United States high-value intangible profits used for manufacturing exports, rather than transferring them overseas. New section 250 tries to accomplish that by providing a deduction for foreign-derived intangible income (FDII) that applies to an amount based on income derived from property sold to non-U.S. persons for foreign use, or from services provided to any person or property not in the United States.
While the FDII deduction benefits taxpayers that have intangible income and non-U.S. sales, it has yet to motivate taxpayers to repatriate intangibles to the United States. That’s a result of various uncertainties: possible challenges to the provision before the WTO, an OECD examination into whether it’s a harmful tax regime, or even whether it will survive a change in congressional control.
In a presentation at the National Tax Association on May 8, Tim Dowd of the Joint Committee on Taxation demonstrated the close correlation between industries that benefited from section 199 (repealed by the TCJA) and the new FDII deduction. If Congress was trying to assure industries that benefited from an old provision that their benefits would remain post-TCJA, there may be better ways to do that without triggering more WTO disputes. Businesses are unlikely to move intangible assets back to the United States, given the uncertainties with the FDII regime.
The Ultimate Technical Correction
Section 904(d)(2)(H) generally provides that foreign tax imposed on an amount that doesn’t constitute income under U.S. tax law will be treated as imposed on the income described in section 904(d)(1)(B). That rule made sense when section 904(d)(1)(B) was the general catchall for taxes not otherwise attributable to income in the passive basket, but it makes no sense following the TCJA’s amendments to section 904(d)(1). Section 904(d)(1)(B) now refers to the foreign-branch basket, and under current section 904(d)(2)(H), all taxes imposed on amounts that don’t constitute income under U.S. tax principles are allocated to that basket.
Mindy Herzfeld is professor of tax practice at University of Florida Levin College of Law, director of its International Tax LLM program, and a contributor to Tax Notes International. Email: herzfeld@law.ufl.edu.