The Tax Cuts and Jobs Act, released on Nov. 2 and scheduled to be marked up by House Ways and Means on Nov. 6, would make major changes to taxation of individuals, corporations and other businesses, foreign income and taxpayers, and exempt organizations. Below is more detail concerning the taxation of foreign income.
Establishment of Participation Exemption System for Taxation of Foreign Income
Deduction for foreign-source portion of dividends.
The Act would replace the current-law system of taxing U.S. corporations on the foreign earnings of their foreign subsidiaries when these earnings are distributed with a dividend-exemption 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.
No foreign tax credit or deduction would be allowed for any foreign taxes (including withholding taxes) paid or accrued with respect to any exempt dividend. The provision would be effective for distributions made after 2017. The provision would eliminate the “lock-out” effect under current law, which encourages U.S. companies to avoid bringing their foreign earnings back into the U.S. (Act Sec. 4001) Repeal of tax on foreign subsidiary investments in U.S. property. Under current law, undistributed earnings of a foreign subsidiary of a U.S. shareholder that are reinvested in U.S. property are subject to current U.S. tax.
This rule prevents a U.S. corporate shareholder from avoiding U.S. tax on the distribution of earnings from a foreign subsidiary by instead reinvesting those earnings in U.S. property. The Act would repeal this provision effective for tax years of foreign corporations beginning after 2017.
The provision would no longer be needed because, as a result of the rule in Act Sec. 4001, no U.S. tax would be avoided by a U.S. parent corporation reinvesting earnings of its foreign subsidiary in U.S. property rather than distributing those earnings. (Act Sec. 4002) Limitation on losses with respect to foreign subsidiaries. A U.S. parent would reduce the basis of its stock in a foreign subsidiary by the amount of any exempt dividends received by the U.S. parent from its foreign subsidiary – but only for purposes of determining the amount of a loss (and not the amount of any gain) on any sale or exchange of the foreign subsidiary. (Act Sec. 4003) Treatment of deferred foreign income upon transition to the new participation exemption system—deemed repatriation.
Under the Act, U.S. shareholders owning at least 10% of a foreign subsidiary generally would include in income for the subsidiary’s last tax year beginning before 2018 the shareholder’s pro rata share of the net post-’86 historical earnings and profits (E&P) of the foreign subsidiary to the extent such E&P has not been previously subject to U.S. tax. The portion of the E&P comprising cash or cash equivalents would be taxed at a reduced rate of 12%, while any remaining E&P would be taxed at a reduced rate of 5%. At the election of the U.S. shareholder, the tax liability would be payable over a period of up to eight years, in equal annual installments of 12.5% of the total tax liability due. (Act. Sec. 4004)
Modifications Related to Foreign Tax Credit System
Repeal of indirect foreign tax credits.
Under the Act, no foreign tax credit or deduction would be allowed for any taxes (including withholding taxes) paid or accrued with respect to any dividend to which the dividend exemption under Act Sec. 4001 would apply. A foreign tax credit would be allowed for any subpart F income that is included in the income of the U.S. shareholder on a current year basis. The provision would be effective for tax years of foreign corporations beginning after 2017 and for tax years of U.S. shareholders in which or with which such tax years of foreign subsidiaries end. (Act Sec. 4101) Change in rule for sourcing income from sales of inventory. Under current law, in determining the source of income for foreign tax credit purposes, up to 50% of the income from the sale of inventory property that is produced within the U.S. and sold outside the U.S. (or vice versa) may be treated as foreign-source income. Under the Act, income from the sale of inventory property produced within and sold outside the U.S. (or vice versa) would be allocated and apportioned between sources within and outside the U.S. solely on the basis of the production activities with respect to the inventory. The provision would be effective for tax years beginning after 2017. (Act Sec. 4102)