New tax law revolutionizes international finance for U.S. companies

The importance of the changes to the U.S. international tax system and their impact on business are hard to overstate. Historically, the United States has had a worldwide tax system under which U.S. companies were taxed on profits earned overseas when they were returned to the United States (or sooner in certain cases).

This lead to the widely reported situation where multinationals tried to localize as much of their profit as possible to low-tax jurisdiction overseas and delay bringing it back to the U.S. as long as possible —

preferably until the U.S. declared a tax holiday for repatriation of foreign earnings.

The double tax was partly mitigated by foreign tax credits for taxes imposed when the profits were earned and when they were repatriated. However, where business was conducted in lower tax jurisdictions, repatriating to the United States still carried a significant tax cost.

The new system turns the world upside down. It is now tax-free to bring profits back from abroad. This is implemented through a new deduction for foreign source dividends that offsets any tax on repatriation of earnings in full. The idea is to reduce the barrier to bringing profits back from overseas so that they can be invested here or distributed to shareholders.

For local businesses, there is still an incentive to conduct activities abroad under the new regime due to the lower local tax rate (not to mention the lower cost of doing business). However, once profits are earned, there is no reason not to repatriate these earnings. The result is greater overall freedom to move cash around the global operations.

Note, however, that when an overseas subsidiary is sold, additional tax may be due under the new regime. As profits are repatriated, the basis in the overseas subsidiary is reduced, so the gain on sale is larger.

In addition, the advantages of this new regime do not apply to S corporations, LLCs or individuals. These entities are more tax favorable because they do not pay corporate taxes, and instead flow through their profits to the shareholder. However, repatriated earnings from abroad will be treated in the same manner as other earnings and will result in U.S. taxation.

The change from a worldwide system to a territorial system posed a conundrum for Congress: What to do about the foreign profits accumulated under the old regime?  When these were earned, it was expected that they would be taxed. However, under the new regime, they would be tax free.

Congress came up with a compromise: Accumulated, unrepatriated, foreign profits would be taxed, but at a reduced rate. The rate for overseas cash is 15.5% and the rate for other overseas assets is 8%, the theory being that it may not be easy to liquidate these assets to generate cash to pay the tax. The tax can be paid in backloaded installments over eight years.

Oddly, the transition tax applies to passthrough entities in addition to C corporations — even though passthroughs are still subject to the old worldwide tax regime. S corporations are, however, allowed to make an election to defer paying this tax until they dispose of their foreign stock.

In addition to these changes, Congress also added a new tax known as the global intangible low-taxed income (“GILTI”) tax. In essence, this is a global alternative minimum tax for US multinationals that applies to overseas returns that exceed a stated rate of return based on the tangible property overseas. However, it can be reduced by foreign tax credits, so it applies most fully to corporations guilty of operating in low tax jurisdictions overseas. In our experience, this is not as uncommon for Rochester businesses as one may think.

The final new tax added by Congress is the base erosion and anti-abuse tax, or BEAT. This is a new tax designed to reduce excessive “earnings stripping” accomplished through payments to foreign affiliates. As it applies only to groups with at least $500 million in annual gross receipts, this tax is unlikely to apply locally.

In addition to these new changes, Congress made changes to the transfer pricing rules, which govern the prices at which companies purchase and sell goods or services to their subsidiaries overseas. Ensuring compliance with these rules is an essential part of working with a foreign subsidiary, however we find that many local companies need a compliance tune up. This is all the more necessary with the change in law, which has broadened these rules by expanding the definition of intangible property for transfer pricing purposes and expanding the IRS’s authority to challenge transfer pricing methods used by taxpayers.

The final news is good news. Congress has now added special provisions for foreign-derived intangible income or “FDII.” Specifically, a new deduction is allowed for income earned by corporate U.S. taxpayers from selling property or providing services outside the U.S. This is intended as an incentive to keep intellectual property, manufacturing and jobs onshore, and sell, lease or license to overseas affiliates and customers. It should be a benefit to local businesses that don’t use the sophisticated overseas holding company techniques favored by the large multinationals.

As should be clear from this brief overview, the US system of international taxation has been nothing short of revolutionized — though it certainly hasn’t been simplified. Generally these changes are intended to make it easier to repatriate foreign funds and reduce the incentive to move corporate activities abroad. Local businesses with international operations should review their structure in light of these changes and consider any updates that should be made to ensure that it remains tax efficient under the revised law.

Josh Gewolb is a partner at Harter, Secrest & Emery, LLP in Rochester, N.Y. Burton Speer is a partner at Mengel, Metzger Barr & Company, LLP in Rochester.