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News Analysis: How Some Taxpayers Got Cut Out of the Tax Cuts and Jobs Act

POSTED ON Jan. 23, 2018
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Many provisions of the Tax Cuts and Jobs Act (TCJA) reflect the strong influence of two groups of taxpayers: large multinationals and individual owners of domestic passthrough businesses.

The tax law accomplished many objectives multinationals have long been clamoring for, including a lower corporate tax rate and a territorial system. It would be incorrect, however, to call it a windfall for multinationals, because their lobbying didn’t result in a definitive legislative victory. Achieving their objectives came with more onerous costs than they might have expected: a repatriation tax with a relatively high rate, a minimum tax on foreign intangibles income earned by controlled foreign corporations, and a base erosion minimum tax.

The second group of beneficiaries, represented by strong lobbying organizations, realized a major victory with the enactment of a new lower rate on business income earned by individuals conducting business in passthrough form. It seems unlikely that the new limitations on business interest expense deductibility will offset the significant benefits achieved via lower rates overall — as seen in corporate releases on the effects of the TCJA, the act is mostly a win for purely domestic businesses, whether operated in corporate or passthrough form.

It’s evident that lawmakers sought to re-level the playing field for large companies and ensure that U.S. multinationals could compete with their foreign-headquartered counterparts. Reducing the rate on passthrough businesses was a matter of political expediency to achieve corporate rate reduction and was consistent with the stated goal of encouraging domestic economic growth and job creation.

Much of the criticism from the left alleges that the law is too generous to wealthy taxpayers, and some nongovernmental organizations have claimed that nonresidents are big beneficiaries. But one group of taxpayers — many of whom likely could be considered wealthy, and some of whom are not U.S. tax resident — seems to have been largely ignored when the benefits of tax reform were being handed out in the drafting of the TCJA: individual owners of businesses that generate cross-border income, whether operating in passthrough or corporate form.

A review of the international provisions of the TCJA suggests that the focus on large multinationals and individual owners of domestic businesses resulted in a patchwork of rules that apply unevenly to individual investors earning cross-border income, as well as to income earned from foreign businesses conducted in passthrough form. The law as applied to individuals with a U.S. tax nexus who generate cross-border income is a confusing mishmash with no policy coherence that’s full of traps for the unwary.

Foreign Passthrough Businesses

In its summary of the TCJA, the House and Senate conference committee said the law modernizes the U.S. international tax system so that “America’s global businesses will no longer be held back by an outdated ‘worldwide’ tax system that results in double taxation” for many job creators. But it’s inaccurate to say the law eliminates the U.S. worldwide system — a key determinant of whether the territorial system will apply to foreign businesses owned by U.S. persons is how those businesses are conducted. That is because the regime has been structured so that a territorial system applies only to income earned by businesses organized as foreign corporations, and not to businesses conducted through vehicles that are treated as passthrough entities for U.S. tax purposes. There’s simply no parallel in the TCJA for the dividends received deduction for foreign businesses operated in passthrough, rather than corporate, form. Income from a non-U.S. business earned by a U.S. corporation directly through a passthrough entity continues to be taxable at the full U.S. corporate rate, with an offset for any foreign tax credits paid.

In imposing different regimes for foreign businesses depending on how they’re organized for U.S. tax purposes, the TCJA isn’t striking new ground. U.S. law has always taxed income from foreign businesses conducted in corporate form (which as a general rule were granted deferral from immediate U.S. tax) differently from foreign income earned through a branch (always taxed immediately in the hands of the branch’s U.S. owners). But while that distinction previously had some policy rationale because of the federal tax system’s sharp difference in treatment of passthrough and corporate income, it becomes harder to justify when earnings from foreign businesses conducted in corporate form are fully exempt from U.S. tax upon repatriation, while income earned through a branch remains fully taxable. It’s also harder to justify in light of new rules that reduce the tax on U.S. business income generated in passthrough form.

The TCJA’s sharp difference in taxing foreign corporate earnings and foreign passthrough earnings could be because widely recognized problems in the old system, such as the buildup of offshore earnings by U.S. multinationals, offshoring of intangibles, and inversions, were derivatives of CFC structures. Foreign businesses conducted by U.S. corporations through a branch didn’t give rise to similar concerns, in part because so few were conducted that way. That could change as businesses reexamine their structures in response to the new regime, giving rise to other problems.

The mismatch in the taxation of foreign income earned in corporate versus passthrough form is made more acute by several new provisions that make it harder — and costlier — to incorporate a foreign business. For one, the law eliminates the active trade or business exception in IRC section 367(a)(3), meaning outbound transfers of assets used in a foreign branch will always be taxable. It also increases the possibility of recognition of gain under section 367(a)(3)(C), which requires recognition when incorporating branches with accrued losses. Both changes mean that businesses operating in branch form will find it more expensive to restructure to take advantage of the participation exemption.

Two other changes make it more likely that U.S. persons will recognize gain on the transfer of a foreign business to a foreign corporation. The definition of intangible property under section 936(h)(3)(B) has been amended to include workforce in place, foreign goodwill, and going concern value. The TCJA gives the IRS more leeway and authority in valuing the outbound transfer of intangibles. It also amends sections 367 and 482 to let the IRS choose among valuation methods if it determines that those methods provide “the most reasonable means” of valuing relevant transfers.

Collectively, the new rules mean that companies that started their operations in branch form will find it difficult to restructure as corporations to take advantage of the participation exemption without incurring U.S. tax.

Foreign Corporations Owned by Individuals

As incoherent as the new rules are when applied to foreign passthrough businesses owned by U.S. corporations, they’re even more disjointed when applied to foreign corporations owned by U.S. individuals. Several aspects of the new law treat those corporations differently from those owned by U.S. corporations, and in each case, individual owners receive comparably unfavorable treatment.

Participation Exemption

In addition to being unavailable to foreign businesses conducted in noncorporate form, the new 100 percent dividends received deduction, intended to transform the United States to a territorial system, limits the types of eligible shareholders. The deduction allowable under new section 245A for dividends received from a foreign corporation is available only to U.S. corporate shareholders; U.S. individuals who own foreign businesses are simply out of luck.

Part of that discrepancy results from how the participation exemption has been inserted into the Internal Revenue Code. Section 245, which has long provided a deduction for a dividend from a foreign corporation attributable to a percentage of U.S.-source earnings of the corporation paying the dividend, applied only to corporate shareholders. Similarly, section 243, which section 245 builds on, and which generally allows a deduction for dividends received, applies only to corporations. Enacting the participation exemption in section 245A as part of the code titled “special deductions for corporations” essentially guaranteed that the participation exemption would be available only to corporate shareholders.

It’s pretty clear that in enacting the participation exemption, lawmakers were trying to address the problems associated with cross-border earned income of U.S. multinationals. But in the process, U.S. individual owners of foreign businesses were left in the dust.

The Repatriation Tax

As part of the cost of transitioning to a more beneficial territorial system, the TCJA imposes a one-time repatriation tax on accrued earnings of foreign companies. Unlike the participation exemption, the transition costs apply equally to corporate shareholders and individual owners of foreign corporations that have at least one U.S. corporate shareholder owning 10 percent of their stock.

As odd as the distinction between corporate and individual ownership of foreign businesses is for determining eligibility for the participation exemption, the discrepancy between the treatment of foreign earnings inherent in the assessment of the repatriation tax heightens the problem and shows that individual shareholders were likely simply left out of the legislative process. The whole justification for the one-time deemed mandatory repatriation tax is that it’s to account for the cost of transitioning to a new system (new section 965 is titled “treatment of deferred foreign income upon transition to participation exemption system of taxation”). Yet individual U.S. owners are required to pay the transition tax even though they might never benefit from the deduction now provided in section 245A.

Other changes enacted as part of the TCJA highlight the inconsistent treatment of individuals and corporations. Changes to the attribution rules in section 958 make it more likely that a person could be treated as a U.S. shareholder, forcing an inclusion under the new law. Changes in the definition of U.S. shareholder that would require an inclusion when a U.S. person owns 10 percent of the vote or value of a foreign company also potentially expand the scope of the inclusion.

Once again, the odd discrepancies between the treatment of corporate and individual shareholders of foreign companies appears to follow necessarily from drafting decisions. Because the repatriation tax was enacted as an amendment to section 965, it falls under the U.S. subpart F regime, which generally requires inclusions from CFCs by both individuals and corporations.

The GILTI Tax

Like the one-time repatriation tax, the tax on global intangible low-taxed income, or GILTI tax — the most onerous of the new international provisions — was enacted as part of the subpart F regime (new section 951A). As a result — and just like the repatriation tax — it imposes a cost on both U.S. individual shareholders and corporate shareholders. Any U.S. shareholder is required to currently include in income any earnings of a 10-percent-owned CFC in excess of a fixed return on its tangible assets, calculated by reference to the tax basis in those assets.

U.S. individual shareholders of foreign companies are triply hit by the GILTI inclusion. Just as in the current subpart F regime, in which the indirect FTC that can be claimed in connection with subpart F income inclusions is available only to domestic corporate shareholders, any credit for foreign taxes paid by a foreign company from which an inclusion is required under section 951A is available only to domestic corporate, not individual U.S., shareholders. That denial of an indirect FTC for individual shareholders who must include amounts in income as a result of the GILTI tax could have a much broader effect than the rules under the older, and more limited, subpart F. Further, while they’re required to include the GILTI amount in income, individual shareholders don’t get the benefit of the reduced rate on that income. The new law might make it much more beneficial for individual shareholders to elect under section 962 to be treated as a corporation to be able to claim credits associated with GILTI inclusions. But it’s unclear whether that election also entitles taxpayers to claim a deduction to be eligible for the reduced rate on GILTI income.

The FDII Benefit

Not only are individual owners of foreign companies penalized in multiple ways under the quasi-new territorial regime, they also get the worst of both worlds as a result of the combination of the GILTI tax and the new beneficial regime for U.S.-owned intellectual property — the foreign derived intangible income (FDII) benefit. The new FDII regime is intended to minimize the penalties associated with the GILTI tax and to encourage U.S. taxpayers to own intangibles in the United States by providing a lower tax rate on export income associated with those intangibles. Under new section 250, U.S. companies may deduct a portion of their income, roughly attributable to income derived from exports attributable to intangibles (calculated similarly to the GILTI tax as a return in excess of a fixed return on tangible assets). If the territorial exemption is the carrot for the repatriation stick, the FDII deduction is the carrot for the GILTI stick.

While individual shareholders must include GILTI in income, they’re not entitled to any deduction for export-related income derived from intangibles.

Sale of Stock

Individual CFC shareholders, although not entitled to an indirect FTC on dividends paid by the foreign company or on subpart F inclusions, have historically been able to offset a portion of U.S. tax on the gain recognized on the sale of CFC stock against foreign taxes paid by a foreign company. Section 1248 generally recharacterizes a portion of the gain from the sale of CFC stock as a dividend (to the extent of the company’s earnings and profits). Section 1248(b) was designed to allow individual shareholders to reach a similar result through a complex mechanism that — while not expressly allowing the indirect credit — was intended to minimize the potential for double taxation on the disposition of those shares to the extent the gain was attributable to accrued earnings.

New section 1248(j) addresses the interaction of the participation exemption with the calculation and character of the tax imposed on the sale of CFC stock. It states that the portion of the gain attributable to the section 1248 amount on the sale of CFC stock may be deducted under section 245A. It’s not at all clear how that provision might interact with the mechanics of section 1248(b). There’s also a glitch in how the new section 1248(j) applies to foreign corporations that aren’t CFCs — while the participation exemption applies to any 10-percent-owned foreign company, section 1248 recharacterizes an amount as a dividend only if the U.S. shareholder owned CFC stock.

Nonresidents Investing in U.S. Corporations

It’s unclear whether the TCJA was intended to encourage foreign investment in the United States or penalize foreign investors. Some provisions support investment, while others suggest penalties may have been Congress’ focus. While foreign individuals investing in U.S. corporations receive the benefit of the lower U.S. corporate rate, the reforms left largely unchanged the withholding rules applicable to distributions from foreign-owned companies. In one important respect, however, foreign owners of U.S. corporations may be in for a rude awakening: The new interest expense limitation is much tighter than the previous limitation under section 163(j), so nonresidents that largely shielded their investments in U.S. businesses from U.S. taxation through the use of debt could be looking at a higher tax burden, despite the reduction in the corporate rate.

Foreign investors that were able to reduce the U.S. rate on their U.S.-owned companies through other types of related-party payments might also consider the new base erosion minimum tax. But here — in contrast with the outbound provisions — the law is more likely to hurt foreign corporations with U.S. investments than foreign individuals. The base erosion minimum tax applies to businesses with at least $500 million in gross receipts, and thus might not affect most privately held investments in U.S. businesses.

Nonresidents Investing in Passthroughs

While the TCJA does not specifically change the rules governing the taxation of foreign owners of U.S. corporations, it does have major ripple effects on closely held businesses owned by foreigners. As Seth Entin of Greenberg Traurig LLP pointed out at the Florida International Tax Conference — where many participants were deeply concerned with the effect of tax law changes on individual nonresidents — various changes to the attribution rules and the calculation of subpart F income could have unexpected negative consequences for foreign investors in both U.S. and foreign corporations. Those owners must closely evaluate their structures to ensure they’re not caught unawares.

The TCJA also changes several aspects of the taxation of U.S. businesses and assets directly owned and operated by nonresidents in passthrough form. It codifies IRS Rev. Rul. 91-32, 1991-1 C.B. 107, which was in place for many years before being called into question by the U.S. Tax Court in 2017 (see Grecian Magnesite Mining Co. v. Commissioner , 149 T.C. No. 3 (2017)). Under new section 864(c)(8), gain recognized by a foreign partner on the sale of an interest in a partnership that is engaged in a U.S. trade or business will be treated as effectively connected income to the extent attributable to gain on assets used in the trade or business. That reverses Grecian Mining and validates the IRS’s position in Rev. Rul. 91-32.

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

Follow Mindy Herzfeld (@InternationlTax) on Twitter.