Tax reform changes: an international affair

What you need to know but may not want to know

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Debra Callicutt, CPA, MBA

With summer upon us, it is a good time to stop and reflect on the first half of 2018; which, as you know, included major tax reform. The impact of the reform touches everything from the standard deduction to international tax law. With the preponderance of international events dominating the news streams, tweets and blogs, it can be difficult for even the most tech savvy person to decipher key aspects of the international tax law changes. To save you time, we have summarized the highs and lows of the international tax changes that might affect some of you. It is worth noting that one major change was in essence a retroactive change and affected taxpayers’ 2017 returns!

Federal toll charge

After years of debating how best to tax profits kept outside the U.S., the administration took action on December 22, 2017 and ‘drew a line in the sand.’ The Tax Cuts and Jobs Act of 2017 created a toll charge for U.S. owners on the amount of earnings deferred offshore. The toll charge, in a nutshell, applies a rate of taxation of approximately 8% to earnings apportioned to cash holdings and 15% to earnings apportioned to non-cash holdings. If instalments and elections were filed timely, the tax would be payable over an eight-year period. If you were lucky enough to have held your foreign entity through a U.S. S Corporation, the IRS is allowing you to defer the toll charge, at least for federal purposes, until a triggering event occurs.

State toll charge

A bit less certain is how this toll charge will be taxed in your resident state. Let’s, by way of example, say you personally own an international business. As it stands now, the State of Arizona will likely tax the earnings you accrued in your offshore entity as of December 31, 2017 without providing for payment of the state tax on these earnings over an eight-year period. Conversely, if you owned your foreign corporation through a U.S. C Corporation, then it appears that the State of Arizona may not tax the amount of federal deemed repatriated earnings. Recent commentary suggests that the Arizona Department of Revenue (AZDOR) has not yet confirmed treatment on this issue.

Global intangible low taxed income (GILTI): some bad news with a hint of good 

First, the bad news, which affects those who personally own a foreign entity or own it through an LLC or S Corporation (i.e. not using a U.S. domestic corporation to hold ownership in a foreign entity).

The old system, which allowed active profits earned in a trade or business offshore to be deferred from U.S. taxation until such time as the profit was repatriated through a dividend, no longer applies. In very general terms, the U.S. individual taxpayer and owner will include these earnings in their taxable income as if a dividend were paid. Unless the individual makes a special tax election under IRC 962, he or she will not be eligible to receive a foreign tax credit for taxes paid at the entity level in the foreign country. The individual owner of the foreign entity is paying an effective tax rate of 40.8% or higher. (Rates will vary depending on your bracket and tax rate in the foreign country.)

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What is one to do? There are a few options:

  1. Check the box election. Be sure your CPA works through the tax effect on making this election. It’s a deemed liquidation at fair market value (FMV) of all the assets in the foreign entity. Therefore, as long as the tax effect on liquidation is tolerable, making this election and obtaining one level of taxation in the future might help to lessen the problem.
  2. Restructure. You may consider contributing your entity’s holdings into a U.S. C Corporation. This option may appeal to some in the short run; however, there will likely be negative tax impacts at time of dividend, liquidation or sale (see further details outlined below).
  3. 962 Election. This is an annual election which taxes the individual, in some ways, as if he or she had held the investment in a U.S. C Corporation. While this election may help lower the individual’s tax rate in the short run, the election will not solve the issue of double taxation when the dividend is paid out in the future. Note: further regulations should be forthcoming and such regulations will help advisors and taxpayers better assess whether or not the election will provide the taxpayer with a better result.

Now, the good news…U.S. domestic corporations achieve a better deal!

For offshore income which is deemed GILTI income, and not, in general terms, a type of passive income, the following tax treatment will apply:

  1. 50% deduction on the annual active income earned offshore.
  2. Foreign Tax Credit for taxes paid at the entity level – maximum 80% of the foreign taxes paid.
  3. 100% Dividends Received Deduction – subject to taxpayer meeting the criteria for the deduction.

The benefits encourage the use of U.S. C Corporations in many instances. Also, starting in 2018, the U.S. C Corporations pay tax at a rate of 21% versus the old highest effective rate of 35%. Before beginning a restructure to that of a corporate form, you will need to look at your exit strategies. Sale of assets in the future, dividend distributions or liquidating events will result in the assessment of a second level of taxation.

Foreign derived intangible income (FDII): pretty much all good news!   

With the passing of this new code section, some have begun to dub the U.S. as the new tax haven! With the stroke of a pen, the U.S. has gone from one of the highest taxed industrial countries, with respect to corporations, to one of the lowest rate of corporate taxes in the world!

Under this new rule, FDII earned in a U.S. C Corporation is taxed at a reduced tax rate of 13.125% through 2025 and 16.40625% in 2026 and after. The reduced rate applies to the portion of its deemed intangible income tax that is derived from serving foreign markets.

To understand how the reduction will be applied to your corporation’s taxable income, you must first understand the new terminology:

  • Foreign-Derived Intangible Income
  • Deemed Intangible Income
  • Foreign-Derived Deduction Eligible Income
  • Deduction Eligible Income
  • Deemed Tangible Income Return

Okay, maybe you do not want to pursue this exercise and will defer to your CPA to handle the details. If you’re a business owner, be sure to clearly categorize all revenue and expenses generated in operations servicing clients or customers residing outside the U.S.

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General data protection regulations

This international change isn’t tax related, but you still need to know about it. We live in a world no longer defined by geographical boundaries and borders. Some of you may have noticed a recent barrage of emails in your inbox referencing something to the effect of general data protection regulations (GDPR). The new European law aims to protect individuals’ data privacy rights and hold corporations accountable. Not so long ago, the U.S. probably would have had little interest in banal legislative matters outside our borders. Now that we live in a virtual world, events happening across the globe may carry significant impact to our personal and/or corporate lives.

Changes expected

As we mentioned, we are still waiting for clarification on some of the international tax provisions covered in this article, so be sure to talk to your Henry+Horne tax advisor if you have questions. You can also stay updated on new developments on tax reform by subscribing to our Tax Insights blog.

Debra Callicutt, CPA, MBA, Partner, specializes in international tax consulting + compliance services for high net worth individuals and closely-held businesses. You can reach her at (480) 483-1170 or DebraC@hhcpa.com