The tax reform bill introduced last week, the Tax Cuts and Jobs Act, includes a number of major provisions related to the taxation of companies’ foreign income and of foreign persons.

The provisions include the exemption of foreign-source dividends from foreign corporations paid to 10 percent U.S. corporate shareholders, repeal of the tax on foreign subsidiary investments in U.S. property, a 12 percent tax on deferred foreign income of 10 percent U.S. corporate shareholders, foreign tax credit changes, modification of Subpart F provisions, prevention of base erosion by currently taxing foreign high returns, limiting certain interest deductions on international intercompany debt, and a 20 percent excise tax on certain payments to related foreign corporations. This article is based on the bill that was introduced last week, but the House Ways and Means Committee has been marking up the bill this week and making changes.

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 percent of the foreign-source portion of dividends paid by a foreign corporation to a U.S. corporate shareholder that owns 10 percent 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.

Form 1120 for corporate taxes

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 Section 4001 of the Act, 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.

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.

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 percent 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 percent, while any remaining E&P would be taxed at a reduced rate of 5 percent.

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 percent of the total tax liability due.

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.

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 percent 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.

Modification of Subpart F Provisions

Repeal of qualified shipping investment rule: The imposition of current U.S. tax on previously excluded foreign shipping income of a foreign subsidiary, if there is a net decrease in qualified shipping investments, would be repealed.

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.

Repeal of foreign base company oil-related income rule: The imposition of current U.S. tax on foreign base company oil-related income would be repealed.

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.

Inflation adjustment for Subpart F de minimis exception: Under current law, a U.S. parent of a foreign subsidiary is subject to current U.S. tax on its pro rata share of the subsidiary's subpart F income. However, a de minimis rule states that if the gross amount of such income is less than the lesser of 5 percent of the foreign subsidiary's gross income or $1 million, then the U.S. parent is not subject to current U.S. tax on any of the income.

Under the Act, the $1 million threshold would be adjusted for inflation.

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.

Foreign subsidiary passive income exception made permanent: Under current law, a U.S. parent of a foreign subsidiary generally is subject to current U.S. tax on passive income earned by the foreign subsidiary. However, for tax years of foreign subsidiaries beginning before 2020, and tax years of U.S. shareholders in which or with which such tax years of the foreign subsidiary end, a special "look-through" rule provides that passive income received by one foreign subsidiary from a related foreign subsidiary generally is not includible in the taxable income of the U.S. parent, provided such income was not subject to current U.S. tax or effectively connected with a U.S. trade or business.

The Act would make this provision permanent.

Modification of CFC status attribution rules: Under current law, a U.S. parent of a controlled foreign corporation is subject to current U.S. tax on its pro rata share of the CFC's subpart F income. A foreign subsidiary is a CFC if it is more than 50 percent owned by one or more U.S. persons, each of which owns at least 10 percent of the foreign subsidiary. Constructive ownership rules apply in determining ownership for this purpose.

The Act would add an additional constructive ownership rule—a U.S. corporation would be treated as constructively owning stock held by its foreign shareholder.

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.

Elimination of 30-day minimum holding period for CFC: Under current law, a U.S. parent of a CFC is subject to current U.S. tax on its pro rata share of the CFC's subpart F income, but only if the U.S. parent owns stock in the foreign subsidiary for an uninterrupted period of 30 days or more during the year.

Under the Act, a U.S. parent would be subject to current U.S. tax on the CFC's subpart F income even if the U.S. parent does not own stock in the CFC for an uninterrupted period of 30 days or more during the year.

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.

Prevention of Base Erosion

Current year inclusion by U.S. shareholders with foreign high returns: Under the Act, a U.S. parent of one or more foreign subsidiaries would be subject to current U.S. tax on 50 percent of the U.S. parent's foreign high returns. Foreign high returns would be the excess of the U.S. parent's foreign subsidiaries' aggregate net income over a routine return (7 percent plus the federal short-term rate) on the foreign subsidiaries' aggregate adjusted bases in depreciable tangible property, adjusted downward for interest expense. Foreign high returns would not include, among other things, income effectively connected with a U.S. trade or business and subpart F income. [An amendment introduced by House Ways and Means Chairman Kevin Brady, R-Texas, would alter this provision.]

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.

Limitation on interest deduction by domestic corporations with international intercompany debt: The deductible net interest expense of a U.S. corporation that is a member of an "international financial reporting group" would be limited under the Act to the extent the U.S. corporation's share of the group's global net interest expense exceeds 110 percent of the U.S. corporation's share of the group's global earnings before interest, taxes, depreciation and amortization. An international financial reporting group is a group of entities that includes at least one foreign corporation engaged in a trade or business in the U.S. or at least one domestic corporation and one foreign corporation, prepares consolidated financial statements, and has annual global gross receipts of more than $100 million.

The provision would be effective for tax years beginning after 2017.

New tax on certain payments from domestic corporations to related foreign corporations: In order to prevent shifting of profits to foreign affiliates, the Act would provide that payments (other than interest) made by a U.S. corporation to a related foreign corporation that are deductible, includible in costs of goods sold, or includible in the basis of a depreciable or amortizable asset would be subject to a 20 percent excise tax, unless the related foreign corporation elected to treat the payments as income effectively connected with the conduct of a U.S. trade or business.

The provision would apply only to international financial reporting groups (as defined by Section 4302 of the Act) with payments from U.S. corporations to their foreign affiliates totaling at least $100 million annually.

The provision would be effective for tax years beginning after 2018.

Provisions Related to Possessions of the U.S.

Extension of Puerto Rico provision under domestic production activities deduction: The domestic production activities deduction allows for a deduction based on qualifying receipts, which are defined as certain types of revenue derived from activities in the U.S. The term "U.S." includes Puerto Rico for this purpose for tax years beginning before Jan. 1, 2017.

The Act would provide that the term "U.S." would include Puerto Rico for tax years beginning before Jan. 1, 2018.

Extension of temporary increase in rum excise tax paid to Puerto Rico and the Virgin Islands: Under current law, the U.S. collects an excise tax on distilled spirits produced in or imported into the U.S. A portion of the tax attributable to run produced in Puerto Rico or the U.S. Virgin Islands is paid to Puerto Rico or the U.S. Virgin Islands. The portion is $13.25 per proof gallon for imports before 2017 and $10.50 per proof gallon for other imports.

The Act would extend the $13.25 amount to rum imported into the U.S. before Jan. 1, 2023.

Extension of American Samoa economic development credit: The Act would extend the American Samoa economic development credit to tax years beginning before Jan. 1, 2023.

Other International Reforms

Restriction on insurance business exception to passive foreign investment company rules: Under current law, U.S. shareholders of a passive foreign investment company are taxed currently on the PFIC's earnings. An exception to this rule applies to certain income derived in the active conduct of an insurance business.

The Act would provide additional requirements before this exception would apply, outlined in Section 4501.

The provision would be effective for tax years beginning after 2017.

Limitation on treaty benefits for certain deductible payments: Under the Act, if a payment of fixed or determinable, annual or periodical income is deductible in the U.S. and the payment is made by an entity that is controlled by a foreign parent to another entity in a tax treaty jurisdiction that is controlled by the same foreign parent, then the statutory 30 percent withholding tax on such income would not be reduced by any treaty unless the withholding tax would be reduced by a treaty if the payment were made directly to the foreign parent.

The provision would be effective for payments made after the date of enactment.