The carrot-and-stick approach to on-shoring intangible value

By Raymond M. Polantz, CPA, Cleveland

Editor: Anthony S. Bakale, CPA
 
The law known as the Tax Cuts and Jobs Act of 2017 (TCJA), P.L. 115-97, ushered in the most significant changes to the Internal Revenue Code since the Tax Reform Act of 1986, P.L. 99-514. In addition to a multitude of domestic changes, the TCJA transformed the U.S. international tax system, dramatically altering the taxation of companies with overseas activities and operations.

One of the goals of international tax reform was to discourage U.S. taxpayers from "offshoring" intangible value and shifting related income outside the United States. The TCJA attempts to address these goals through various provisions, including the foreign-derived intangible income (FDII) provisions of Sec. 250, the global intangible low-taxed income (GILTI) provisions of Sec. 951A, and the base-erosion and anti-abuse tax provisions of Sec. 59A. Collectively, these provisions seek to curb the erosion of the U.S. tax base and have been referred to as a "carrot and stick" approach to on-shoring intangible value.

Deduction for foreign-derived intangible income

For tax years beginning after Dec. 31, 2017, new Sec. 250 permits a "domestic corporation" (other than regulated investment companies (RICs) and real estate investment trusts (REITS)) a deduction equal to 37.5% of the corporation's FDII. Given the TCJA's reduction of the corporate tax rate to 21%, this deduction results in an effective tax rate of 13.125% on FDII. For tax years beginning after Dec. 31, 2025, the deduction is reduced from 37.5% to 21.875% (Sec. 250(a)(3)(A)).

The term "domestic corporation" refers to a U.S. C corporation, meaning that individuals, S corporations, partnerships, and trusts are not eligible to claim this deduction.

A domestic corporation's FDII is the foreign portion of its deemed intangible income, expressed by the following formula: FDII = Deemed intangible income × Foreign-derived deduction-eligible income ÷ Total deduction-eligible income.

A domestic corporation's deduction-eligible income is its gross income, less allocable deductions. For these purposes, gross income excludes (1) any Sec. 951(a) Subpart F income; (2) any Sec. 951A GILTI inclusion; (3) any financial services income (as defined in Sec. 904(d)(2)(D)); (4) any controlled foreign corporation (CFC) dividends received by that domestic corporation; (5) any domestic oil and gas extraction income; and (6) any foreign branch income (as defined in Sec. 904(d)(2)(J)) (Sec. 250(b)(3)(A)).

A domestic corporation's deemed intangible income is the excess (if any) of its deduction-eligible income over its "deemed tangible income return" — 10% of the corporation's qualified business asset investment (QBAI) (Secs. 250(b)(2)(A) and (B)). QBAI for a tax year is the average of the aggregate of adjusted bases in specified tangible property used in its trade or business and of a type with respect to which a Sec. 167 depreciation deduction is allowable, measured at the close of each quarter of the tax year (Secs. 250(b)(2)(B) and 951A(d)). Because such property must be of a type for which a Sec. 167 depreciation deduction is allowable, assets such as inventory and land are not included. The adjusted bases of the specified tangible property must be determined using the alternative depreciation system (ADS) under Sec. 168(g).

"Specified tangible property" is any tangible property used in the production of deduction-eligible income. If such property is used both for the production of deduction-eligible income and income that is not deduction-eligible income (i.e., dual-use property), the percentage of adjusted basis in dual-use property that is included in QBAI equals the deduction-eligible gross income produced with respect to the property divided by the total gross income produced with respect to the property (Sec. 951A(d)(2)(B)).

Example 1: A building is used in the production of $1,000 of total gross income for a tax year, $250 of which is domestic oil and gas extraction income and the remaining $750 of which is deduction-eligible gross income; 75% of a domestic corporation's average adjusted basis in the building is included in QBAI for the tax year.

A domestic corporation's deduction-eligible income is considered to be "foreign-derived" to the extent any deduction-eligible income that the corporation derived in connection with either (1) property sold (including a lease, license, exchange, or other disposition) to any non-U.S. person for use outside the United States; or (2) services provided to a person, or with respect to property, located outside the United States (Sec. 250(b)(4)(A)).

Example 2: Company A, a domestic corporation, has $250,000 of net income from the sale of products. Company A has QBAI of $500,000. One-half of Company A's product sales are to non-U.S. persons for use outside the United States. Company A's FDII deduction is $37,500 (50% × [$250,000 — ($500,000 × 10%)] × 37.5%).

The foreign-use requirement is critical in determining whether eligible income is considered "foreign-derived." Generally, "foreign use" means any use, consumption, or disposition outside the United States (Sec. 250(b)(5)(A)). However, special rules apply to property sold or services provided to domestic intermediaries and to transactions with related parties (generally defined as greater than 50% common ownership).

If a taxpayer sells property to another person (other than a related party) for further manufacture or other modification within the United States, the foreign-use requirement will not be met, even if the other party subsequently uses or sells that property outside the United States (Sec. 250(b)(5)(B)(i)).

If a taxpayer provides services to another person (other than a related party) located within the United States, the foreign-use requirement will not be met, even if that person uses those services in providing qualified foreign services (Sec. 250(b)(5)(B)(ii)).

For sales of property to foreign related parties, the foreign-use requirement will only be met if either (1) the property is ultimately sold by the related party to an unrelated person for foreign use; or (2) the property is used by the related party in connection with property sold or services provided to an unrelated foreign person for foreign use (Sec. 250(b)(5)(C)).

For services provided to a related party outside the United States, the foreign-use requirement will be met only if the services are not substantially similar to services provided by the related party to persons located within the United States (Sec. 250(b)(5)(C)(ii)).

Example 3: Company A, a domestic corporation, is a U.S. manufacturer of equipment. Company A sells this equipment to Company B, an unrelated taxpayer that modifies the equipment in the United States. Company B then sells this equipment to non-U.S. customers for use outside the United States. Company A will not be permitted to claim an FDII deduction, but Company B may be able to claim the deduction, provided it is a domestic corporation and meets the other Sec. 250 requirements.

The FDII provisions of Sec. 250 are intended to provide an incentive for domestic corporations to maintain intangible value in the United States and use it to generate income from non-U.S. markets. It is possible that the European Union will challenge this provision as violating international trade standards, including World Trade Organization obligations. The ultimate timing and outcome of any potential challenges are unknown as of this writing. In the meantime, domestic corporations can use the provisions of Sec. 250 to achieve a lower effective tax rate on FDII.

Global intangible low-taxed income

For tax years beginning after Dec. 31, 2017, new Sec. 951A requires a U.S. shareholder of a CFC to include in gross income its share of GILTI. A U.S. shareholder's GILTI is the excess (if any) of its "net CFC tested income" over its "net deemed tangible income return" for the year (Sec. 951A(b)(1)).

A U.S. shareholder's "net CFC tested income" for a tax year is defined as the excess (if any) of the U.S. shareholder's aggregate pro rata share of tested income of its CFCs, over that shareholder's aggregate pro rata share of tested losses of its CFCs (Sec. 951A(c)). "Tested income" of a CFC is the excess of the CFC's gross income for the year (less applicable exclusions), over allocable deductions (Sec. 951A(c)(2)(A)). For these purposes, the following categories of income are excluded from tested income: U.S. effectively connected income, Subpart F gross income, gross income excluded from foreign base company income or insurance income under the high-tax exception of Sec. 954(b)(4), and any foreign oil and gas extraction income (within the meaning of Sec. 907(c)(1)) (Sec. 951A(c)(2)(A)(i)). Tested loss of a CFC is the excess of its allocable deductions, over its tested gross income (Sec. 951A(c)(2)(B)). Accordingly, for any tax year, a CFC can have tested income or tested loss, but not both.

A U.S. shareholder's "net deemed tangible income return" for a tax year equals the excess (if any) of 10% of the U.S. shareholder's aggregate pro rata share of the QBAI, over the amount of interest expense taken into account in determining the U.S. shareholder's net CFC tested income to the extent that the interest income attributable to the expense is not taken into account in determining the U.S. shareholder's net CFC tested income (Sec. 951A(b)(2)). For this purpose, interest payable to an unrelated lender would be considered a subtraction in calculating a shareholder's net deemed tangible income return.

For these purposes, QBAI is defined similarly to the FDII provisions. It is the average of its aggregate adjusted bases (using ADS depreciation and measured as of the close of each quarter of the tax year) in specified tangible property used by the CFC in a trade or business for the production of tested income (Sec. 951A(d)).

Example 4: U.S. Shareholder A owns 100% of CFC1. CFC1 has $6,000 of net CFC tested income, $40,000 of QBAI, and no interest expense. Shareholder A's 2018 GILTI inclusion is $2,000 ($6,000 - [10% × $40,000]). If CFC1's QBAI is instead $60,000, Shareholder A's GILTI inclusion is $0 ($6,000 - [10% × $60,000]).

Sec. 250 permits a domestic corporation a 50% deduction for its share of GILTI inclusion. For tax years beginning after Dec. 31, 2025, the deduction is reduced to 37.5% (Sec. 250(a)(3)(B)). As with the Sec. 250 FDII deduction, the term "domestic corporation" refers to a U.S. C corporation, meaning that individuals, S corporations, partnerships, and trusts are not eligible to claim this deduction.

A domestic corporate shareholder is also permitted a Sec. 960 indirect foreign tax credit equal to 80% of its ratable share of tested foreign income taxes (Sec. 960(d)). Specifically, the allowable foreign tax credit is 80% of the domestic corporation's inclusion percentage, times its aggregate tested foreign income taxes paid or accrued by the CFCs (Sec. 960(d)(1)). A U.S. corporation's "inclusion percentage" for a tax year is the ratio of its GILTI inclusion to the aggregate of its pro rata shares of the tested income of its CFCs (Sec. 960(d)(2)). Tested foreign income taxes with respect to a domestic corporation are the foreign income taxes paid or accrued by a CFC of the domestic corporation that are attributable to the tested income that is taken into account by the domestic corporation under Sec. 951A. Even though only 80% of foreign tax credits are allowed, Sec. 78 has been amended so that 100% of the related foreign tax credits are considered to be deemed dividends. This deemed-dividend inclusion is eligible for the 50% deduction under Sec. 250.

Example 5:A U.S. shareholder owns 100% of a foreign corporation that is considered a CFC. The CFC has income of $100,000 and has paid $4,000 of foreign income tax. The CFC's QBAI and net deemed tangible income return are both zero. The U.S. shareholder's taxable GILTI amount is $52,000, and the net tax on this income is $7,720, calculated as follows:

  • GILTI (before Sec. 250 deduction): $100,000 = $100,000 - $0
  • Sec. 78 gross-up: $4,000
  • Sec. 250 deduction: $52,000 = ($100,000 + $4,000) × 50%
  • Deemed paid foreign tax credit (FTC): $3,200 = $4,000 × 80% × 100%
  • GILTI taxation after FTC: $7,720 = ($100,000 + $4,000 - $52,000) × 21% - $3,200

The GILTI provisions are intended to discourage U.S. companies from holding low-basis assets such as intangibles offshore. Because of the residual approach used in calculating the deemed tangible income return, it is less likely that a company with foreign operating subsidiaries (such as manufacturing operations) will be subject to this inclusion due to the presence of potentially higher-basis assets such as machinery and equipment. The formula could encourage U.S. taxpayers to locate operations and fixed assets overseas to increase their GILTI threshold amount.

Base-erosion and anti-abuse tax

For tax years beginning after Dec. 31, 2017, new Sec. 59A provides for a new base-erosion and anti-abuse tax (BEAT) that requires an applicable taxpayer to pay a base-erosion minimum tax amount equal to 10% of its modified taxable income, less its regular tax liability (reduced by certain credits). The BEAT rate is 5% for 2018 and 12.5% for tax years beginning after Dec. 31, 2025 (Sec. 59A(b)(2)(A)).

An "applicable taxpayer" is defined as a corporation (other than a RIC, a REIT, or an S corporation) with average annual gross receipts of at least $500 million for the three-year period ending with the preceding tax year, and that has a base-erosion percentage of at least 3% for the year (Sec. 59A(e)).

For purposes of determining the annual-gross-receipts test, members of a controlled group (including related foreign persons) are aggregated and treated as a single employer. If a foreign person is included in the controlled group, only its portion of gross receipts that are effectively connected with the conduct of a U.S. trade or business are aggregated (Sec. 59A(e)(2)(A)).

"Modified taxable income" is the applicable taxpayer's taxable income, adding back any base-erosion tax benefit of any base-erosion tax payment, or the base-erosion percentage of any net-operating-loss deduction (Sec. 59A(c)).

A "base erosion tax benefit" is (1) any allowable deduction with respect to a base-erosion payment; (2) any allowable deduction for depreciation or amortization with respect to the property acquired with such a payment; (3) in the case of reinsurance payments, any return premiums and premiums and other consideration arising out of indemnity reinsurance; or (4) any payment resulting in a reduction in gross receipts in computing gross income of a surrogate foreign corporation (Sec. 59A(c)(2)).

A "base erosion payment" generally is (1) any amount paid or accrued by a corporation to a foreign related party and with respect to which a deduction is allowed (including amounts paid or accrued to acquire depreciable or amortizable property); (2) any premium or other consideration paid or accrued to a foreign related party for certain reinsurance payments; and (3) any amount that reduces the taxpayer's gross receipts that is paid to or accrued by the taxpayer with respect to a related surrogate foreign corporation (as defined in Sec. 7874(a)(2)(B)) or a foreign person that is a member of the same expanded affiliate group as the surrogate foreign corporation. For this purpose, the only foreign corporations considered are ones that first became a surrogate foreign corporation after Nov. 9, 2017 (Sec. 59A(d)(4)).

The following payments are excluded from the definition of base-erosion payments: (1) any amount that constitutes reductions in gross receipts, including payments for cost of goods sold (except, as noted above, for surrogate foreign corporations) (Sec. 59A(d)(4)(A)); (2) amounts to the extent that U.S. tax has been withheld under Sec. 1441 or 1442; (3) any amount paid or accrued by a taxpayer for certain services if those services have no markup and meet requirements for eligibility for use of the services-cost method under Sec. 482 (determined without regard to whether the services contribute significantly to fundamental risks of business success or failure) (Sec. 59A(d)(5)(A)); and (4) certain qualified derivative payments (Sec. 59A(h)(3)).

The "base erosion percentage" for any tax year is the aggregate amount of base-erosion tax benefits for the year divided by the aggregate allowable deductions (including base-erosion payments and deductions for depreciation and amortization on property acquired with a base-erosion payment), plus base-erosion benefits related to indemnity insurance and reinsurance and reductions in gross receipts for payments to surrogate foreign corporations (Sec. 59A(c)(4)).

With respect to an applicable taxpayer, a related party is any 25% owner of the taxpayer, or any person who is related to the taxpayer or any 25% owner of the taxpayer (within the meaning of Sec. 267(b) or 707(b)(1)), or any person related to the taxpayer within the meaning of Sec. 482. The constructive ownership rules of Sec. 318 apply, except under Sec. 318(a)(2)(C), a 10% test is used instead of a 50% test. For these purposes, a foreign person's ownership is not attributed to a U.S. person under Secs. 318(a)(3)(A), (B), and (C) (Sec. 59A(g)).

Special rules apply to banks and registered securities dealers. These taxpayers are subject to a rate one percentage point higher - 6% for 2018, 11% for 2019-2025, and 13.5% thereafter (Sec. 59A(b)(3)). In addition, the 3% base-erosion percentage threshold used in determining whether a person is an applicable taxpayer is reduced to 2% (Sec. 59A(e)(1)(C)).

Example 6: Corporation A is an applicable taxpayer for BEAT purposes. Corporation A has gross income of $1,000 and base-erosion tax payments of $600. As such, Corporation A's regular taxable income is $400 ($1,000 - $600). Corporation A's regular tax liability is $84 (21% × $400). Corporation A's modified taxable income is $1,000 ($400 + $600). Ten percent of Corporation A's modified taxable income is $100 (10% × $1,000). Corporation A's base-erosion minimum tax amount is $16 ($100 - $84).

Challenges and planning opportunities

The goals of international tax reform were to discourage U.S. taxpayers from "offshoring" intangible value and undertaking transactions to move income outside the U.S. tax system. Whether this carrot-and-stick approach of the FDII, GILTI, and BEAT provisions will help accomplish those goals is yet to be determined. Nevertheless, these new provisions provide both opportunities and challenges to U.S. taxpayers trying to maintain tax-efficient international tax structures.

EditorNotes

Anthony Bakale is with Cohen & Company Ltd. in Cleveland.

For additional information about these items, contact Mr. Bakale or tbakale@cohencpa.com.

Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.

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