A version of this article was previously published in the Denver Business Journal.
Tax reform, also known as the Tax Cuts and Jobs Act, moves the United States toward a hybrid territorial system.
Under the prior taxation system, US companies were taxed on their worldwide income. Any double taxation was mitigated through a complex tax-credit system.
US companies are taxed only on their US income under the new taxation system, with some important exceptions. The system includes income-inclusion exceptions that take aim at base-erosion tax-planning strategies to help ensure income doesn’t escape US taxation by remaining offshore.
This has significant implications for technology companies, many of which generate revenue outside the United States.
Transitioning to a Hybrid Territorial System
The transition to a hybrid territorial system is accomplished through several important provisions:
- Implementing a transition tax
- Changing how future income is taxed
- Reinstating a revised corporate minimum tax
A transition tax is a low, one-time, deemed-repatriation tax on accumulated foreign earnings earned and kept offshore. This tax was instated for the 2017 tax year, subjecting these foreign earnings to the following effective tax rates:
- Fifteen-and-one-half-percent tax on cash and cash equivalents
- Eight-percent tax on other liquid assets
The aim of the transition tax was to incentivize US companies to reinvest in US capital expansion once foreign earnings previously sitting offshore had been taxed in the United States through deemed repatriation.
Additionally, after deemed repatriation, dividends paid from foreign subsidiaries to their 10% US-based C-corporation shareholders would be eligible for a 100% dividend-received deduction—making the dividends essentially tax free.
There are several nuances to this new dividend-received deduction, however, such as:
- It only applies to the foreign-source portion of the dividend.
- Shareholders have to meet certain holding requirements.
Similar to deemed repatriation of foreign income, the dividend deduction aims to generate additional US investments by allowing those funds to come back to the United States tax free.
Global Intangible Low-Taxes Income and Foreign-Derived Intangible Income
The taxation of income going forward is especially relevant to technology companies, which often are less capital intensive and tend to make large investments in intellectual property.
Global Intangible Low-Taxes Income
An exception to the territorial tax system is a new concept: global intangible low-taxes income (GILTI). GILTI creates a US-income inclusion for US companies that earn profits related to intangible property offshore—aiming to incentivize companies to return these profitable activities to the United States.
At a high level, GILTI requires US shareholders holding at least 10% of a controlled foreign corporation (CFC) to include excess profits from offshore activities in their current taxable income. These excess profits are equal to net CFC-tested income divided by the net deemed-tangible-income return, which is essentially 10% of aggregate qualified-business-assets investment.
It’s important to note these provisions are defined broadly enough to catch many profitable offshore business activities, whether there are intangibles or not. However, with the availability of an 80% foreign tax credit and other potential tax deductions, GILTI may only impact activities subject to a foreign tax rate of less than 13.125%. These benefits are only available to C corporations owning a CFC.
Foreign-Derived Intangible Income
The inverse of the GILTI provision is the deduction for foreign-derived intangible income (FDII), which serves as an incentive to grow US sales offshore. Available as an offset to GILTI, FDII creates a deduction based on excess returns from goods and services sold offshore by US C corporations.
At a high level, FDII is calculated as the amount equal to the deemed-intangible income multiplied by foreign-derived, deduction-eligible income divided by total deduction-eligible income. Deduction-eligible income includes property sold or licensed or services provided to foreign persons.
To take advantage of this deduction, technology companies must track these activities and the related income. As a caution, FDII is only available to corporations and is likely to face legal challenges as an unfair trade practice in front of the World Trade Organization courts.
Corporate Minimum Tax
While companies were celebrating the repeal of the corporate alternative-minimum tax included in tax reform, the IRS introduced the base-erosion anti-abuse tax (BEAT).
BEAT is a minimum tax rate applied to taxable income, computed without regard to base-erosion payments. In this instance, a base-erosion payment includes any amount paid or accrued to a related foreign person for whom a US tax deduction is allowed.
Fortunately, BEAT only applies to large corporations that have average annual gross receipts of at least $500 million and a base-erosion percentage of at least 3%. A significant portion of technology companies will likely fall below this threshold and won’t be subject to BEAT.
What Happens Next
Tax reform is ultimately meant to encourage companies—especially those within the technology industry—to bring back high-value, high-profit offshore activities to the United States.
As taxpayers await further guidance and clarification from the IRS, it remains to be seen whether the tax complexities and unintended consequences of these provisions will ultimately result in additional investment.
We’re Here to Help
To learn more about how these changes could affect you or your technology company, contact your Moss Adams professional or visit our dedicated tax reform webpage.