Article:

US tax reform – Summary of the international provisions

13 November 2017

On 2 November 2017 the US House of Representatives released the Tax Cuts and Jobs Act (the Bill). It proposes some key amendments to the current US tax system, which includes rules on how foreign income and foreign persons are taxed which could be of particular relevance to UK groups with US subsidiaries or UK subsidiaries of US-parented groups. Most of the provisions of the Bill are intended to take effect in 2018.

 

Key proposals
 

Reduction in corporate tax rate

The main impact for businesses as a result of the Bill is that the federal corporate tax rate would reduce from 35% to 20%, and certain “business income” from pass-through entities would be taxed at 25% instead of an owner’s individual rate. This will, therefore, reduce the natural arbitrage in corporate tax between the US and the UK (with the current UK rate being 19%, reducing to 17% at 1 April 2020).

Additionally, the Bill would repeal the corporate alternative minimum tax (AMT) and make existing AMT credit carry forwards refundable over a period of five years.

 

Participation exemption – one-off profits tax

Under the proposed Bill, the taxation of a US corporation’s foreign income would change from a worldwide system to an exemption system. There would be a 100% exemption from US tax for the foreign source portion of dividends paid by a foreign subsidiary to US corporate shareholders that own 10% or more of the foreign subsidiary. In order to claim the exemption, the Bill requires that a six month holding period along with certain other ownership conditions be met. The provisions would be effective for distributions made for tax years ending after 31 December 2017.

No foreign tax credit or deduction would be permitted for any foreign taxes (including withholding taxes) paid or accrued with respect to any exempt dividend, and no deductions for expenses properly allocable to an exempt dividend (or shares that give rise to exempt dividends) would be taken into account for purposes of determining the US corporate shareholder’s foreign-source income. The exemption would not apply to dividends received from a passive foreign investment company that is not a controlled foreign corporation.

The new system would, therefore, provide an exemption to dividends paid from UK subsidiaries to US parent companies within a group. The removal of the tax credit would not affect UK-US payments because the UK does not levy withholding tax on dividends under its domestic legislation.

 

Transition tax – one-off ‘deemed repatriation’ of earnings and profits

As part of the migration to the exemption system, the Bill also includes a transition tax for untaxed foreign earnings accumulated under the current worldwide taxing system. This will potentially impose a large tax liability on US parented groups, depending on the historical earnings and profits (E&P) of their UK (and other foreign) subsidiaries.

The US shareholders would be required to include in income for the last tax year beginning before 1 January 2018 a pro-rata share of the net post-1986 historical E&P of the foreign subsidiary to the extent that such E&P has not previously been subject to US tax. This E&P is determined as the higher of this amount at 2 November 2017 or 31 December 2017 (an anti-forestalling measure to prevent taxpayers from shifting or reducing E&P before the end of 2017).

The historic E&P is classified as assets in the form of either cash and cash equivalents - which would be subject to transition tax at 12%, or E&P that has been reinvested in the foreign subsidiary’s business - which would be taxed at a reduced 5% rate. Foreign tax credit carry-forwards would be fully available to offset against the transition tax. However, any foreign tax credits triggered by the deemed repatriation of the E&P would be partially limited when offsetting against the US tax.

The US shareholder can elect to pay this transitional tax over a period of up to eight years in equal annual instalments (ie 12.5% of the total liability). For S-corporations, the shareholders may elect to defer the payment of the transition taxes until a number of situations occur, including when the S-corporation ceases to exist or conduct business.

 

Interest restriction

The Bill includes clauses to disallow a deduction for net interest expense in excess of 30% of the business’s adjusted taxable income. Any interest amounts disallowed under the provision would be carried forward to the succeeding five taxable years. These new rules are effective for tax years beginning after 31 December 2017 and repeal the existing ‘s163J’ interest deduction limitation rules. Businesses with average gross receipts of $25m or less would be exempt from these interest limitation rules, as are certain regulated public utilities and real property trades or businesses.

The new interest limitation rules are therefore broadly similar to those that are being implemented in the UK and further afield, where interest limitation deductions are broadly being restricted to 30% of tax-EBITDA.

For US corporations that are members of an international financial reporting group a special interest limitation rule could apply (companies would have to calculate both this special interest limitation rule and the 30% limitation rule outlined above and apply the largest interest restriction). The special rule limits the US interest expense deduction where the US corporation’s share of the group’s global net interest expenses exceeds 110% of the US corporation’s share of the group’s global EBITDA to this amount. Any disallowed interest expense would be carried forward for up to five years with carryforwards exhausted on a first in, first out basis. For these purposes, an international financial reporting group is a group of entities that:

  1. Includes at least one foreign corporation engaged in a US trade or business or at least one domestic corporation and one foreign corporation
  2. Prepares consolidated financial statements, and
  3. Has average annual global gross receipts for the three reporting year period ending with such reporting year or more than $100m.

Therefore, this special interest limitation rule could affect UK-parented (or other foreign-parented) US groups with a turnover of $100m or more which prepare consolidated financial statements.

 

Next steps

On 9 November 2017, the Senate Finance Committee released its own tax reform bill – which would delay the corporation tax cut to 2019. So it is clear that there will be many more weeks of negotiations between Republicans and Democrats in both the House of Representatives and the Senate before any final reforms are agreed.

For a more detailed analysis of the wider impacts of the US House of Representatives Bill please refer to the November tax alert and Summary of the International Provisions Included in the Tax Cuts and Jobs Act prepared by BDO USA LLP.

You can also join our US tax reform webinar on 30 November to hear US and UK international tax experts will explain the latest developments.

For help and advice on international tax issues involving the USA please contact Malcolm Joy or Howard Veares.

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