The Tax Cuts and Jobs Act (TCJA) significantly revised the taxation of cross-border enterprises and transactions, changing not only statutory details, but also, in many cases, affecting fundamental principles and incentives. This article summarizes some of the most significant changes to cross-border taxation relevant to private equity transactions, focusing on four areas—the scope of the “controlled foreign corporation” (CFC) regime, the treatment of cross-border payments, the “toll charge” imposed to transition from the old system of taxing US owners to the new system under the TCJA and the current taxation of US owners of a CFC under the new and subtly named “GILTI” regime. The TCJA marks a fundamental shift in the US international tax regime, offering planning opportunities for private equity funds while also creating a number of new complexities and traps for the unwary.
Changes to the Controlled Foreign Corporation Regime
One of the most far-reaching changes to the taxation of non-US companies under the TCJA is the expansion of the CFC regime. A CFC is a foreign corporation that is more than 50% owned by US persons that directly or indirectly own at least 10% of the stock of the corporation (10% US Shareholders). The TCJA dramatically expands the “attribution” rules such that a US corporation owned by a foreign parent can cause other foreign companies owned by the same parent to be treated as CFCs. Further, under the TCJA, 10% US Shareholders now include US shareholders owning 10% or more of the value (as opposed to just voting power, which was the case under prior law) of a foreign corporation’s stock. 10% US Shareholders may be required to include CFC income for US tax purposes.
These changes effectively mean that almost all non-US corporations in multinational structures will be CFCs. Under the TCJA, the key question for investors will be whether a foreign corporation has any 10% US Shareholders, rather than whether the corporation is a CFC, likely resulting in more funds using non-US structures to avoid the broad scope of these rules.
The BEAT Goes On
Prior to the TCJA, a US corporation could deduct payments, such as interest and royalties, made to foreign affiliates. Although there were some limitations on claiming such deductions, the limitations were generally lax. The regime incentivized inversion transactions, in which a US company would first became a subsidiary of a foreign company and then make large deductible payments to the foreign company, thereby stripping taxable earnings out of the US.
The TCJA introduced a new “Base Erosion and Anti-Abuse Tax,” commonly known as the “BEAT,” to curtail earnings-stripping transactions. The BEAT only applies to corporations with average annual gross receipts over a rolling three-year period of $500 million or more and that engage in more than de minimis earnings-stripping transactions.
The BEAT is an add-on tax to the regular tax and is similar in function to the corporate alternative minimum tax that was repealed by the TCJA. It is equal to the excess of 5% (10% starting in 2019 and increasing to 12.5% after 2025) of the corporation’s “modified taxable income” (MTI) over the corporation’s regular tax liability. MTI is the corporation’s regular taxable income after adding back certain deductible payments made to related foreign parties (applying a 25% test for relatedness).
To illustrate, suppose a US company with income of $1,000M makes a $600M royalty payment in 2019 to a related foreign party, thereby reducing taxable income to $400M. The BEAT and total tax are determined as follows.
- Regular tax liability: 21% ($1,000M-$600M) = $84M
- MTI: $400M (eroded tax base) + $600M (base erosion payment) = $1000M
- BEAT: 10% of $1,000M (MTI) - $84M (regular tax) = $16M
- Total tax: $84M (regular tax) + $16M (BEAT) = $100M
The example illustrates that the royalty reduces US tax to a certain extent (from 21% of $1,000M, or $210M, to $100M), but cannot reduce US tax below $100M. In other words, absent the BEAT, the $600M royalty payment would have reduced the US tax liability by 21% of $600M, or by $126M. The BEAT adds back $16M of tax, making approximately $76M of the royalty ineffective to reduce US tax.
The BEAT appears only to take into account the gross deductible payment to the foreign recipient, as opposed to the net amount after subtracting the amount received from the foreign company. As a result, the BEAT may put a large strain on US companies that engage in cross-licensing with related foreign companies and, in certain cases, incentivizes US companies to enter into licenses with unrelated foreign companies because the BEAT only applies to deductible-related party payments.
The TCJA allows foreign earnings to be brought back into the United States tax-free by granting a deduction for dividends received by a US corporation from a 10% owned foreign subsidiary. This represents an effort fundamentally to shift the US corporate tax system from “worldwide” taxation of non-US earnings to a “territorial” system under which the US generally does not tax such earnings (although, as discussed below, the TCJA also includes new “GILTI” rules that significantly undercut the “territorial” nature of the post-TCJA regime). The TCJA also includes a one-time “toll charge,” or deemed repatriation tax, on untaxed foreign earnings of a CFC or foreign corporation with a 10% US corporate owner. This serves as a transition rule for earnings generated under the old system.
Specifically, the TCJA requires certain US owners of a CFC subject to the toll charge to include an amount equal to the previously undistributed earnings of the CFC in income for 2017 or 2018, even if no actual distributions are made. However, this one-time inclusion is generally taxed at reduced rates of 8% for foreign earnings held in illiquid assets and 15.5% for foreign earnings held in cash and cash equivalents. Further, the taxpayer may elect to pay the resulting tax liability over eight years in increasing installments.
Earnings subject to the toll charge may be repatriated without being subject to further US tax. Thus, a US portfolio company with CFC subsidiaries will be able to access those offshore earnings in a way not previously feasible. Such cash may be used for any purpose, including repayment of debt, dividends, share buybacks, investments in their US businesses and add-on acquisitions.
On the buy-side, the fact that the repatriation tax will usually be paid in installments over eight years will add some complexity to acquisitions of US companies with significant foreign operations. Sponsors should take into account future installments of the toll charge, imposed on pre-transaction earnings, when pricing and negotiating acquisitions of such companies.
Foreign Earnings Found GILTI
Before the TCJA, US owners of CFCs could generally defer paying US tax on offshore earnings until repatriation, with the exception of “Subpart F” income—generally, passive income. The TCJA fundamentally revises the taxation of such companies by introducing a new category of income (called “GILTI”) that is taxed in the United States whether or not repatriated. In other words, the United States has moved from a system of general deferral of foreign income to a system of general inclusion of foreign income, and private equity buyers should take this into account when pricing deals.
GILTI is, in broad terms, defined as net offshore income (excluding Subpart F income) in excess of a deemed 10% return on the basis in certain tangible assets. GILTI included by a US corporation is taxed at a significantly reduced rate: 10.5% through 2025 and 13.125% thereafter.
Taken together, GILTI and Subpart F require close to full inclusion of offshore earnings in US taxable income on a current basis, rather than the limited inclusion required under prior law. The GILTI rules are particularly harmful to 10% US Shareholders that are not corporations because they receive neither the benefit of the lower rates nor the ability to use foreign tax credits. The stated goal of this dramatic change is to discourage the transfer of high-margin businesses offshore.
The GILTI regime’s goals are reinforced by a corresponding reduced rate applicable to “foreign derived intangible income” or FDII—income earned by a US corporation from selling property or providing services to foreigners in excess of a “routine” return of 10% on the corporation’s investment in depreciable tangible property. FDII enjoys an effective lower tax rate of 13.125% until 2025 and 16.406% thereafter. The GILTI tax rates are equal to 80% of the FDII rates and reflect that GILTI may be subject to foreign taxes, only 80% of which are creditable against the GILTI tax.
Taxation of GILTI and FDII will significantly affect the incentives driving portfolio company structures. For example, it may be beneficial in certain cases to hold non-US businesses under a domestic corporation to qualify for the reduced rate on GILTI and the benefit of tax-free repatriation. Further, elections under Section 338(g) of the Internal Revenue Code may offer benefits to US corporate sellers of CFCs by converting taxable gain on a stock sale into lower-taxed GILTI generated by a deemed asset sale.