Going from a credit system to a territorial system is like going from Earth to Mars

“We don’t know what we don’t know.”

How many times have you heard that before? Well, when it comes to international tax (and related penalties), claiming ignorance is no longer an excuse.

If you’re a CPA or a manager in a corporate finance department, it’s more important than ever to understand how the new tax law affects cross-border transactions and international tax. Since the Tax Cuts & Jobs Act (TCJA) was passed in late 2017, millions of individuals and entities have had to rethink their tax planning and tax structures completely. Going from a credit system to a territorial system is a monumental shift—you might as well be going from Earth to Mars. Everything you did in the past is no longer valid. You need to start fresh.

Radical Shift From Credit System to Territorial System

The longstanding credit system required U.S. taxpayers to pay tax on their worldwide income. After doing so, they would receive credit on their U.S. tax returns for those taxes paid overseas. But now, C-Corporations are taxed under the territorial system. In the long run, corporations will be better off. But, in order to switch from the credit system to the territorial system, they must pay a one-time toll tax on all accumulated un-repatriated earnings and profits (15.5% on cash and 8% on illiquid assets). Doing so frees up capital to be deployed without restriction around the world. U.S. individuals are still taxed on worldwide income. After they pay tax abroad, they receive Foreign Tax Credits (FTCs) in the U.S. for the taxes they paid overseas.

Rethinking Cross-Border Transactions (and Potential Penalties)

Cross-border transactions have become very important in the current environment. Thanks to tax reform, more foreign companies than ever want to do business in the U.S. Likewise, more U.S. companies seek to do business abroad, assuming they can take advantage of the new tax law.

However, if you’re not aware of certain aspects of international tax and compliance—or if you mistakenly omit certain forms that your company or clients should be filing—you could face major penalties. For example, if you forget to file Form 5471 (Information Return of U.S. persons with respect to certain foreign corporations), you could be subject to a $10,000 penalty. If you forget to file Form 5472 (foreign person owning more than 25% of a U.S. entity), you could be facing a $25,000 penalty. 

A Nw International Corporate Tax Landscape

After TCJA was passed, there were substantial changes to international tax law. This has resulted in major ramifications for multinational corporations:

• U.S. corporate tax rate was lowered substantially to 21% from 35%.
• U.S. is now very competitive (and stable) on a global comparison basis.
• C-Corps still face double taxation, but the burden is much less (21% vs. 35%.)
• S-Corporations are taxed only once—at the individual rate—and they get a special pass-through entity (PTE) deduction of 20% deduction for Qualified Business Income (QBI).
• The new rules free up capital to move anywhere in the world where corporations can get the highest return.

Top 10 International Corporate Tax Issues

Here are 10 of the most important international corporate tax changes that were ushered in as part of the landmark 2017 TCJA. It’s been a radical shift from a worldwide system of taxation to a territorial system of taxation. Also, a substantial lowering of the U.S. corporate tax rates has resulted in a lot more foreign investment money flowing into the United States. You owe it to yourself and your company to get up to speed on the following:

1. Change from a credit system to a quasi-territorial system for U.S. C-Corporations.

2. Major drop in the U.S. corporate tax rate (35% to 21%).

3. Dividend Received Deduction (DRD). You receive 100% of the dividend reduction for foreign-sourced income.

4. Foreign Derived Intangible Income (FDII). There’s now a 37.5% deduction. If an entity has a U.S. patent and you earn income from that patent in a foreign country, then you get a 37.5% deduction on that income.

5. Global Intangible Low-Taxed Income (GILTI). If you are a U.S. corporation and own a patent for use outside of the United States, you now get a 50% deduction on the foreign income derived from that patent.

6. One-time toll tax on un-repatriated profits. This implies that all the accumulated un-repatriated earnings and profit will be taxed once and only once (@15.5% on liquid assets, 8% on illiquid assets).

7. Inventory. There used to be a system in which you could allocate 50% of inventory to the U.S. and 50% to foreign operations. Now, it’s based on the production of the item and in which country the item is produced.

8. Subchapter-F. Now, 10% of the valuation has been added.

9. Limitation on interest deduction. Interest is limited to 30% of earnings before interest, taxes, depreciation, and amortization. The reason for this change is to prevent thinly capitalized companies making the U.S. bear an undue burden for the interest deduction of those companies.

10. Base Erosion and Anti-Abuse Tax (BEAT). This is the minimum tax paid by large corporations.

Digging Deeper Into TCJA Changes

Let’s take a closer look at certain highlights of the corporate changes above:

GILTI and FDII. The rules have changed on hard-to track intangible income. GILTI is income earned from foreign affiliates on intangible assets such as patents, copyrights, etc. Section 951A requires GILTI income to be included on Controlled Foreign Corporation (CFC) shareholder’s K-1.  Similarly, Foreign-Derived Intangible Income (FDII) refers to income earned on intangible assets (patents, trademarks, copyrights, etc.) that are licensed for use abroad by foreign persons.

GILTI Deduction. C-Corps are entitled to a 50% deduction on GILTI income. After January 1, 2026, that deduction goes down to 37.5%, resulting in an effective tax rate of 10.5% (13.5% after 2026).

Example—Let’s say your taxable income is $100 and your GILTI deduction is $50 (i.e., 50%). So, your taxable income after GILTI is $50. With the new corporate tax rate of 21%, your effective tax rate is half of that (i.e., 10.5%). It’s hard to argue that 10.5% is an extremely low corporate tax rate. It’s very worthwhile to have GILTI income and pay the low U.S. tax rate on it, as opposed to the old system in which you moved the intangibles abroad and tried to pay tax in the low-taxed foreign country.

Source: Nazareth CPAs 2019

FDII Computation

• Deductible Eligible Income (DEI)* of $500,000
• $100,000 in Foreign Derived Deduction Eligible Income (FDDEI)
• Qualified Business Asset Investment (QBAI) of $2,000,000

(DII) Deemed Intangible Income = 10% of QBAI = $500,000 - (10% of $2,000,000) =  $300,000  

• FDII = DII (FDDEI/DEI)
• $300,000 x ($100,000/$500,000) = $60,000
• FDII Deduction:$60,000 x 37.5% = $22,500

* DEI refers to gross income minus allowable deductions

 
One-time toll tax. Until late 2017, the foreign earnings of U.S. corporations were not taxed. Approximately $2.3 trillion was parked outside the United States. However, TCJA imposed a mandatory tax on untaxed accumulated earnings and profits at a rate of 15.5% on liquid assets and 8% tax on illiquid assets. Further, that tax could be paid all at once, or in eight yearly installments.

 
Income Sourcing – U.S. vs. Foreign

Source: Nazareth CPAs 2019

The first step is to figure out whether the income is U.S.-sourced or foreign-sourced.

Take interest income. It depends on whether the debtor is a U.S. domestic corporation or foreign corporation. If a U.S. corporation, then the income is U.S.-sourced. If the debtor is a foreign corporation, that income is considered foreign-sourced. Take U.S. behemoths such as General Electric or Apple Computer, for example. Their income is U.S.-sourced. But for foreign companies such as Philips or BMW that are issuing interest income on their debt, then that income is considered foreign-sourced income.

The same logic applies to dividends. If you’re a U.S. corporation that’s issuing dividends, then those dividends are considered U.S.-sourced income. Foreign corporate dividends are considered foreign-sourced income.

When it comes to personal services, it all depends on where those services are rendered. If those services are rendered in the U.S., then it’s considered U.S.-sourced income. If those same services are rendered abroad, then it’s considered foreign-sourced income. Suppose you work 9 months a year in the U.S. and 3 months a year in Canada. If you earn $120,000 a year total, you have to prorate your income accordingly—$90,000 (U.S.) and $30,000 (Canada).

Rents and royalties. It all depends on where the rental property is used. If the property is in the U.S., then it’s considered U.S.-sourced income. If the property is abroad, then it’s considered foreign-sourced income.

Gain on sale of real property. It all depends on where the property is based. If the property is in the U.S., then it’s considered U.S.-sourced income. If the property is abroad, then it’s considered foreign-sourced income.

Special rules for sale of U.S. property to nonresidents. According to the Foreign Investment in Real Property Tax Act (FIRPTA), whenever you sell real estate in the United States, the attorney at your closing impounds 15% of the gross proceeds of the sale and sends that money to the IRS. This is to prevent nonresidents from going back to their home country and not paying the tax.

Sale of personal property. If the seller is a U.S. resident, then it’s considered U.S. income. If the seller is a foreign resident, then it’s considered foreign income.

For all of the cases above, it’s critically important to keep the sourcing rules intact.

Penalties

This is an important area where many CPAs get into trouble. If your client owes more than $50,000 to the IRS, his or her passport can be revoked so they can’t fly outside the country. This new rule is being very strictly enforced. Here are the most ways that taxpayers are being penalized.

Form 5471. If you’re a director or 10% shareholder in a foreign entity, you could face a $10,000 penalty every year that you neglect to file Form 5471.

Form 5472. This one is even more dangerous. If a nonresident owns more than 25% of a U.S. corporation, he or she must include Form 5472 in their filing or risk paying a $25,000 penalty for omission.

Real estate professionals. You need to show more than 750 hours per year to quality as a real estate professional. It’s very important to maintain documentation because real estate professionals can deduct passive losses on rental properties. Passive losses are under a lot more scrutiny than they used to be. If you’re not a bona fide real estate professional, you cannot set off these passive losses against active income.

Summary

I strongly urge you to gain a better understanding of international tax rules and best practices because the penalties are getting steeper and enforcement is being more strictly enforced.

1. Penalties are very stiff for failing to report and comply with international tax law.

2. Moving from a credit system to a territorial system is a radical shift in the way multinational corporations’ income is taxed.

3. Take advantage of deductions for income earned on mobile and intangible assets, such as licensing, patents, and copyrights. Get up to speed on GILTI and FDII.

Cecil Nazareth, CPA, CA, MBA