Prior to the Tax Cuts and Jobs Act of 2017 (TCJA), the US had a worldwide taxation system. The TCJA changed the tax system to a hybrid territorial system. Under the hybrid territorial system, income earned by US Corporations outside of the US is either eliminated or reduced. There are a few major tax items put into place under this new system.
Foreign-Derived Intangible Income (FDII) Deduction
As a benefit of the hybrid territorial system, the TCJA created a deduction for C-Corporations that generate income derived from tangible and intangible products and services from foreign markets. As an incentive for C-Corporations to generate revenue from foreign markets, the provision applies a preferential tax rate of 13.13% to a portion of eligible income.
In essence, selling products or services to foreign customers for use in a country outside of the US may qualify for the FDII deduction. Certain restrictions do apply for sales to related parties. Income that meets these qualifications is considered foreign-derived deduction eligible income (FDDEI). The company’s total revenue that fits these qualifications but is sold to both inside and outside of the US is considered the deduction eligible income (DEI). The ratio of FDDEI over DEI is known as the foreign derived ratio. To determine the FDII deduction, the foreign derived ratio is multiplied by the return on assets used in the production of foreign derived income. The deduction is 37.5% of FDII until 2025 when the rate is lowered to 21.87%.
The deduction, of course, is only eligible for C-Corporations with taxable income for the year. No deduction is allowed for taxpayers operating at a loss.
Controlled Foreign Corporations (CFCs) & GILTI
A foreign corporation is a CFC if it is majority owned (greater than 50%) by a US shareholder. The TCJA introduced the Global Intangible Low-Taxed Income (GILTI) under Code Section 951A, whereby US persons greater than 10% ownership of CFCs may be subject to additional taxation on the income of the CFC. GILTI provides for immediate inclusion of the shareholder’s pro-rata share of income in US taxable income the amount determined to be in excess of a specified return.
However, once the earnings are taxed under GILTI, any distributions made to the US shareholder are not taxable. Under the worldwide tax system, US corporations would have been subject to a 35% tax rate on the dividends received from the CFCs. With the GILTI taxed at 10.5% (with the 50% section 250 deduction), US corporations are actually benefiting from the GILTI taxation. This was part of the intent, as it encourages US Corporations to bring the cash back onshore as it is already taxed.
To prevent corporations from treating their previously undistributed earnings (prior to 1/1/18) from CFCs as tax-free dividends, the TCJA required a one-time repatriation of those earnings. The repatriation tax was 15.5% of accumulated net earnings. Corporations were required to file repatriation with their 2017 tax returns, however, are able to pay the tax over a span of 8 years.
As you can see there are quite a few items related to corporate foreign transactions. We can help you navigate these taxations and maximize eligible deductions. If you would like to discuss tax planning in this or any other areas, please feel free to contact us.