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Supporters of the Tax Cut and Jobs Act (TCJA) describe it as a shift from a worldwide tax system to a territorial model. But the pre-TCJA system didn’t really tax all world-wide income of a US-based multinational currently since companies could defer US tax on profits of foreign subsidiaries until they repatriated their overseas income back to the US. And the new law isn’t really a territorial system where the income of foreign subsidiaries of US-based firms is never subject to US tax because foreign profits potentially face an annual minimum tax. Instead, Congress has maintained a hybrid system in which firms pay a lower effective tax rate on foreign profits than on domestic earnings, with an explicit rate differential replacing their ability to defer tax on foreign earnings.
In a blog post introducing a recent article I wrote for AEI’s Economic Perspectives, AEI’s Stan Veuger describes this approach as replacing “subdued worldwide corporate income taxation to one of territorial taxation with a worldwide backstop.”
The TCJA follows the basic outlines of proposals introduced in recent years by leaders from both parties, including former House Ways and Means Committee Chair Dave Camp (R-MI), Senators Rob Portman (R-Ohio) and Charles Schumer (D-NY), and the Obama Administration.
Like those plans, it has three main components. It:
- Eliminates the tax on repatriated dividends that US-resident multinational corporations receive from their foreign subsidiaries.
- Introduces a new low rate tax on intangible profits of US company subsidiaries located in low-tax foreign countries.
- Imposes a one-time transition tax on past profits of foreign affiliates of US companies.
This table summarizes how the TCJA implements these changes.
First, it allows US-resident companies to deduct from US taxable income 100 percent of the dividends they receive from their foreign affiliates, thereby eliminating the old repatriation tax.
Second, it imposes a new tax on Global Intangible Low Tax Income (GILTI) accrued within foreign affiliates in excess of 10 percent of the firm’s tangible overseas capital investment (less depreciation). Between 2018 and 2025, companies can claim a 50 percent deduction for GILTI, creating a 10.5 percent effective rate (half the 21 percent corporate rate). Companies also can claim an 80 percent credit for foreign taxes attributable to GILTI. The result: GILTI tax applies to income in any country with an effective rate of less than 13.125% (10.5/0.8). After 2025, the GILTI deduction declines to 37.5%, the effective tax rate increases to 13.125%, and GILTI will apply in countries with corporate rates of less than 16.406%.
Third, TCJA imposes a one-time tax on pre-2018 profits of foreign affiliates at rates of 15.5 percent for cash and other liquid assets and 8 percent for non-cash assets. This transition tax is payable over 8 years. Firms still get a foreign tax credit for the tax payments previously made, but it is reduced in proportion to the cut in the US tax rate on those profits.
The TCJA includes two other significant provisions with new acronyms.
The first would allow US corporations to deduct a portion of foreign-derived intangible income (FDII), income from exporting of products tied to intangible assets held in the United States. Imagine, for example, foreign sales of a drug where the patent is held in the US. The deduction reduces the effective tax rate on this income to 13.125% through 2025 and to 16.406% after 2025.
The provision largely eliminates the incentive for US companies to locate intangible assets in their low-tax foreign subsidiaries when selling into foreign markets. However, because it only applies to profits on foreign sales, it may be subject to challenge under World Trade Organization (WTO) rules as a backdoor export subsidy. This was a problem with previous statutes and earlier proposals that used international tax rules to promote exports and discourage imports.
The second, the Base Erosion Alternative Minimum Tax (BEAT), intends to limit the ability of both US and foreign-resident multinational corporations to strip profits out of their US affiliates by making deductible payments to related parties in low-tax countries. The BEAT is a complex alternative minimum tax of 10% (12.5% after 2025) on modified taxable income, calculated by disallowing deductibility of payments to certain related foreign parties. It also may be challenged under WTO rules since denying deductions to foreign firms could be considered a selective import tariff. At the same time, firms may be able to circumvent the BEAT by routing purchases through unaffiliated firms.
The TCJA’s international reforms are significant. Combined with the reduced corporate rate, they largely eliminate the incentive for US firms to accrue assets overseas, while seeking to protect the tax base from avoidance by both US and foreign-based multinationals.
However, the TCJA does not eliminate the incentive for US firms to invest or report profits in low-tax foreign countries since foreign profits still get preferential tax treatment. And US companies still must compete with foreign-based firms that pay little or no tax on their foreign profits. In addition, the provisions are highly complex and tax planners may find new ways to circumvent them.
In the meantime, all of us will need to learn a new set of acronyms – GILTI, FDII, and BEAT.
Posts and comments are solely the opinion of the author and not that of the Tax Policy Center, Urban Institute, or Brookings Institution.
Shizuo Kambayashi/AP Photo