The Tax Cuts and Jobs Act (“TCJA”) led a shift from a “worldwide” tax system towards a territorial tax system—more accurately, a “quasi”-territorial tax system. The TCJA accomplished this through several major reforms. First, it enacted a “toll charge,” or transition tax—a one-time tax on the deemed repatriation of earnings held offshore. In exchange, it implemented a “Participation Exemption System” that gives certain taxpayers a dividends received deduction (“DRD”) for foreign-sourced dividends received from certain corporations. This structure was designed to encourage the flow of capital that was parked offshore back into the United States. In other words, it taxed that built-up capital sitting offshore, then encouraged its repatriation back into the United States by removing the tax on that repatriation (again, for certain taxpayers).
In reality, though, the prior system was not really a pure “worldwide” tax system. For example, as a general rule, it actually allowed for the deferral of US tax on profits earned by foreign subsidiaries until they were repatriated to the United States. The controlled foreign corporation (“CFC”) regime and passive foreign investment company (“PFIC”) regimes were notable exceptions to this general rule. And the new law under the TCJA is, in reality, not a pure territorial system either, given (for example) that the foreign-source income of many foreign subsidiaries is subject to a sort of minimum tax in the United States due to the new law’s structure. It is probably more correct to call the TCJA’s international tax regime a hybrid system.
The Transition Tax—Section 965
Section 965 imposed the new, one-time “transition” tax, which applies to the last taxable year of a “deferred foreign income corporation” (“DFIC”) that begins before January 1, 2018.
Under Section 965(a), the subpart F income of a DFIC for the last taxable year that begins before January 1, 2018 (known as the “inclusion year”) is increased by the greater of (i) the “accumulated post-1986 deferred foreign income” of the DFIC determined as of November 2, 2017, or (ii) the “accumulated post-1986 deferred foreign income” of such corporation determined as of December 31, 2017.
A United States shareholder must include, in its gross income, its pro rata share of this subpart F income, subject to certain reductions. This is known as the U.S. shareholder’s Section 965 inclusion amount.
The Participation Exemption—Section 245A
The 100-percent DRD is only available to domestic C corporations. Other taxpayers do not qualify for the DRD under section 245A. Thus, individuals, S corporations and partnerships may not take advantage of the DRD.
More precisely, under section 245A(a), in the case of any dividend received from a “specified 10-percent owned foreign corporation” by a domestic corporation that is a U.S. shareholder with respect to such foreign corporation, section 245A allows a deduction equal to the foreign-source portion of the dividend. For many corporations, this will be all of the dividend. A specified 10-percent owned foreign corporation is defined in section 245A(b) as any foreign corporation (other than certain passive foreign investment companies) with respect to which a domestic corporation is a U.S. shareholder.
Note that gains treated as a dividend under section 1248, and section 946(e) dividends from the gain on the sale of a lower-tier CFC treated as dividends, may be eligible for the section 245A DRD.
Taxpayers still need to consider the impact of the Subpart F rules and Controlled Foreign Corporation (“CFC”) reporting requirements, as well as the Passive Foreign Investment Company (“PFIC”) rules. These rules remain in place after the TCJA. However, in addition to the CFC and PFIC rules, taxpayer need to be aware of several new categories of foreign-source income, such as global intangible low-taxed income (“GILTI”) and foreign derived intangible income (“FDII”).