To understand the implications of the recent tax legislation and its reform of the international tax system, one first needs a grounding in basic U.S. international tax policies before delving into the major code changes. By understanding the origins of the system, we can see the policy behind the new provisions—and hopefully make them easier to digest.
Citizenship – Individuals
The fact that you may have to pay taxes to the United States government for money you earned offshore might come as a surprise to many. In fact, the United States is the only industrialized country to tax its citizens solely based on their citizenship. All other industrialized countries only tax income earned inside their borders—the “territorial approach.”
For example, under the territorial approach, a French citizen who lives and earns wages in Singapore would only pay taxes to Singapore. Conversely, under the U.S.’s worldwide tax system, a U.S. citizen who lives and earns wages in Singapore would be subject to both Singapore and U.S. taxes. This can be frustrating if a taxpayer is only a U.S. citizen by birth but lives most of his or her life in another country—so-called “accidental” citizens.
However, there is a silver lining. The U.S. government allows citizens who earn less than a certain threshold (in 2018, the threshold is $104,100) to exclude their foreign earned income. Adjusted yearly for inflation, the Foreign Earned Income Exclusion (“FEIE”) and the Foreign Housing Exclusion (“FHE”) allow individuals who live abroad and earn under a certain threshold to pay little to no U.S. taxes.However, a U.S. income tax return should still be filed.
Another option available to U.S. individuals is the Foreign Tax Credit (“FTC”). The FTC allows U.S. citizens to offset their U.S. income tax liabilities with income taxes that they paid to other governments. If an individual earns income above the FEIE threshold, FTCs could be used to offset his or her U.S. income tax liabilities. Even if the FEIE threshold has not been met, a taxpayer should seek advice from a qualified professional in deciding between the two. There are times when the FTC could offer a greater benefit than the FEIE. For example, if a taxpayer temporarily resides in a country where the individual tax rate is higher than that of the U.S., it would be more beneficial to take an FTC and offset the U.S. income taxes than to claim the FEIE.
Similar to individuals, domestic corporations (“DCs”)—those created or organized in the U.S.—are also taxed on their worldwide income. At the previous corporate rate of 35%, U.S. corporations were severely disadvantaged compared to their foreign competitors. Unlike DCs, Foreign Corporations (“FCs”) only pay U.S. income tax on income earned in the U.S. For example, Country X has an income tax rate of 28%. FC operates in the U.S. and in Country X. FC would pay 35% in taxes on income earned in the U.S. and 28% on earnings connected to Country X. Meanwhile, a DC would pay 35% on both its U.S. and Country X’s earnings.
The 35% tax on foreign earnings of DCs is not necessarily immediate. In fact, if actually earned by subsidiaries, these earnings are only taxed after they have been repatriated back to the U.S. in the form of a dividend. Consequently, DCs have been incentivized to keep profits offshore to avoid the 35% tax and thereby to invest less capital in the U.S. economy.
Congress attempted to stop this kind of deferred tax planning through various provisions—all seeking to stop income from being stored outside the U.S. Prior attempts included the Subpart F inclusion, which requires certain US taxpayers to recognize income when it is earned and not merely when it is repatriated through dividends. Another attempt has been through repatriation tax holidays where repatriated dividends are subjected to lesser tax.However, where there is a law, there is a work around. A DC just needs to make sure they plan around Subpart F or wait until the next tax holiday to repatriate this income.
In November 2017, Congress passed the Tax Cuts and Jobs Act (“Act”), which may provide a permanent solution to prevent DCs from keeping their earnings offshore.Put simply, the Act lowers the corporate tax rate from 35% to 21%, making the U.S. more competitive as a country for corporations.Additionally, the Act provides an exclusion equal to the amount of a dividend from foreign generated income.To put it another way, § 245A transforms the U.S.’s citizenship-based tax approach into a territorial tax approach for certain taxpayers—DCs who own 10-percent or more of a FC. Thus, the Act essentially changes the taxing regime for certain DCs, while individuals remain under the citizen-based taxing scheme. We’ll explore § 245A in more detail in my next article.
In moving from a 35% citizenship tax approach to a 21% territorial tax approach may seem like the U.S. will lose a large amount of revenue. However, to make this up, the Act also added four new taxes in an attempt to justify the switch: Transition (for more, see here), GILTI (global intangible low-taxed income), FDII (foreign-derived intangible income), and a base erosion minimum tax (informally referred to as the base erosion anti-abuse tax or BEAT). Combined, the international provisions are estimated to bring in $68.9 billion of revenue in 2018 alone.
Now that you have the background on the provisions, next time we’ll look at §245A in detail.
I.R.C. §7701 (The term “citizen” is loosely defined to include resident alien and individuals meeting the substantial presence test).
See Cook v. Tait, 265 U.S. 47 (1924) (The Supreme Court held that U.S. taxation of the taxpayer’s worldwide income does not violate the U.S. Constitution nor international law. The taxing scheme is justified on the theory that the benefits of citizenship extend beyond territorial boundaries.). See Grover Norquist & Patrick Gleason, American expats are left high and dry by Trump’s tax reform, NBC NEWS(Jan. 17, 2018), https://www.nbcnews.com/think/opinion/american-expats-are-left-high-dry-trump-s-tax-reform-ncna838006(the only other country which has the same tax regime is Eritrea).
I.R.C. § 911.
I.R.C. §§ 901-905; see also IRS Form 1116.
26 U.S. Code Subpart F – Controlled Foreign Corporations.
Martin A. Sullivan, Corporate Tax Reform: Taxing Profits in the 21st Century, p. 83, ISBN 143023928X.
I.R.C. § 11.
I.R.C. § 245A.
I.R.C. § 245A(a), (f).