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Part I of this blog series addressed the larger thematic issues for Swiss financial institutions and investors from the new US tax code provisions. Part II set out the scope and consequences of the reduced corporate tax rate and changes relevant to taxation of certain US investments. Part III explores several more relevant topics, including the movement towards a territorial tax system for US corporations and notable miscellaneous provisions before ending with a light-hearted, non-technical look at some of the more idiosyncratic elements of the Trump Tax Bill.
Towards a Territorial Tax System
Most countries operate a territorial tax system. That means, that income is taxed where earned, irrespective of where the taxpayer is located. Historically, the US does not. Instead, the US relies on a quasi-territorial system for corporate tax under which a US corporation was subject to taxation on income earned by its subsidiaries abroad. However, the US parent could defer such taxation until the subsidiary distributed such earnings to the parent by means of a dividend. Receipt of such a dividend payment often entitled the US parent corporation to claim a foreign tax credit (FTC) for taxes paid by the subsidiary in its home jurisdiction. Nonetheless, for dividend payments from subsidiaries operating out of tax-friendlier jurisdictions, the FTC was substantially lower than the tax rate imposed in the US. Therefore, many US corporations hoarded cash in overseas subsidiaries, rather than repatriate it. This approach was upended in December.
Per the new tax bill, dividends paid from non-US subsidiaries (or at least the portion consisting of non-US earnings) are entitled to a 100% dividends received deduction (DRD). The result of this DRD is non-taxation of such dividends for the US corporate parent (provided it owns 10% or more of the non-US subsidiary). In parallel, the provision granting an FTC for any taxes paid by the non-US subsidiary is repealed (as is any FTC attached to any dividend entitled to the 100% DRD). The overall re-shaping through these two changes looks a lot like a move to a pure territorial tax system.
However, there are other international bits of the US tax code – new and pre-existing – that maintain some aspects of the previous universal (i.e. non-territorial) system. The most obvious one is the treatment of the historical aggregate earnings and profits (E&P) of the non-US subsidiaries that were not yet distributed (i.e. the amount that would have been subject to US taxation had the dividends been paid under the previous system). Per the recent changes, this E&P will be deemed to have been repatriated (i.e. paid to the US parent as a dividend), even though it was not yet. This hoarded E&P will be taxed at varying rates, depending essentially on whether it is held in liquid (cash or equivalent) or non-liquid form (15.5% and 8%, respectively). The amount owed pursuant to the deemed repatriation provision may be paid in installments as set forth in the tax code. Once taxed, dividends containing such historical E&P are also entitled to the 100% DRD deduction.
Furthermore, certain exceptions will constrain the 100% DRD going forward, such as:
Oddly, branch profits remittances seem not to enjoy similar tax exemptions, remaining subject to the existing quasi-universal system with US headquarters taxed on the difference between the local tax rate and the new US corporate tax rate. Additionally, a new loss limitation basket for FTCs was introduced specifically for foreign branch operations. This differential treatment is bound to influence the business judgment of US corporations when deciding on the form of their overseas operations. All things being equal, branch operations will be less attractive economically due to their US tax treatment. This differential seemingly violates a cardinal norm of international taxation: To avoid tax rules that distort business decisions.
Meanwhile, in other parts of the tax code, the non-territorial aspects of the US corporate tax regime continue to prevail. Foremost, the controlled foreign corporation (CFC) rules remain intact, meaning that certain non-US corporations owned in part by US Persons will continue to pay US taxes on specified types of current income earned outside the US. Moreover, new treatments for certain types of income derived from intangible assets further muddy the subpart F waters. Non-US investors ought to take another look at the rules governing CFCs – the new ones and their effect on the existing ones – in order to spot any knock-on consequences to their investments.
Miscellaneous Items of Interest
Scattered changes that merit a mention include the following:
In order to close on a lighter note, let’s consider some of the odder elements of the Trump tax bill. Sometimes, strange revisions may address quirks or lacunae in the current rules and are thus bonafide clean ups of debris leftover in the tax system from previous revisions. However, other times, these curios are the products of the personal leverage of individual politicos over the drafting process. Such “pork-barrel” provision are promoted by or promised to one or a small cadre of legislators for the benefit of a narrow and/or local constituency. A few provisions in the new bill stand out as particularly peculiar (and smell a bit bacon-y), such as:
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