Cross-Border Mergers and Acquisitions Under the Tax Cuts and Jobs Act

The 2017 Tax Cuts and Jobs Act (“TCJA”) made several key changes that US taxpayers will need to review in structuring cross-border mergers and acquisitions.  The TCJA signed into law December 22, 2017, is the most comprehensive tax reform in over thirty years and requires new considerations in this area, including the taxation of controlled foreign corporations (“CFC”).  The changes to the tax law present a range of questions, opportunities, and traps for the unwary.  

 

TCJA’s Changes to International Taxation

Under prior law, foreign income of a US person was subject to current taxation at regular US tax rates.  The foreign income of a foreign subsidiary of a US company was divided into two categories that were taxed differently in the US.  Subpart F income was subject to current taxation at regular US tax rates unless the income was subject to a sufficiently high foreign tax rate (high-tax kickout income).  Once the Subpart F income was taxed, the shareholder of the foreign subsidiary had an account for previously taxed income (“PTI”) with respect to the foreign subsidiary/CFC, and distributions from the PTI account were not subject to additional US tax provided the US tax accounting correctly traced the PTI account.  All other income of the foreign subsidiary was not subject to US taxation until the profits were distributed/repatriated back to the US shareholder or the US shareholder sold its investment in the foreign subsidiary.  When the US shareholder sold its investment in the foreign subsidiary, gain from the sale was treated as a dividend to the extent of the CFC’s untaxed earnings. Gain above the untaxed earnings was taxed as a capital gain, either short or long term depending on the holding period.

Under the TCJA, income of a foreign subsidiary that is a CFC is divided into several categories that are subject to tax at different rates and require many items to be tracked.  The income of the US shareholder is divided into regular income and Foreign Derived Intangible Income (“FDII”).  The regular income is subject to tax at regular US tax rates.  FDII is taxed at a reduced rate of 13.125 percent. FDII is income from the sale of property for foreign use to or performance of services for foreign customers.  

The income of the foreign subsidiary is split into additional categories under the TCJA than under prior law.  The Subpart F income rules are generally the same, the other foreign income is divided between global low-tax intangible income (“GILTI”), which, with certain exceptions, is subject to current US taxation at a rate of 10.5 percent and included in the US shareholder’s PTI account, and the net deemed tangible return (“NDTR”), which is generally not subject to current US taxation.  The NDTR is 10 percent of the tangible asset basis of the foreign subsidiary and GILTI is all income, other than Subpart F income and high-tax kickout income, in excess of the NDTR.  

The NDTR and high-tax kickout income are generally not subject to US taxation when earned or for a US corporation when repatriated to the US as a dividend under the new participation exemption.  However, if the CFC uses such earnings to make an investment in certain US property, the earnings will be included in the US parent’s income and subject to regular US taxation. When the US parent sells its interest in the CFC, the participation exemption can apply to the portion of the gain that is recharacterized as a dividend.

There are new rules for the foreign tax credit.  Only 80 percent of foreign taxes paid on income that constitute GILTI are creditable, and there are no carryforwards for foreign tax credits associated with GILTI.  Foreign tax credits paid on income that constitutes NDTR or high-tax kickout income cannot be claimed if the earnings are distributed as a dividend (now exempt from taxation under the participation exemption), but can be claimed if the earnings are deemed to be repatriated because the CFC makes an investment in US property (income is now taxable).  The pooling approach to foreign tax credits was eliminated and foreign tax credits are now apportioned to income under an annual tracing rule. Where a CFC has no income in a given category for a year, foreign taxes paid with respect to that category in that year may be lost and never creditable against US tax.

The rules above are materially different for US individuals, partnerships, or S corporations.  The reduced tax rates for FDII and GILTI and the new participation exemption for high-tax kickout income and the NDTR are not available to taxpayers other than C-corporations.  For non C-corporation taxpayers, all income of a CFC other than NDTR and high-tax kickout income is subject to current US taxation at individual tax rates on ordinary income. Distributions of high-tax kickout income and NDTR are taxable as dividends and foreign tax credits cannot be claimed for foreign taxes imposed on CFCs – however, foreign taxes on the dividend distributions are creditable.  

Individuals that include GILTI or Subpart F income from CFCs usually can make an election to be taxed as though the CFC interest was held through a domestic C-corporation for purposes of taxing the inclusions in income (IRC § “962 election”).  Where a 962 election is made, the GILTI or Subpart F inclusion is subject to tax at the corporate income tax rate and foreign tax credits are available for foreign taxes paid by the CFC, subject to the 20 percent reduction for GILTI inclusions.  When the CFC distributes the income, it is subject to US tax to the extent the amount of the distribution exceeds the amount of US tax previously imposed. The 962 election is not available where the CFC stock is held through a partnership or S-corporation.  

 

TCJA Changes to Definition of CFC

A CFC is any foreign corporation if more than 50 percent of its voting power or value is owned by US shareholders on any day during the foreign corporation’s taxable year.  A US shareholder is any US person that is a 10 percent shareholder in the foreign corporation. Only US shareholders of CFCs are required to include Subpart F income and GILTI in their income.  Thus, a US person is not required to include Subpart F income or GILTI if their ownership in the CFC stock is less than 10 percent. For Subpart F and GILTI inclusions, the US shareholder only include their proportionate share of the items which do not include the percentage of ownership indirectly or constructively attributed in determining US shareholder status.

Under prior law, a US person had to own 10 percent or more of the total voting power of the CFC to be a US shareholder.  Under the TCJA, the US person is a US shareholder if they own 10 percent or greater of the total voting power or value of the foreign corporation.  

 

Partnerships

Many structures use partnerships or other transparent entities to own interest in foreign corporations.  Where a US partnership owns 10 percent or more in a foreign corporation, the partnership may now be required to recognize Subpart F and GILTI inclusions even though under the prior law the foreign corporation would not be a CFC.  In addition, if the partnership’s voting power is under 10 percent but its ownership in the value of the CFC stock is 10 percent or more, the partnership could now be a US shareholder of the CFC. The reduced tax rate for GILTI inclusions may be unavailable to a partnership unless it elects to be taxed as a C-corporation and therefore subjecting the partnership to multiple levels of taxation.  

The determination of whether to own the foreign corporation stock through a US corporation will depend on the foreign tax credits and the desirability of current distributions of profits.  Where the foreign tax credits are high enough, it may be tax efficient to treat the foreign corporation as a partnership for US tax purposes, avoiding the 20 percent haircut on foreign tax credits from GILTI inclusions.  In contrast, where the foreign taxes are low enough, it may be more tax efficient to hold the interest through a domestic C-corporation.

 

IRC § 338(g) Elections

Asset Protection Strategies for clients

Under prior law, a US acquirer would purchase a foreign target and the US acquirer would routinely make an IRC § 338 election that causes the target foreign corporation to be treated for US tax purposes as having sold all of its assets to a new corporation and liquidated.  The tax attributes of the target foreign corporation are eliminated and the target foreign corporation receives a step-up in the basis of its assets to fair market value. In the case of a domestic target corporation, the deemed asset sale would result in double taxation and was therefore undesirable to the domestic target corporation.  Under prior law, the target foreign corporation was often not subject to US taxation on the deemed asset sale so the IRC § 338(g) election was usually beneficial to the US acquiring company.

The elimination of tax attributes, such as earnings and profits and foreign taxes paid, would permit the acquiring company to determine the character of future distributions and related foreign tax credits more easily.  The step-up in basis allows additional amortization and depreciation deductions, which would reduce Subpart F income and, subject to limitations, possibly permit the parent to utilize more excess foreign tax credits than if there were no IRC § 338(g) election.  The IRC § 338(g) election would eliminate the risk that a purchaser would be required to include Subpart F income earned in the pre-acquisition period. The negative implications are the PTI accounts and foreign taxes paid would be lost, and any US property of the foreign target subject to the grandfather exception of IRC § 956 would lose its grandfather status for certain assets acquired before the corporation became a CFC.

Under the TCJA, the benefits and costs are significantly different, and so acquirers will need to reconsider the benefits of the IRC § 338(g) election.  The new participation exemption means that distributions out of the foreign earnings of the foreign target will not be subject to US taxation, and further eliminates the availability of foreign tax credits for those earnings.  Thus, retaining untaxed earnings and profits of a foreign target may be beneficial to the acquirer. Foreign tax credits paid will still be relevant to the extent that the foreign corporation makes an investment in US property.  Where the untaxed earnings of a foreign target were subject to sufficiently high foreign taxes, it may be beneficial for an acquirer to cause the target to invest in US property. Foreign subsidiaries of US companies may have significant PTI accounts, and the elimination of the PTI accounts is probably undesirable.  The step-up in asset basis also presents new considerations. The increased depreciation and amortization deductions may reduce the amount of Subpart F income and increase the GILTI generated by the foreign corporation. The increase in asset basis may increase the NDTR. Similarly, the elimination of the grandfather status for US property for purposes of IRC § 956 may be less significant of a cost, given, that many CFCs will have limited or no income other than GILTI or Subpart F income.  

 

Check the Box and Sell Transactions

Another common acquisition tactic was to have the foreign subsidiary check the box to be treated as a disregarded entity prior to sale which would cause the transaction to be treated as a sale of assets.  Under prior law, the sale of stock would be Subpart F income but the sale of assets would not. Under the TCJA, the same check the box election can be made but the treatment as an asset sale would likely generate GILTI income.  The reduced US tax rate for corporate US shareholders of CFC sellers is beneficial, but the GILTI inclusion will change the desirability of such structures.

 

IRC § 965 Deemed Repatriation Transition Tax

The TCJA imposed a one-time repatriation tax on the deferred foreign income of certain foreign corporations.  Certain US persons that owned interest in certain foreign corporations were required to take into account a one-time inclusion based on their aggregate deferred income of the foreign corporation.  This inclusion was subject to a reduced rate of US tax, at either 8 percent or 15.5 percent, depending on the cash position of the foreign corporation. This tax could be paid in annual installments over an eight-year period.  Given the potentially large transition tax liabilities of companies over the next several years, significant due diligence will be required to ensure that all such liabilities have been paid or appropriately reflected in the purchase price.  

The deemed repatriation transition tax (“DRTT”) was imposed on earnings of any “specified foreign corporation”, a term that includes both CFCs and any foreign corporation with respect to which one or more US corporation is a US shareholder.  This is broader than just CFCs and may not have been tracked by the US shareholder and the change to the constructive ownership rules increased the number of US shareholders in 2017 than in prior years.  Many companies with indirect minority holdings in a foreign corporation may not have access to the information necessary to determine whether the foreign corporation was a specified foreign corporation, or, if so determined, the amount of DRTT liability.

Many companies and individuals subject to the DRTT elect to pay the tax in eight annual installments.  The installment payments are back loaded, with the majority of the tax due in the final years, so material DRTT liabilities will continue throughout the eight-year period.  

 

Sales by CFC Subsidiaries of Foreign Corporations

Where a CFC disposes of stock in a foreign corporation in which the CFC is at least a 10 percent shareholder, the gain recognized by the CFC is treated as a dividend to the extent of the untaxed earnings of the foreign corporation accumulated while the CFC held the foreign corporation stock.  This deemed dividend likely will not result in US tax to the US shareholders under the new participation exemption. Where there is gain in excess of the amount treated as a dividend, such gain is usually Subpart F income. Under the TCJA, many foreign subsidiaries of CFCs are now CFCs. Therefore, dispositions of lower-tier stock by such CFCs may trigger deemed dividends, Subpart F income, and GILTI.

 

Foreign Derived Intangible Income (FDII) for Asset Acquisitions

Asset sales by US corporations may benefit from reduced rates of taxation.  If a US corporation sells assets to a foreign acquirer for use outside the US, gain from the sale should constitute FDII subject to a reduced federal income tax rate.  This may result in providing foreign purchasers with an advantage over domestic purchasers in acquiring targets heavy with intellectual property assets. This may also prompt US corporations to effect acquisitions through their CFCs rather than directly.  

 

Conclusion

The TCJA made significant changes to the US tax law.  The changes affect cross-border merger and acquisitions and there are many traps for the unwary.  Many structures that are now in place should be reviewed based on the changes to TCJA to see if the structure should be changed.  

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