Income from inventory produced in the U.S. and sold abroad is no longer eligible for split sourcing but must be fully U.S.-sourced.
That rule change is among the many modifications in the Tax Cuts and Jobs Act (TCJA). Unless otherwise noted, the changes mentioned in this article are for tax years beginning after December 31, 2017.
Sourcing income from sales of inventory
Prereform. In determining the source of income for foreign tax credit purposes, up to 50% of the income from the sale of inventory property that was produced within the U.S. and sold outside the U.S. (or vice versa) could be treated as foreign-source income.
New law. Gains, profits and income from the sale or exchange of inventory property produced partly in and partly outside the U.S. must be allocated and apportioned on the basis of the location of production with respect to the property.
For example, income derived from the sale of inventory property to a foreign jurisdiction is sourced wholly within the U.S. if the property was produced entirely in the U.S., even if title passage occurred elsewhere. Likewise, income derived from inventory property sold in the U.S., but produced entirely in another country, is sourced in that country even if title passage occurs in the U.S. If the inventory property is produced partly in and partly outside the U.S., the income derived from its sale is sourced partly in the U.S.
Fair market value of interest expense apportionment
Prereform. Taxpayers had to determine U.S.-source and foreign-source income for various purposes. The Internal Revenue Code provides rules for allocating interest, etc., for those purposes.
New law. For purposes of such determinations, members of a U.S.-affiliated group can’t allocate interest expense on the basis of the fair market value of assets. Instead, the members have to allocate interest expense based on the adjusted tax basis of assets.
Stock compensation of insiders in expatriated corporations
Prereform. An excise tax was imposed on the value of the specified stock compensation held by disqualified individuals if a corporation expatriated and gains on any stock in the expatriated corporation were recognized by any shareholder in the expatriation transaction. The excise tax was 15% of the value of the specified stock compensation.
New law. For corporations becoming expatriated after the reforms are enacted, the excise tax on stock compensation in an inversion is increased from 15% to 20%.
Deduction denied for certain related-party payments
Prereform. No deduction was allowed for losses from sales or exchanges of property (except in corporate liquidations), directly or indirectly, between certain related persons. There was no explicit disallowance of a deduction for any disqualified related-party amount paid or accrued under a hybrid transaction or by, or to, a hybrid entity. A disqualified related-party amount is any interest or royalty paid or accrued to a related party to the extent that:
- There is no corresponding inclusion to the related party under the tax law of the country of which such related party is a resident for tax purposes, or
- Such related party is allowed a deduction with respect to such amount under the tax law of such country.
New law. There’s no deduction for any disqualified related-party amount paid or accrued pursuant to a hybrid transaction or by, or to, a hybrid entity. In general, a hybrid transaction is one that involves payment of interest or royalties that aren’t treated as such by the country of residence of the foreign recipient. And, in general, a hybrid entity is an entity that is treated as fiscally transparent for federal income purposes but not for purposes of the tax law of the foreign country, or vice versa.
Surrogate foreign dividends
Prereform. Qualified dividend income was taxed at capital gains rates, rather than as ordinary income. Generally, qualified dividend income includes dividends received during the tax year from domestic corporations and qualified foreign corporations.
New law. Any dividend received by an individual shareholder from a corporation which is a surrogate foreign corporation (other than a foreign corporation that is treated as a domestic corporation), and which first became a foreign surrogate corporation after the date the reforms are enacted, isn’t entitled to the lower rates on qualified dividends.
Restriction on insurance business exception to PFIC rules
Prereform. U.S. shareholders of a passive foreign investment company (PFIC) were taxed on the PFIC’s earnings. An exception to this rule applied to certain income derived in the active conduct of an insurance business.
New law. The test based on whether a corporation is predominantly engaged in an insurance business is replaced with a test based on the corporation’s insurance liabilities. Under the provision, passive income for purposes of the PFIC rules doesn’t include income derived in the active conduct of an insurance business by a corporation:
- Subject to tax if it were a domestic corporation, and
- For which the applicable insurance liabilities constitute more than 25% of its total assets as reported on the company’s applicable financial statement for the last year ending with or within the taxable year.
For a no-obligation discussion on the possible impact and steps you should take now, contact Lien Le, the head of our International Tax practice.