The Tax Cuts and Jobs Act (TCJA) includes provisions relating to base erosion and creates a base erosion antiabuse tax (BEAT).
The far-reaching legislation also contains stipulations on income shifting and foreign tax. Unless otherwise noted, the changes apply to years starting after December 31, 2017.
Base erosion refers to payments between a domestic corporation and related foreign parties that are deductible for U.S. tax purposes. While a withholding tax applies to many such payments, treaties frequently reduce the withholding tax and, at times, eliminate it. If a withholding tax doesn’t apply, deductible payments of interest, royalties, and management fees reduce the U.S. tax base.
Prereform. There was no minimum tax that had to be paid on certain deductible payments to a foreign affiliate.
New law. For base erosion payments paid or accrued, certain corporations with average annual gross receipts of at least $500 million must now pay a BEAT equal to the base erosion minimum tax for the tax year.
For any tax year beginning before January 1, 2026, the base erosion minimum tax is the excess of 10% of the modified taxable income of the taxpayer for the tax year,
- Over an amount equal to the regular tax liability reduced (but not below zero) by the excess (if any) of credits, and
- Over an amount that includes the general business credit allowed for the tax year allocable to the research credit.
For tax years beginning after December 31, 2025, the tax is 12.5% of the modified taxable income of the taxpayer for the tax year — over an amount equal to the regular tax liability of the taxpayer for the tax year.
In other words, the regular tax liability is reduced by an amount equal to all credits allowed, including the general business credit.
Members of affiliated groups that include a bank or securities dealer will pay the BEAT tax at an 11% rate, increasing to 13.5% after 2025.
“Modified taxable income” means the taxable income of the taxpayer. It is determined without regard to any base erosion tax benefit with respect to any base erosion payment, or the base erosion percentage of any net operating loss deduction allowed.
A “base erosion payment” generally means any amount paid or accrued by a taxpayer to a foreign person that is a related party to which a deduction is allowable. This includes any amount paid or accrued to the related party in relation to the taxpayer’s acquisition from the related party of property of a character subject to the allowance of depreciation (or amortization).
Excluded are any amounts paid or incurred for services that don’t contribute significantly to fundamental risks of business success or failure and are the total services cost with no markup.
There is also an exception for certain derivative payments made in the ordinary course of a trade or business.
Foreign tax credit system
The new law also makes modifications related to the foreign tax credit system:
Prereform. A U.S. corporation that owned at least 10% of the voting stock of a foreign corporation was allowed a deemed-paid credit for:
- Foreign income taxes paid by the foreign corporation that the U.S. corporation treated as having paid when the income on which the foreign tax was paid was distributed as a dividend, and
- Foreign taxes paid by the controlled foreign corporation on the portion of its earnings that the U.S. shareholder was required to include in income under Subpart F.
New law. No foreign tax credit or deduction is allowed for any taxes (including withholding taxes) paid or accrued with respect to any dividend to which the deduction for the foreign-source portion of dividends applies. This is for tax years of foreign corporations that begin after December 31, 2017, and for tax years of U.S. shareholders in which or with which such tax years of foreign subsidiaries end.
A foreign tax credit is allowed for any subpart F income that is included in the income of the U.S. shareholder on a current year basis.
Separate basket for foreign branch income
Prereform. The foreign tax credit limitation was calculated separately for two categories (or “baskets”) of income:
- Passive, and
- General category.
New law. Foreign branch income must be allocated to a specific foreign tax credit basket. “Foreign branch income” refers to the business profits of a U.S. person that are attributed to one or more qualified business units in one or more foreign countries.
Foreign tax credit limitation
Prereform. For purposes of the limitation on the foreign tax credit, if a taxpayer sustained an overall domestic loss for any tax year, then, for each succeeding year, an amount of U.S.-source taxable income was recharacterized as foreign-source income if it was lower than:
- The full amount of the loss to the extent not carried back to prior tax years, or
- 50% of the taxpayer’s U.S.-source taxable income for that succeeding tax year.
New law. For any tax year of the taxpayer that begins after December 31, 2017, and before January 1, 2028, the taxpayer may, with respect to pre-2018 unused overall domestic losses, elect to substitute, for the above 50% amount, a percentage greater than 50% but not greater than 100%.
Limits on income shifting through intangible property transfers
Prereform. A U.S. person that transferred intangible property to a foreign corporation in an otherwise nonrecognition transaction was generally treated as having sold the property in exchange for payments contingent on the property’s productivity, use or disposition. In these cases, the U.S. transferor included an amount in income each year, over the useful life of the property.
New law. The changes address recurring issues of definition and methodology that have arisen in controversies over transfers of intangible property that use the statutory definition of “intangible property.”
The definition is revised and the IRS authority to require certain valuation methods is confirmed. The basic approach of the existing transfer pricing rules with regard to income from intangible property remains unchanged. Workforce in place, goodwill (both foreign and domestic), and going concern value are intangible property, as is the residual category of “any similar item” the value of which isn’t attributable to tangible property or the services of an individual.
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.