Robert O’Neil, CPA explains the key changes to foreign income taxation under the “Tax Cuts and Jobs Act.”
The new tax law under the “Tax Cuts and Jobs Act” passed just before the end of the year, resulted in a lot of changes mostly taking effect as of 1/1/2018. In addition to the many changed provisions that impact most US Taxpayers, there were also several key changes to foreign income taxation. This article will focus on those changes that impact the small business and individuals who have foreign income sources and may be impacted by these new rules.
The first change is to the repatriation or bringing income earned outside the US back into the US. Generally, under the pre-act rules, a US Person that owns a foreign corporation does not pay tax on the foreign corporation’s income until repatriated back to the US Person in the form of a dividend. Under the new law, there will be a deduction for these dividends received to relieve the tax burden companies’ face when bringing the foreign income back into the US. This deduction is only available to most C Corporations (excluding real estate investment trusts and regulated investment companies) that have a 10% or greater ownership in the foreign corporation. In addition, there are holding periods that apply to how long the US Corporation must hold the foreign stock to be eligible for the deduction.
In addition to some of the more complex changes to foreign income and taxation, the act further modified some existing definitions and rules relating to controlled foreign corporations (CFC). Prior to 2018, a US Shareholder of a CFC had to own 10% or more of the combined voting power of all classes of stock. The new rule is based on 10% or more of the total value of shares of a foreign corporation. Next, under the pre-2018 rules a foreign subsidiary was considered a CFC if greater than 50% of its stock is owned by US persons, each owning a minimum of 10%. Constructive ownership in this case did apply, however, it did not include attributing stock a foreign person held in the calculation of a US owners interest if they were related. Under the new rules the constructive ownership has been modified to include the foreign related person’s interest in calculating whether the US person constructively owns more than 10%. Last, the 30 day minimum holding period for a US parent to be considered an owner of a CFC for the tax year has been removed. Therefore, a US parent will be subject to US tax on its subpart F income in the year it is earned regardless of time held.
The last rule this article will discuss is the change to the calculation of the foreign tax credit limitation. In general, a taxpayer is allowed a tax credit for the foreign taxes they pay on their foreign source income. The limitations are that the tax credit is the lessor of the US taxes on their foreign income or the foreign taxes they actually paid. However, in the case where a taxpayer had their foreign income wiped out by US losses they would not be allowed a tax credit in that year for those foreign taxes paid. Instead they would be required to carryforward the foreign taxes paid to be used as a credit against future foreign source income. This can create an issue where the taxpayer may never be able to claim the credit. To help avoid this, a taxpayer prior to 2018 could in the following years treat up to 50% of their US source taxable income to the extent of the foreign source income lost as foreign source income. Therefore allowing the taxpayer the ability to recognize the foreign tax credits lost in the loss year. The change for 2018 through 2027 is that the new act swaps the 50% for 100% of US source taxable income.