The complicated new rules for multi-national businesses were one of the headlines of the new tax law. In this episode, Frazier & Deeter’s International Tax guru Mike Whitacre discusses the implications for U.S. businesses with foreign earnings as well as foreign companies with U.S. businesses. Passthrough entities with substantial foreign earnings should definitely give this podcast their undivided attention to hear about the scenarios they need to consider.
New International Tax Law Implications Podcast Transcript
This transcript was assembled by hand and may contain some errors.
It has been edited for readability.
This podcast was recorded on April 30, 2018
Bob: Hi, this is Bob Woosley with Frazier & Deeter and this is part of our Untangling the Technical podcast series, and today we’ve got a really interesting one. We’re talking with Mike Whitacre, an international tax partner, and we’re going to be talking about our new tax law in the United States and the impact for both domestic and foreign companies. Hi, Mike, how are you doing?
Mike: Good, how are you doing, Bob?
Bod: Good. So, before we get started here, tell us a little about yourself and what you do at the firm.
Mike: I’m a tax partner, as you mentioned. I have several U.S. based outbound clients, but I also do quite a bit of work with foreign companies coming into the U.S. I probably spend 12 to 15 weeks a year over in Europe meeting with European clients coming into the U.S.
Bob: From what I understand this is the most comprehensive law we’ve passed in what, how many years?
Mike: Over 30 years, since the 1986 tax act. A big part of the fundamental change is the international provisions in the new law.
Bob: Which we’ve heard a lot about on all the talk shows, and what we’re hoping today is that you’re going to give us a high level view point of it. Maybe we can break it down. The way my mind works, you have two buckets: the U.S. companies doing business abroad and then international companies making decisions about doing business in the United States. Let’s go with the first one, what’s your view point on the impact of this law on U.S. companies that are doing business abroad?
Mike: A lot of the provisions in the new law really relate to C-Corporations. You need to look at whether you’re a C-Corp or a Pass-Through, Partnership or an S-Corp or an LLC, and it has different impacts on them. But one of the big things is if you have accumulated foreign earnings overseas. Historically that was not taxed until you brought it into the U.S. But the first step of this new law is through the end of 2017, any accumulated earnings are being taxed, and actually the first payments are due with the companies’ 2017 tax returns, so that’s a current issue right now.
Bob: People are filing those right now.
Mike: Correct. Now, you can pay that tax in over 8 years, but it starts right now. That’s step one, to basically tax the accumulated earnings that have not been brought back into the U.S. And then we move to this new system called the Participation Exemption Regime, which is similar to what most of the rest of the world does. Going forward, the income you make in your foreign subsidiaries is not taxed when it comes back. So that’s a big change. Those are the two big initial steps in the change in the tax law.
Bob: So let me make sure I understand, you have a C-Corporation that has accumulated taxable income but it is foreign, they obviously have domestic as well, so this tax law says, okay, enough with that, we’re going to tax it. But you have 8 years to pay it.
Mike: Yes, tax is due on accumulated earnings through 2017.
Bob: So your first payment is this year and you have 8 years, this is like an installment payment?
Mike: Yeah, you can pay it over 8 years.
Bob: And there’s no way for a company to get out of that, right?
Mike: No, but it’s a lower tax rate than standard. 15.5% on your cash assets and 8% on your non-cash assets. So it’s kind of a break, but you have to pay the tax.
Bob: So a lot of what our clients are talking about is how this is a good thing for the United States economy because it repatriates that money back.
Mike: It repatriates that money back, but I think bigger than that, it allows companies to move that money around into more productive areas. They could move it other countries, or to the U.S. or whatever. Before, they were hesitant to do that, because they had to pay the higher U.S. tax when they brought it back in. That’s all gone now.
Bob: So is this the end of tax haven countries?
Mike: I think the U.S. would like it to be. We’ll get into that further as we go along here, but I think that’s one of the goals, absolutely, to keep the business in the U.S.
Bob: Which is a good thing. You mentioned C-Corporations, now were you going to talk about passthroughs?
Mike: If you’re a passthrough entity, which is an S-Corporation or a partnership or an LLC, generally, the participation exemption is really not relevant, does not apply. Because you are a passthrough when you bring the money back in, you’re going to get taxed on it. Just like the “old days,” last year, the repatriation aspect is relevant because if you’re a passthrough owning foreign subs, you’re going to be subject to that same tax, except there is a division for S-Corporations that they can essentially avoid paying that tax until they have a significant transaction, which is really selling the company down the road.
Bob: Okay. I heard that some people are thinking about converting to a passthrough because of this?
Mike: Well if anything, it’s probably the opposite; they’re probably looking at going the other way.
Bob: To get the lower rate?
Mike: To get the lower rate, and then there’s some other aspects that we’re going to talk about I think in a minute that passthroughs don’t really benefit from.
Bob: Okay, that’s excellent. Well, tell us, what are the two or three points you want our listeners to understand about this as it relates to domestic corporations?
Mike: I think beyond the repatriation, the participation exemption, the two big unusual new regimes out there are, one is called GILTI, Global Intangible Low-Taxed Income. What it essentially says is, if you have offshore foreign subsidiaries, we’re going to put a minimum tax on that, even if you don’t bring it back in. Essentially what that equates to is if you’re paying 13% tax in your foreign country subsidiary, you’ll have this income but you won’t pay any tax because of the foreign tax credit.
But that’s kind of the “stick” approach, back to what we were referring to earlier, where if you have valuable businesses offshore, they’re telling you “we’re going to tax you,” put a minimum tax on it to encourage you to put it back in the U.S. And the second leg to this is called FDII, or Foreign Derived Intangible Income. This is the carrot to either keep your business activities in the U.S. or move them back, potentially. And what that says is if you keep it in the U.S., we’re going to only charge you a 13.125% tax rate.
So if you think about all that, a lot of these companies, for the last 30 years, have spent a lot of money, a lot of time structuring themselves offshore to reduce their taxes. And essentially what the U.S. is saying is, hey, just keep that here, and we’re only going to charge you 13% on those types of things.
Bob: It gives them a real incentive not to take it offshore. So FDII is the incentive part and GILTI is the stick part. That’s interesting. So, we talked about FDII and GILTI, but I’ve heard about this other thing called BEAT that’s kind of an alternative minimum tax calculation. Can you talk a little bit about that?
Mike: Sure, so BEAT stands for Base Erosion anti-Avoidance Tax, and what that’s targeted at is U.S. companies making substantial payments out of the country to related parties. This impacts foreign owned U.S. companies, but it could also affect U.S. companies making payments out to foreign subsidiaries. Basically, it only applies if the U.S. group has over $500M in revenue and these payments are equal to at least 3% of the group’s revenues, and those payments do not include cost of goods sold. So if the U.S. company is buying a product from its foreign parent, for instance, it doesn’t count. There’s also some transfer pricing payments that are allowed under the rules too, but basically it’s an alternative minimum tax calculation for U.S. companies and if they have a lot of these payments going out, you add them back to your taxable income, we’ll run a 10% tax rate on it. If it’s higher than your regular tax, then you’re going to owe that higher alternative tax.
Bob: So, BEAT sounds like a mechanism to catch those large payments going out to related foreign entities, like a royalty payment, so you’re not undershooting your U.S. income tax liability.
Mike: But let’s go back to the passthroughs for a second here, so the passthroughs have to pick up this income, but just because of the quirks in the law, for instance, under GILTI, they do not get the 10.5% rate because that rate is only for C-Corporations. They have to pick up that income in the U.S., but the other issue is because it is foreign sourced income, it was recorded in their foreign subsidiary, they have to pay the full tax rate, and as a passthrough that may be 37%. So this little aspect is 10.5% for C-Corporations and 37% for passthroughs, and they do not get the 20% qualified business income deduction because it’s not domestic income.
Bob: Okay, so I bet companies around the country and your clients, you’re running scenarios looking at their foreign and domestic earnings and you’re running which form of entity I should be, what are the tax impacts here. What are some of the strategies that you see they’re doing if they get into the bad spot?
Mike: Well, I think the big takeaway here is that the GILTI outcome is bad for a passthrough because they’re paying 37% versus 10.5. But on FDII, if they get the 20% qualified business income deduction, they’re paying essentially 30%, which is the regular rate, but they don’t get the break of the 13% rate. They’re not getting penalized, they’re paying the normal rate on that income. I think the big thing that passthrough companies that have a lot of foreign income should look at, is do we need to be a C-Corporation. And the outcome of that is just totally dependent on the characteristics of that particular company.
Bob: And being a C versus a passthrough has other ramifications, like when you sell your company, and so you have to take look at a broad picture. C-Corporation stock may not work as well as a passthrough.
Mike: Right. That’s why it may not make sense to convert to a C even if the tax rate is a lot lower currently because when you sell your company, eventually being a passthrough is a substantial benefit. But companies should look at this just so they understand what’s going on, and there may be a reason to switch to a C-Corporation depending on their situation.
Bob: So, Mike, what I hear you saying there is you better look at your situation. Look at it in a broader spectrum, not just because of this tax law, but certainly because of this tax law.
Mike: Correct, and I think most or all of this is generally beneficial for C-Corporations, but if you’re a passthrough, you definitely need to look at what’s going on and make sure you understand how you’re impacted.
Bob: You and I were talking before we started recording about foreign companies and their view on this, they may be looking at setting up an operation in the United States, maybe not, but talk to me a little bit about what they were thinking before this tax law and what impact this tax law might have on their decisions.
Mike: Beyond taxes, obviously, it’s a big economic decision. I think the last several years, foreign companies have looked very favorably at the U.S. because it’s the biggest market in the world, the economy has been growing probably faster than most of the rest of the world, or at least steadily, and that’s been enticing to foreign owned companies. But I think now because most of them are structured as C-Corporations, they’ll benefit from this drop in tax rate from 35 to 21. For those companies who are on the fence, I think this is a big inducement for them to come in and go ahead and set up a business in the United States.
Bob: So clearly, that was one of the goals of the tax law, by reducing the rates, it provides incentives for you to stay. And now you have international companies that might have a greater incentive because part of their incentive is a lower tax rate.
Mike: Right, and that was talked about for years, where the U.S. had the highest tax rate of all the industrialized nations, and everyone realized that that was a competitiveness problem. That was a big driver behind trying to get that corporate tax rate down to make it more attractive for foreign companies to come into the U.S. or for U.S. companies not to take their business outside of the U.S.
Bob: Well this is fascinating; this tax law’s got more entanglements than I had originally thought. I know we have some published information on our website, www.frazierdeeter.com, and Mike, give us your email address.
Mike: My email address is firstname.lastname@example.org.
Bob: Before we finish up, is there anything unsettled about the law that you’re looking for guidance on or do you pretty much know what you need to do with a client right now?
Mike: I think generally people know what they need to do, but because this was such a comprehensive change and it was moved so quickly through congress to get it done, there’s a lot of devil in the details. The tax practitioners are waiting to get clarification on the mechanics of a lot of these things, and the IRS is putting out notices on a regular basis trying to provide guidance. But I think generally, from a big picture, everyone understands what the outcomes of these new rules are, it’s just an implementation issue more than a strategic one.
Bob: As you’re helping clients implement over the next 6, 8, 9 months or longer, maybe we could ask you to come back. Maybe 3 or 4 months from now you can tell us some horror stories, would that be okay?
Bob: Well great, Mike, we appreciate it, and thanks to all our listeners.