Two possible approaches
The discussion draft envisions two possible approaches (described as “Option Y” and “Option Z”), each of which would represent a substantial change in how the United States taxes international operations of U.S.-based corporate groups through controlled foreign corporations.
Notably, neither option describes any current proposals to change the treatment of foreign income earned through a branch or partnership—as under current law, those amounts would remain fully subject to U.S. tax (with possible reduction due to foreign tax credits).
In addition, the discussion draft proposes certain changes to be made regardless of which option is adopted.
Summary of Option Y
Under current law, income earned by “controlled foreign corporations” benefits from deferral (i.e., it generally is not subject to U.S. tax until distributed to a U.S. shareholder) unless that income is specified as a form of “subpart F income.”
Option Y would retain the notion of defining specific classes of income as subpart F income that are subject to immediate U.S. taxation, but would change the treatment of the residual class from deferral to complete exemption—no U.S. tax would be imposed on such earnings when earned or when distributed.
Under Option Y, however, the definition of subpart F income would be substantially modified to include income subjected to a foreign tax rate of less than [a rate to be determined, tentatively set at 80%] of the U.S. corporate tax rate, as well as income generated with respect to services rendered to U.S. persons or property that is or will be imported into the United States.
Summary of Option Z
Option Z differs from both current law and Option Y in providing for the immediate inclusion of all income of a controlled foreign corporation by its U.S. shareholders.
Option Z also defines a favored class of income as “active foreign market income,” which benefits from a deduction [tentatively set at 40%] when computing the amount included in the U.S. shareholder’s taxable income (in effect, subjecting such income to a 21% effective rate of U.S. tax, assuming that the corporate rate remains at 35%).
Broadly speaking, “active foreign market income” would consist of income derived by the controlled foreign corporation from trade or business activities to which the officers and employees of the corporation substantially contributed by engaging in economically significant activities outside the United States.
Similar to Option Y, this favorable treatment would not be available for income generated with respect to services rendered to U.S. persons or property that is or will be imported into the United States.
Note that under Option Z, unlike either current law or Option Y, it would be the residual class that would be subject to full and immediate U.S. taxation.
Foreign tax credits
Under each option, foreign tax credits would remain available to offset U.S. tax liability with respect to foreign source income that is included in the U.S. tax base.
Under Option Y, the foreign tax credit limitation would be computed separately for each of six categories of income, while under Option Z, there would be only three categories.
Under Option Y, no foreign tax credit would be available with respect to distributions from a controlled foreign corporation that qualify for complete exemption.
Similarly, under Option Z, foreign tax credits attributable to “active foreign market income” would be reduced by 40% to reflect the partial exclusion of such income from the U.S. tax base.
Both Option Y and Option Z would apportion a fraction of a U.S. shareholder’s interest expense to exempt income of its controlled foreign corporations (i.e., the wholly exempt income of Option Y or the [40%] portion of “active foreign market income” of Option Z) and would permanently disallow such amounts. Such apportionment would be done on a group-wide basis.
Other provisions (common to or independent of Options Y and Z)
- Transition rules - As a transition rule applicable to either option, accumulated deferred earnings of a controlled foreign corporation would be includible by its US shareholders and subject to a 20% tax, payable in installments over eight years.
- Treatment of intangibles - The draft would expand the definition of intangible property in the international context to include going concern value and goodwill, as well as any item the value of which is not attributable to tangible property or the services of an individual. The provision also clarifies the IRS authority to choose the method of valuation of intangible property—for example, valuing multiple intangibles on an aggregate basis or using the “realistic alternative principle” in determining the arm’s length price for a transfer or license of intangibles.
- Base erosion transactions - The discussion draft includes a complex provision designed to prevent reduction of the U.S. tax base through the use of payments to related parties involving structures intended to avoid foreign tax on such payments. Broadly speaking, the draft seems to be intended to reach (but is not explicitly limited to) payments that would avoid U.S. withholding (for example, due to a recipient’s entitlement to treaty benefits) while simultaneously avoiding foreign taxation. The transactions targeted are those involving:
- A hybrid transaction or instrument
- A hybrid entity
- An exemption arrangement (generally defined as any provision of foreign law that has the effect of reducing the generally applicable statutory rate of foreign income tax by 30% or more), or
- A conduit financing arrangement
- Other issues - The discussion draft would treat as corporations all business entities wholly owned within a group of controlled foreign corporations. In effect, this would repeal the “check-the-box” rules for foreign entities that exist entirely within a single group. The draft would also repeal the “portfolio debt” rules and subject all interest paid by domestic corporations to foreign persons to withholding at 30% except to the extent reduced or eliminated by treaty.
Other areas that would be changed by the draft include the treatment of dividends from so-called “10-50 corporations;” various aspects of the passive foreign investment company rules; FIRPTA rules dealing with foreign pension plans; U.S. real property holding companies and REITS; the sourcing of income from inventory sales; sales of interests in partnerships engaged in a U.S. trade or business; and reinsurance transactions with foreign affiliates.
In addition, the temporary (but repeatedly extended) look-through rule allowing deferral on payments of interest, dividends, and royalties that has been in place since 2005 would be allowed to expire, while the active financing exception to subpart F income would be made permanent.
The special regime for domestic international sales corporations (DISCs) would be repealed, as would be the rules governing dual consolidated losses.
For more information, contact a tax professional with KPMG’s Washington National Tax:
+202 533 3127
+202 533 3022