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Home >> TII EDIT
By D P Sengupta
Jan 29, 2018

YOU can't beat the Americans in making complex regulations in the name of simplification and of course in inventing ever new acronyms that they would want everybody else to understand and use. By all means the 2017 tax reforms are historic and perhaps more radical than even the 1986 Regan reforms. To whose benefits though, there is a raging debate going on. We now get to see on TV, President Trump signing some important bills and what impressed me in particular is the thickness of the tome that he had placed on the table. I have since downloaded the document. It contained 503 pages of actual text!

The Bill was initially tabled in the House by the republicans as the Tax cut and Jobs Act. Apparently, President Trump wanted it to be called 'The Cut Cut Cut Act'. But, finally, the Bill is without a title to overcome some arcane rules that would have allowed a democratic filibuster and is now known as Public Law no: 115-97.

On the individual tax front, the Act reduces the number of brackets from the current 7 to 5. The highest tax rate is set at 37.5% as compared to the earlier 39%. So, there is not any significant change there. Of course, the standard deduction has been increased.

It is in the area of corporate tax that the significant changes have taken place. The most important of such changes is the headline rate of taxation. Till now, in the USA, corporates were being taxed in a progressive manner as follows:

Taxable income

Tax rate

< $50000








Besides, an additional 5% tax was imposed on a corporation's taxable income in excess of $100,000, the maximum additional tax being 11750; a second additional 3% tax was also imposed on a corporation's taxable income in excess of 15 million USD.

It has been argued that the top headline rate of 35%, for US companies is one of the highest in the world and has made these companies uncompetitive and resulted in their investing abroad rather than in the USA. It is a different matter that the effective tax rate paid by US Corporation was only about 24%. Under the new law, the corporate tax rate has been made flat and fixed at 21%. (The President in his campaigns had wanted the maximum at 15%).

At the same time the AMT which was more or less like the Indian MAT has been abolished for the corporates. The AMT for others however, continues although with an increase in threshold. There is also the provision for 100% depreciation for capital expenditure on plant and machinery for five years, after which it tapers off.

The underlying philosophy for such massive tax cuts and benefits for the corporate sector is that it will encourage companies to invest more and thereby create jobs in the USA. While this is likely to have ripple effect and demand for competitive tax cuts elsewhere, it will be instructive to remember that corporate tax accounts for only 9% of total federal tax revenue.

In India, we mostly had a flat tax for corporates. Even in India, the FM had promised to reduce corporate tax for domestic companies to 25% over a period of time. Since our dependence on corporate tax is rather heavy, the promise could not be entirely fulfilled with the result that now we have the 25% tax rate for companies having turnover or gross receipts in the previous year 2015-16 up to INR 50 crores. Above that limit, the headline rate continues to be 30%. Of course, there are surcharge and cess that also vary according to income levels. The headline rate for foreign companies continues to be 40%. The budget is just a few days away. One has to see whether the FM follows the US example in this regard.

The other significant change in the tax system of the USA is the introduction of the so-called territorial system as opposed to the worldwide taxation system followed till now. In a territorial system, income that accrues only within a country is taxed and foreign incomes are not taken into consideration. There are only few countries that follow a pure territorial system, the main ones being Hong Kong, Malaysia, Panama and a few others. Countries following a pure territorial system may pose significant challenges for other countries if they allow foreign firms to be easily formed there that can then show foreign incomes, which will not be taxed.

So far the USA has followed a hybrid system under which US companies were taxable on their worldwide income. But the income of US subsidiaries were not taxed till such time as these were not repatriated. This was known as the deferral system. American multinationals used to complain that this system made them uncompetitive as their European and Asian competitors followed a territorial system. Actually, countries such as Germany, UK follow what is known as participation exemption. If a company receives dividend from the various subsidiaries abroad, that dividend is often not taxed in the capital exporting country subject to fulfilment of certain conditions. So, it is not correct to say that these countries were following a territorial system. [It may be noted in this connection that even In India from 2012, foreign dividends received by Indian companies from 26% owned foreign subsidiaries are taxed at a concessional rate of 15% in terms of section 115BBD of the Income Tax Act.]

The USA has now changed its rules in the same direction although not entirely. Only foreign-source dividends received from a foreign corporation that is not a CFC and that is owned at least to the extent of 10% by a US Corporation will henceforth be entitled to a 100% deduction in the USA. This is known as the dividend received deduction (DRD). The provision applies in respect of distributions made after 31.12.2017.

According to the explanation to the Act, a domestic corporation is not permitted a DRD in respect of any dividend on any share of stock that is held by the domestic corporation for 365 days or less during the 731-day period beginning on the date that is 365 days before the date on which the share becomes ex-dividend with respect to the dividend. For this purpose, the holding period requirement is treated as met only if the specified 10-percent owned foreign corporation is a specified 10-percent owned foreign corporation at all times during the period and the taxpayer is a U.S. shareholder with respect to such specified 10-percent owned foreign corporation at all times during the period.

Besides, the DRD is also not available if the dividend is a hybrid dividend. A hybrid dividend is an amount received from a controlled foreign corporation for which it received a tax deduction (or other tax benefit) in any foreign country.

No foreign tax credit or deduction is allowed for any taxes paid or accrued with respect to any portion of a distribution treated as a dividend that qualifies for the DRD.

Deemed repatriation:

And what about the past profits of US MNCs that are supposedly stashed offshore variously estimated at trillions of dollars? As a onetime measure, these will be deemed to be repatriated and then taxed at a concessional rate in the hands of the US shareholder. The US shareholder will thus have to pay the tax whether or not the amount has actually been repatriated. It is stipulated that the US shareholder will have to include pro rata non-previously taxed post- 1986 foreign earnings of the foreign corporation. The rate of tax will depend on whether the stash is held in cash or other liquid assets or in other illiquid forms. The tax is 15.5% on liquid assets and 8% on illiquid assets. Since the tax is substantially more on liquid assets. therefore, in order to prevent conversion of liquid assets to illiquid assets in the interim it has been provided that the base for calculating the deemed repatriation will be the earnings and profit amounts as on 2nd November 2017 and 31st December, 2017 whichever is earlier. The US shareholder can opt to pay the tax amount over a period of up to 8 years.

Thus from 2018, foreign source dividends repatriated from foreign companies doing active business overseas will be tax exempt. CFCs rules (Sub-part F) will however remain.

Taxation of intangibles- GILTI and FDII

The importance of intangibles in the ultimate productivity and profitability is acknowledged across the world. A firm's competitiveness depends on its expenses on intangibles. However, the intangibles are by definition mobile and MNC firms have been quick to locate much of their valuable intangibles to low tax jurisdictions resulting in base erosion both in the source and residence countries. This is a cause of concern but has resulted in curious responses by different jurisdictions. Thus, even when the BEPS project was ongoing, many countries introduced patent boxes that gave preferential tax treatment to intangible income. IP regimes were identified as harmful in the interim BEPS Action 5 report of 2014. Subsequently, agreeing to suggestions from UK and Germany, the OECD introduced the so called modified nexus approach in Action 5 that now requires that the patent boxes should comply with the substance requirement.

The US companies have been the master players in the game of intangibles. The use of Ireland, Netherlands by Apple, Google and others is now known to all. In its tax reforms, the USA has adopted a twofold approach in respect of intangibles. On the one hand, there is the provision for a reduced rate for income from intangibles. On the other hand, it has introduced a new tax liability for US CFCs' intangible related profits that do not currently come under sub-part- F rules. It is called Global Intangible low taxed income (GILTI). GILTI is defined in the newly introduced provision of section 951A of the IRC. Tax on GILTI is payable on current basis by the US shareholders. There is a high tax exception though.

The method of calculation of GILTI is complicated and involves identifying the CFC's qualified business asset investment (QBAI). The effort is to separate the tangible assets of a company and identify the intangible ones. The GILTI income of a CFC is included in the income of the shareholder and then there is a deduction available only for the corporate shareholders under section 250 of the Revenue Code that is 50% for years up to the year 2025 and 37.5% from 2026 with the result that the tax payable on GILTI income is 10.5% (50% of 21%) and 13.125% respectively. In case the CFC has paid foreign taxes, the shareholder will get a credit to the extent that such tax relates to the GILTI income. However, the tax credit is limited to 80% of the relevant tax paid by the CFC.

In short, the GILTI provision seems to translate the assertion by the USA during the BEPS project that the intangible incomes of its multinationals held overseas properly belong to the USA for taxation. Remember that Robert Stack from the earlier administration had stated: "I agree that, right now under our tax system, a lot of money is trapped in tax havens. No doubt about it. And that is the tax reform we need to do, but it's not necessarily the case that you need to pull that income into countries where digital companies have markets."

The other important aspect of taxation of intangibles is the deduction to be given for development of such intangibles that ultimately result in income streams. This is given through an incentive called the foreign derived intangible income (FDII). Again there is a complex calculation that requires finding out the company's deemed intangible income and then the foreign derived intangible income. As in the case of GILTI income, section 250 then allows a deduction that is 37.5% of FDII for years up to 2025 and 21.875% thereafter. As a result the effective tax on such income will be 13.125% and 16.406% respectively (assuming the headline tax rate to remain at 21%). The interesting aspect of this incentive is that it is targeted at export income alone.

Even before the passing of the bill, the Finance Ministers of France, Germany, Italy, Spain and the UK had complained to the treasury Secretary that this measure will amount to subsidizing exports and that the design of the regime was different from the accepted IP regimes.

It may be recalled that under the modified nexus approach of Action 5, the only IP assets that could qualify for tax benefits under an IP regime are patents and other IP assets that are functionally equivalent to patents. Besides, the incentive should also be limited to the R&D activities performed by the taxpayer or unrelated parties. The US legislation does not do so.

Although India has also gone ahead and put in place a patent box regime in section 115BBF of the IT Act that taxes royalties from patents developed and registered in India at a concessional rate of 10%, it is complaint with the recommendations of Action 5.

One has to therefore see how other countries react. Even though US participated and in fact dictated the BEPS project (perhaps to ensure that its interests are protected), it has not signed the MLI saying that it was already compliant of all the BEPS minimum requirements. It is unlikely though that the USA would change its regime.

The BEAT tax

And that brings us to the American response to the base erosion issue. There is indeed a significant provision in the form of a new base erosion anti-avoidance tax- the BEAT tax. The legislation is complex and can be found in the newly introduced section 59A of the tax code. This will be supplemented by the guidelines to be issued. Since this will impact almost all foreign companies operating in the USA, I am reproducing only a part of the provision as below:

"(a) IMPOSITION OF TAX. -There is hereby imposed on each applicable taxpayer for any taxable year a tax equal to the base erosion minimum tax amount for the taxable year. Such tax shall be in addition to any other tax imposed by this subtitle.

"(b) BASE EROSION MINIMUM TAX AMOUNT. - For purposes of this section-

"(1) IN GENERAL. - Except as provided in paragraphs (2) and (3), the term 'base erosion minimum tax amount' means, with respect to any applicable taxpayer for any taxable year, the excess (if any) of-

"(A) an amount equal to 10 percent (5 percent in the case of taxable years beginning in calendar year 2018) of the modified taxable income of such taxpayer for the taxable year, over

"(B) an amount equal to the regular tax liability (as defined in section 26(b)) of the tax- payer for the taxable year, reduced (but not below zero) by the excess (if any) of-?"(i) the credits allowed under this chapter against such regular tax liability, over

"(ii) the sum of-?"(I) the credit allowed under section 38 for the taxable year which is properly allocable to the research credit determined under section 41(a), plus

"(II) the portion of the applicable section 38 credits not in excess of 80 percent of the lesser of the amount of such credits or the base erosion minimum tax amount (determined without regard to this subclause). …."

Cutting through the clutter, it is, in essence, a minimum tax imposed in respect of payments to related overseas companies and is applicable to payments for taxable years after 31.12.2017. The tax is payable by 'applicable taxpayers' that are basically C corporations as also foreign branches. (S corporations are excluded from its ambit). The important point to note is that the tax is imposed on US payers and not on the recipients of the income and consequently, there may be risk of double taxation.

Under the provision, an applicable taxpayer is required to pay a tax equal to the base erosion minimum tax amount for the taxable year. The minimum taxable amount is the excess of a percentage of the modified taxable income of the taxpayer for the taxable year over an amount equal to the regular tax liability of the taxpayer for the taxable year. And the modified taxable amount essentially is the taxable income determined without regard to the base erosion payments. Again there are lots of ifs and buts. For example, the tax will not apply in respect of cost of goods sold (inventories) except in case of inversions. It will also not apply if withholding tax @30% has been applied in respect of the base eroding payments. Similarly, outbound service payments charged without mark up will also not come under its ambit. There are many more.

The percentage is 5% for 2018 and thereafter 10% up to 2025 and thereafter 12.5%. Of course, there is a de minimis limit of average annual gross receipt over preceding three years of USD 500 million. The tax does not apply, unless the foreign-related party deductible payments made are 3% (2% in the case of Banks etc.) or more of the corporation's total deductible payments. But almost all deductible payments to related foreign entities come within its ambit. Similar payments made to domestic companies are, however, fully deductible. Indian Tribunals would have certainly thought that this is discriminatory in terms of Article 24 of tax treaties. But here we are dealing with the USA that has its own rules.

These are only some of the main international aspects of the American tax reforms. Already intense debate is going on about various aspects of the same. It will take a lot of time to properly understand the entirety of the reforms and their effects. One thing is sure though. There is enough material for quite a few PhD theses.

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