Barely a week after President Trump signed the Tax Cuts and Jobs Act into law, the U.S. Treasury Department and the Internal Revenue Service issued a guidance that could ease the confusion CFOs might have had about how corporations should calculate the act’s “transition tax” on offshore earnings.
In amending section 965 of the Internal Revenue Code, the new law slaps the transition tax on the previously untaxed earnings of foreign subsidiaries of U.S. companies by deeming those earnings to be “repatriated,” or subject to U.S. corporate income tax.
Under the act, which became law on December 22, 2017, companies will now be taxed on foreign earnings held as cash and cash equivalents at a 15.5% rate and on the remaining non-cash earnings at an 8% rate. In contrast, companies will see their maximum tax rates on domestic income slashed from a previous maximum of 35% to a flat 21% rate.
Companies can string out the transition tax payments in installments over an eight-year period, according to the act. Prior to the December 29 guidance from Treasury and the IRS, however, it wasn’t clear how companies should calculate the one-time transition tax.
(After paying the tax, U.S. companies will no longer be able to defer payment of U.S. tax on foreign earnings. Instead they will have to decide whether earnings are truly onshore or offshore in the current year, and then be taxed just on the onshore earnings.)
The guidance should help ease CFOs’ worries about complying with the part of the new tax law that concerns offshore earnings, according to Pat Jackman, a principal in the international tax group of KPMG’s Washington national tax practice.
Concluding that the guidance is, on balance, “taxpayer friendly,” Jackman points to a provision in the act that had company executives concerned that the new law would require companies to “double count” earnings on transactions made by their subsidiaries — and therefore pay a higher transition tax on them.
“There was lots of uncertainty in terms of how certain calculations [would be] done, and, in some cases, there was a concern that the amount of cash would be overstated in the way that the statute was drafted,” Jackman says. “This notice clarifies that the procedure that taxpayers are allowed to employ will avoid overstating the amount of cash.”
In terms of double counting (or double non-counting, for that matter), the tax years of two foreign subsidiaries of the same U.S. parent company may end on different dates. Such a situation could result in the parent company having to treat a transaction between the two subsidiaries two times, thereby overstating or understating its taxable income when it repatriates.
The guidance provides an example in which USP, a calendar-year taxpayer, wholly owns CFC1, which has a December 31, 2017, year end, and CFC2, which has a November 30, 2018, year end. Further, USP’s share of the cash position of each of CFC1 and CFC2 is $100 for each of their taxable years, with the result that USP’s aggregate foreign cash position would be overstated at $200.
Under the example, CFC1 might make a payment in, say, interest or royalties, to CFC2. Before the guidance, the parent company might have been expected to pay a 15.5% transition tax on that whole $200.
The new guidance provides the IRS with the authority to clarify the situation in favor of the parent company that would halve the taxable cash-based income in the example. The revenue service could now adjust the company’s earnings “to ensure that a single item of a specified foreign corporation is taken into account only once,” according to the guidance.