Worldwide vs. Territorial – 2017 Tax Reforms in Depth

Worldwide vs. Territorial – 2017 Tax Reforms in Depth

We previously discussed a number of points of interest from the Tax Cuts and Jobs Act of 2017. This article discusses one of the most significant changes in the new tax system – the transition from a worldwide system of taxation for corporations to a territorial system. Under the worldwide tax system, an American company must pay corporate income tax on all its income, whether earned in the U.S. or overseas. The tax is not paid until the foreign earnings are “repatriated” by bringing the income back to the U.S. This system provides an incentive to leave earnings overseas and thereby defer taxation. The territorial tax system shifts the timing and trigger of taxation. Income is now taxed as it is earned, regardless of whether or not the income is repatriated, or distributed, to the U.S. entity (either the taxpayer or U.S. parent corporation). The other consequence is that the distribution of the income now becomes a non-taxable event. The territorial tax system provides a substantial benefit to multinational corporations, however it causes a significant burden to many individual owners of foreign corporations.   To transition to this new system of taxation, the 2017 tax reform includes an amendment of Section 965 called the Repatriation Tax. This creates a deemed repatriation of foreign retained earnings. In other words, all previously deferred income that is held in foreign corporations will be recognized as taxable income on the 2017 U.S. Tax Return. The Repatriation Tax specifically affects owners of a Controlled Foreign Corporation (CFC) or any foreign company with U.S. shareholders. Any foreign corporation that is controlled by U.S. persons falls into this category. For example, in Israel a chevrat ba’am that has more than 50% of its stock owned by American citizens would be considered a CFC.

How to calculate?

The exact calculation is a bit complex, but the general idea is to create a 15.5% tax on the cash portion of retained earnings and an 8% tax on the non-cash portion. The amount taxed is the larger value of the corporation’s retained earnings on 2-November-2017 or 31-December-2017. Because the tax law went into effect on 22-December-2017, there was no opportunity for tax planning. The income included is before any dividends paid in 2017. This tax can be offset by foreign tax credit, such as foreign tax paid on your general income and any foreign tax credit carryovers. However, if you took a dividend from your foreign corporation and paid tax in Israel – since the tax is related to the repatriation income – you can not take a full foreign tax credit and need to disallow a portion based on deduction to repatriated income. One should also keep in mind that the 3.8% Net Investment Income Tax triggered by taking dividends can not be offset by a foreign tax credit.

When is tax due?

One can elect to pay the tax in eight annual installments. However, the payment of first installment must be paid by 15-June-2018, assuming one lives outside the United States. If you would like to make this election, we need your 2017 corporate financials (dochot kaspim) by the first week of June to prepare calculation and advise payment. We hope this discussion was helpful, and please join us for our next installment, coming soon!