Under the existing U.S. worldwide tax system, the taxation of profits earned by foreign subsidiaries generally is deferred until the profits are repatriated to the United States. At that time, the profits are subject to a 35% income tax rate, with a credit available for the foreign taxes paid. Plans to set up a territorial tax system, however, are currently under discussion in Washington.
In a territorial tax system, income is taxed in the country where it’s earned, and isn’t taxed later when it’s repatriated to its foreign parent. The House Ways and Means Committee’s “Better Way” blueprint supports the replacement of the worldwide tax system with a territorial tax system. In contrast, when he was a candidate, President Trump favored a “one-time deemed repatriation of corporate cash held overseas at a significantly discounted 10% tax rate, followed by an end to the deferral of taxes on corporate income earned abroad,” according to a plan his campaign released in September. That proposal dropped off his campaign website, however, and all indications are that a territorial tax system will be the preferred policy option.
Worldwide Vs. Territorial Tax System
For illustrative purposes, let’s assume a U.S. corporation has a foreign subsidiary that cumulatively has earned $50 million of pretax profits. The tax rate in the home country of the foreign subsidiary is 20%, resulting in $10 million of cumulative taxes paid.
Assuming no prior distributions, there would be no U.S. taxes paid on the income. If the foreign subsidiary were to make a $40 million distribution to its U.S. parent, representing the cumulative net earnings of the subsidiary, the U.S. shareholder would include in income the pretax income of $50 million and be entitled to a foreign tax credit of $10 million, assuming no withholding taxes on the distribution. After the foreign tax credit, however, the U.S. tax burden on the repatriation would be $7.5 million ($17.5 million tax on the dividend paid to the parent at 35% less $10 million foreign tax credit). Under a territorial tax system, no additional U.S. tax would be due when the cumulative earnings and profits of the foreign subsidiary are distributed to the U.S. parent corporation.
The potential shift to a territorial system begs a few important questions. They include: What would happen to unrepatriated and untaxed foreign profits? And what steps should businesses take now to prepare for the potential transition?
President Trump’s campaign proposals called for tax on a deemed repatriation of foreign profits at a 10% rate. While not currently listed on Trump’s website, at one point his proposal allowed for the tax to be payable over 10 years. The blueprint also calls for a deemed repatriation of foreign profits in connection with the transition to a territorial tax system.
The House blueprint provides that the tax would be payable over 8 years at a tax rate of 8.75% for unrepatriated earnings held in cash or cash equivalents, with the remainder subject to tax at 3.5%. In either the House or the President’s scenario, it is likely that no foreign tax credits will be available to offset the tax on deemed repatriation.
Preparing for the Possibility of Change
For now, companies are in a quandary as they wait for clarity. Recently, both Apple and Microsoft announced significant borrowing plans to meet cash needs even though they have significant amounts of cash outside the United States. Businesses should consider the following steps now to plan for the possible deemed repatriation of foreign profits:
- Determine where you would stand today if you were to repatriate your foreign profits. Would the U.S. tax paid on repatriation be greater or less than the tax that would be due under the deemed repatriation proposals?
- If the U.S. tax on repatriation of foreign profits is lower than the tax liability under Trump’s proposals or the blueprint, businesses should consider repatriating profits before any changes are made in the law.
- For most U.S. corporations, the U.S. tax on repatriation, after the foreign tax credit, will be greater than the proposed tax liability under Trump’s proposals or the blueprint. Those companies should avoid repatriation until the potentially favorable rates on a deemed repatriation are available.
- If possible, U.S. corporations might consider borrowing in the United States to fund their cash needs and deferring repatriation of foreign profits until after legislation has passed.
Besides the actual cash impact, businesses will need to consider the ASC 740 income tax accounting aspects of the deemed repatriation. Under current accounting rules, companies generally are not required to record a deferred tax liability on the unrepatriated income of a foreign subsidiary if they have adopted an indefinite reinvestment policy. A deemed repatriation of foreign earnings would render those policies moot, and the company likely would need to record a tax liability for the unrepatriated foreign profits.
John Kelleher is a partner and Howard Wagner a managing director at Crowe Horwath.