Corporations Must Pay Transition Tax to Bring Home Tax-Free Future Foreign Earnings

June 25, 2018

U.S.corporations with operations overseas might have been thrilled with tax reform that lets them bring home future foreign earnings free of federal tax.

But before corporations can enjoy that benefit, they have a potential mountain of paperwork ahead of them. Most will find the information needed to calculate a one-time transition tax overwhelming, since it’s based on figures going back three decades.

They need to act fast to estimate a key portion of that tax. And they need to file an extension for 2017 so they can have time to plow through the rest.

In addition, individuals, partnerships and S corporations will have this issue but without any benefit of the exclusion of future foreign dividend income.

What Changed

Federal tax reform passed in December includes a major departure from decades of tax law, one that is generally welcomed by businesses with operations overseas.

Previously, U.S. citizens, corporations and partnerships that conducted foreign business through a non-US subsidiary were generally not subject to U.S. income taxes until income was distributed as a dividend to the U.S. parent.

Now, tax law permits a U.S. corporate shareholder of a foreign corporation to deduct 100 percent of foreign-source dividends if the shareholder owns 10 percent or more of the voting stock of the foreign corporation.

In effect, U.S. corporations are now afforded a 100 percent dividend received deduction (DRD) for foreign-source earnings and are thus able to repatriate future foreign-source earnings free of U.S. tax.

This is widely referred to as a partial “territorial” tax regime; wherever you earn money is where you pay taxes on it, generally.

This affects any American company with an international presence. It will have profound effect on cross-border tax issues for all of them.

Still, until further guidance or regulations are provided by the IRS, many aspects of the new tax laws are unclear.

One-Time Transition Tax

To shift to the new “territorial” tax regime, those companies must pay a one-time transition tax based on their post-1986 undistributed earnings and profits (E&P).

That will be a difficult number to come up with, so businesses should be collecting as much information as possible now to bring to their tax accountants.

That’s why an extension is essential for the company’s 2017 tax return.

But since the one-time fee is a 2017 tax liability, companies will need to be able to figure in an estimate of what’s due on the 2017 return.

Confused?

Consult a CPA-based consulting firm for expert guidance right away.

Beyond the accounting challenges, though, are further lucrative benefits. Companies will be taxed at a lower rate, either 15.5 or 8 percent, on the overseas income. And they’ll be able to pay it in eight installments over eight years, without any interest.

What To Do Now

Most companies probably haven’t consistently tracked their deferred foreign E&P on an annual basis since the 1980s.

They should gather historical financial statements and calculate each foreign corporation’s accumulated E&P. This is no small task.

Moreover, taxpayers are encouraged to gather sufficient documentation of all foreign income tax payments to support foreign tax credits. It’s likely that much of this historical information is not readily available.

Start gathering these documents for their tax accountants as soon as possible.

Summary

Under the new partial “territorial” tax regime, U.S. corporations with foreign subsidiaries will generally be able to repatriate future earnings free of U.S. income tax, except for a one-time transition tax.

Most will need help figuring that.

Since much of the new law remains unclear pending IRS clarification, companies should begin gathering documents and discussing next steps with their tax advisor.