The new territorial tax system replaced the worldwide tax system within our tax laws when the Tax Cuts and Jobs Act was signed into law. This new territorial tax system, a key feature of the TCJA, is part of the effort to further lower business taxes by taxing only income earned within the U.S. Business Takes Center Stage
What is the new territorial tax system?
The new territorial tax system is part of our new tax laws, but is more a hybrid system, merging with the worldwide tax system. The best way to define the new territorial tax system is to broadly describe the results or goals of the worldwide tax system (ending 2017) and a territorial tax system:
Under a worldwide tax system, a U.S. company doing business in (for example) the UK first paid the British corporate tax of 19%. When the U.S. company paid those profits back to the U.S., those profits were subject to U.S. tax equal to the difference between the U.S. rate of 35% and the British rate of 19%. The goal was that all profits of U.S. multinational corporations faced a tax rate of no less than 35%. However, U.S. companies could avoid the additional tax burden on their foreign profits by moving their headquarters to, say, the Cayman Islands.
Under a non-hybrid territorial tax system, the income of foreign subsidiaries of US-based firms would never be subject to U.S. tax because foreign profits potentially face an annual minimum tax. This would eliminate the need for the U.S. company to invert, or move it’s headquarter location to a more tax-friendly jurisdiction.
Merged together, the new territorial tax system has been described by Stan Veuger as replacing our “subdued worldwide corporate income taxation to one of territorial taxation with a worldwide backstop.”
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The hybrid new territorial tax system and profit shifting
Until the TCJA was signed into law, the U.S corporate tax rate was the highest in the industrial world. However, U.S. businesses used everything available to whittle that 35% down to practically nothing. Profit shifting, one of the best strategies applied for tax avoidance, simply shifted profits to low-tax countries. Changing to the new territorial tax system, a hybrid territorial system, as it turned out, was intended to (as Bloomberg reported in February, 2018) “take the profit out of profit shifting.”
3 major changes the hybrid new territorial tax system brings
The TCJA lowered the corporate tax rate from 35% to 21% which puts the U.S. below the worldwide average of 22.5%. The other 3 main changes brought about by the hybrid new territorial tax system are the:
- Elimination of taxes on repatriated dividends from foreign affiliates. Previously U.S.-resident multinational corporations, as noted above, received credit for foreign income taxes up to the 35% U.S. tax rate. These companies are now able to deduct from U.S. taxable income a 100% dividend deduction. That means no taxes. This provision has no end date.
- Introduction of a new tax on Global Intangible Low Tax Income (GILTI). Prior to the TCJA, no tax was imposed until repatriation of this income. The TCJA now taxes intangible profits at 10.5% with credit for 80% of foreign income taxes up to the U.S. tax rate, now 21%. Beginning 2026, the 10.5% rate will increase to 13.125% with the same 80% credit.
- Taxation on pre-2018 accrued profits of foreign affiliates. Prior to the TCJA, there was no tax imposed until repatriated, at which time those profits were taxable at 35% with credit for foreign income taxes. Now, a one-time tax on these profits is set at 15.5% for cash and other liquid assets, and 8% for non-cash assets, payable over 8 years. Companies still get a foreign tax credit for the tax payments previously made, but it is reduced in proportion to the U.S. tax rate on those profits.
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As always, the answer is YES. The TCJA includes two other significant provisions you should also consider. The first, Foreign-Derived Intangible Income (FDII) deals with, for example, foreign sales of a product where the patent is held in the U.S. The other, Base Erosion Alternative Minimum Tax (BEAT), deals with deductible payments made to low-tax countries.
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The bottom line
We specialize in business tax strategy. Without a tax plan, a flexible strategy and an overall business and life financial goal, you’re at the mercy of the IRS and the tax person who probably allows you to consistently file an extension. Most any tax person or bookkeeper can prepare a fairly accurate account of what happened last year. That is not tax planning.
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