Partial Repeal of Foreign Tax Credits by the Tax Cuts and Jobs Act: Resulting Behavioral Incentives, Self-Help, and New Mechanics for Some Remaining Portions of the Credit

Abstract

The new Tax Cuts and Jobs Act repeals approximately one-third of the foreign tax credit system. (The foreign tax credit generally reduces U.S. tax by the amount of the U.S. taxpayer’s foreign income taxes, subject to many requirements.) Essentially, partial repeal will make it much harder to claim credits for foreign taxes imposed on a foreign subsidiary’s active income, other than limited credits for certain foreign taxes associated with the newly created GILTI (“global intangible low-taxed income”) inclusion. However, taxpayers are likely to engage in self-help by creating do-it-yourself replacements for the repealed provision. These self-help strategies may use hybrid entities (entities treated differently under U.S. and foreign law) and the legal liability rule’s deference to the relevant foreign law’s determination of which taxpayer bears the foreign tax. Absent such self-help, partial repeal of the foreign tax credit is likely to change taxpayer behavior, because it alters the incentives for choosing between locations for earning income. Foreign tax rates are now more likely, compared to pre-2018 taxable years, to make a difference when taxpayers choose between doing business in the U.S. and doing business abroad, and between various foreign countries. The net result may be an incentive to earn active income in low-tax foreign countries, rather than in the U.S. or in high-tax foreign countries. In addition, the mechanics have drastically changed for one of the remaining portions of the foreign tax credit. The “deemed paid” credit for certain foreign subsidiaries’ foreign taxes, available in connection with a U.S. shareholder’s inclusion of the “subpart F” (usually passive-type) income of such subsidiaries, formerly cross-referenced a pro rata formula. That formula has been repealed. Now such deemed paid taxes will be computed using a completely different approach that requires identifying the “properly attributable” foreign taxes. Because this new concept is undefined, taxpayers can take aggressive interpretations of the new standard until agency guidance is issued.