At a glance
US GAAP guidance for accounting for outside basis differences in foreign subsidiaries has not changed significantly in over 45 years. However, 2017 US tax reform has dramatically changed the landscape for US taxation of foreign earnings. For many companies, that change may shift their operational and treasury mindsets. Marrying the decades-old accounting guidance with a new vision for worldwide cash management may require many accountants to do something they likely have not done much in the past -- record deferred tax liabilities for outside basis differences. Doing so may not be as straightforward as it seems.
This In depth was updated on December 19, 2018 to remove a case study. The facts used in the case study were no longer applicable after the issuance by the US Treasury of proposed regulations related to foreign tax credits and Treasury Notice 2019-01 on previously taxed income. Key concepts from the case study that were not affected by the Treasury releases were incorporated into the “Measurement considerations” section of this publication.
Prior to the Tax Cuts and Jobs Act of 2017 (the 2017 Act), the US essentially had a worldwide tax regime. Earnings of US-owned foreign subsidiaries were taxable in the US, but assessment of the tax was generally deferred until the earnings were distributed to the US owner. For companies with profitable foreign subsidiaries, this often created a situation in which the book basis of the investment in the subsidiary reflected the foreign earnings, but the tax basis of the investment in the subsidiary did not. ASC 740
, Income taxes
, requires companies to record a deferred tax liability on this book-over-tax outside basis difference, unless the parent has the ability to, and asserts its intent to, indefinitely prevent the reversal of the outside basis difference. Due in part to the relatively high tax rate in the US prior to tax reform, many companies asserted indefinite reinvestment of the foreign earnings, and therefore did not record deferred tax liabilities on their book-over-tax outside basis differences.
The 2017 Act reduced the US corporate tax rate to 21% and fundamentally changed the way the US taxes the earnings of US-owned foreign subsidiaries. First, it required a one-time mandatory deemed repatriation of post-1986 undistributed foreign earnings and profits (E&P). This had the effect of taxing historical foreign earnings and increasing the federal tax basis of the US shareholder's investment in its foreign subsidiaries.
Second, the 2017 Act changed the worldwide tax regime prospectively by providing a 100% dividend received deduction (DRD) on certain qualified dividends from foreign subsidiaries. Conceptually, this had the effect of exempting future foreign earnings from federal tax unless a tax is triggered on foreign currency gains upon repatriation, by Subpart F of the tax code, or by the new GILTI provisions.
GILTI (global intangible low-taxed income) provisions were designed to tax US companies that have foreign earnings that are generated without a large aggregate foreign fixed asset base and whose earnings have been taxed at a low tax rate. GILTI applies regardless of whether such earnings are distributed to the US. Despite its name, the reality of the GILTI mechanics is that it can trigger US tax on foreign earnings that are neither generated from intangible assets nor earned in low-tax jurisdictions.
Finally, the 2017 Act revised the foreign tax credit (FTC) regime. In concept, the FTC regime existed to prevent double taxation on foreign earnings (e.g., tax in the foreign jurisdiction and in the US). Post reform, the ability to use FTCs against differing sources of foreign income is more restricted. For example, FTCs related to taxes paid on GILTI inclusions can only be applied to reduce any US tax on those inclusions and cannot be carried forward. Similarly, FTCs related to foreign branch operations can only be utilized against US tax on foreign branch income, although they can be carried forward. Additionally, FTCs are not available for taxes paid or accrued on dividends to which the 100% DRD applies because those earnings are no longer taxed for US federal purposes.
In response to US tax reform, we expect many companies to reassess their plans with respect to unremitted foreign earnings (for example, they may choose to no longer assert indefinite reinvestment), which would cause them to have to record deferred tax liabilities on book-over-tax outside basis differences—something few companies have done before. Determining the amount of the outside basis difference and measuring any necessary deferred tax liabilities will be complicated by the interaction of the various US provisions, including GILTI and FTCs, as well as foreign withholding taxes.
Companies that disclosed that their indefinite reinvestment assertions were provisional under SAB 118 should make a good faith effort to finalize their accounting as soon as possible, but no later than the period that includes December 22, 2018.
As described above, changes resulting from the new tax law have made it even more critical to track all of the various levels of outside basis differences and account for any necessary deferred taxes in accordance with ASC 740
. As a result, companies may want to consider taking a fresh look not just at their indefinite reinvestment assertion, but at their related systems, processes, and controls. If a company decides to maintain an indefinite reinvestment assertion, it should also take a fresh look at its disclosures.