Exporters have always been the backbone of the Wisconsin economy. Exporters produce manufacturing jobs, the type of jobs for which labor needs a strong back and a reliable alarm clock.
The 2017 Tax Cuts and Jobs Act has resulted in a lot of commentary, little of which is pertinent to Wisconsin manufacturers who export. This article focuses on the good, the bad and the ugly, with planning suggestions for exporters to deal with the bad and the ugly.
Three provisions bring good news to Wisconsin exporters.
The new participation exemption simplifies the taxation of dividends received from a foreign subsidiary. Suppose a C corporation manufactures widgets for export through a foreign subsidiary. To repatriate cash, the foreign subsidiary distributes a dividend. In the past, the C corporation would have to deal with the complex deemed paid foreign tax credit, which, because U.S. tax rates were higher than foreign tax rates, resulted in a total tax at the higher U.S. rates. Now, the new participation exemption makes the taxation much easier. The C corporation simply excludes the foreign dividend from income.
Despite originally being on the chopping block in the Senate, the interest charge domestic international sales corporation survived and remains one of the top benefits available for exporters. An IC-DISC permits a U.S. manufacturer to convert a portion of export income, typically taxed as ordinary income at marginal rates, into qualified dividends taxed at only 20 percent. An ICDISC is a specially elected corporation, with virtually no functions, that receives a deductible commission from a U.S. exporter before paying a dividend at favorable tax rates to individual owners.
The new deduction for foreign derived intangible income offers a C corporation a 13.125 percent tax rate on highly-profitable exports. More specifically, a C corporation can deduct 37.5 percent of any high returns (those in excess of a 10 percent return on assets) to the extent those high returns are attributable to foreign sales and foreign services.
The participation exemption and the FDII deduction are only available to C corporations. S corporations, LLCs, partnerships, and sole proprietors will have to conduct some planning to obtain their benefits.
Suppose, for example, that an S corporation owns the shares of a foreign subsidiary. The S corporation should consider contributing the shares of the foreign subsidiary to a C corporation. Under the new participation exemption, there will not be any U.S. tax on a dividend from the foreign subsidiary to the C corporation.
Exporters that incur foreign income tax will incur double taxation due to the lack of foreign tax credits. The foreign tax credit has always been limited by the U.S. tax on what the Internal Revenue Code characterizes as foreign source income. As a result, any recharacterization of foreign source income as U.S. source income reduces the foreign tax credit and causes double taxation.
Previously, half the income from exports of U.S. manufactured goods was typically foreign source income. Unfortunately, the 2017 Act characterizes all the income for U.S. manufactured products as U.S. source income. The end result is that none of the income will be foreign source and no foreign tax credits will be available to these exporters. Accordingly, the income will be taxed twice – once by a foreign country and again by the United States.
These exporters may have to restructure their supply chain into a manufacturing corporation and a distribution corporation, as different sourcing rules apply to a distributor. The distributor should try to have title pass abroad to have the income characterized as foreign source income.
The 2017 Tax Act does provide good news to Wisconsin exporters. Prudent planning can help lower the exporter’s tax costs resulting from the bad and the ugly.
A shareholder with the law firm of Reinhart Boerner Van Deuren s.c., Robert Misey is president of the Milwaukee Tax Club and chair of the international tax committee for the American Bar Association