Multinationals that prepaid royalties to seize a loophole in the new tax law could face higher taxes in future years due to a proposed IRS rule aimed at blocking that benefit.
The IRS is now trying to secure future revenue by plugging that gap in proposed rules (REG-106013-19) released Tuesday, tax professionals said. The rules address what are known as hybrid arrangements: an abusive form of cross-border tax planning in which companies exploit differences in jurisdictions’ tax laws.
Until now, intellectual property-intensive companies have been able to offset future taxes by exploiting a timing gap between a beneficial deduction and the onset of a new foreign tax. The proposed rules are Treasury’s attempt to bar companies from keeping a 100% deduction on early payments of their royalties agreements.
“Treasury is using the hybrid rules aggressively to police bad behavior,” said Mike DiFronzo, International Tax Services leader at PwC LLP.
Treasury is trying to close a gap created in the 2017 tax law between the time companies could claim the 100% deduction and the time that income would be subject to tax, because it’s considered global intangible low-taxed income. GILTI kicks in on Nov. 1, 2019, for fiscal-year controlled foreign corporations, or CFCs, and the deduction was available starting Dec. 31, 2017.
“Treasury must have thought this is a widespread issue or else they would not be rushing it into this hybrids package,” said Kathleen Dale, a principal in the international tax group of the Washington National Tax practice of KPMG LLP.
The proposed rules apply when there is a U.S. company that owns two or more CFCs that are the payer and recipient of the royalties. CFCs are foreign entities that are 50% U.S.-owned by 10% U.S. shareholders.
Ultimately it is the U.S. shareholder who is denied the deduction and sees a higher tax bill.
“The responsibility falls on the U.S. shareholder, and that shareholder would now have to track this new concept of a hybrid dividend account, which generally leads to a higher compliance burden,” said Yoram Keinan, partner at Kostelanetz & Fink, LLP.
Hybrid dividend accounts are used to trace and track deductions through several layers of entities. Compliance could get challenging for companies that have to track deductions over multiple tax years.
Companies have to track various international taxes and deductions, “and a hybrid dividends account adds a layer of complexity,” DiFronzo said.