New Tax on Overseas Earnings Hits Unintended Targets

By Richard Rubin 

WASHINGTON -- A new tax aimed at overseas income earned by U.S. technology and pharmaceutical firms is hitting unexpected places, including Kansas City Southern, a U.S. railroad company.

The new minimum tax on foreign earnings will cost Kansas City Southern $25 million a year, according to the company, which warns the measure also encourages it to borrow money outside the U.S.

Kansas City Southern's predicament is an example of the shifts in international taxation emanating from last year's rewrite of the U.S. tax code, and of the potential unintended consequences that companies are starting to see. Congress lowered the corporate tax rate to 21% from 35% and tried to change the way the U.S. taxes profits abroad, in an effort to boost domestic investment and help U.S. firms compete globally.

In the past, the U.S. taxed corporate profits earned overseas at the domestic rate of 35%. Companies could avoid that tax by booking their income overseas and keeping it there. The new system in theory aims to lighten the overseas tax burden and target it more carefully.

Congress set a minimum tax known as GILTI, for Global Intangible Low-Taxed Income, of roughly 10.5% on a portion of corporate income earned overseas. GILTI is directed at trademarks and patents of technology and pharmaceutical firms, which are easy to transfer to low-tax foreign countries. It was supposed to create a floor on taxing those highly mobile profits, an assurance that companies would pay something while stopping short of the full U.S. tax rate. Without it, lawmakers worried, U.S. companies could have an even larger incentive to move intangible assets and profits offshore.

Kansas City Southern, based in Kansas City, Mo., doesn't seem to fit the profile of companies the tax was aimed at. Its assets are railcars, not patents, and its only substantial foreign operation is in Mexico, where it pays a relatively high 30% tax rate.

But it could get hit with the GILTI tax anyway.

"We should have been exempt from these provisions," Mike Upchurch, Kansas City Southern's chief financial officer, said in an interview. The company had projected that the new tax law would drop its 34% tax rate to 29% or 30%, but it has since revised that projection upward by 1 to 1.5 percentage points, Mr. Upchurch said.

GILTI is hitting Kansas City Southern and other companies like it because of the way the new tax interacts with other provisions in the tax code, specifically the treatment of foreign tax credits that are supposed to prevent two countries from taxing the same income. When companies calculate the credits they receive for paying taxes overseas, the law typically requires them to assign some of their domestic expenses to foreign jurisdictions. The result for some companies is that, for U.S. tax purposes, their foreign income and foreign taxes look smaller than they actually are, shrinking their credits. That, in turn, could force them to pay the new minimum tax on top of their foreign tax bills.

The quirk particularly affects companies with overseas operations and significant domestic expenses for interest, administrative costs and research. It hits companies with operations in high-tax countries like Mexico, Germany and Japan.

"It's already hit a third of companies that we deal with, and the other two-thirds are going to have a harsh reality to face in the coming weeks, " said Albert Liguori of tax advisory firm Alvarez & Marsal Taxand LLC.

Congressional aides are aware of the issue, which could be addressed in legislation or Treasury Department regulations later this year. Part of the challenge, however, is that loosening the rules for some companies could open tax-avoidance strategies for others.

The U.S. Chamber of Commerce included this issue in its list of regulatory priorities for Treasury, arguing that Congress intended to limit GILTI when foreign taxes exceed 13.125%. That is the simple case outlined in the House-Senate conference report -- but lawmakers didn't make changes to other tax rules, such as accounting for foreign tax credits, that make the goal achievable.

Euronet Worldwide Inc., which runs automated teller machines around the world, also expects to pay GILTI. It gets 75% of its revenue from outside the U.S. Despite the cut in the U.S. corporate tax rate, the company's effective tax rate will increase from 22% to 25% or 26% because of the GILTI provision, said Rick Weller, the company's chief financial officer.

"What we think was a tax provision targeted at covering the intangible assets in low-tax jurisdictions ended up being a tax against all foreign business or income that you generate from foreign sources," he said.

The system creates odd incentives. Some companies will be better off moving domestic expenses such as interest costs to foreign countries, where they can get deductions against the higher rates and mitigate the GILTI impact. Kansas City Southern could benefit if it borrowed money in Mexico instead of the U.S. Euronet could gain if it hired administrative staff outside the U.S. instead of at its Leawood, Kan., headquarters.

"All that would do is to encourage us to shift our jobs out of the United States," Mr. Weller said. "It seems to be illogical."

The system also could encourage U.S. companies to find low-tax foreign countries, rather than operating in high-tax countries and paying GILTI on top of that, said Ed Kleinbard, a tax law professor at the University of Southern California.

"It's a great example of what happens when legislation is rushed," he said. "There's a great deal of anxiety about this issue, enormous anxiety."

Write to Richard Rubin at [e-mail]

(END) Dow Jones Newswires

March 26, 2018 05:44 ET (09:44 GMT)

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