Tax reform is now history, and taxpayers expect big changes in the taxes they pay over the coming year. Even as Americans have come to terms with the most obvious changes in the tax laws as a result of reform efforts, such as declines in individual and corporate tax rates, they're only now starting to parse through some of the more complex parts of the bill to see what impact they'll have.
One of the most important changes in tax reform governed the treatment of multinational corporations with extensive foreign operations. U.S.-based companies had held trillions of dollars in offshore businesses in order to take advantage of tax deferral opportunities that existed under previous law. To their credit, lawmakers chose not to implement one-time patches that have had mixed success in past years. Instead, they made major changes to international taxation that essentially forced multinationals to bring back their overseas assets .
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How the new rules work
Tax reform changed the way that entities known as deferred foreign income corporations get taxed. Previously, such entities could generally defer taxation until they paid dividends to related U.S. corporations, triggering taxes at corporate income tax rates.
Section 14103 of the tax reform bill forces companies generally to increase their taxable income by the amount of deferred foreign income they had accumulated after the 1986 tax changes. However, the effective tax rate on that deemed taxable income is less than the new corporate tax rate. The legislation does so by offering a deduction to offset that increased taxable income. Mechanically, the amount of the deduction is engineered so that the company pays a 15.5% effective tax rate on cash held overseas. Any accumulated foreign income that exceeds the cash balance -- for instance, that has been invested in equipment or other capital assets -- gets a larger deduction to make the effective tax rate 8%.
This combination of income and deductions happens regardless of what the companies actually do with their overseas assets. That's the secret of its success in spurring Apple (NASDAQ: AAPL) and many other businesses with extensive holdings in related international entities to bring back assets to their U.S. operations.
Why past efforts failed
The latest tax reform effort isn't the first time that the federal government has tried to get companies to bring capital back to their domestic business entities. What changed, though, is that past efforts were voluntary in nature, and although some companies took advantage of them, others held out for the potential for a better future deal.