2/2/2018. Part I: Inbound Base Erosion Provision in socalled Tax Cut and Jobs Act. Inbound Planning & Developments

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1 Inbound Planning & Developments Inbound International Tax Issues with a Focus on Tax Reform 2017 PLI, New York February 6, 2018 Peter Glicklich Davies Ward Phillips & Vineberg LLP Oren Penn PricewaterhouseCoopers LLP Paul M. Schmidt BakerHostetler AGENDA I. Base Erosion Under Tax Reform A. Interest Expense Limitations (Sec. 163(j)) B. Base Erosion and Anti-Abuse Tax (BEAT) C. Hybrid Transactions and Hybrid Entities D. Status of Section 385 II. Sale of Partnership Interests A. Rev. Rul /Grecian Magnesite Repeal III. Broad Inbound Implications of Tax Reform and Miscellaneous Considerations A. Withholding Tax Rates (Including Branch Taxes) B. Inversions C. Implications of Sub F Attribution Rule D. Treaties E. OECD BEPS F. Portfolio Interest 2 Part I: Inbound Base Erosion Provision in socalled Tax Cut and Jobs Act 3 1

2 Interest Expense Limitations under New Section 163(j) 4 New Section 163(j) Enacted in Section of TCJA. Major game change for business borrowers. New Section 163(j) is effective for tax years beginning after December 31, Section 163(j): In General Deduction for business interest expense cannot exceed the sum of: Business interest income, 30% of adjusted taxable income, plus Floor plan financing interest. Floor plan financing interest is interest on debt used to acquire a motor vehicle and secured by the motor vehicle. From a practical standpoint, the deduction for net interest expense is limited to 30% of adjusted taxable income. (The increase for floor plan financing interest is not expected to be widely applicable.) Limitation does not apply to investment interest. 6 2

3 Section 163(j): Adjusted Taxable Income Adjusted taxable income means taxable income, computed without regard to: Non-trade or business income or expense, Business interest income or expense, NOLs, Qualified business income under new Section 199A, and Until 2022, depreciation and amortization. The 30% limitation is generally based on EBITDA until 2022, and then changes to EBIT. The switch is likely to have a huge impact on industries that depend on equipment or other tangible assets, such as mining, manufacturing, etc. Adjusted taxable income differs from EBITDA in that it is based on taxable income (not book income), does not back out non-recurring charges, and does not add back non-cash charges other than depreciation and amortization. 7 Section 163(j): Trade or Business Issues Business interest income and expense means interest income and expense properly allocable to a trade or business (and does not include investment income or investment interest expense). Trade or business does not include: Performing services as an employee, An electing real property trade or business, This is a real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage trade or business (see Section 469(c)(7)(C)) that makes an election. An electing farming business, This is a farming business (see Section 263A(e)(4)) or a agricultural or horticultural cooperative (see Section 199A(g)(2)) that makes an election. Certain energy, water, sewage, gas and steam related businesses. The elections allow certain real estate and farming businesses to elect out of the Section 163(j) limitation. 8 Section 163(j): Additional Rules Gross Receipts Test: Section 163(j) does not generally apply to taxpayers whose gross receipts are less than $25 million per year, adjusted for inflation. Carryforwards: Business interest for which a deduction is disallowed under Section 163(j) can be carried forward to future taxable years indefinitely. Unclear how carryforwards from pre-tcja periods should be treated. Unlike old Section 163(j), excess limitation does not carry forward. 9 3

4 Section 163(j): Passthrough Entities For partnerships, limitation is determined at partnership level. Compare old Section 163(j), which applied limitation at partner level. If the limitation is greater than the amount of the interest at the partnership level, the partners receive an allocation of excess taxable income, which increases the partners own adjusted taxable income and therefore allows them to take additional deductions for business interest expenses from other sources. Excess taxable income equals: 30% of the partnership s adjusted taxable income minus the partnership s net interest expense, divided by 30% of the partnership s adjusted taxable income, multiplied by The partnership s adjusted taxable income. If the partnership s business interest expense exceeds the limitation, the excess is allocated to partners and becomes a carryforward, but can only be used with respect to interest from that partnership. Similar rules apply to S corporations. 10 Section 163(j): Passthrough Example A Assume partnership P has two partners, X and Y, who hold interests in ratio. P has $120 of adjusted taxable income and $30 of net interest expense for the current taxable year. Applying Section 163(j) at the partnership level results in a limitation of 30% $120, or $36. Since P s net interest expense is less than the limitation, P allocates all $30 of expense to its partners (i.e. $15 to each of X and Y). The excess taxable income is equal to $20: $120 ($36 - $30) / $36 = $20 Excess taxable income of $10 is allocated to each of X and Y, which increases X and Y s adjusted taxable income. Each of X and Y can deduct up to $3 (30% $10) of additional net interest expense. If X and Y can utilize all of the excess taxable income, total deductions will be $36, which is equal to P s Section 163(j) limitation. 11 Section 163(j): Passthrough Example B P has $120 of adjusted taxable income and $60 of net interest expense for the current taxable year. Applying Section 163(j) at the partnership level results in a limitation of 30% $120, or $36. Since P s net interest expense is greater than its limitation, P can only allocate $36 of its net interest expense to its partners (i.e. $18 to each of X and Y). The excess taxable income is equal to $0, because the 163(j) limitation is less than the net interest expense. P allocates the unused $24 to its partners ($12 to each of X and Y) as excess business interest, which X and Y can carry forward. X and Y can only use the $12 carryforward with respect to interest from partnership P. 12 4

5 Section 163(j): Coordination with Other Rules In a tax-free asset-based reorganization, the acquiring corporation succeeds to the target s Section 163(j) carryforwards under Section 381. Section 163(j) carryforwards are included in a corporation s prechange losses for the purposes of the limitation on NOLs under Section 382. The BEAT rules provide that interest disallowed under Section 163(j) is treated as paid to unrelated parties first, which should maximize the remaining interest subject to the BEAT. Unclear how Section 163(j) carryforwards are treated in connection with divorce, death, etc., or in the context of consolidated returns. 13 Section 163(j): Differences from Old Rule Old Section 163(j) Only applied to debt or guarantees between related parties and only applied to borrowers that were C corporations. Did not apply unless the borrower s debt-to-equity ratio exceeded 1.5 to 1. Included provisions on how to apply the limitation in the context of consolidated returns. Explicitly applied before the passive loss rules of Sections 465 and 469. Applied regardless of the type of business the taxpayer is engaged in. New Section 163(j) Applies to individuals, partnerships, S corporations, trusts, etc., in addition to C corporations, regardless of the level of debt. Does not include clear rules for consolidated returns. Lacks coordination with Sections 465 and 469, as well as certain other limitations on the deductibility of interest (such as the hybrid transaction / hybrid entity provision in Section 267A and Section 385). Does not apply to real property businesses or farms that elect out, or to certain energy businesses. 14 Base Erosion and Anti-Abuse Tax ( BEAT ) 15 5

6 Base Erosion Anti-Abuse Tax (BEAT) Overview BEAT is essentially a 10% minimum tax (5% for tax year beginning in 2018) calculated on a base equal to the taxpayer s income determined without the tax benefits arising from base erosion payments. Base erosion minimum tax amount: equal to 10% (5% in the case of taxable years beginning in calendar year 2018 and 12.5% for tax years beginning after December 31, 2025) of the modified taxable income over the regular tax liability, reduced (but not below zero) by the excess of credits allowed under Chapter 1 over the sum of: - Credits allowed under Section 38 which are properly allocable to the research credit under Section 41, plus - The portion of the applicable Section 38 credits not in excess of 80% of the lesser of the amount of such credits or the base erosion minimum tax amount (determined without regard to the applicable Section 38 credits). 16 BEAT Framework BEAT is imposed only on a taxpayer that is an applicable taxpayer. Applicable taxpayer: - (1) a corporation other than a RIC, a REIT, or an S corporation, - (2) with average annual gross receipts of at least $500 million for the three taxyear periods ending with the preceding tax year, and - (3) which has a base erosion percentage of 3% or higher (2% for banks or registered securities dealers) for the tax year. Aggregation rule: for purposes of determining base erosion percentage and the gross receipts threshold, members of a controlled group within the meaning of Section 1563 (as modified) are treated as a single taxpayer Effective date: applies to base erosion payments (defined below) paid or accrued in tax years beginning after December 31, 2017 Rates applicable to banks and securities dealers: the 10% rate is increased to 11% (6% in the case of tax years beginning in 2018) for any taxpayer that is a member of an affiliated group that includes a bank or securities dealer. For tax years beginning after December 31, 2025, the rate is 13.5%. 17 BEAT Framework Applicable Section 38 credits: allowable to: - Section 42(a) low-income housing credit, - Section 45(a) renewable electricity production credit, and - the portion of the Section 46 investment credit allocable to the Section 48 energy credit. Modified taxable income: taxable income determined without regard to: - any base erosion tax benefit with respect to any base erosion payment, or - the base erosion percentage of any NOL allowed for the tax year. 18 6

7 BEAT Framework Base erosion payment: any amount paid or accrued by the taxpayer to a foreign person that is a related party and with respect to which a deduction is allowed. Also includes: - any amount paid or accrued to a related foreign person in connection with the acquisition of depreciable or amortizable property - any premium or other consideration paid or accrued to a related foreign person for reinsurance payments - any amount paid or accrued to a surrogate foreign corporation or a member of the expanded affiliated group which results in a reduction of the gross receipts of the taxpayer 19 BEAT Framework Base erosion payments exclude: - Any amount paid for services if the services are eligible for using the services cost method (without regard to the requirement that the services not contribute significantly to fundamental risks of business success or failure) and the amount constitutes the total services cost with no markup component - Any qualified derivative payment, i.e., a payment made pursuant to a derivative with respect to which the taxpayer marks to market, treats any gain/loss as ordinary, and treats gain/loss on any payment made under the derivative as ordinary 20 BEAT Framework Base erosion tax benefit: any deduction allowed with respect to a base erosion payment for the taxable year. - Cost of goods sold is a reduction in gross receipts, not a deduction, by definition, not included as a base erosion benefit Base erosion percentage: determined by dividing the aggregate amount of base erosion tax benefits by the aggregate amount of the deductions allowable under Chapter 1, taking into account base erosion tax benefit for which a deduction is allowed and not taking into account any deduction allowed under Sections 172, 245A or

8 BEAT Framework Coordination rules - Any tax erosion benefit attributable to a base erosion payment is disregarded to the extent it is subject to full-rate withholding tax under Section 871/881 - For purposes of computing modified taxable income, any interest deduction disallowed under Section 163(j) is allocated first to interest paid to unrelated persons Regulatory Authority - Section 59A(i) provides the Secretary with broad regulatory authority to provide guidance including rules to prevent the avoidance of the section through: - the use of unrelated persons, conduit transactions or other intermediaries; - transactions or arrangements designed in whole or part to avoid payments being classified as base erosion payments; and - rules to prevent the avoidance of qualifying as a related party by reason of section BEAT Inbound and Outbound Companies Inbound company: Outbound company: 23 BEAT Flowchart 24 8

9 BEAT Example In General 25 BEAT Example with NOL Carryforwards Net operating losses - In calculating modified taxable income, taxpayer adds back the base erosion percentage of any net operating loss deduction allowed under Section 172 for the taxable year. - Is there increased exposure as a result of using NOL carryforwards? - How is the calculation impacted if NOL carryforwards exceed current year taxable income? Is the starting point for calculating modified taxable income zero? Ex. 1 Ex. 2 NOL Carry Forward Gross Income Base Eroding Deductions Other Deductions Taxable Income (before NOL) NOL Taxable Income (after NOL) 0 50 Regular Tax Liability (21%) BEAT Addback: Base eroding deductions Base eroding % of NOL Adjusted Taxable Income Tax (10%) Additional Tax BEAT Observations & Open Questions Does BEAT apply to net or gross payments? How does the NOL add-back provision under section 59A(d)(4) apply when utilizing a NOL carryforward? Is interest disallowed under section 163(j) that is deducted in a subsequent year subject to BEAT as a base erosion payment? How are COGS defined? (e.g., section 263A costs or sales based royalties) What is the scope of services exception under section 59A(d)(5)? How does BEAT apply to partnerships? (e.g., Is a payment made to a domestic partnership with foreign corporate partners subject to BEAT?) 27 9

10 Related Party Payments in Hybrid Transactions or to Hybrid Entities 28 Hybrid Transactions The Act denies a deduction for any disqualified related party amount paid or accrued pursuant to a hybrid transaction or by or to a hybrid entity A disqualified related party amount is any interest or royalty paid to a related party where the related party (1) does not include the payment in its income in the country in which it is a resident or (2) is allowed a deduction with respect to the amount in the country in which it is a resident Any payment that is included in the US shareholder s gross income under section 951(a) is excluded from the definition A related party is determined under section 954(d)(3) A hybrid transaction is any transaction, series of transactions, agreement, or instrument where one or more payments is treated as interest or royalties for US federal tax purposes but not treated as interest or royalties by the country in which the related party is resident 29 Hybrid Transactions A hybrid entity is any entity that is: Fiscally transparent for US tax purposes but not transparent under foreign law, or Fiscally transparent for foreign law purposes, but not transparent for US tax purposes. Rulemaking authority is delegated to Treasury to provide rules: Denying deductions for conduit arrangements that involve a hybrid transaction or hybrid entity Applying the provision to foreign branches Applying the provision to certain structured transactions Denying all or a portion of a deduction claimed for interest or royalties paid that are subject to certain preferential tax regimes or a participation exemption system Determining the tax residence of a foreign entity Identifying exceptions to the general rule

11 Status of Section 385 Regulations and What Next? 31 Policy Considerations F F Debt Interest Equity Dividends US US Interest generally deductible Interest potentially subject to lower withholding tax than dividends Repayments of principal not subject to tax Dividends not deductible Dividends potentially subject to higher withholding tax than interest 32 Overview Catalyst: Response to Inversions Historic US Co Shareholders Bank Loan Note owed to New Parent New Parent (UK) Lux Finco (Lux) Historic Foreign Co Shareholders Note owed to Lux Finco HoldCo 1 (US) Foreign Co US Co International Subsidiaries US Subsidiaries US Assets CFCs International Subsidiaries US Operations 33 11

12 Section 385: Overview Section 385(a) provides Treasury with the authority to issue regulations as may be necessary or appropriate to determine whether an interest in a corporation is to be treated for federal tax purposes as: stock or indebtedness; or in part stock and in part indebtedness Section 385(b) states that the regulations shall set forth factors which are to be taken into account in determining with respect to a particular factual situation whether a debtor-creditor relationship exists or a corporation-shareholder relationship exists. Those factors may include, among other factors: Whether there is a written unconditional promise to pay a sum certain and fixed rate of interest Whether there is subordination to or preference over any indebtedness of the issuer The issuer s debt-to-equity ratio Whether there is convertibility into the issuer s stock The relationship between holding stock of the issuer and the interest in question Section 385(c) states that the issuer s characterization of an interest at the time of issuance is binding on the issuer and each holder of the interest, unless, and except as provided in regulations, the holder discloses the inconsistent treatment. The issuer s characterization is not binding on the IRS, however. Section 385(c) also provides Treasury with authority to require information necessary to carry out the provisions of the subsection 34 Section 385 Regulations Documentation rules Require documentation of certain debt-factors Apply super-factors for debt/equity analysis Transactional rules Focus on debt issued in transactions that do not increase issuer s assets Address earnings stripping Existing law continues to apply Debt/equity authorities 163(j) anti-earnings stripping rules 35 Where do the 385 regulations stand? April 8, 2016: Proposed 385 regulations released Oct. 21, 2016: Final 385 regulations published April 21, 2017: President Trump s Executive Order (13789) Treasury to address regulatory burdens for tax regulations that (i) impose an under financial burden; (ii) add undue complexity or (iii) exceed statutory authority July 7, 2017: Notice , Treasury interim report includes section 385 regulations 36 12

13 Where do the 385 regulations stand? July 26, 2017: Notice : delays the effective date of the documentation rules. Previously, applied to interests issued on or after January 1, The Notice extends it for one year to interests issued on or after January 1, 2019 Sept. 18, 2017: Final report due Sept. 27, 2017: Republican framework for tax reform released Sept. 29, 2017: District Court holds inversion regulations (promulgated same day) violated APA (Chamber of Commerce v. IRS, W.D. Texas) 37 Treasury Final Report on EO October 4, 2017: Treasury Issued Final Report (dated Oct. 2) Falls short of immediate repeal Provides that documentation rules will be revised and streamlined Suggests relief for ordinary course trade payables Transaction rules (distribution rules) retained pending tax reform Earnings stripping should be addressed in tax reform but regulations are needed in the meantime If tax reform does not address earnings stripping, regulations may be modified to simplify and ease compliance burdens 38 Recent Developments As recently as December 1, 2017, Treasury officials have suggested that: Documentation rules need to be simplified Some of documentation rules depart substantially from current practice The documentation rules as currently drafted could compel taxpayers to build expensive new systems Impact of Tax Reform New Section 163(j) limiting interest expense BEAT Hybrid Rules Are they necessary? 39 13

14 Part II: Sale of Partnership Interests 40 Rev. Rul Sale of Partnership Interest Foreign Partner Partnership USTB/PE Sale of Partnership Interest Nonresident alien is partner in partnership (domestic or foreign) that conducts USTB through a permanent establishment Foreign partner sells interest in partnership IRS concluded that gain on sale was ECI to the extent attributable to property of partnership that would give rise to ECI if sold by partnership (look-through approach) Concluded that similar approach applied for purposes of U.S. tax treaties Rev. Rul was rejected, however, in recent case (Grecian Magnesite Mining v. Commissioner, 149 T.C. 3 (2017)) 41 Grecian Magnesite Mining v. Commissioner, 149 T.C. 3 (2017) GMM (Greece) Premier USTB Conducted mining business in United States Distributions in redemption of GMM s partnership interest GMM was partner in Premier, an LLC classified as a partnership. Premier conducted USTB of mining and selling magnesite. Premier redeemed GMM s partnership interest, causing GMM to recognize gains on its partnership interest. Tax Court held that gains (other than gains attributable to US real properties) were not ECI based on entity approach to partnerships, citing: Subchapter K provisions treating redemption as sale or exchange of capital asset (partnership interest), 897(g), which applies an aggregate approach to partnership interests for purposes of FIRPTA as a special rule Gains on partnership interest were foreign-source and non-eci because (i) GMM was nonresident and (ii) gains were not attributable to USOFPB (of Premier, itself) Tax Court rejected Rev. Rul , finding its reasoning unpersuasive Tax Court also rejected IRS s argument that USOFPB of Premier was material factor in realization of gains on grounds that (i) USOFPB effectuated redemption transactions and (ii) USOFPB increased going concern value of partnership Tax Court s reasoning should apply equally to actual sale or exchange of partnership interest. Does decision create loophole by way of 754 election? 42 14

15 Sections 864(c) & 1446 for Sale of Partnership Interests Sale, exchange, or disposition of partnership interests by foreign persons Gain or loss taxed on look-through basis; i.e., treated as effectively connected with a US trade or business to the extent the foreign person would have had effectively connected gain or loss had the partnership sold all its assets at FMV (hypothetical sale approach) Determined in same manner as non-separately stated items FIRPTA trumps Codifies rule similar to that in Rev. Rul , which the Tax Court declined to follow in Grecian Magnesite Mining, Industrial & Shipping Co. v. Comm r, 149 T.C. No. 3 (July 2017) 43 Sections 864(c) and 1446 for Sale of Partnership Interest Tax Reform imposes a new withholding by the transferee of 10% of the gain realized, except if the transferor provides a valid affidavit, or Notice delays withholding for certain publicly traded partnership interests Broad grant of regulatory authority including for special rules for brokers to withhold; also for exchanges described in sections 332, 351, 354, 355, 356, or 361. Effective Dates: For characterization of gain or loss, rules are effective for sales, exchanges, and dispositions on or after November 27, Withholding rules are effective for sales, exchanges or dispositions after December 31, 2017 (but deferred for publicly traded partnerships per Notice ). 44 Part III: Broad Inbound Implications of Tax Reform and Miscellaneous Considerations 45 15

16 Broad Inbound Implications and Misc. Considerations Sourcing changes- revisions to section 863(b); sourcing based on place of production regardless of title passage Withholding tax rates, including branch taxes remain at 30% Implications for inversion transactions Modification to Subpart F attribution rules under section Reporting implications Treaty implications OECD BEPS Portfolio interest rules 46 16