Tax Reform Issues Related to Group Financing - 163j, 267A, BEAT and GILTI Issues International Tax Institute, Inc. June 11, 2018 James Tobin, Ernst & Young LLP Kevin Glenn, King & Spalding LLP
TCJA International Provisions Impacting Financing 163(j) Interest limitations 267A Hybrid provisions 59A BEAT 951A GILTI 2
Other Issues / Considerations 385 Regulations US Treaty / LOB issues BEPS impact treaty shopping Base erosion and hybrid rules Transfer pricing CFC rules 3
Agenda High level review of provisions Impact on US multinationals re outbound investment Impact for inbound investment 4
Old Section 163(j) Disallowed a deduction for disqualified interest paid or accrued by a corporation in a taxable year if: The payor s debt-to-equity ratio exceeded 1.5 to 1 and The payor s net interest expense exceeded 50 percent of its adjusted taxable income (generally, income computed without regard to deductions for net interest expense, net operating losses, domestic production activities under section 199, depreciation, amortization, and depletion) Disqualified interest is interest paid or accrued to A related party when no US tax imposed on the interest An unrelated party in certain cases where a related party guaranteed the debt A real estate investment trust (REIT) by a taxable REIT subsidiary of such trust Disallowed interest expense could be carried forward indefinitely 5
Base Erosion and Profit Shifting (BEPS) Action 4 In October 2015, the Organisation for Economic Co-operation and Development (OECD) released its final report on recommended limitations on interest expense deductions (Action 4) Recommendations: Fixed ratio rule to limit net interest deductions to a fixed percentage (somewhere between 10% and 30%) of EBITDA. Adopt a group ratio rule to supplement (but not replace) the fixed ratio rule. Provide flexibility for highly-leveraged groups or industry sectors. Equity escape rule: interest expense allowed if an entity s debt-to-equity ratio does not exceed that of its worldwide group. Allow carryforward and/or carryback of disallowed interest expense and/or unused interest capacity. Exclusions for interest paid to third party lenders on loans used to fund public-benefit (infrastructure) projects and for entities with net interest expense below de minimis thresholds. 6
General rule - TCJA Rule: Deduction for business interest in a taxable year cannot exceed the sum of Taxpayer s business interest income for the taxable year, 30 percent of the taxpayer s adjusted taxable income for the year, and Taxpayer s floor plan financing interest for the taxable year 7
General rule: Application and effective date Application Effective date House Report states that, similar to old section 163(j), new section 163(j) is generally intended to apply after the application of provisions that subject interest to deferral, capitalization or other limitation Effective Date: Applies to taxable years beginning after December 31, 2017 No phase in period No grandfathering of existing debt 8
Scope Applies to all business interest regardless of whether the payee is a related person Applies to all taxpayers except taxpayers that meet the gross receipts test in section 448(c), as amended (i.e., the average annual gross receipts of the taxpayer for the three prior taxable years does not exceed $25 million) 9
Key terms: Business interest and trade or business Business interest is any interest paid or accrued on debt related to a trade or business Trade or business does not include: Performing services as an employee An electing real property trade or business Any business described in section 469(c)(7)(C) (i.e., any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business) Election is irrevocable An electing farm business Farming business, as defined in section 263A(e)(4) Trade or business of a specified agricultural or horticultural cooperative, as defined in new section 199A(g)(2) Election is irrevocable Certain regulated public utilities 10
Key terms: Adjusted taxable income (ATI) ATI is taxable income, computed without regard to Income, gain, deduction or loss that is not allocable to a trade or business Business interest or business interest income Any net operating loss deduction under section 172 Any deduction allowed under section 199A For taxable years beginning prior to January 1, 2022, any deduction allowable for depreciation, amortization and depletion Section 163(j)(8)(B) authorizes the Treasury to provide for other adjustments to the computation of ATI Neither the statute nor the legislative history addresses the treatment of interest equivalents 11
Carryforward of disallowed interest expense The amount of business interest not allowed as a deduction is treated as business interest paid or accrued in the succeeding taxable year No limitation on disallowed business interest carryforward period No carryforward of excess limitation Business interest carried forward is a section 381(c) item and a pre-change loss for section 382 purposes 12
Application to partnerships Limitation is determined at the partnership level and any deduction for business interest is taken into account in the non-separately stated taxable income of the partnership Thus, partnership is treated as an entity Intended to prevent taxpayers from using a partnership to avoid section 163(j) 13
Action 2 Hybrid mismatch arrangements Overview Hybrid mismatch linking rules D/NI Indirect D/NI DD Deduction with no taxable income inclusion arising from a hybrid financial instrument, or payments made to or by a reverse hybrid (financial instruments or entities) Payments that give rise to an indirect deduction with no inclusion arising from an imported mismatch (financial instruments or entities) Deductible payment made by a hybrid entity or a dual resident that gives rise to a double deduction (entities only) Specific recommendation on dividend exemption for instruments Primary rule: deny deduction Defensive response: include payment in ordinary income 14
EU Developments: ATAD anti-hybrid rules Overview and summary of relevant rules Treatment of mismatch outcome (article 9) In case a hybrid mismatch results in deduction without inclusion: Deduction without inclusion If the payer jurisdiction is a Member State, that Member State shall deny the deduction; or If the payer jurisdiction is a third country that has not denied the deduction, the Member State that is the payee jurisdiction shall include the payment in its income. Double deduction In case a hybrid mismatch results in double deductions: If the investor jurisdiction is a Member State, that Member State shall deny the deduction; or If the investor jurisdiction is a third country that has not denied the deduction, the Member State that is the payer jurisdiction shall deny the deduction. Optional limitation to scope ATAD allows Members States to exclude mandatory income inclusion in the case of certain hybrid mismatch situations that result in a deduction without inclusion, if the payment has its source in a third country: Differences in allocation of payments to a hybrid entity; Differences in allocations of payments between a head office and PE; Payments to a disregarded PE; and Deemed payments between a head office and PE. Ultimate implementation date January 1, 2020 15
EU Developments: ATAD anti-hybrid rules Overview and summary of relevant rules Hybrid financial instrument Hybrid entity Permanent establishments Hybrid transfers The tax treatment of a financial instrument differs between two jurisdictions. A payment to or by an entity that is qualified as non-transparent under the laws of one jurisdiction and qualified as transparent by another jurisdiction. Situations resulting in a deduction without inclusion due to differences in the allocation of payments between the head office and PE(s), payments to a disregarded PE and deemed payment between the head office and PE(s) whereby the payment is disregarded under the law of the payee jurisdiction. Situations where an arrangement to transfer a financial instrument gives rise to a difference in tax treatment, if the underlying return of a financial instrument is treated as derived by more than one of the parties to the arrangement. As such, the payment could give rise to a deduction for the payer while being treated as a return on the underlying investment by the payee. Imported mismatch The effect of a hybrid mismatch between parties in third countries is shifted into the jurisdiction of a Member State through the use of a non-hybrid instrument thereby undermining the effectiveness of the rules that neutralize hybrid mismatches. This includes a deductible payment in a Member State under a non-hybrid instrument that is used to fund expenditure involving a hybrid mismatch. 16
Section 267A Overview and summary of relevant rules Sec.267A(a) No deduction shall be allowed under this chapter for any disqualified related party amount paid or accrued pursuant to a hybrid transaction or by, or to, a hybrid entity Sec. 267A(a) has a two prong test. This slide outlines the first test. The term disqualified related party amount means any interest or royalty paid or accrued to a related party to the extent that Such amount is not included in the income of such related party under the tax law of the country of which such related party is a resident for tax purposes or is subject to tax, OR Such related party is alloweda deduction with respect to such amount under the tax law of such country. Such term shall not include any payment to the extent such payment is included in the gross income of a United States shareholder under section 951(a). The term related party means a related person as defined in section 954(d)(3), except that such section shall be applied with respect to the person making the payment described in paragraph (1) in lieu of the controlled foreign corporation otherwise referred to in such section. Effective for taxable years beginning after December 31, 2017. 17
Section 267A Overview and summary of relevant rules Sec.267A(a) No deduction shall be allowed under this chapter for any disqualified related party amount paid or accrued pursuant to a hybrid transaction or by, or to, a hybrid entity Sec. 267A(a) has a two prong test. This slide outlines the second test. A hybrid transaction is any transaction, series of transactions, agreement or instrument: One of more payments with respect to which are treated as interest or royalties for US federal income tax purposes, and Which are not so treated for purposes the tax law of the foreign country of which the recipient of such payment is resident for tax purposes or is subject to tax. A hybridentity means any entity that is either: Treated as fiscally transparent for US federal income tax purposes but not so treated for purposes of the tax law of the foreign country of which the entity is resident for tax purposes or is subject to tax, or Treated as fiscally transparent for purposes of such tax law but not so treated for US federal income tax purposes [reverse hybrid] 18
Section 267A Overview and summary of relevant rules Sec.267A(e) The Secretary shall issue such regulations or other guidance as may be necessary or appropriate to carry out the purposes of this section, including regulations or other guidance providing for- In other words, Sec. 267A(e) grants significant, broad and specific regulatory authority which needs to be monitored going forward / consider potential for retroactive effective date 1. Rules for treating certain conduit arrangements which involve a hybrid transaction or a hybrid entity as subject to the provision 2. Rules for the application of the provision to branches or domestic entities 3. Rules for the application of the provision to certain structured transactions 4. Rules for treating a tax preference as an exclusion from income for purposes of a disqualified related party amount if the tax preference has the effect of reducingthe generally applicable statutory rate by 25% or more 5. Rules for treating the entire amount of interest or royalty as a disqualified related party amount if such amount is subject to a participation exemption system or similar system which provides for the exclusion or deduction of a substantial portion of such amount 6. 7. 8. Rules for determining the tax residence of a foreign entity if the entity is otherwise considered resident in more than one country, or of no country Exceptions to the general rules for (i) case in which the disqualified related party amount is taxed in a third jurisdiction, and (ii) other cases the Secretary determines do not present a risk of eroding the federal tax base Requirements for record keeping and information reporting in addition to any requirements imposed by Section 6038A 19
BEAT Applicable taxpayer New Section 59A imposes a base erosion minimum tax amount on each applicable taxpayer. The base erosion minimum tax is in addition to any other income tax imposed on the applicable taxpayer. An applicable taxpayer is a taxpayer, with respect to any taxable year, which is: A corporation (other than a RIC, REIT, or S-corporation); That has average annual gross receipts of at least $500 million for the three-year period ending with the preceding taxable year (gross receipts test); and A base erosion percentage of 3% (2% for banks and securities dealers) or more for that taxable year. 20
Base erosion minimum tax amount An applicable taxpayer s base erosion minimum tax amount for any taxable year beginning in calendar year 2018 is: 5% of modified taxable income for the taxable year - Regular tax liability for the taxable year reduced (but not below zero) by the excess, if any, of credits allowed under Chapter 1 over the sum of (i) the credit allowed under section 38 (general business credits) allocable to the research credit plus (ii) applicable section 38 credits (not to exceed 80% of the lesser of such credits or the base erosion minimum tax determined without taking into account such applicable section 38 credits) Tax rate increased to 10% after the first year. For years beginning after December 31, 2025, the tax rate is increased to 12.5% and regular tax liability is reduced by an amount equal to all credits allowed under Chapter 1. Increased rates of 6%, 11% and 13.5%, respectively, for members of an affiliated group which includes a bank or registered securities dealer. Applicable section 38 credits refers to the low-income housing credit, the renewable electricity production credit, and the investment credit to the extent properly allocable to the energy credit. 21
Base erosion minimum tax amount Modified taxable income An applicable taxpayer's modified taxable income equals its taxable income determined under Chapter 1 without regard to any deduction (or reduction in gross premiums or gross receipts in certain instances) allowed for the taxable year (a base erosion tax benefit ) with respect to any base erosion payment, and without regard to the base erosion percentage of any NOL deduction allowed under section 172 for the taxable year. The base erosion percentage for any taxable year is: aggregate base erosion tax benefits for the year aggregate deductions allowable under Chapter 1 for the year (plus reductions in gross premiums or gross receipts in certain instances) The denominator excludes: Deductions allowed under sections 172, 245A or 250; Deductions for certain services; and Deductions for qualified derivative payments not treated as base erosion payments. It is unclear whether the base erosion percentage to be applied with respect to an NOL deduction is the base erosion percentage for the year in which the deduction is claimed or the base erosion percentage for the year in which the NOL arises. 22
Base erosion minimum tax amount Base erosion payments A base erosion payment includes Any amount paid or accrued by the taxpayer to a foreign related party and with respect to which a deduction is allowable; Any amount paid or accrued by the taxpayer to a foreign related party in connection with acquisitions of depreciable or amortizable property; Any premium or other consideration paid or accrued by the taxpayer to a foreign related party for any reinsurance payments which are taken into account under sections 803(a)(1)(B) or 832(b)(4)(A); and Any amount that results in a reduction of the gross receipts of the taxpayer that is paid or accrued by the taxpayer with respect to (1) a surrogate foreign corporation (as defined in section 7874(a)(2)) (where status as foreign surrogate is obtained after November 9, 2017) which is a related party of the taxpayer, or (2) a foreign person that is a member of the same expanded affiliated group as the surrogate foreign corporation. 23
Base erosion minimum tax amount Base erosion payments (cont.) Only base erosion payments paid or accrued in taxable years beginning after December 31, 2017 are subject to the provision. E.g., depreciation deductions allowed in a taxable year beginning after December 31, 2017 with respect to a depreciable asset acquired in a taxable year prior to December 31, 2017 are not subject to the provision. Any interest disallowance under section 163(j) is first treated as allocable to third party interest for BEAT purposes. A base erosion payment is still subject to the provision even if the payment results in either a subpart F income inclusion or GILTI income inclusion under sections 951(a) or 951A(a), respectively. Likewise, a base erosion payment is still subject to the provision even if the payment results in ECI taxable under section 882(a) to the recipient. 24
Overview of the carrot and the stick provisions: FDII and GILTI Section 951A provides for immediate US income inclusion for an amount determined to be in excess of a specified return. While Section 250 provides US corporations with a deduction for a portion of such excess and its foreign intangible income. Section 951A requires each US shareholder of any CFC to include in gross income such shareholder's global intangible low-taxed income (GILTI) for such taxable year. Section 250 allows a US corporation to take a deduction for a portion of its foreign-derived intangible income (FDII) and GILTI inclusion (including any corresponding Section 78 dividends). The GILTI provision has been referred to as the stick and the FDII as the carrot. 25
Outbound Current State US P External Debt CFC Holdco Loans Loans CFC Finco 1 CFC Finco 2 Loans CFC OPcos Loans 26
Tax Reform Impact 163(j) 30% limit on net interest Interest income from outbound loans Application to CFC s GILTI Interest income in finco s taxed under 951A GILTI (until/unless CFC look through sunsets) 861 allocation to GILTI? Other Still forex risk on direct loans Still 956 so watch guaranties 27
Other Considerations BEPS / Treaty shopping issues re CFC Holdco PPT for treaties CFC risks for Holdco Base erosion interest limits and limits for payments to havens BEPS Actions 8-10 re financing income of CFC Finco 1 and CFC Finco 2 28
Inbound Current State FP External Debt Guaranty Fee Foreign Finco Debt US Group Foreign OPcos Loans External Debt CFC s CFC Finco 29
Tax Reform Impact 163(j) 30% limit All debt What to do if excess debt BEAT Related party interest Other payment including related party guaranty fee Based on current year impact e.g., 267(A)(3), 163(j) carryover, etc. No escape clause re overall group leverage 30
Tax Reform Impact 267(A) hybrids Application to direct related party debt (or unrelated structures arrangements) Regulatory authority for conduit debt GILTI Application to CFCs including CFC Finco Impact of repeal of 958(b)(4) 31
Other Considerations 385 Regulations Impact of foreign CFC rules Effect of US tax rate reduction US Treaty LOB impacts US withholding tax rate still 30% BEPS makes low tax finco s much more difficult 32