On November 2, 2017, the House Ways and Means Committee (the "House Committee") released the Tax Cuts and Jobs Act (the "Bill"), which proposes the largest overhaul to the U.S. tax code (the "Code") since 1986. Various amendments to the Bill were released as part of the legislative markup process, and on November 9, 2017, the House Committee approved the Bill.
If enacted in its current form, the Bill would fundamentally transform the U.S. tax system by introducing sweeping changes to the corporate and international tax provisions of the Code, including a reduction of the corporate tax rate to a flat 20% (25% for certain personal service corporations) from the current 35% maximum graduated rate.
Territorial Tax Regime
The Bill would implement a territorial tax system designed to reduce the scope of income subject to U.S. tax for domestic corporate taxpayers. Under this European-style regime, only income generated from U.S. sources would be subject to U.S. corporate tax. This would be achieved largely via the application of a participation exemption whereby foreign-source dividends paid by a foreign corporation to a U.S. corporate shareholder owning 10% or more of the foreign corporation would be fully deductible for U.S. tax purposes upon receipt.
As compared to the worldwide tax system currently used in the U.S. that imposes U.S. corporate tax on foreign-source income that is physically transferred to the United States, the proposed territorial regime encourages U.S. companies to repatriate offshore earnings. As such, the benefit of tax deferral structures that have been widely used by U.S. multinationals to accumulate cash outside of the United States may be significantly eroded.
Mandatory Repatriation Pipeline
As part of the transition to a territorial tax system, the Bill would require that all foreign earnings currently accumulated offshore by U.S. corporate taxpayers are mandatorily deemed repatriated to the United States at a reduced tax rate of 14% for cash earnings and 7% for non-cash earnings. This one-time "toll charge" would be imposed regardless of whether the earnings were physically transferred to the United States. The U.S. shareholder recognizing the deemed or actual repatriation may elect to pay the tax liability over an eight-year period, in equal annual installments.
By including this mandatory repatriation pipeline, the Bill likely negates the tax deferral incentive for keeping previously accumulated foreign earnings outside of the United States. Based on whether a U.S. shareholder has a commercial or financial need to access such offshore cash, it could consider this to be either a tax holiday opportunity or a punitive tax burden.
Interest Expense Limitations
The Bill introduces revised earnings stripping rules that could impact the ability to reduce U.S. taxable income via debt-financed acquisitions and intercompany leveraging transactions. In particular, U.S. entities would only be allowed to deduct net interest expense up to a defined limit effectively equal to 30% of EBITDA. This limitation would apply regardless of whether the business was thinly capitalized. In addition, U.S. and foreign multinational groups would be subject to worldwide debt cap rules whereby a U.S. corporation's net interest expense would be disallowed to the extent it exceeds its share of the worldwide group's net interest expense, determined by reference to the U.S. business's relative portion of the group's global consolidated EBITDA.
As compared to the current interest deductibility rules that provide a thin capitalization safe harbor and impose a higher interest expense limitation effectively equal to 50% of EBITDA, the Bill appears to be more restrictive with respect to a U.S. corporation's ability to reduce its taxable earnings via interest expense deductions. As such, the tax benefit derived by debt-leveraged acquisitions and intercompany debt arrangements may be minimized.
Expanded Subpart F Inclusion: Foreign High Return Amount
The Bill expands the definition of subpart F (i.e., phantom income currently includible for certain U.S. shareholders of foreign subsidiaries) to include certain income of a controlled foreign corporation (CFC) from intangible property, which under current law would be eligible for deferral. Specifically, the Bill would impose current U.S. income tax on a U.S. shareholder of a CFC, with respect to 50% of the U.S. shareholder's "foreign high return amount" each year. The "foreign high return amount" is computed by starting with the U.S. shareholder's "net CFC tested income" (generally consisting of gross income other than income effectively connected with a U.S. trade or business, subpart F income, and active finance and insurance income) and then subtracting the product of the "applicable percentage" (defined as the federal short-term rate plus 7%) multiplied by the "qualified business asset investment" (generally consisting of the adjusted basis of tangible property used in the business).
Under this formula, the current income inclusion should be higher for U.S. shareholders of CFCs that have little or no tangible property. As a simplistic, hypothetical illustration, a U.S. corporate shareholder of a CFC that has zero tangible assets would be subject to a 20% U.S. corporate income tax rate on 50% of its non subpart F income (i.e., 10% of 100%). The Bill's proposed changes to the subpart F rules create a new layer of complexity that will require granular balance sheet analysis for U.S. taxpayers that hold interests in CFCs.
Other relevant provisions include a foreign tax credit for the U.S. corporate shareholder of a CFC up to 80% of the foreign taxes properly attributable to the tested income, in a separate basket, without carryover.
Corporate Excise Tax
The Bill includes a 20% excise tax on certain amounts paid or incurred by domestic corporations to certain foreign affiliates that would substantially impact existing supply chain structures of both U.S. and foreign multinationals.
Specifically, the Bill would impose an excise tax equal to the highest corporate income tax rate (proposed to be 20% under the Bill) on certain payments by domestic corporations that are made to any foreign corporation that is a member of the domestic payor's international financial reporting group (IFRG). Covered payments are defined very broadly and, subject to a few exclusions, generally include payments of any amount (other than interest) that is deductible or includable in COGS, inventory, or the basis of a depreciable or amortizable asset. An IFRG is, in general, a consolidated group for financial reporting purposes, provided that the average annual covered payments of such group exceed $100 million per year during the three-year reporting period ending with the reporting year being tested. The excise tax would not be deductible for U.S. federal income tax purposes. As a result, where it applies, it has the effect of eliminating U.S. tax benefits associated deductions and other cost recovery mechanisms. In that regard, it bears some similarity to the "import" leg of the border adjustment tax proposed as part of the Republican tax reform plan.
As an alternative to paying the excise tax, the foreign payee corporation may elect to treat affected outbound payments as income that is effectively connected with the foreign payee's conduct of a U.S. trade or business (so-called ECI) through a U.S. permanent establishment; such ECI would be subject to both U.S. net income and, potentially, branch profits taxes. In computing U.S. federal income tax on elective ECI, foreign corporations would be permitted to deduct "deemed expenses," which would be determined based on the IFRG's ratio of modified net income to revenue. Notably, the foreign payee would be permitted to claim foreign tax credits for 80% of the amount of foreign taxes paid or accrued.
This proposal impacts both U.S.-parented and foreign-parented multinational companies and implicates intercompany payments (e.g., royalties or service fees paid to a foreign affiliate, and payments for inventory acquired from an affiliate). Affected companies will need to undertake detailed modeling to determine the impact of this proposal on their effective tax rates.
Senate Tax Reform Package
On November 9, 2017, the Senate Finance Committee (the "Senate Committee") released a comprehensive tax reform package (the "Senate Tax Plan"). The Senate Tax Plan proposes the same foundational changes as those encompassed in the Bill, but includes notable differences in the underlying provisions. In particular, a comparison of the key corporate and international provisions of the Code can be made as follows:
- Territorial Tax Regime. The Senate Tax Plan generally replicates the territorial tax regime and participation exemption mechanism set forth in the Bill. However, the Senate Tax Plan would require (1) the U.S. shareholder to own its interest in the foreign corporation for more than one year, and (2) the foreign corporation to include the dividend in its local taxable income.
- Mandatory Repatriation Pipeline. The Senate Tax Plan will impose a similar mandatory repatriation toll charge at rates of 10% for cash earnings and 5% for non-cash earnings. In addition, it will increase the statute of limitations to six years for assessments involving repatriation inclusions and a penalty for U.S. shareholder entities that expatriate within 10 years of the proposed tax reform enactment.
- Interest Expense Limitations. The Senate Tax Plan generally adopts the same interest deductibility limitations for U.S. corporations.
- Expanded Subpart F Inclusion. The Senate Tax Plan imposes current U.S. income tax on "global intangible low-taxed income" (having the memorable acronym GILTI), the definition of which is conceptually similar to the "foreign high return amount" set forth in the Bill. GILTI is the excess of the net CFC tested income, over a 10% return on the qualified business asset investment (in contrast to the federal short-term rate plus 7% as set forth in the Bill). The Senate Tax Plan includes all of the GILTI, potentially offset by a deduction determined under a complex formula.
- Corporate Excise Tax. The Senate Tax Plan contains a 10% minimum tax on certain base-eroding payments that operates in a manner similar to the Bill's proposed corporate excise tax. However, under the Senate Tax Plan (i) the minimum tax does not include an ECI election, and (ii) the base-eroding payments subject to the minimum tax do not include payments included in COGS.