U.S. Tax Reform – A 21% Corporate Income Tax Sounds Great, but what are the Collateral Issues for Inbound Investment?
By Andre Benayoun, Partner, International Tax Services
As many practitioners are now aware, the U.S. has had major international tax reform in 2018 via the, colloquially called, Tax Cuts and Jobs Act (“TCJA”). The provisions of the TCJA are complicated and explanation in the form or Treasury Regulations (including Proposed and Temporary) and Notices are coming out almost every day. It is hard for U.S. practitioners to keep track of, and probably even more so for international practitioners. Not only that, but once the law is understood from a basic perspective, practitioners must then turn to the task of identifying collateral issues (i.e., secondary issues) arising from these law changes. One such change, was the well-publicized reduction of the federal corporate income tax rate from 35% to 21% (State and local taxes could apply separately). Furthermore, this 21% federal corporate income tax rate may even be dropped further under the new Foreign Derived Intangible Income (“FDII”) rules of Sec. 250. The new FDII rules incentivize U.S. corporations to export goods and services. The result of which is a reduction in the federal corporate income tax rate from 21% to 13.125% (and moving up to 16.4% in 2026). This rate change, and the incentivization of exports through FDII, are generally seen as positive changes for U.S. economic growth, and I agree.
Having said that, there are some collateral issues that inbound investors should consider due to the change in tax rate. While there are many issues, some presumably yet undiscovered, this article will focus on just two them including: (1) financing considerations on inbound investment; and (2) potential implication of controlled foreign corporation (“CFC”) regimes of other countries with respect to U.S. subsidiaries post-tax reform.
As part of the TCJA, a new interest deduction limitation rule was created under Sec. 163(j). This new rule replaces the previously existing U.S. tax rule regarding interest deduction limitation. The previous rule looked only at related party debt and had a safe harbor if the debt-to-equity ratio of the U.S. person was less than 1.5:1. The new interest deduction limitation rule applies to all debt, from related parties or not, and now follows a more European model that limits debt to 30% of EBITDA (moving to EBIT in 2023). Furthermore, these new rules apply to CFCs of U.S. taxpayers such that interest deduction may be lower for U.S. federal income tax purposes than is shown on the local GAAP books or even the local tax return.
The TCJA also implemented new Sec. 267A which generally denies an interest (or royalty) deduction on payments paid or accrued by a U.S. corporation to a related foreign party that is pursuant to a “hybrid transaction” or made by a “hybrid entity” if there is: (1) no income inclusion to the foreign party; or (2) the foreign party is allowed a deduction for foreign tax purposes (for example, due a notional interest deduction regime). Note that this new rule was actually made effective for 2017 instead of 2018.
For completeness purposes, the above changes are in addition to general financing issues that were not changed by the law such as normal debt vs. equity analysis under Sec. 385. The existing financing related issues are outside of the scope of this Article.
1. Debt Financing Structures
First of all, the reduced corporate income tax rate to 21% from 35% could make it such that existing related party debt with a foreign related party is no longer a positive rate arbitrage transaction. For example, presume that a Mexican Company owned a U.S. subsidiary. Purely based on corporate income tax rates (forgetting withholding tax, for example), the Mexican parent company would consider lending money to the U.S. subsidiary instead of contributing it as capital because the resulting interest deduction would give rise to a tax benefit in the U.S. at 35% (federal before State tax savings) and give rise to income in Mexico at 30% (the corporate income tax rate in Mexico outside of the free trade zone). The result of such debt is a net tax benefit to the global operations of U.S. and Mexico. Today, with a 21% federal income tax rate, and a rate below 30% even with most State income taxes included, such interest on debt would no longer result in net global tax savings. In other words, there is now a negative rate arbitrage on the interest deduction that would not have existed prior to reform. This change requires foreign investors in the U.S. to consider capitalizing or restructuring their debt in certain cases.
This same issue arises due to the new 163(j) limit rules. In the past, among other things, there was a safe harbor exception to interest deduction limitation in the U.S. when the debt-to-equity ratio was less than 1.5:1. Today, that safe harbor no longer exists and debt is generally capped to 30% of EBITDA through 2022 and then to 30% of EBIT in 2023 and thereafter. In the case where an interest deduction will not be fully allowed under the new rules, long term debt lent by a foreign corporation to a related subsidiary, or even unrelated bank debt taken on by the U.S. subsidiary should be looked at again. For example, perhaps the foreign related party should consider borrowing from a bank where the interest deduction will not be limited under their local law and then contribute the loan proceeds to the related U.S. subsidiary.
Lastly, as discussed above the U.S. no longer allows a deduction for interest at all in cases where the recipient-lender does not take the interest payment into income or is able to reduce that income via a deduction allowed under local law. These perceived abusive structures can be created in several ways. First, a legal document, or series of legal documents, could be drafted in such a way so as to treat payments under the agreement(s) as debt for U.S. federal income tax purposes, while the recipient jurisdiction treats the payments as equity and then does not tax such “dividend” amounts under a local participation exemption regime. Another way to create this type of structure is using the U.S. “check-the-box” rules. In short, these rules allow a U.S. taxpayer to treat a U.S. or foreign entity differently for U.S. federal income tax purposes than it is treated for legal or non-U.S. tax purposes. For example, a foreign owner could create a U.S. partnership and then under the check-the-box rules, treat such partnership as a C corporation for U.S. federal income tax purposes. The result would be that for U.S. tax purposes, any debt in the partnership would be treated as debt of a corporation, but for non-U.S. tax purposes, the partners would pick up their share of interest deduction from the partnership and offset their interest income in the local jurisdiction against such deduction. Yet another example comes from the fact that some countries (e.g., Cyprus and Italy) have a notional interest deduction (“NID”) regime. The NID regime functions to allow deductions on equity under a specified published rate. As such, cash contributed into Cyprus or Italy, under the right facts, can give rise to a deduction in Cyprus or Italy. The on-lending of debt from this entity to the U.S. may give rise to little or no tax on interest income to Cyprus or Italy once the interest income from the U.S. is offset against the NID on equity. These sorts of structures are also captured under the new Sec. 267A hybrid regime. As such, any foreign taxpayers reducing U.S. federal income tax through one of these structures, and others not described here, needs to consider the lost benefit under these new rules and consider restructuring their global financial arrangements with U.S. subsidiaries where necessary.
2. New CFC Regimes
As you may be aware, the U.S. has a CFC regime in which non-U.S. entities that are controlled by U.S. taxpayers may have their income picked up on a current basis in the U.S. without allowing for the customary deferral that one would get by operating in subsidiary form. These rules already exist in many countries, but the newest Anti-Tax Avoidance Directive (“ATAD II”) is pushing such a regime throughout Europe (albeit with two different models from which to choose). As the world’s tax systems become more evolved, I expect CFC regimes to increase around the world. One of the hallmark features of a CFC regime is to tax certain income (usually passive) earned by a controlled corporation to its controller if the income tax rate in the subsidiary is not high enough. With the change in U.S. federal income tax rate to 21% (exclusive of State or local taxes), or the even lower effective income tax rate of 13.125% for use of the FDII regime by a C corporation, some U.S. corporations may be treated as “low-taxed” for purposes of a parent country’s CFC regime.
For example, Mexico already has a CFC regime in place. To avoid potential CFC issues in Mexico, the non-Mexican subsidiary must be taxed at a rate greater than 75% of the Mexican corporate income tax rate (which is 30%). Therefore, a U.S. subsidiary of a Mexican parent whose effective tax rate is below 22.5% (i.e., 75% * 30%), may find itself subject to Mexican CFC rules. This can occur if the U.S. company is not subject to State tax or if the FDII regime is has sufficiently reduced the effective tax rate in the U.S. such that even with State and local income tax, the effective rate is below 22.5%.
Another example would be, Germany. Certain passive income can be subject to the German CFC rules if the effective tax rate on such income is below 25%. Again, a U.S. subsidiary of a German corporation, could conceivably have an effective tax rate including State and local taxes of below 25% even if it does not avail itself of the lower federal income tax rate afforded to exporters through the FDII regime. In such a case, certain income of the U.S. subsidiary could be subject to immediate tax in Germany.
While there are other countries with CFC rules for which the U.S. corporate federal income tax rate could be implicated, the above examples should prove the point.
In summation, the change in U.S. federal corporate income tax rate is likely to be helpful in attracting increased U.S. business activities and stimulate the U.S. economy. It is also likely to increase exportation of goods and services by U.S. corporations through the FDII Regime. Having said both of these things, there are some collateral issues for which foreigners investing in the U.S. should be aware. First, foreign corporations with U.S. operations need to take another look at their current debt structures with U.S. subsidiaries in light of the reduced U.S. federal corporate income tax rates as well as the increased scrutiny, and potential lack of interest deduction allowed in the U.S., due to new Secs. 163(j) and 267A.
Furthermore, with a lower effective federal corporate income tax rate in the U.S., U.S. controlled subsidiaries could fall into harsh CFC rules in the local jurisdiction of their controller. As mentioned above, both Germany and Mexico have CFC regimes for which, under the correct facts, income of a U.S. subsidiary could be picked-up on a current basis by such parent. Furthermore, with many European countries adopting CFC rules in the next two years as part of the ATAD II. Those countries could easily provide an effective tax rate threshold that could leave a U.S. subsidiary squarely in the crosshairs of such regimes.