Since the "new tax act" (the Tax Cuts and Jobs Act or TCJA) was signed into law in December 2017, tax has received a newly heightened importance. Although tax considerations have always been critical, the TCJA made tax a mainstream conversation. This increase in awareness is beneficial since considering tax implications at the beginning of a project is important and can lead to more optimal and streamlined results.
The US tax laws are a complicated maze of rules that continue to change and must be carefully navigated. During the past year and a half, the Treasury and the Internal Revenue Service (IRS) have been, and continue to, issue thousands of pages of Treasury regulations to update the tax laws. As a result, previous transactions that had no adverse tax implications may now create unexcepted issues. In addition, it is not only important to understand the tax consequences of a contemplated business change, it is also important to analyze existing business operations in light of the new rules.
Minimum Tax on Base-Erosion Payments
The TCJA codified a new "base erosion and anti-abuse tax," or the BEAT, that has required multinational companies to model out their exposure and reevaluate their existing business operations, including restructuring customer contracts. The BEAT operates as an alternative minimum tax on US corporations that have average annual gross receipts of at least $500 million during the preceding three tax years and have a "base erosion percentage," or generally the percentage of its deductions that are "base erosion payments," of at least 3 percent during the current year. The BEAT tax in an extra tax that is applied at a rate of 5 percent for 2018 and 10 percent starting in 2019.
In particular, the BEAT is relevant to multinationals that make payments to foreign affiliates that are deductible on the US entity's tax return or if the US entity purchases property from a foreign related party for which the US corporation can claim amortization or depreciation deductions on its tax return. Generally, these payments and deductions increase the base erosion percentage and once the percentage reaches 3 percent, the BEAT is "turned on" and applies to all base erosion payments. Thus, it is critical to try and stay under the 3 percent threshold.
As a result, multinationals who have reached the 3 percent threshold have been restructuring their contracts with their customers so customers are contracting directly with foreign affiliates for the work being performed by the foreign affiliates, rather than the US entity. Once the contracts are renegotiated to be directly with the foreign affiliate, payments are no longer made between the US entity and the foreign affiliates. This decreases the base erosion payments and, in turn, the base erosion percentage, with the goal of maintaining the base erosion percentage below 3 percent.
The BEAT can also apply in unexpected circumstances under the proposed Treasury regulations. For example, acquisition of depreciable or amortizable property can be treated as a purchase that results in BEAT payments even if the property is acquired in an otherwise tax-free transaction such as a capital contribution or a tax-free reorganization. As a result, multinational corporations need to consider any BEAT impacts of internal restructurings or post-acquisition reorganizations that prior to the TCJA might have been standard practice with no adverse tax consequences.
US Tax Consequences of Foreign Operations
Prior to the TCJA, the US immediately taxed certain earnings and profits of controlled foreign corporations (CFCs – foreign companies that are at least 50% owned by 10% US shareholders), as subpart F income. After the TCJA, a US shareholder of a CFC must now also immediately include in its income "global intangible low-taxed income" (GILTI) of a CFC that exceeds a certain return on tangible assets.
The included income, or tested income, is treated as subpart F income and is deemed to be currently distributed to a CFC's 10 percent US shareholders. As a result of these TCJA changes, most of a CFC's income is currently included by a US corporate holder either as subpart F or GILTI, with little, if any, foreign income being able to be deferred from US tax. In addition, GILTI makes the widely publicized dividends received deduction that allows foreign earnings to be brought back to the US tax-free largely inoperative unless the CFC has a high amount of tangible assets. These changes, along with other new tax provisions, are relevant in analyzing whether certain operations should be conducted from the US or from a foreign subsidiary and where a company's intellectual property should be located.
Business Interest Deduction Limitation
Changing to conform with many European countries, the TCJA also revised the section 163(j) interest deduction limitation. The interest limitation limits annual business interest deductions to 30 percent of a US taxpayer's adjusted taxable income (ATI), which affects the business consideration of utilizing debt, including in intercompany contexts. The new proposed regulations include a special "grouping election" that is generally favorable and can be made to eliminate interest income and expense on debt between CFCs and include GILTI and subpart F in a US taxpayer's ATI, which typically results in an increase in the section 163(j) limitation. However, the grouping election is irrevocable and must be carefully considered.
Companies with entities in their legal structure that are located in offshore jurisdictions such as Bermuda, the Cayman Islands, the Bahamas, the British Virgin Islands, and Jersey should be apprised of the economic substance requirements that many of these jurisdictions have been implementing during the past year. The new rules can impose significant penalties and are spurred by the jurisdictions' desire to comply with certain EU Council requirements so these countries are not placed on the EU Council's list of noncooperative jurisdictions or blacklist.
The economic substance laws vary by jurisdiction, but their goal is to introduce substance requirements to prevent international businesses from transferring profits to jurisdictions that impose little or no income tax while having practically no employees or physical presence in the relevant jurisdiction. The new rules typically require minimum activity in the country, such as the company being managed and directed from that jurisdiction, the company having core income-generating activities in that jurisdiction, including locating its employees in that country, or the company maintaining certain minimum physical presence in that jurisdiction. An analysis of the economic substance rules should be considered if a company has an entity in an offshore jurisdiction in its legal entity structure. As a result of these new rules, many US multinationals are restructuring out of these countries.
Due to the everchanging tax rules both in the US and abroad, it is highly recommended that the tax consequences of a corporation's business and legal entity structure are periodically reconsidered. In addition, before business operations outside of the US commence, involving a tax professional to assist in identifying and solving for tax issues is not only prudent, but is typically also financially advantageous in the long run.