After a year of speculation about the legislative capabilities of a Republican-held Congress, the United States has managed to pass its first major tax bill in three decades.1 The bill, commonly referred to as the Tax Cuts and Jobs Act ("TCJA"), is certainly a major transformation in some respects. The corporate income tax rate will decrease from 35 to 21 percent, the United States will finally transition to a territorial system of taxation, and a laundry list of specialized business deductions will be erased from the Internal Revenue Code. Yet, in other respects, the TCJA falls short of comprehensive reform. For multinational corporations, the TCJA both changed the international tax landscape and kept much of US international tax law intact. The transition to a territorial system required a new web of base-protecting provisions for multinational corporations to comply with, while retaining much of the existing inbound and outbound regimes.
Congress passed the bill with remarkable and unprecedented speed, relative to its complexity and the branch's regular order. The TCJA was first introduced in the House on November 2nd, passed out of the Committee on Ways and Means on November 9th, and was approved by the full House on November 16th. The Senate introduced its own bill on November 9th, passed the bill out of the Senate Finance Committee on November 16th, and approved the bill on December 2nd. Republican leadership then stepped in to create a final bill from the two versions which would be acceptable to both houses of Congress, with a nominal Conference Committee appointed for the process. The Conference bill was approved by the House on December 15th, and President Trump signed the bill into law on December 22nd.
The final bill includes – and omits – some curious elements, in large part due to forced compromises under the reconciliation procedures. These streamlined procedures were invoked solely to pass a tax bill with a simple majority and limited debate –provided the bill met the "reconciliation instruction" passed earlier this year which permitted tax legislation that added no more than $1.5 trillion to the budget deficit over the next decade. As a result, the budgetary score of each provision, and whether it could be offset, indicated whether it would make it into the final bill. The bill is "tax reform" to the extent it could be paid for – with certain reforms getting the axe because they would increase the deficit, and a patchwork of other provisions being added as "pay-fors" to balance out the bill. The final bill therefore falls short of the major, comprehensive tax reform of 1986, and may simply be the first step in an iterative reform and technical corrections process going forward.
The transition to a territorial system will erase the "lock-out" experienced by US corporations which have been holding foreign earnings offshore. However, the anti-base erosion measures put in place as offsets for the territorial system reach both domestic and foreign corporations. The TCJA includes the Base Erosion and Anti-Abuse Tax (the "BEAT"), which was drafted as an inbound base erosion rule meant to level the playing field between US and foreign companies.2 The BEAT is meant to target intercompany payments which strip earnings out of the US taxing jurisdiction due to their deductibility.
Starting in 2018, corporations (other than RICs, REITs, or S corporations) with average annual gross receipts over the past three taxable years of at least $500 million, and a "base erosion percentage" of at least 3%, will be subject to the BEAT. The BEAT is imposed if 10%3 of the US corporation's "modified taxable income" is greater than the US corporation's regular tax liability for the year. The amount of the tax is the excess of 10% of the modified taxable income, over the regular tax liability reduced by the excess of the credits allowed to the taxpayer under Chapter 1 of the Code minus certain credits. The calculation changes for taxable years beginning after December 31, 2025, when the 10% amount is increased to 12.5%. Finally, the BEAT includes new information reporting requirements under section 6038A.
This tax introduces several new terms of art which are defined as follows:
- "Modified Taxable Income" is the taxpayer's taxable income, but without regard to any "base erosion tax benefit" for any
"base erosion payment" or the "base erosion percentage" of any net operating loss deduction under Section 172. This essentially means that most deductible payments to foreign related parties are added back into the taxpayer's taxable income.
- "Base Erosion Tax Benefit" is any deduction allowed for a "base erosion payment," including deductions for depreciation or amortization for property acquired with such payment. This does not include payments on which tax has been deducted and withheld under Section 1441 or 1442. To the extent withholding tax is reduced or eliminated by an applicable treaty such exclusion should either be prorated or excluded from modified taxable income.
- "Base Erosion Payment" is any amount paid or accrued to a foreign related person for which a deduction is allowable, including amounts paid in connection with an acquisition of property subject to the allowance for depreciation or amortization.
° Payments for services are excluded from this definition if such services qualify for the services cost method under Section 482, and such amount constitutes total services without the markup component. This determination is made without regard to the requirement that the services do not contribute significantly to fundamental risks of the business. Thus, services that constitute the group's core business can qualify if they are charged out at cost. The services must also (i) be low margin (i.e. the median comparable markup must be less than or equal to 7%); and (ii) not be excluded services such as manufacturing, R&D and reselling.
° Taxpayers electing to make such payments at cost to remove the intercompany payments from the BEAT equation must consider consequences in the foreign jurisdiction. An affirmative transfer pricing adjustment may be required to satisfy local transfer pricing requirements, and taxpayers should consider whether the local jurisdiction will impose withholding on the resulting deemed dividends.
° Payments that constitute cost of goods sold (COGS) are excluded from the definition of a "base erosion payment", except for companies that inverted after November 9, 2017.
- "Base Erosion Percentage" is the aggregate amount of base erosion tax benefits divided by the sum of aggregate base erosion payment deductions and base erosion tax benefits, excluding (1) deductions under sections 172, 245A and 250, (ii) deduction for amounts paid or accrued for services which meet the services cost method, and (iii) deduction for qualified derivative payments not treated as base erosion payments.
In practice, the BEAT would work as follows:
1. USCo determines its modified taxable income.
|Deductible royalties paid to foreign related parties (includes markup)||$60|
|Management & Marketing fee at cost-plus, paid to foreign related parties(included, because of markup)||$40|
|Non-deductible dividends paid to foreign related parties||$30|
|Available credits under Chapter 1 of the Code||$2|
|Modified Taxable Income = $70 + $60 + $40 =||$170|
2. USCo determines whether 10% of its modified taxable income is greater than the USCo's regular tax liability. 10% of the company's $170 in modified taxable income is $17. The company's regular tax liability will be $14.70, i.e. 21% of the company's $70 in taxable income. Because 10% of the company's modified taxable income ($17) is greater than the company's regular tax liability ($14.70), BEAT is owed.
3. USCo determines the amount of the BEAT:
|1||10% of modified taxable income||$17|
|2||Regular tax liability||$14.70|
|3||Excess Credits ($2) – Research Credits ($0)||$2|
|BEAT (Line 1 – Line 2 – Line 3)||$0.30|
Companies assessing their BEAT exposure should consider the risk of double taxation. The "base eroding payments" targeted by the BEAT can also constitute Subpart F income of a CFC, or can give rise to income that falls within the new Global Intangible Low-Taxed Income ("GILTI") provision.
The BEAT may also create conflicts with US tax treaties, primarily because of its focus on related party payments made to foreign persons – rather than any related person. Many of the US treaties include a nondiscrimination article that guarantees that interest, royalties, and other payments made by a US resident to a resident of the treaty partner will be deductible under the same conditions as if paid to a US resident. These provisions typically include an exception for domestic laws which enforce the arm's length standard. It is unlikely that the BEAT would fall within that exception, as its application does not depend on compliance with the arm's length standard. Treaty partners may therefore raise issue with the BEAT, impairing treaty relations and potentially precipitating retaliatory legislation.
Corporate Rates, Expensing, and the Limitation on Interest Deductibility
Starting in 2018, corporations will see a marked decrease in their income tax rates from 35 percent to 21 percent. In addition, the TCJA provides for temporary immediate expensing. Current expensing is available for property acquired and placed into service between September 27, 2017 and December 31, 2022. This benefit is phased out over several years thereafter. Thereafter only property that qualified for bonus depreciation, as well as qualified film, television, and live theatrical performances, will qualify for immediate expensing. The property can be either new or used.
These generous reforms are offset by several base-protecting or base-broadening provisions. Net operating loss ("NOL") carrybacks have been eliminated, and carry-forwards are limited to 80% of taxable income for losses in years beginning after December 31, 2017. In addition, the TCJA provides an entirely new section 163(j) interest deduction limitation regime. Borrowing concepts from Action 4 of the Base Erosion and Profit Shifting ("BEPS") project, the new section 163(j) limits interest expense to 30% of adjusted taxable income ("ATI"). ATI is defined as essentially equal to earnings before interest, taxes, depreciation and amortization ("EBITDA") for taxable years beginning before January 1, 2022, and as EBIT for the years thereafter. Disallowed interest can be carried forward indefinitely, and can be carried over in certain corporate acquisitions pursuant to section 382.
A new provision also denies deductions for interest payments (and royalties) made to related parties where the amount is paid to a hybrid entity or is paid in a hybrid transaction – i.e. if the recipient entity is transparent for US purposes but regarded for foreign purposes, or vice versa; or if the payments are treated as interest or royalties in one jurisdiction, but not treated as such in the other. Such deductions are disallowed if (1) the amount paid is not included in the recipient's income in the foreign jurisdiction in which the related party is resident or subject to tax; and if (2) the foreign jurisdiction allows the related party recipient a deduction for the amount of the interest or royalty. While there are some similarities between this rule and the BEPS approach to hybrid entities, this hybrid rule differs in one significant aspect–it applies only to outbound payments, not inbound payments to US entities.
The hybrid rule will need guidance, as the legislation does not address its application to several common entities, structures, and transactions. For example, the bill is silent as to how the provision will apply to conduit arrangements, structured transactions, foreign entities benefiting from a tax preference, and foreign participation exemption systems applying only a partial exemption. In addition, the hybrid rule will need to be reconciled with existing branch rules, and the definitions of "tax residence." The current language may also bring within its scope situations where base erosion risk is limited, such as when the foreign related party is subject to tax on the income in a jurisdiction other than its jurisdiction of residence (e.g. through a third-country permanent establishment). However, Treasury has broad authority to limit the scope of the rules to transactions that do not present a risk of eroding the Federal tax base.
The TCJA created a new "pass-through deduction", which provides to non C corporation taxpayers a potential 20% tax rate reduction with respect to certain income earned through a pass-through entity as set forth in new Section 199A. Note that C corporations receiving income from pass-through entities are not affected. Under the new pass-through deduction, in order to put pass-through entities on par with corporations after the drop in the corporate rate, non-corporate taxpayers are allowed a deduction against their share of qualified business income to give individuals and trusts a maximum marginal tax rate of 29.6%, as opposed to 37%. The deduction is limited by a portion of the business's W-2 wages and/or depreciable tax basis such that many may not receive the full benefit of the deduction. The TCJA also codified Revenue Ruling 91-32, which provides that a non-US partner's share of gain from the sale of a partnership interest would be treated as income effectively connected with a US trade or business ("ECI") to the extent the seller would have been allocated ECI if the partnership had sold its assets. In addition, a new withholding rule was enacted that requires the transferee of the partnership interest to withhold 10% of the amount realized by a non-US partner on the sale or exchange of a partnership interest absent certification that the transferor is exempt from withholding. Recognizing administrative challenges of this withholding provision for publicly traded securities, Treasury and the IRS have suspended this withholding provision with respect to owners of interests in publicly traded partnerships until further guidance.
The Process Continues
Though Congress has come a long way from its years of discussions about reforming the Code, the tax reform effort is far from over. The legislation signed by the President is merely the first step in a long process. The text will need to be supplemented by significant guidance, especially for the new, complex international provisions. Errors in the text will also need to be revised through the technical corrections process, especially given the haste with which the bill was passed.
The legislative history of the bill is also still being written. The House Ways and Means Committee and the Senate Budget Committee released committee reports on their respective bills, and the Conference Committee that was at least nominally appointed to draft the final, consolidated bill also issued a Joint Explanatory Statement that described the changes made to the House and Senate bills during the conference process. Though these reports are typically considered the definitive legislative history for most bills, tax legislation is also summarized and reported by the Joint Committee on Taxation ("JCT"), the non-partisan office that assists both the House and the Senate in drafting, scoring, and explaining new tax legislation. JCT will issue a summary, commonly referred to as a "bluebook," of the TCJA, likely during the first half of 2018. Though JCT bluebooks are released after final passage of the bill and are not technically legislative history because they are drafted by non-partisan staff without input from members of Congress, they typically carry the same or similar interpretive weight for purposes of interpreting the statutory text and assessing Congressional intent. The Bluebook will also be also be influential when Treasury and the IRS draft regulations.
The bill may continue to evolve through the technical corrections process. A "technical corrections" bill is exactly what it sounds like–an opportunity for Congress to correct errors (i.e. adding words that are obviously missing or correcting erroneous cross-references) in the original legislation. Because technical corrections are meant to correct errors in the original bill, they should not affect JCT's original score of the provision. Proposals which would affect JCT's score by altering assumptions or the intended scope of the provision are therefore inappropriate for the technical corrections process. Technical corrections are also given retroactive effect to the effective date of the original bill.
Republican leadership announced its intent to introduce a technical corrections bill in early 2018. However, because the technical corrections bill should not have a score attached to it, it is not eligible for the reconciliation process. As a result, any corrections will need Democratic support to meet the 60 vote threshold in the Senate. Thus, any efforts to advocate for a technical correction will need to have support from both sides of the aisle.
Finally, the Treasury Department has begun the critical work of issuing guidance implementing the bill. On December 29, 2017, Treasury and the Internal Revenue Service released Notice 2018-7, which describes regulations that Treasury intends to issue implementing the transition tax. This Notice will be the first of several guidance items on this provision. Issuing guidance on the transition tax and on withholding for individual income taxes are Treasury's top priorities but, once those items are addressed, Treasury will turn its attention to identifying other areas where guidance is needed. Taxpayers should reach out to Treasury to alert them to areas where there are ambiguities and to inform Treasury as to which items are a priority for taxpayers (particularly areas where guidance is needed for non-tax reasons, such as for financial statement purposes).
Taxpayers should be mindful that the dust is still settling with respect to US tax reform. There are likely to be changes made over the next year, and the guidance process will be long, but important. In addition, the domestic and international political implications of the bill could both affect future guidance and international tax relations as a whole.
- * Marc M. Levey is a Principal in Baker & McKenzie LLP in its New York office Alexandra Minkovich is Of Counsel, Joshua D. Odintz is a Principal and Kathryn E. Rimpfel is a tax associate in the firm's Washington DC office. All authors are members of the firm's Tax Policy Group. All rights reserved®
- Public Law No. 115-97.
- See Itai Grinberg's draft paper, The BEAT is a Pragmatic and Geopolitically Savvy Inbound Base Erosion Rule, of November 12, 2017
- (available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3069770).
- This amount is reduced to 5% for 2018.