On June 11, 2018, the International Tax Institute (ITI) held a session on “Tax Reform Issues Related to Group Financing – 163j, 267A, BEAT and GILTI Issues.” The speakers included James Tobin, Senior Tax Partner at EY and Kevin Glenn, Tax Partner at King & Spalding.
The discussion focused on current financing structures for inbound and outbound transactions, and the impact that the international provisions of the U.S. Tax Cuts and Jobs Act (TCJA) will have on these structures.
In a typical outbound structure, the U.S. Parent holds various controlled foreign corporations (CFCs) (i.e., “Fincos,” “Holdcos,” “Opcos”). CFC Fincos are generally located in low-tax jurisdictions. CFC Holdcos and Opcos are generally located in high-tax jurisdictions. Fincos loan money to Holdcos and Opcos. As a result, the Holdcos and Opcos deduct the interest expense at a higher rate, while the Fincos are taxed on the interest income at a lower rate.
The TCJA introduced the global intangible low-taxed income (GILTI) provision. Under this provision, U.S. shareholders of CFCs must include GILTI in gross income for the taxable year. See section 951A. For the relevant taxable year, GILTI is defined as the excess of the U.S. shareholder’s net CFC tested income over its net deemed tangible income return (i.e., excess of 10% of the aggregate pro rata share of tangible assets of each CFC over interest expense).
Under the GILTI calculation, a higher interest expense leads to a higher GILTI inclusion for the U.S. shareholder. Therefore, U.S. MNEs should be mindful of structures where CFCs are deducting interest expense at a high tax rate. In addition, taxpayers are prohibited from carrying back or forward any foreign taxes paid or accrued on GILTI. (See section 904(c)).
Under section 245A, the U.S. provides a 100% dividends-received deduction (DRD) on distributions from a CFC to its U.S. shareholder. Section 245A(e)(1) disallows the deduction where the CFC distributes a “hybrid dividend” (i.e., where the CFC received a deduction (or other tax benefit). A situation where this may arise is when a Luxembourg holding company (e.g., CFC) is funded by Convertible Preferred Equity Certificates (CPECs). CPECs are hybrid instruments that are typically treated as debt in Luxembourg and as equity in the U.S.
Section 267A disallows a deduction for any interest or royalty paid or accrued to a related party if the amount is not included in the related party’s income in the foreign jurisdiction, or if the related party can take a deduction in the foreign jurisdiction. See BEPS Action 2. An exception arises where the payment is included in the U.S. shareholder’s gross income under section 951(a). Section 267A(e) grants Treasury broad regulatory authority, and taxpayers should consider the possibility of a retroactive effective date of future regulations.
One benefit of the tax reform is that U.S. corporate taxpayers can take advantage of the reduced corporate tax rate of 21% on Subpart F income.
A typical inbound structure has a Foreign Parent holding U.S. and foreign subsidiaries. A foreign Finco subsidiary may loan money to the U.S. subsidiary, which pays interest expense to Finco. With the addition by the TCJA of the base erosion and anti-abuse tax (BEAT), the taxpayer may need to consider whether these deductible payments are “base erosion payments” under section 59A(d) (e.g., deductible amount paid or accrued by the taxpayer to a foreign related party). For purposes of calculating the base erosion minimum tax amount, deductions for base erosion payments are added back to determine the modified taxable income.
Taxpayers also need to consider the limitation on deductions for business interest under section 163(j). Deductions cannot exceed the sum of: (1) business interest income; (2) 30 percent of adjusted taxable income (ATI); and (3) floor plan financing interest. This limitation applies to business interest on related and third-party debt. For taxable years beginning prior to January 1, 2022, ATI is computed without regard to any deduction allowable for depreciation, amortization, or depletion. This is in line with other countries, as well as BEPS Action 4, which recommends a limitation on net deductions for interest, and payments economically equivalent to interest, of 10% – 30% of earnings before interest, taxes, depreciation, and amortization (EBITDA). For taxable years beginning on or after January 1, 2022, the U.S. will switch to EBIT, which penalizes its taxpayers compared to the rest of the world. It remains to be see whether future Treasury Regulations will be retroactive.
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