The Tax Cuts and Jobs Act (the New Tax Law), signed into law in late December by President Donald Trump, makes major permanent and temporary changes to the US federal tax system. The changes will have a significant impact on the structuring of US and foreign investments.
Proponents of the changes expect them to reduce capital flight and inversions to other jurisdictions and make investment through United States corporate structures more attractive, particularly for United States individuals owning interests in controlled foreign corporations (CFCs).
CORPORATE RATE REDUCTION
The New Tax Law permanently reduces the corporate income tax rate to 21 percent, beginning in 2018 and eliminates the corporate alternative minimum tax. For corporations with a non-calendar fiscal year, the new corporate tax rate should apply to the portion of a corporation's taxable year that falls in 2018.
Observation: In light of the reduction in the corporate tax rate, changes to certain international provisions and introduction of the deduction for pass-through qualified business income, the optimal choice of entity is highly fact specific and should be evaluated in light of each taxpayer's or business's specific circumstances.
LIMITATION ON BUSINESS INTEREST DEDUCTION
For tax years after 2017, the deductibility of net business interest is capped at 30 percent of "adjusted taxable income." For tax years beginning during 2018 through 2021, "adjusted taxable income" is an amount that is similar to EBITDA. For tax years beginning after 2021, "adjusted taxable income" is an amount that is similar to EBIT. Generally, any disallowed amounts may be carried forward indefinitely. Real estate firms, regulated utilities and small businesses (with $25 million or less of gross receipts) would be exempt from this limitation.
Observation: Clarification will be needed in determining whether related businesses are considered one business for purposes of applying this limitation.
Capital expenditures for qualified property (which excludes real estate – eg, land and buildings and certain utility property) placed in service after September 27, 2017 and before January 1, 2023 (including used property acquired from third parties) may be deducted in full in the year the property is acquired or placed in service. The deduction is phased down by 20 percent each year beginning in 2023.
Observation: For many businesses, the accelerated depreciation deductions will offset the impact of the limitation on interest deductions and ability to use NOLs, discussed below. It will also make asset acquisitions more attractive and less costly on an after-tax basis for purchasers of many businesses.
The New Tax Law limits the NOL deduction to 80 percent of taxable income (determined without regard to the deduction) for losses arising in taxable years beginning after December 31, 2017. Unused NOLs can be carried forward indefinitely, but, with the exception of certain farming losses, can no longer be carried back. For property and casualty insurance companies, however, the tax bill retains existing law.
The New Tax Law generally requires a taxpayer to recognize income no later than the tax year in which such income is taken into account as income on an applicable financial statement or another financial statement under rules to be specified by the Internal Revenue Service.
The New Tax Law introduces a three-year holding period requirement for partnership interests held in connection with raising capital and managing assets in order to benefit from the preferential capital gains rate. This new holding period requirement generally should not apply to recipients of profits interests that only provide services to portfolio companies.
Observation: While this holding period is not expected to have a significant impact on private equity fund managers or on the investment activities of such funds, the drafting of the law leaves open a number of interpretational issues that may further mitigate the impact of this new law.
The New Tax Law creates a new deduction for qualifying business income earned through a pass-through entity. Significantly, income from investment management services and other service businesses in which the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners is not qualifying business income, except to the extent that the taxable income of the individual taxpayer does not exceed the Threshold Amount of $157,500 ($315,000 if married filing jointly), subject to a complete phase-out of the exception. For owners of other pass-through entities earning qualified business income, the deduction, which can result in an effective tax rate on qualified business income not in excess of 29.6 percent, is subject to limitation based on either the wages paid by the business or a combination of wages and a specified return on capital invested in qualifying property if the taxable income of the individual owner exceeds the Threshold Amount.
GAIN ON THE SALE OF PARTNERSHIP INTEREST
For sales and exchanges of partnership interests by foreign persons after Nov. 27, 2017, the New Tax Law codifies the Internal Revenue Service's prior position, which was recently invalidated in a US Tax Court decision, and taxes gain from the sale or exchange of an interest in a partnership (including an LLC taxed as a partnership) that is engaged in a US trade or business. Thus, foreign partners will be subject to United States net income tax on such gain to the extent that the partner or member would have been subject to tax had the partnership sold all of its assets at fair market value as of the date of the sale or exchange. The New Tax Law further requires the acquirer of the partnership interest to withhold 10 percent of the amount realized on the sale unless the selling partner certifies that it is not a nonresident alien individual or foreign corporation. If the acquirer fails to withhold the correct amount, the partnership will be required to deduct and withhold from distributions to the acquirer partner an amount equal to the amount the acquirer failed to withhold.
Observation: The introduction of the deduction for qualifying business income will create an incentive for US taxpayers to invest in many operating businesses through pass-through entities. Foreign partners will, however, still need to invest through corporate entities in order to avoid being required to file US income tax returns to report and pay tax on the income of such businesses and to avoid being subject to US income tax on the sale of an interest in such business.
FOREIGN SOURCE DIVIDENDS RECEIVED DEDUCTION
Effective for taxable years beginning after December 31, 2017, a corporation which is a US Shareholder of a CFC and is not a RIC, REIT or Subchapter S corporation, may deduct 100 percent of the foreign-source portion of dividends distributed by such CFC. The deduction is not available if the foreign corporation is a passive foreign investment company that is not also a CFC; nor is the deduction available if the dividend is a "hybrid dividend" – namely, a dividend for which the dividends received deduction would otherwise be allowed and for which the CFC received a deduction or other tax benefit with respect to any income, war profits or excess profits taxes imposed by a foreign country. As noted below, under the New Tax Law, a domestic corporation will be a US Shareholder if it owns at least 10 percent of the vote or value of a CFC.
As part of the transition to a territorial regime and in order to partially offset the cost of the reduction in the corporate income tax rate, the New Tax Law imposes a one-time tax on un-repatriated earnings and profits of foreign subsidiaries at a rate of 15.5 percent on those earnings held in cash and cash equivalents and 8 percent on earnings held in the form of other types of assets.
The impact of this tax, which can be paid in installments over eight years, will be borne by all United States persons who own 10 percent of the vote or value of a foreign company. Thus, this provision could impact not just US corporations owning foreign subsidiaries, but also private equity funds and their US owners who directly or indirectly own 10 percent of a foreign portfolio company through a flow-through entity.
ELIMINATION OF 30-DAY REQUIREMENT FOR SUBPART F INCLUSION
The New Tax Law eliminates the requirement that a CFC must be owned for an uninterrupted period of 30 days or more during the taxable year for purposes of including such CFC's subpart F income in the gross income of the US Shareholder. As a result, so-called 30-day-Rule planning techniques designed to be executed within the last 30 days of the tax year in order to avoid adverse subpart F implications are no longer available.
CHANGES TO STOCK ATTRIBUTION RULES FOR DETERMINING CFC STATUS
The New Tax Law eliminates the rule that provided that stock owned by a foreign person may not be attributed to a US person to cause such person to be a US Shareholder of a foreign corporation (or to cause a foreign corporation to be treated as a CFC). As a consequence of this change, any commonly controlled subsidiaries of a foreign-parented US corporation will be treated as CFCs.
Observation: While such US corporation should not have any Subpart F inclusion except to the extent of its direct or indirect ownership in such CFCs, any US person that owns at least 10 percent of the foreign parent will be required to include its share of the CFC's Subpart F income, irrespective of the motives regarding the investment by the US person.
NEW ANTI-DEFERRAL RULES
The New Tax Law adds new anti-deferral (GILTI) rules designed to prevent deferral of tax on CFC income that is not already subject to the Subpart F rules, effectively connected with a US trade or business, foreign oil and gas extraction income or dividends received from a related person and that exceeds a 10 percent return on adjusted basis in depreciable property used in production of the CFC income.
This new anti-deferral regime applies to all US Shareholders of a CFC (ie, US persons owning at least 10 percent of vote or value), but applies differently to domestic corporations and US citizen or resident individuals. For example, in the case of corporate US Shareholders, this provision imposes US income tax, at a reduced rate of 10.5 percent, on such excess return (this reduced rate increases in 2026), which is less than the rate of tax applied to Subpart F income or income effectively connected with a US trade or business. Ordinary income tax rates apply to GILTI income earned by US individual citizens and residents. In addition, corporate US Shareholders can credit 80 percent of the foreign taxes paid on GILTI income against US income tax, meaning that no residual US corporate income tax will apply to GILTI income if it is subject to an effective foreign tax rate of at least 13.125 percent. Individual US citizens and residents do not benefit from foreign tax credits to offset US income tax on GILTI income.
Observation: The modifications to the CFC rules and introduction of the GILTI rules can result in US individual taxpayers earning phantom income in a greater number of situations and being subject to less favorable rules than domestic corporations. Thus, existing ownership structures and future acquisition structures should be evaluated to determine whether US investors or owners would be subject to a lower effective tax rate on foreign income by moving investment partnerships offshore or by investing in foreign companies through a US corporation. Also, the tax on GILTI income is computed on a global basis, which may allow for an investment in depreciable property (and a corresponding increase in adjusted basis) in one or more jurisdictions, resulting in a lower taxable GILTI income without a corresponding increase in foreign taxes.