It has been a little over one year since President Trump signed the Tax Cuts and Jobs Act 2017 (the ‘Act’) into law. However, a year on, the attitude of most US multinational companies towards the law can be described at best as ‘cautious’; and that word also fairly describes the attitude of the US Treasury. (For a summary of the entire Act, see our article ‘US tax reform: examining the Tax Cuts and Jobs Act of 2017’, Tax Journal, 12 January 2018.)
For most companies, significant changes to their international operations were delayed until the US Treasury Department and the Internal Revenue Service (IRS) had issued key proposed regulations (the most significant of which were issued very late in 2018 and will be described below and in a subsequent article), and the companies had a chance to digest them. In the meantime, hundreds of billions of dollars of past profits remain offshore, and a number of companies are realistically treating much of the tax cut provided by the Act as a windfall rather than a permanent change.
Since September 2018, the US Treasury and the IRS have issued four sets of proposed regulations which are important for multinationals. If adopted, these will implement the most significant international changes of the Act and have long-term effects on the taxation of cross-border investment from and into the US. These proposed regulations should be of interest to all multinational enterprises that have operations in the US, as well as US multinationals that operate outside the US. Two of the proposed regulations affecting primarily investment into the US will be discussed below. Two other sets of proposed regulations that primarily affect outbound investment by US multinationals will be discussed in a subsequent article.
Under the US Internal Revenue Code (the ‘Code’) and applicable administrative law, the Department of the Treasury/IRS have discretion in administering (i.e., interpreting and/or implementing) laws like the Act, especially if they adopt regulations to do so. Most importantly, regulations properly adopted by the Treasury/IRS are entitled (under existing case law) to significant deference by the courts, and it is very difficult for taxpayers to successfully challenge a regulation interpreting or administering a law promulgated by an administrative agency like the IRS unless the relevant statute is clearly contrary to the regulation.
In order, however, for a rule adopted by an administrative agency like the IRS to qualify as a ‘regulation’ entitled to deference, certain procedures must be followed by the agency. These generally include a requirement that the regulation, before being adopted, must be promulgated in proposed form so that affected parties may have notice about its contents and the opportunity to provide comments. Thus, these proposed regulations are not merely general ideas that the IRS is currently considering, but real first steps in making the rules set forth in the proposed regulations ‘final’ and generally binding on taxpayers. In addition, the IRS will generally allow taxpayers to rely on the rules set forth in proposed regulations in filing tax returns. For these reasons, even though only ‘proposed’, these rules will likely have significant effects on affected taxpayers.
The Act enacted new rules limiting the deductibility of net business interest expense by taxpayers. Prior to the Act, section 163(j) of the Code disallowed deductions for ‘disqualified interest’ paid or accrued by corporations to related parties if the taxpayer’s debt-to-equity ratio exceeded a statutory threshold and their net interest expense exceeded 50% of their adjusted taxable income. Section 163(j), as amended by the Act, disallows a taxpayer’s business deductions for net interest expense, generally defined as the excess of business interest expense over business interest income, if such net interest expense exceeds 30% of the taxpayer’s ‘adjusted taxable income’ (ATI). This limitation applies irrespective of whether the interest is paid to related or unrelated parties. The section 163(j) limitation applies, however, only to business interest and does not apply to investment interest. The statute also provides that the section 163(j) limitation applies to a partnership at the partnership level and not at the partner level. There is no grandfathering for debt issued prior to the enactment of the Act.
For taxable years beginning before 1 January 2022, a taxpayer’s ATI is generally equal to their taxable income after adding back non-business and exempt business income and deductions, interest, taxes, depreciation and amortisation (subject to certain other adjustments). The section 163(j) limitation for subsequent taxable years will be determined in the same manner without any add-back for depreciation and amortisation.
Deductions disallowed by the section 163(j) limitation are generally carried forward in the same manner as net operating loss (NOL) carryforwards. Thus, subject to a special rule for partnerships, disallowed business interest deductions may be carried forward indefinitely. A taxpayer’s disallowed business interest deductions are also subject to limitation following a change in ownership of the taxpayer.
On 26 November 2018, the Treasury/IRS issued proposed regulations under section 163(j). The proposed regulations provide critical guidance regarding many of the technical provisions in section 163(j), as well as the application of section 163(j) to different types of entities, including partnerships, controlled foreign corporations and corporate members of a tax consolidated group.
Highlights of the proposed regulations include the following provisions that are not clearly present in the statute itself.
The definition of ‘interest’ for section 163(j) purposes is defined broadly to include not only amounts generally treated as interest for federal income tax purposes, but also certain items of income and expense that are related to debt instruments, such as gains and losses from hedges of debt instruments, substitute interest payments under a securities loan, loan commitment fees and debt issuance costs. As this rule is part of the definition of interest, income from these types of transactions also counts as interest income for purposes of determining net interest expense.
The proposed regulations include a broad anti-avoidance rule under which any deductible expense or loss ‘predominantly incurred in consideration of the time value of money’ would also be treated as interest expense for section 163(j) purposes. Although the preamble (regulations and proposed regulations are typically issued with a ‘preamble’ that explains in discursive language the rules that have been promulgated and provides, where warranted, a rationale for them) and the proposed regulations themselves call this provision an anti-avoidance rule, the rule, as drafted, does not require that the taxpayer has an intent or motive to avoid the application of section 163(j). Therefore, section 163(j) could apply to ordinary course transactions that are not motivated by section 163(j) considerations. For example, the anti-avoidance rule could arguably apply to interest equivalent payments under a swap or prepayments under a financial instrument, even if section 163(j) considerations are not a factor in the structure for the applicable transaction.
This may be particularly problematic for financial institutions that enter into offsetting transactions since this recharacterisation rule applies only to expenses and not to income. Accordingly, the expense from one side of the transaction could be treated as interest for section 163(j) purposes, while the income from an offsetting transaction would not likewise be treated as interest income for section 163(j) purposes.
Of particular importance to non-US multinationals that guarantee the debt of their US subsidiaries, the proposed regulations neither specifically exclude nor explicitly include guarantee fees in the definition of interest for section 163(j) purposes, even though it is possible that in certain cases guarantee fees could be treated as interest under general tax principles (in which case guarantee fees would likewise be so treated for section 163(j) purposes) or that guarantee fees could be treated as interest for section 163(j) purposes under the anti-avoidance rule discussed above.
The proposed regulations also provide that, notwithstanding that the statute applies only to business interest, all interest paid or received by a corporation is business interest unless the corporation or the interest is otherwise exempt from section 163(j) under the statutory rules that grant exemptions; for example,for real estate businesses.
The determination as to whether interest expense that is incurred by a partnership is subject to section 163(j) is made at the partnership level based on the income and expenses of the partnership. Any disallowed interest under section 163(j) would then be allocated to the partners in the partnership. Detailed rules, however, coordinate the section 163(j) limitation of the partnership with that of its partners.
As indicated in the statute, a foreign corporation would be subject to section 163(j) to the extent it had income effectively connected with US trade or business or permanent establishment. The proposed regulations, however, expand this rule and would also subject a controlled foreign corporation (CFC) to the section 163(j) limitation for the purposes of computing its subpart F income and/or GILTI tested income or loss (i.e. income of the CFC taxable to its US shareholders even if not currently distributed), even if the CFC itself is not subject to US tax. As a result, under the proposed regulations, section 163(j) would limit the extent to which a CFC’s business interest expense is deductible for the purposes of computing the subpart F income, GILTI tested income or loss, and income effectively connected to a US trade or business for the CFC and its US shareholders, as appropriate.
For the purposes of calculating the section 163(j) limitation of a CFC’s US shareholder and subject to the discussion below regarding a CFC group election, the US shareholder’s ATI would not include subpart F income, GILTI or deemed paid foreign tax credits allocable to the CFC, even if the CFC has excess section 163(j) limitation. (As is the case with respect to a domestic corporation, any interest deduction that is disallowed under section 163(j) would reduce the earnings and profits of a CFC. Accordingly, a US shareholder of a CFC that earns only subpart F income may not be affected if the CFC’s interest deductions are disallowed under section 163(j), because the US shareholder’s subpart F inclusion cannot exceed the earnings and profits of the CFC.)
The section 163(j) limitation of a US consolidated tax group would be applied to the group as a whole, as if the group were a single taxpayer and would not be applied separately to each member of the group. With respect to CFCs, however, as a general matter, each CFC in an affiliated group would be subject to the CFC’s own section 163(j) limitation, and there is no equivalent to the rule described above for domestic consolidated groups that would apply a single section 163(j) limitation to an affiliated group of CFCs. Thus, subject to the CFC group election discussion below:
The proposed regulations, however, provide that an affiliated group of CFCs can make a ‘CFC group election’, under which:
A CFC’s allocable share of the group’s net interest expense would equal a fraction: the numerator of which is the CFC’s net interest expense; and the denominator of which is the aggregate net interest expense of all of the members of the CFC group (in each case determined without disregarding transaction within the group). Thus, under these rules, and unlike the rules described above for domestic consolidated tax groups, CFCs that are subject to a CFC group election would still need to determine the section 163(j) limitation individually for each member of the CFC affiliated group. In addition, under the proposed regulations, CFCs conducting a financial services business would be treated as a separate subgroup subject to special allocation rules.
In addition to the CFC group election consequences described above, the proposed regulations also provide that a CFC group that is subject to a CFC group election may ‘roll up’ a lower tier CFC group member’s excess section 163(j) limitation to higher tier CFC group members, until the highest tier CFC group member. Also, any excess section 163(j) limitation of the highest tier CFC group member would ‘roll up’ to such member’s US shareholders, in an amount not greater than the income included by the shareholder from the CFC under subpart F and GILTI. Accordingly, a CFC group election may be particularly advantageous to an affiliated group of CFCs that has:
If finalised, the proposed regulations would generally apply to taxable years ending after the date the proposed regulations are finalised. However, taxpayers and their related parties may apply the proposed regulations for all taxable years beginning after 31 December 2017. Taxpayers that make this election are subject to the entirety of the proposed regulations and cannot elect to apply only certain portions of them. Thus, while some provisions of the proposed regulations, such as the CFC group election, could be beneficial if implemented as soon as possible, taxpayers will need to assess whether such benefits would be outweighed by drawbacks caused by other provisions of the proposed regulations, such as the broad definition of interest rules.
It is important to note, moreover, that neither the preamble to the proposed regulations, nor the proposed regulations provide guidance on what it means for taxpayers to apply the proposed regulations before they are finalised. Some provisions of the proposed regulations, such as the CFC group election rules, are not part of the statute and are clearly provisions that cannot be applied now without applying all of the proposed regulations. However, it is unclear whether other provisions of the proposed regulations are simply interpretations of the existing statute that could be followed by a taxpayer now without requiring the taxpayer also to apply all of the rest of the proposed regulations.
While the proposed base erosion and anti-abuse tax (BEAT) regulations provide new guidance on significant aspects of BEAT that were not addressed in the statutory language of the Act, the proposed regulations still leave many questions unanswered.
Section 59A of the Code, added by the Act, introduced the concept of BEAT. Conceptually, BEAT imposes a minimum tax on an alternatively computed tax base of certain taxpayers (both US and non-US) intended, as its name suggests, to reduce the incentive for such taxpayers to make deductible payments to related foreign persons that would reduce the US tax base.
The actual imposition of BEAT works generally in a mechanical manner, requiring the determination of several BEAT-specific items. First, only a corporate taxpayer that meets the following conditions is subject to BEAT (such a taxpayer is an ‘applicable taxpayer’):
For purposes of the gross receipts test, special aggregation rules apply to treat a group of corporations under common control as one person, and each member of the group is treated as an applicable taxpayer if the group so qualifies. If determined to be an applicable taxpayer, the taxpayer must then identify all so-called ‘base erosion payments’ (i.e.payments to a non-US person deemed to be related to the applicable taxpayer under special attribution rules) and the tax benefits ‘with respect to’ such base erosion payments (such tax benefits are the ‘base erosion tax benefits’).
(Note that base erosion payments and base erosion tax benefits include, respectively, the acquisition of depreciable or amortisable property from a related person and the depreciation or amortisation deductions attributable to such property in the hands of the acquirer. Certain service costs, however, are excluded from the definition of base erosion payments if they are computed under a permissible transfer pricing method, as are certain ‘qualified derivative payments’.)
Next, the applicable taxpayer must determine its so-called ‘base erosion percentage’ by dividing the aggregate amount of base erosion tax benefits for the taxable year by the sum of the total amount of deductions and any other tax benefits treated as a base erosion tax benefit for the taxable year. Then the applicable taxpayer must apply the base erosion test: if the base erosion percentage exceeds 3% (2% in the case of a member of an affiliated group that includes certain financial institutions), the applicable taxpayer has ‘passed’ the base erosion test and must compute its BEAT tax liability. In applying the base erosion percentage test, special aggregation rules apply to treat a group of corporations under common control as one person (such aggregated corporations are the ‘aggregate group’).
If the applicable taxpayer has ‘passed’ the base erosion test, it must first determine its ‘modified taxable income’, which is the taxpayer’s regular taxable income determined without regard to any ‘base erosion tax benefit’ and the ‘base erosion percentage’ of any NOL deduction allowed under section 172 of the Code for the taxable year.
Once such BEAT specific items are determined, the amount of tax imposed by the BEAT on the applicable taxpayer equals the excess (if any) of:
The BEAT rate is 5% for taxable years beginning in 2018; 10% for taxable years thereafter until 2025, and 12.5% for taxable years beginning after 31 December 2025. In the case of a member of an affiliated group that includes a bank or a registered securities dealer, each of the percentages mentioned in the preceding sentence is increased by 1% (i.e. 6% in 2018, 11% until 2025, and 13.5% thereafter).
On 13 December 2018, the Treasury/IRS issued proposed regulations on the BEAT. As discussed below, the proposed regulations would clarify some of the key aspects of the BEAT regime, but also include a number of surprises and do not provide specific rules on other issues that could have a critical impact on a taxpayer’s ultimate BEAT liability.
Highlights of the proposed regulations include the following.
For the purposes of determining whether a ‘base erosion tax benefit’ exists, the proposed regulations would not establish any specific rules for determining whether and when a deduction exists; whether a payment gives rise to a deduction; or whether a deduction is allowed ‘with respect to’ a payment made to a related foreign person. Rather, the preamble states that these questions must be resolved under general principles of federal income taxation.
Existing law may not provide clear guidance in some situations, however, given the novelty of the BEAT regime. In particular, the proposed regulations do not specifically address the question of whether expenditures included in the costs of goods sold (i.e. inventory costs) are ever treated as deductible payments. Thus, it would appear that royalties paid to related persons that are included in inventory costs by the licensee would not be treated as giving rise to a base erosion tax benefit.
Resolving a complicated ‘glitch’ in the statute, the proposed regulations exclude foreign corporations from the controlled group for the purposes of applying the aggregation rules, except to the extent that the foreign corporation has effectively connected income that is subject to US corporate tax. This clarifies that payments made by a domestic corporation, or a foreign corporation with respect to its effectively connected income, to a related foreign corporation are not excluded from the base erosion percentage test.
The proposed regulations adopt an ‘add-back’ approach to computing modified taxable income, rather than a ‘recomputation’ approach. Thus, to the extent that a disregarded base erosion tax benefit affects the calculation of another item entering into the tax calculation, an applicable taxpayer does not recompute the affected other item in determining its modified taxable income (i.e. its tax liability without the disregarded base erosion tax benefit). Significantly, however, the IRS accepts that the starting point for computing modified taxable income prior to the add-back can be negative if losses in the current year exceed gross income. The proposed regulations nonetheless would limit the use of NOL carryovers from previous years to the actual taxable income of the current taxable year. As a result, excess NOL carryovers cannot be used to replace disregarded base erosion payments for the current taxable year in computing modified taxable income. Thus, BEAT tax may be due even if an applicable taxpayer has unused NOL carryovers from prior years. This may increase the significance of the timing of loss recognition.
The proposed regulations provide that ‘the amount of any base erosion payment is determined on a gross basis, regardless of any contractual or legal right to make or receive payments on a net basis’. This may have unexpected effects on the treatment of group cash-pooling arrangements and groups that have transactions running back and forth among affiliates. However, the preamble notes that there may be situations where otherwise generally applicable law would require computation to be done on a net basis, suggesting that the legal obligations giving rise to such payments can themselves be netted (or constitute a single obligation).
The proposed regulations would generally allow the exclusion of ‘cost plus’ payments for services from base erosion treatment under a ‘bifurcation approach’ previously advocated by taxpayers. Only the amount paid in excess of the total cost of services (i.e. the markup component) would be disqualified from the services cost method exception and would therefore give rise to base erosion payments.
Foreign exchange losses (so-called ‘section 988 losses’) would be entirely disregarded in the BEAT regime, and would therefore be excluded from both the denominator and the numerator of the base erosion percentage. The preamble explains that exchange losses do not present the same base erosion concerns as other types of losses that arise in connection with payments to a related foreign party. It is not clear, however, why losses arising in transactions with unrelated parties should likewise be excluded from the denominator.
Partnerships are viewed as aggregates of their partners rather than as entities, and thus payments to and from the partnership are treated as payments to and from the partners for purposes of applying BEAT. This can have unanticipated consequences for transactions between a partnership and its partners if the partnership has both foreign and domestic related partners.
The proposed regulations appear to treat certain property transfers by applicable taxpayers to related foreign persons as ‘payments’ to those persons. Thus, the preamble to the proposed regulations states that a loss recognised on a transfer of property by an applicable taxpayer to a foreign party could give rise to a base erosion payment, even though such a loss likewise does not result in base erosion. The tax benefits from such a loss to the taxpayer may be limited under the related party transaction rules. In addition, the preamble specifically references certain non-recognition transactions (e.g. inbound section tax-free liquidations of subsidiaries, tax-free capital contributions to a domestic corporation and tax-free merger transactions, as well as certain contributions to a partnership by a related foreign partner) as potentially giving rise to base erosion tax benefits as a result of deemed or actual non-cash payments or accruals by an affected taxpayer. It is not at all clear what exactly will be covered by this concept. (For example, the actual or deemed transfer of the affected taxpayers’ shares to a related foreign corporation in a merger transaction may be deemed to be a non-cash payment to that corporation in the form of those shares.)
The status of section 163(j) interest expense carryovers as base erosion payments would be determined by reference to the year in which the interest expense accrued. The IRS, however, has reversed its position in Notice 2018-28 by providing in the proposed regulations that disallowed business interest carried forward from a taxable year prior to 1 January 2018 would not give rise to any base erosion payments.
The proposed regulations have several provisions that principally affect financial institutions and security or commodities dealers.
The base erosion percentage test with a lower (2%) threshold applies not only to US banks and registered securities dealers, but also to:
Foreign banks that are licensed to conduct banking in the US are excluded from the definition of ‘banks’ for this purpose.
The proposed regulations would expressly require items to be determined annually on a net basis where the taxpayer has adopted a mark-to-market method of accounting. This should serve to limit the duplication of gains and losses in both the numerator and the denominator of the base erosion percentage.
Payments pursuant to any sale-repurchase transaction (‘repos’) or securities lending transaction would be excluded from the ‘qualified derivative payments’ exception and would therefore give rise to base erosion payments. This might be deemed (for now at least) to include even stock loans, given the technical language of relevant cross-references.
Interest payments on ‘total loss-absorbing capacity’ (TLAC) securities issued to foreign parents by US subsidiaries would not be base erosion payments to the extent such issuance was required by the Federal Reserve (and thus interest on such TLAC securities would likewise not be included in the numerator of the base erosion percentage, and would not be included in the denominator either, except to the extent such interest was ECI). However, the proposed regulations would not provide similar exceptions for foreign banks that have ECI and that issue debt subject to similar requirements by foreign bank regulators.
The proposed regulations would generally provide that a foreign corporation that has interest expense allocable to ECI under the existing apportionment and allocation rules of section 1.882-5 of the Treasury Regulations (i.e.interest expense allocable to a branch) will have a base erosion payment to the extent the interest expense results from a deemed payment or accrual to a related foreign party. The proposed regulations would not adopt the rule of section 884(f) of the Code that treats the excess of accrued interest expense over booked interest expense as paid to a related foreign parent. Rather, the proposed regulations would treat such excess interest as paid to a related foreign parent in proportion to the character of the interest paid by such related foreign parent based on a scaling ratio.
Finally, the proposed regulations set out three anti-abuse rules that focus on the taxpayer having ‘a principal purpose’ of:
If finalised on or before 22 June 2019, the proposed regulations would generally apply to taxable years beginning after 31 December 2017. However, if finalised after 22 June 2019, such final regulations would generally apply to taxable years ending on or after 17 December 2018.
One final point needs to be made about the eventual implementation of these rules by the government and taxpayers. Over the past decade, taxpayers have argued in a number of court cases that the issuance of regulations by Treasury and the IRS have not been in accord with the administrative procedural rules governing the issuance of regulations by US federal agencies. And in some of the cases, courts have been open to such arguments.
So far, the successful challenges have been limited to cases where the taxpayer was already under audit by the IRS; that is, the issue was raised in the cases of an actual controversy involving a specific taxpayer. However, it is expected that such challenges might become more common, including situations where the regulations are newly issued and one or more taxpayers (or associations such as the US Chamber of Commerce) try to challenge the regulations even before they are effective or where a specific taxpayer is audited by the IRS regarding an issue set forth in the particular regulation at issue. If such litigation becomes commonplace, it may lead companies to further defer making any significant changes to their structures until courts weigh in on the new regulations.
In a forthcoming edition, the authors will examine the proposed regulations on global intangible low-taxed income and foreign tax credits.
It has been a little over one year since President Trump signed the Tax Cuts and Jobs Act 2017 (the ‘Act’) into law. However, a year on, the attitude of most US multinational companies towards the law can be described at best as ‘cautious’; and that word also fairly describes the attitude of the US Treasury. (For a summary of the entire Act, see our article ‘US tax reform: examining the Tax Cuts and Jobs Act of 2017’, Tax Journal, 12 January 2018.)
For most companies, significant changes to their international operations were delayed until the US Treasury Department and the Internal Revenue Service (IRS) had issued key proposed regulations (the most significant of which were issued very late in 2018 and will be described below and in a subsequent article), and the companies had a chance to digest them. In the meantime, hundreds of billions of dollars of past profits remain offshore, and a number of companies are realistically treating much of the tax cut provided by the Act as a windfall rather than a permanent change.
Since September 2018, the US Treasury and the IRS have issued four sets of proposed regulations which are important for multinationals. If adopted, these will implement the most significant international changes of the Act and have long-term effects on the taxation of cross-border investment from and into the US. These proposed regulations should be of interest to all multinational enterprises that have operations in the US, as well as US multinationals that operate outside the US. Two of the proposed regulations affecting primarily investment into the US will be discussed below. Two other sets of proposed regulations that primarily affect outbound investment by US multinationals will be discussed in a subsequent article.
Under the US Internal Revenue Code (the ‘Code’) and applicable administrative law, the Department of the Treasury/IRS have discretion in administering (i.e., interpreting and/or implementing) laws like the Act, especially if they adopt regulations to do so. Most importantly, regulations properly adopted by the Treasury/IRS are entitled (under existing case law) to significant deference by the courts, and it is very difficult for taxpayers to successfully challenge a regulation interpreting or administering a law promulgated by an administrative agency like the IRS unless the relevant statute is clearly contrary to the regulation.
In order, however, for a rule adopted by an administrative agency like the IRS to qualify as a ‘regulation’ entitled to deference, certain procedures must be followed by the agency. These generally include a requirement that the regulation, before being adopted, must be promulgated in proposed form so that affected parties may have notice about its contents and the opportunity to provide comments. Thus, these proposed regulations are not merely general ideas that the IRS is currently considering, but real first steps in making the rules set forth in the proposed regulations ‘final’ and generally binding on taxpayers. In addition, the IRS will generally allow taxpayers to rely on the rules set forth in proposed regulations in filing tax returns. For these reasons, even though only ‘proposed’, these rules will likely have significant effects on affected taxpayers.
The Act enacted new rules limiting the deductibility of net business interest expense by taxpayers. Prior to the Act, section 163(j) of the Code disallowed deductions for ‘disqualified interest’ paid or accrued by corporations to related parties if the taxpayer’s debt-to-equity ratio exceeded a statutory threshold and their net interest expense exceeded 50% of their adjusted taxable income. Section 163(j), as amended by the Act, disallows a taxpayer’s business deductions for net interest expense, generally defined as the excess of business interest expense over business interest income, if such net interest expense exceeds 30% of the taxpayer’s ‘adjusted taxable income’ (ATI). This limitation applies irrespective of whether the interest is paid to related or unrelated parties. The section 163(j) limitation applies, however, only to business interest and does not apply to investment interest. The statute also provides that the section 163(j) limitation applies to a partnership at the partnership level and not at the partner level. There is no grandfathering for debt issued prior to the enactment of the Act.
For taxable years beginning before 1 January 2022, a taxpayer’s ATI is generally equal to their taxable income after adding back non-business and exempt business income and deductions, interest, taxes, depreciation and amortisation (subject to certain other adjustments). The section 163(j) limitation for subsequent taxable years will be determined in the same manner without any add-back for depreciation and amortisation.
Deductions disallowed by the section 163(j) limitation are generally carried forward in the same manner as net operating loss (NOL) carryforwards. Thus, subject to a special rule for partnerships, disallowed business interest deductions may be carried forward indefinitely. A taxpayer’s disallowed business interest deductions are also subject to limitation following a change in ownership of the taxpayer.
On 26 November 2018, the Treasury/IRS issued proposed regulations under section 163(j). The proposed regulations provide critical guidance regarding many of the technical provisions in section 163(j), as well as the application of section 163(j) to different types of entities, including partnerships, controlled foreign corporations and corporate members of a tax consolidated group.
Highlights of the proposed regulations include the following provisions that are not clearly present in the statute itself.
The definition of ‘interest’ for section 163(j) purposes is defined broadly to include not only amounts generally treated as interest for federal income tax purposes, but also certain items of income and expense that are related to debt instruments, such as gains and losses from hedges of debt instruments, substitute interest payments under a securities loan, loan commitment fees and debt issuance costs. As this rule is part of the definition of interest, income from these types of transactions also counts as interest income for purposes of determining net interest expense.
The proposed regulations include a broad anti-avoidance rule under which any deductible expense or loss ‘predominantly incurred in consideration of the time value of money’ would also be treated as interest expense for section 163(j) purposes. Although the preamble (regulations and proposed regulations are typically issued with a ‘preamble’ that explains in discursive language the rules that have been promulgated and provides, where warranted, a rationale for them) and the proposed regulations themselves call this provision an anti-avoidance rule, the rule, as drafted, does not require that the taxpayer has an intent or motive to avoid the application of section 163(j). Therefore, section 163(j) could apply to ordinary course transactions that are not motivated by section 163(j) considerations. For example, the anti-avoidance rule could arguably apply to interest equivalent payments under a swap or prepayments under a financial instrument, even if section 163(j) considerations are not a factor in the structure for the applicable transaction.
This may be particularly problematic for financial institutions that enter into offsetting transactions since this recharacterisation rule applies only to expenses and not to income. Accordingly, the expense from one side of the transaction could be treated as interest for section 163(j) purposes, while the income from an offsetting transaction would not likewise be treated as interest income for section 163(j) purposes.
Of particular importance to non-US multinationals that guarantee the debt of their US subsidiaries, the proposed regulations neither specifically exclude nor explicitly include guarantee fees in the definition of interest for section 163(j) purposes, even though it is possible that in certain cases guarantee fees could be treated as interest under general tax principles (in which case guarantee fees would likewise be so treated for section 163(j) purposes) or that guarantee fees could be treated as interest for section 163(j) purposes under the anti-avoidance rule discussed above.
The proposed regulations also provide that, notwithstanding that the statute applies only to business interest, all interest paid or received by a corporation is business interest unless the corporation or the interest is otherwise exempt from section 163(j) under the statutory rules that grant exemptions; for example,for real estate businesses.
The determination as to whether interest expense that is incurred by a partnership is subject to section 163(j) is made at the partnership level based on the income and expenses of the partnership. Any disallowed interest under section 163(j) would then be allocated to the partners in the partnership. Detailed rules, however, coordinate the section 163(j) limitation of the partnership with that of its partners.
As indicated in the statute, a foreign corporation would be subject to section 163(j) to the extent it had income effectively connected with US trade or business or permanent establishment. The proposed regulations, however, expand this rule and would also subject a controlled foreign corporation (CFC) to the section 163(j) limitation for the purposes of computing its subpart F income and/or GILTI tested income or loss (i.e. income of the CFC taxable to its US shareholders even if not currently distributed), even if the CFC itself is not subject to US tax. As a result, under the proposed regulations, section 163(j) would limit the extent to which a CFC’s business interest expense is deductible for the purposes of computing the subpart F income, GILTI tested income or loss, and income effectively connected to a US trade or business for the CFC and its US shareholders, as appropriate.
For the purposes of calculating the section 163(j) limitation of a CFC’s US shareholder and subject to the discussion below regarding a CFC group election, the US shareholder’s ATI would not include subpart F income, GILTI or deemed paid foreign tax credits allocable to the CFC, even if the CFC has excess section 163(j) limitation. (As is the case with respect to a domestic corporation, any interest deduction that is disallowed under section 163(j) would reduce the earnings and profits of a CFC. Accordingly, a US shareholder of a CFC that earns only subpart F income may not be affected if the CFC’s interest deductions are disallowed under section 163(j), because the US shareholder’s subpart F inclusion cannot exceed the earnings and profits of the CFC.)
The section 163(j) limitation of a US consolidated tax group would be applied to the group as a whole, as if the group were a single taxpayer and would not be applied separately to each member of the group. With respect to CFCs, however, as a general matter, each CFC in an affiliated group would be subject to the CFC’s own section 163(j) limitation, and there is no equivalent to the rule described above for domestic consolidated groups that would apply a single section 163(j) limitation to an affiliated group of CFCs. Thus, subject to the CFC group election discussion below:
The proposed regulations, however, provide that an affiliated group of CFCs can make a ‘CFC group election’, under which:
A CFC’s allocable share of the group’s net interest expense would equal a fraction: the numerator of which is the CFC’s net interest expense; and the denominator of which is the aggregate net interest expense of all of the members of the CFC group (in each case determined without disregarding transaction within the group). Thus, under these rules, and unlike the rules described above for domestic consolidated tax groups, CFCs that are subject to a CFC group election would still need to determine the section 163(j) limitation individually for each member of the CFC affiliated group. In addition, under the proposed regulations, CFCs conducting a financial services business would be treated as a separate subgroup subject to special allocation rules.
In addition to the CFC group election consequences described above, the proposed regulations also provide that a CFC group that is subject to a CFC group election may ‘roll up’ a lower tier CFC group member’s excess section 163(j) limitation to higher tier CFC group members, until the highest tier CFC group member. Also, any excess section 163(j) limitation of the highest tier CFC group member would ‘roll up’ to such member’s US shareholders, in an amount not greater than the income included by the shareholder from the CFC under subpart F and GILTI. Accordingly, a CFC group election may be particularly advantageous to an affiliated group of CFCs that has:
If finalised, the proposed regulations would generally apply to taxable years ending after the date the proposed regulations are finalised. However, taxpayers and their related parties may apply the proposed regulations for all taxable years beginning after 31 December 2017. Taxpayers that make this election are subject to the entirety of the proposed regulations and cannot elect to apply only certain portions of them. Thus, while some provisions of the proposed regulations, such as the CFC group election, could be beneficial if implemented as soon as possible, taxpayers will need to assess whether such benefits would be outweighed by drawbacks caused by other provisions of the proposed regulations, such as the broad definition of interest rules.
It is important to note, moreover, that neither the preamble to the proposed regulations, nor the proposed regulations provide guidance on what it means for taxpayers to apply the proposed regulations before they are finalised. Some provisions of the proposed regulations, such as the CFC group election rules, are not part of the statute and are clearly provisions that cannot be applied now without applying all of the proposed regulations. However, it is unclear whether other provisions of the proposed regulations are simply interpretations of the existing statute that could be followed by a taxpayer now without requiring the taxpayer also to apply all of the rest of the proposed regulations.
While the proposed base erosion and anti-abuse tax (BEAT) regulations provide new guidance on significant aspects of BEAT that were not addressed in the statutory language of the Act, the proposed regulations still leave many questions unanswered.
Section 59A of the Code, added by the Act, introduced the concept of BEAT. Conceptually, BEAT imposes a minimum tax on an alternatively computed tax base of certain taxpayers (both US and non-US) intended, as its name suggests, to reduce the incentive for such taxpayers to make deductible payments to related foreign persons that would reduce the US tax base.
The actual imposition of BEAT works generally in a mechanical manner, requiring the determination of several BEAT-specific items. First, only a corporate taxpayer that meets the following conditions is subject to BEAT (such a taxpayer is an ‘applicable taxpayer’):
For purposes of the gross receipts test, special aggregation rules apply to treat a group of corporations under common control as one person, and each member of the group is treated as an applicable taxpayer if the group so qualifies. If determined to be an applicable taxpayer, the taxpayer must then identify all so-called ‘base erosion payments’ (i.e.payments to a non-US person deemed to be related to the applicable taxpayer under special attribution rules) and the tax benefits ‘with respect to’ such base erosion payments (such tax benefits are the ‘base erosion tax benefits’).
(Note that base erosion payments and base erosion tax benefits include, respectively, the acquisition of depreciable or amortisable property from a related person and the depreciation or amortisation deductions attributable to such property in the hands of the acquirer. Certain service costs, however, are excluded from the definition of base erosion payments if they are computed under a permissible transfer pricing method, as are certain ‘qualified derivative payments’.)
Next, the applicable taxpayer must determine its so-called ‘base erosion percentage’ by dividing the aggregate amount of base erosion tax benefits for the taxable year by the sum of the total amount of deductions and any other tax benefits treated as a base erosion tax benefit for the taxable year. Then the applicable taxpayer must apply the base erosion test: if the base erosion percentage exceeds 3% (2% in the case of a member of an affiliated group that includes certain financial institutions), the applicable taxpayer has ‘passed’ the base erosion test and must compute its BEAT tax liability. In applying the base erosion percentage test, special aggregation rules apply to treat a group of corporations under common control as one person (such aggregated corporations are the ‘aggregate group’).
If the applicable taxpayer has ‘passed’ the base erosion test, it must first determine its ‘modified taxable income’, which is the taxpayer’s regular taxable income determined without regard to any ‘base erosion tax benefit’ and the ‘base erosion percentage’ of any NOL deduction allowed under section 172 of the Code for the taxable year.
Once such BEAT specific items are determined, the amount of tax imposed by the BEAT on the applicable taxpayer equals the excess (if any) of:
The BEAT rate is 5% for taxable years beginning in 2018; 10% for taxable years thereafter until 2025, and 12.5% for taxable years beginning after 31 December 2025. In the case of a member of an affiliated group that includes a bank or a registered securities dealer, each of the percentages mentioned in the preceding sentence is increased by 1% (i.e. 6% in 2018, 11% until 2025, and 13.5% thereafter).
On 13 December 2018, the Treasury/IRS issued proposed regulations on the BEAT. As discussed below, the proposed regulations would clarify some of the key aspects of the BEAT regime, but also include a number of surprises and do not provide specific rules on other issues that could have a critical impact on a taxpayer’s ultimate BEAT liability.
Highlights of the proposed regulations include the following.
For the purposes of determining whether a ‘base erosion tax benefit’ exists, the proposed regulations would not establish any specific rules for determining whether and when a deduction exists; whether a payment gives rise to a deduction; or whether a deduction is allowed ‘with respect to’ a payment made to a related foreign person. Rather, the preamble states that these questions must be resolved under general principles of federal income taxation.
Existing law may not provide clear guidance in some situations, however, given the novelty of the BEAT regime. In particular, the proposed regulations do not specifically address the question of whether expenditures included in the costs of goods sold (i.e. inventory costs) are ever treated as deductible payments. Thus, it would appear that royalties paid to related persons that are included in inventory costs by the licensee would not be treated as giving rise to a base erosion tax benefit.
Resolving a complicated ‘glitch’ in the statute, the proposed regulations exclude foreign corporations from the controlled group for the purposes of applying the aggregation rules, except to the extent that the foreign corporation has effectively connected income that is subject to US corporate tax. This clarifies that payments made by a domestic corporation, or a foreign corporation with respect to its effectively connected income, to a related foreign corporation are not excluded from the base erosion percentage test.
The proposed regulations adopt an ‘add-back’ approach to computing modified taxable income, rather than a ‘recomputation’ approach. Thus, to the extent that a disregarded base erosion tax benefit affects the calculation of another item entering into the tax calculation, an applicable taxpayer does not recompute the affected other item in determining its modified taxable income (i.e. its tax liability without the disregarded base erosion tax benefit). Significantly, however, the IRS accepts that the starting point for computing modified taxable income prior to the add-back can be negative if losses in the current year exceed gross income. The proposed regulations nonetheless would limit the use of NOL carryovers from previous years to the actual taxable income of the current taxable year. As a result, excess NOL carryovers cannot be used to replace disregarded base erosion payments for the current taxable year in computing modified taxable income. Thus, BEAT tax may be due even if an applicable taxpayer has unused NOL carryovers from prior years. This may increase the significance of the timing of loss recognition.
The proposed regulations provide that ‘the amount of any base erosion payment is determined on a gross basis, regardless of any contractual or legal right to make or receive payments on a net basis’. This may have unexpected effects on the treatment of group cash-pooling arrangements and groups that have transactions running back and forth among affiliates. However, the preamble notes that there may be situations where otherwise generally applicable law would require computation to be done on a net basis, suggesting that the legal obligations giving rise to such payments can themselves be netted (or constitute a single obligation).
The proposed regulations would generally allow the exclusion of ‘cost plus’ payments for services from base erosion treatment under a ‘bifurcation approach’ previously advocated by taxpayers. Only the amount paid in excess of the total cost of services (i.e. the markup component) would be disqualified from the services cost method exception and would therefore give rise to base erosion payments.
Foreign exchange losses (so-called ‘section 988 losses’) would be entirely disregarded in the BEAT regime, and would therefore be excluded from both the denominator and the numerator of the base erosion percentage. The preamble explains that exchange losses do not present the same base erosion concerns as other types of losses that arise in connection with payments to a related foreign party. It is not clear, however, why losses arising in transactions with unrelated parties should likewise be excluded from the denominator.
Partnerships are viewed as aggregates of their partners rather than as entities, and thus payments to and from the partnership are treated as payments to and from the partners for purposes of applying BEAT. This can have unanticipated consequences for transactions between a partnership and its partners if the partnership has both foreign and domestic related partners.
The proposed regulations appear to treat certain property transfers by applicable taxpayers to related foreign persons as ‘payments’ to those persons. Thus, the preamble to the proposed regulations states that a loss recognised on a transfer of property by an applicable taxpayer to a foreign party could give rise to a base erosion payment, even though such a loss likewise does not result in base erosion. The tax benefits from such a loss to the taxpayer may be limited under the related party transaction rules. In addition, the preamble specifically references certain non-recognition transactions (e.g. inbound section tax-free liquidations of subsidiaries, tax-free capital contributions to a domestic corporation and tax-free merger transactions, as well as certain contributions to a partnership by a related foreign partner) as potentially giving rise to base erosion tax benefits as a result of deemed or actual non-cash payments or accruals by an affected taxpayer. It is not at all clear what exactly will be covered by this concept. (For example, the actual or deemed transfer of the affected taxpayers’ shares to a related foreign corporation in a merger transaction may be deemed to be a non-cash payment to that corporation in the form of those shares.)
The status of section 163(j) interest expense carryovers as base erosion payments would be determined by reference to the year in which the interest expense accrued. The IRS, however, has reversed its position in Notice 2018-28 by providing in the proposed regulations that disallowed business interest carried forward from a taxable year prior to 1 January 2018 would not give rise to any base erosion payments.
The proposed regulations have several provisions that principally affect financial institutions and security or commodities dealers.
The base erosion percentage test with a lower (2%) threshold applies not only to US banks and registered securities dealers, but also to:
Foreign banks that are licensed to conduct banking in the US are excluded from the definition of ‘banks’ for this purpose.
The proposed regulations would expressly require items to be determined annually on a net basis where the taxpayer has adopted a mark-to-market method of accounting. This should serve to limit the duplication of gains and losses in both the numerator and the denominator of the base erosion percentage.
Payments pursuant to any sale-repurchase transaction (‘repos’) or securities lending transaction would be excluded from the ‘qualified derivative payments’ exception and would therefore give rise to base erosion payments. This might be deemed (for now at least) to include even stock loans, given the technical language of relevant cross-references.
Interest payments on ‘total loss-absorbing capacity’ (TLAC) securities issued to foreign parents by US subsidiaries would not be base erosion payments to the extent such issuance was required by the Federal Reserve (and thus interest on such TLAC securities would likewise not be included in the numerator of the base erosion percentage, and would not be included in the denominator either, except to the extent such interest was ECI). However, the proposed regulations would not provide similar exceptions for foreign banks that have ECI and that issue debt subject to similar requirements by foreign bank regulators.
The proposed regulations would generally provide that a foreign corporation that has interest expense allocable to ECI under the existing apportionment and allocation rules of section 1.882-5 of the Treasury Regulations (i.e.interest expense allocable to a branch) will have a base erosion payment to the extent the interest expense results from a deemed payment or accrual to a related foreign party. The proposed regulations would not adopt the rule of section 884(f) of the Code that treats the excess of accrued interest expense over booked interest expense as paid to a related foreign parent. Rather, the proposed regulations would treat such excess interest as paid to a related foreign parent in proportion to the character of the interest paid by such related foreign parent based on a scaling ratio.
Finally, the proposed regulations set out three anti-abuse rules that focus on the taxpayer having ‘a principal purpose’ of:
If finalised on or before 22 June 2019, the proposed regulations would generally apply to taxable years beginning after 31 December 2017. However, if finalised after 22 June 2019, such final regulations would generally apply to taxable years ending on or after 17 December 2018.
One final point needs to be made about the eventual implementation of these rules by the government and taxpayers. Over the past decade, taxpayers have argued in a number of court cases that the issuance of regulations by Treasury and the IRS have not been in accord with the administrative procedural rules governing the issuance of regulations by US federal agencies. And in some of the cases, courts have been open to such arguments.
So far, the successful challenges have been limited to cases where the taxpayer was already under audit by the IRS; that is, the issue was raised in the cases of an actual controversy involving a specific taxpayer. However, it is expected that such challenges might become more common, including situations where the regulations are newly issued and one or more taxpayers (or associations such as the US Chamber of Commerce) try to challenge the regulations even before they are effective or where a specific taxpayer is audited by the IRS regarding an issue set forth in the particular regulation at issue. If such litigation becomes commonplace, it may lead companies to further defer making any significant changes to their structures until courts weigh in on the new regulations.
In a forthcoming edition, the authors will examine the proposed regulations on global intangible low-taxed income and foreign tax credits.
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