Update on US tax reform
Weil, Gotshal & Manges, Miami
Report on session at the 11th IBA Annual Finance and Capital Markets Tax Virtual Conference
Kimberly Blanchard Weil, Gotshal & Manges, New York
James Barry Mayer Brown, Chicago
Peter Blessing Internal Revenue Service, Washington, DC
Devon Bodoh Weil, Gotshal & Manges, Washington, DC
Paul Carman Chapman and Cutler, Chicago, Illinois
Jack L Heinberg Allen & Overy, New York
The panel discussion focused on the following five topics:
- an overview of United States tax reform, particularly certain provisions included in the Build Back Better Act (BBB, Senate Finance Committee version);
- US offshore lending developments;
- proposals affecting the deductibility of interest expense;
- recent changes to the passive non-US investment company (PFIC) regulations; and
- updates on global intangible low taxed income (GILTI) and other developments affecting worldwide minimum taxes.
Overview of US tax reform
Kimberly Blanchard introduced the first topic by noting that the BBB began as an ambitious tax reform package, which has subsequently been pared back and, to date, has stalled in the US Congress. As things stand, it is unlikely the BBB will be passed in its current form. However, some of the current proposals are worthy of review, as some of the tax reform proposals may become law in the future and will have an impact on US and non-US taxpayers.
Blanchard discussed four proposals. The first proposal is the new corporate alternative minimum tax (AMT), which would impose a 15 per cent tax on a US corporation’s income based on the corporation’s adjusted financial statement income. Blanchard noted that the AMT is worth studying, as it is a true minimum tax that could remain in the legislative picture, and which would have some interaction with the Organisation for Economic Cooperation and Development’s (OECD) Pillar Two initiative.
The second proposal is a new limitation on interest deductions in new proposed section 163(n) of the US Internal Revenue Code 1986, as amended (the Code). Blanchard briefly provided some context on the new provision (discussed in more detail by Devon Bodoh later in the panel), noting that proposed section 163(n) is a worldwide percentage limitation that had been previously included as part of the 2017 US tax reform proposals, but was ultimately not included as part of the 2017 Tax Cuts and Jobs Act (the TCJA).
Third, the BBB includes several changes to GILTI and other provisions introduced by the TCJA. The proposed changes would increase the tax rates and broaden the tax base, but also included certain changes that would be favourable to taxpayers, particularly around how taxes are computed. Blanchard believes these changes are potentially intended to harmonise the various US tax provisions with the proposed OECD Pillars; if that is the case, there remains a lot of work to be done.
Finally, the BBB includes certain changes to the non-US tax credit (FTC) provisions. Specifically, the BBB introduced per-country limitations to the FTC rules. Blanchard noted that this is significant because US taxpayers are subject to tax based on their worldwide income: the FTC remains the primary way through which US taxpayers avoid double taxation.
US offshore lending developments
James Barry began the next topic by providing an overview of the two US statutory schemes generally applicable to non-US taxpayers engaging in these types of transactions. Under one of these schemes, a non-US person is subject to tax on income that is ‘effectively connected with the conduct of a US trade or business’ (ECI), similar to US taxpayers.
Barry noted that the difficulty in determining whether a non-US person is ‘engaged in a US trade or business’ is that the term is not defined in the Code. Cases and administrative guidance address the issue, but the analysis is a highly factual inquiry that generally turns on whether the taxpayer meets one or more factors, such as:
- the number and frequency of loans;
- the time and effort devoted to lending activities;
- whether the loans are made to customers;
- whether the taxpayer advertises, solicits business or has a reputation as a lender; and
- whether the taxpayer provides services.
Additionally, the activities of agents may be attributed to their non-US principals. The Code, however, provides an exception whereby gains from trading in securities for one’s own account does not give rise to ECI, even if such trading is conducted within the US (the trading safe harbour); ‘securities’ includes all forms of debt instruments.
Barry proceeded to discuss two non-binding pieces of administrative guidance that illustrate the uncertainty of these issues (including qualifying under the trading safe harbour) for taxpayers. First, in a 2009 generic legal advice memorandum (GLAM), the Internal Revenue Service (IRS) determined that a non-US corporation was engaged in a US trade or business and recognised ECI as a result of the activities attributed to the non-US corporation, through a US corporation that originated loans for the non-US corporation through a services agreement. The IRS determined the services included ‘considerable, continuous and regular’ solicitation of borrowers, negotiation of loan terms, credit analysis and other functions, although the US corporation could not enter into contracts on behalf of the non-US corporation. Barry noted that the IRS failed to follow the principles of a particular regulation, which could be read to say that the activities of an independent agent are not attributed to the principal.
Second, in a 2014 internal legal memorandum (ILM), the IRS concluded that a non-US fund (the taxpayer in the YA Global case currently in the US Tax Court) investing in a private investment in public equity (PIPE) transactions, including purchasing convertible debt and notes with warrants, and in which the fund’s managers spent extensive time engaging in negotiation, due diligence, soliciting, sourcing and originating such transactions, was engaged in a US trade or business. The issuers in such transactions also paid commitment, structuring and due diligence fees to the fund.
Barry then proceeded to discuss guidelines (which have become the market standard) developed by practitioners to avoid being treated as engaged in a US trade or business. Blanchard asked Peter Blessing whether the lack of guidance from the IRS and Congress is because the issues are so inherently factual, and whether there is any thinking to provide actual guidance for taxpayers to rely on. Blessing noted that one reason for the lack of guidance is that the IRS is pressed for resources and are focused on other regulatory projects, but agreed that the issues are so factual that it is hard to even consider what any guidance would look like.
Barry concluded by discussing the new IRS audit campaign, which included the acquisition of loans by non-US persons. However, the IRS has not specified exactly what it looks for during these audits. Asked by Barry if he could provide additional guidance on the audit topics, Blessing was unable to clarify exactly what the IRS’s audit branch would be looking for, but noted that they view the partnership audit area as an underserved area by the IRS examination unit and taxpayers should expect a general review of their activities. With respect to YA Global, Blessing noted it is an interesting case which the IRS expects will address some of the issues with respect to:
- investment versus business;
- distinctions between loan origination and trading in securities with respect to the trading safe harbour, and
- issues related to attribution of activities between the loan originator and the fund acquiring the loans.
Additionally, Blessing noted the following. First, Blessing thinks the question is ‘what is the right nexus for taxation?’ or, stated differently, how a non-US person can avoid US taxation by having someone else do certain activities. In this regard, Blessing noted the word ‘agent’ should be used carefully, as people may look to commercial law for an understanding of what the term means. Blessing does not think that is the right standard, but rather whether one person is acting on behalf of another person in a broader sense.
Second, Blessing does not think the distinction of whether the agent is dependent or independent is meaningful – the regulation referenced by Barry with respect to the GLAM assumes that the person is engaged in a US trade or business. It looks to the activities of the agents not for purposes of determining whether the non-US person has an office in the US, but for whether the non-US person has non-US-source interest income and thus is not relevant.
Finally, Blessing thinks origination is a very labour-intensive activity that generally carries a fee. Under the Code, a service is per se a trade or business, and so to the extent that the activities resemble a service, it is on the borderline of that per se trade or business.
Limitations on interest deductions
Bodoh began the discussion of the limitations on interest deductions by providing a brief background on US debt-equity analysis. He noted that, under US tax law, interest owed to a related non-US person is not deductible until paid. Bodoh also briefly discussed regulations under section 385 of the Code, effective in 2018, which would have treated certain debt as equity if the instrument is issued in, or in connection with, certain transactions (including transactions occurring within a 72-month window). However, the IRS announced its intention to modify these regulations and remove the 72-month window rule. Blessing noted that the published intention does not actually modify the regulations, and that these remain in effect.
Bodoh moved on to describe section 163(j) of the Code. Prior to the TCJA, section 163(j) generally applied to debt between US and non-US related parties; however, the TCJA amended the rules to cover all US taxpayers (with some exceptions) and all debt (whether issued to a related or third party). Today, section 163(j) generally limits interest deductions to 30 per cent of ‘adjusted taxable income’ (adjusted taxable income approximates EBITDA pre-2022, and EBIT starting in 2022). Section 163(j) allows disallowed interest expense to be carried forward indefinitely.
Section 163(j) also applies at the partnership level (ie, treating the partnership as an entity), although there are legislative proposals to repeal this rule. Blessing noted that the expansion of section 163(j) to cover all domestic businesses motivated the choice to have partnerships be treated as entities under these rules, given the large amount of domestic businesses that are conducted as partnerships. However, the rule has created a lot of complexity with respect to compliance and administration. Bodoh agreed that the burden of compliance has greatly increased for taxpayers and the government with the changes to these rules. Bodoh finished the discussion of section 163(j) by noting there is a broad anti-abuse rule that taxpayers and their advisors need to keep in mind.
Bodoh then moved on to discuss current interest limitation proposals in President Biden’s Green Book, the 2021 Senate Proposal (section 163(n)) and the OECD’s base erosion profit shifting (BEPS) Action 4. These provisions generally align, particularly in adopting rules that limit net interest expense to the proportionate share of the financial reporting group’s total financial statement net interest expense.
Bodoh noted that one big difference between the Green Book and the 2021 Senate Proposal is that the Green Book includes an alternative method for calculating net interest expense (equal to 10 per cent of adjustable taxable income as defined in section 163(j)), but the 2021 Senate Proposal does not. Bodoh noted that this is likely because of the US legislative process under which the proposal would be enacted, which requires the legislation to be revenue neutral – alternative methods tend to make the legislation more expensive and are therefore disfavoured under the particular legislative process. Bodoh and Blanchard noted that both the Green Book and the 2021 Senate Proposal allow the lesser of the limitation under section 163(j) or the proposal to apply; in contrast, the OECD’s rule allows for the greater of the fixed ratio (eg, section 163(j)) or the group ratio (eg, Green Book/section 163(n)) to apply.
Bodoh concluded the section by discussing the practical effect of the proposed section 163(n) and the repeal of section 864(f) of the Code. Bodoh noted that the proposed rule would adversely impact US taxpayers with significant debt, including a corporate group which includes a US taxpayer and has significant non-US operations. Because these rules increase the cost of debt financing, and particularly impact US companies in industries that rely on debt financing, the impact of section 163(n) could be significant.
Bodoh also noted that section 163(n)’s reliance on financial accounting standards will present challenges for tax practitioners, given that there are significant differences between the concepts and underlying policies of the Code and the accounting standards. It may be difficult to get those different concepts and policies to interact in a harmonious manner. Bodoh noted that it is unclear how section 163(n) would operate given the repeal of section 864(f) (which generally allowed taxpayers to make an election to allocate interest expense on a global basis), given we have a proposed rule to limit interest expense on a global basis but Congress has moved away from allocating interest expense in the same manner.
PFIC considerations – regulatory updates
Jack Heinberg began the section by providing a high-level overview of the PFIC rules. A non-US corporation is generally a PFIC for any taxable year in which, after applying certain look-through rules with respect to the income and assets of certain subsidiaries, 75 per cent or more of the corporation’s gross income consists of passive income (eg, dividends, interest and royalties) (the income test) or 50 per cent or more of the average quarterly value of the corporation’s gross assets consists of assets that produce, or are held for the production of, passive income (the asset test). The PFIC rules affect the taxation of US shareholders of the PFIC, not the PFIC itself.
Despite this, Heinberg noted that the PFIC rules remain relevant to non-US corporations, particularly where the non-US corporation is involved in:
- initial public or other equity offerings;
- structured finance ‘repacks’ in which passive assets are packaged in a non-US corporation; or
- certain joint-ventures and similar private equity investments that involve the restructuring of passive assets, as US investors weigh the potential adverse impact of the PFIC rules on their investment (including the reporting requirements).
Blanchard noted that the PFIC regime generally, but particularly the default ‘excess distribution’ regime, is intended to be punitive. In situations where the US taxpayer disposes of PFIC shares, the tax under the excess distribution regime could be greater than the gross proceeds from the disposition. The alternative taxation regimes under the PFIC rules include a mark-to-market regime and a ‘qualified electing fund’ election that, in essence, causes the PFIC to be treated as a pass-through entity with respect to the US shareholder.
Heinberg then proceeded to discuss the regulatory updates. Final and proposed regulations published in 2021 and 2022 address, among other things:
- look-through and attribution rules;
- passive income and assets generally;
- the active banking and insurance exceptions; and
- other general considerations.
With respect to the attribution rules, Heinberg noted that the final regulations try to achieve a true aggregate approach, with tiered ownership structures analysed under a top-down approach.
Heinberg proceeded to explain the changes to the look-through rules, which he noted are at the core of the new regulations. Generally, the application of these rules depends on whether the non-US corporation is: (1) a related party (measured through 50 per cent control by vote or value); (2) a look-through entity (ie, a subsidiary or partnership); or (3) neither (1) nor (2). If clause (3) applies, income from the non-US corporation is generally treated as passive income, regardless of the character of the income earned by the entity, and the interest in the non-US entity are passive assets. For purposes of clause (1), the rules look to allocate income on a rateable basis for interest and royalties, while the allocation of dividend income also requires taking into account the entity’s accumulated and current earnings and profits.
Turning to clause (2), Heinberg noted the rules generally treat a non-US corporation as owning the assets of, and directly deriving the gross income of, a look-through subsidiary or a look-through partnership. Generally, a look-through subsidiary or look-through partnership is an entity for which the non-US corporation owns at least 25 per cent of the interests (by value). If the non-US corporation owns less than 25 per cent of the assets, it can also satisfy an ‘active partner’ test and have the partnership be a look-through partnership. The active partner test requires the non-US corporation to not be a PFIC without taking into account its interest in the look-through partnership – Heinberg noted that it is possible to have a case where a non-US corporation, which would otherwise satisfy the active partner test and would not be a PFIC as a result of owning interests in the partnership, will be treated as a PFIC as a result of this requirement. Blanchard commented that this is one of the most counterintuitive rules in the regulations, noting that if a group of corporations operates an active business through several non-US corporations, one of which solely operates through a joint venture in which it is a less than 25 per cent partner, the activities of the joint venture will not be considered an active business.
The most interesting change with respect to the active banking and insurance exceptions is in the proposed regulations addressing the active banking exception. Under the statute, passive income does not include income derived in the active conduct of a banking business by an institution licensed to do business as a bank in the US, or to the extent provided in regulations, by any other corporation. Absent regulations, there may be many active banking businesses that would potentially be PFICs; the proposed regulations are helpful guidance, generally providing that a non-US corporation will not be a PFIC as a result of the active banking exception if it is licensed to do business as a bank in its jurisdiction of formation and engages in typical active banking activities (eg, accepting deposits from unrelated customers). Blanchard asked Blessing about the status of these proposed regulations, to which Blessing replied that they are not a top priority for finalisation but that he does not expect many changes to the provisions.
GILTI and minimum taxes
Paul Carman provided a general overview of the GILTI rules. Generally, under the GILTI rules, a 10 per cent US shareholder (ie, a US person that holds 10 per cent of the vote or value of the controlled foreign corporation (CFC) at any time during the taxable year) of any CFC must include in gross income for a taxable year its GILTI amount, which is generally the CFC’s active income in excess of a deemed return on the CFC’s investment in its assets. Carman noted that GILTI is currently determined on a worldwide basis, but there is a proposal to calculate GILTI on a country-by-country basis.
Carman also noted that recently finalised regulations provide rules with respect to how US partnerships are treated for purposes of the GILTI rules. Generally, US partnerships are US persons and have historically been treated as US shareholders. Regulations finalised, in part in 2018 and in part in 2022, treat the partners in the US partnership as directly owning their proportionate share of CFC stock for purposes of the GILTI rules and also for purposes of the US anti-deferral rules generally.
Carman proceeded to discuss an example in the regulations, where PRS2, a US partnership, owns all of the stock of a CFC. PRS1, a US partnership, and Individual B, a non-US individual, own 90 per cent and 10 per cent, respectively, of PRS2. USP, a US corporation, and Individual A, a US individual, own 90 per cent and 10 per cent, respectively, of PRS1. In the example, USP and Individual A are both US shareholders of the CFC under the current rules and would potentially have GILTI inclusions. Blessing clarified that Individual B will not, and under the prior rules would not have had, a GILTI inclusion, because there would not be an allocation of GILTI to a non-US person with no taxation nexus to the US. Blanchard asked if that meant that the 10 per cent inclusion that might have been allocated to Individual B would have been allocated to a US person – both Blessing and Blanchard agreed that would not be the case and that the income would disappear. However, under the prior rules, a five per cent US partner (Individual C) of PRS2 would have been allocated five per cent of PRS2’s GILTI income, even though Individual C would not have been a US shareholder if they owned their proportionate share of CFC stock directly.
Blessing noted that the purpose of the rules is to treat the US partnership as transparent and that such entities are on the same footing as non-US partnerships (ie, ignoring where the partnership is formed). Blessing then noted that, for purposes of determining whether Individual A is a US shareholder, the constructive ownership rules would make Individual A a ten per cent owner of the CFC. However, the allocations and inclusion of the CFC’s GILTI income are done arithmetically, so Individual A would only be allocated nine per cent of the GILTI income from CFC (USP would include 81 per cent of the GILTI income and Individual B would not include any GILTI income). Blessing also noted that there is no mechanism for adjusting the basis between PRS1 and PRS2 to reflect the income inclusion, and that the IRS needs to issue regulations addressing this point.
Finally, Blessing noted that, under the new rules, Individual C would be subject to the PFIC rules under the new regulations, as that person would be treated as owning the stock of the PFIC.