Focus on Finance: Impact of Tax Reform on the Banking and Finance Industry and Financing Transactions
FOCUS ON FINANCE Impact of Tax Reform on the Banking and Finance Industry and Financing Transactions Michele Alexander, Partner Ryan Davis, Associate
Michele J. Alexander Partner, New York T: 212.508.6109 email@example.com
Ryan Davis Associate, New York T: 212.508.6112 firstname.lastname@example.org
KEY ISSUES • Interest Deduction Limitation • Limitation on NOL Carryovers • Select International Issues ‒ Base Erosion and Anti-Abuse Tax ‒ “GILTI” Tax ‒ “Hybrid” Transactions ‒ Controlled Foreign Corporations: What changed and what did not?
INTEREST DEDUCTION LIMITATION • Under prior law, interest payments on debt generally were deductible, with limitations - including for related party debt (notably, “earnings stripping” rules requiring 1.5:1 debt/equity ratio to avoid limitation). • Under the TCJA, borrowers may deduct only up to the sum of business interest income and 30% of adjusted gross income. ‒ Interest disallowed by this limitation may be carried forward indefinitely to succeeding taxable years ‒ Earnings stripping rules are now repealed ‒ There are exceptions for (i) taxpayers whose annual gross receipts over a prior three year period do not exceed $25 million and (ii) certain regulated public utilities
INTEREST DEDUCTION LIMITATION – THE POTENTIAL IMPACT • Impact on financial transactions: ‒ Potential borrowers may reconsider or pursue alternative methods of financing. o Despite initial indications, possible dip in borrowing activity as the market adjusts o Consider impact of lower corporate rate ‒ Borrowers with international operations may continue to utilize interest deductions available in non-U.S. jurisdictions, subject to OECD/treaty limits and internal tax laws in such jurisdictions (and international pressure on other countries).
INDEFINITE CARRYFORWARD OF INTEREST • Interest carryforward: The indefinite nature of the carryforward raises unique questions under other areas of tax law and possibly impacts borrower behavior. ‒ Cancellation of Indebtedness (COD) income: Borrower’s ability to reduce COD income by payments that would be deductible if paid – query whether the limit would apply for purposes of this determination ‒ Borrowers/Issuers may wish to prepay debt/redeem notes when a substantial portion of the interest on the notes no longer is currently deductible (will depend on the redemption provisions and prepayment penalties)
LIMITATION ON NET OPERATING LOSS CARRYOVERS • Corporations now generally are limited in their ability to utilize NOL carryovers to 80% of taxable income - applies starting in 2018. • Such NOLs may be carried forward indefinitely (versus 20 year limit under former law) - but two year carryback is eliminated. • The new limit may increase tax liability even in light of lower rates. ‒ Consider tax distribution provisions in credit agreements (also, immediate expensing and interest deduction limit) ‒ Troubled taxpayers with taxable COD income
BASE EROSION AND ANTI-ABUSE TAX • The TCJA also includes a provision meant to prevent U.S. corporations from artificially reducing U.S. taxable income by making deductible payments to foreign affiliates. • The Base Erosion and Anti-Abuse Tax (“BEAT”) is levied on corporations with average annual gross receipts (that are effectively connected with a U.S. trade or business) of $500 million. • BEAT has an effective rate of 10% and will be phased in. For 2018 the tax is 5% (6% for financial institutions) and increases to 12.5% in 2026.
BASE EROSION AND ANTI-ABUSE TAX – POTENTIAL PROBLEMS • Potential pitfalls: ‒ The law does not specify if determination is on gross or net basis ‒ Gross basis requirement could overstate the amount of targeted deductible payments going out of the United States by not accounting for U.S. tax paid by U.S. branch ‒ Scope may be unintentionally broad, e.g. narrow exclusion for derivatives • BEAT versus OECD anti-base erosion measures
GLOBAL INTANGIBLE LOW-TAXED INCOME TAX • The Global Intangible Low-Taxed Income Tax (GILTI Tax) is designed to impose a minimum tax on companies that hold patents and copyrights offshore. ‒ Effort to combat corporate inversions by large pharmaceutical and tech companies ‒ Hope is to encourage such companies to hold valuable intellectual property in the United States • The law applies only where a company’s non-U.S. tax bill is below a minimum threshold or where there is “excess foreign profit.” • Significant deductions are available that reduce the effective tax rate to 10.5% through 2025 before increasing to 13.125%.
GLOBAL INTANGIBLE LOW-TAXED INCOME TAX (CONT.) • Unintended consequence, including to banks: ‒ The Act doesn’t define “intangible,” raising concerns that the term could be interpreted expansively and include assets beyond the patents and licenses the provision was meant to address ‒ Banks frequently hold assets such as goodwill or going concern value ‒ Those with operations abroad could be hit with a substantial tax liability on income that normally would not be taxed until repatriation
HYBRID TRANSACTIONS • The new law denies a deduction for disqualified related party amounts paid (i) pursuant to hybrid transactions and (ii) to hybrid entities. ‒ Disqualified Related Party Amount – interest or royalty payments made to a foreign party when (i) there is no corresponding inclusion or (ii) there is an available deduction for the amount of the payments under the tax law of the foreign jurisdiction ‒ Hybrid Transactions – transactions in which interest or royalty payments are not treated as such under the tax laws of the foreign jurisdiction ‒ Hybrid Entities – entities treated as transparent in the United States but as nontransparent in the recipient’s country, or vice-versa
HYBRID TRANSACTIONS (CONT.) • International impact:
‒ Will impact treaty structures that rely on the treatment of payments as nontaxable return of capital or nontaxed foreign earnings in the foreign jurisdiction, but as interest payments domestically ‒ May help U.S. banks as tower and repo structures (with typical non-US. Borrowing) cease to be utilized ‒ Like BEAT and GILTI – can this new hybrid rule violate international treaty laws?
CFC ISSUES: SECTION 956 • “Deemed Dividend” Rule ‒ requires banks to accept limitations on their collateral and security packages with respect to foreign subsidiaries ‒ limits the ability of foreign corporations to be co-borrowers with U.S. entities • Both the House and Senate bills repealed Section 956 domestic corporations but absent f rom the final bill – even as U.S. moves to territorial system for domestic corporations.
CFC ISSUES: DEFINITIONS • The TCJA (i) expanded the definition of a U.S. shareholder to include a U.S. person who directly, indirectly, or constructively, owns 10% or more of either the vote or value (not both, as under prior law) of the stock in a foreign corporation and (ii) allows for the attribution of stock ownership from foreign persons to U.S. persons. • These changes mean that a foreign subsidiary that is more than 50% owned by a foreign corporation is now considered a Controlled Foreign Corporation (CFC) if the foreign corporation also owns more than 50% of a domestic subsidiary.
CFC ISSUES (CONT.) • The new definition is retroactive, meaning that entities that were not CFCs previously could now be considered as such under the TCJA. • Implications on security and collateral arrangements?
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