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by this limitation may be carried forward indefinitely to succeeding taxable years ‒ Earnings stripping rules are now repealed ‒ There are exceptions for (i) taxpayers whose annual gross receipts over a prior three year period do not exceed $25 million and (ii) certain regulated public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?