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U.S. tax reform for busy Canadians (Part 2 – Senate Update)

Author(s): Paul Seraganian, Jennifer Lee, Jennifer Cao, Julie Geng, Ramin Wright

Nov 15, 2017

One week after the House released its draft tax bill, the U.S. Senate Finance Committee released a 253-page summary of its tax reform proposals (the Senate Summary) on November 9, which was further amended in a 103-page summary [PDF] (the Senate Modifications) on November 14. The Senate plan is as sprawling and ambitious as the House Bill, if not more so. Many of the provisions included in the Senate Summary parallel the proposals just approved by the U.S. House Ways & Means Committee (24-16 in a vote along party lines) to advance to the full House for a vote expected to be on November 16. A number of other Senate proposals represent a marked deviation from the House plan. No proposed legislative text has been released with the Senate Summary; instead, the Senate Finance Committee announced its intention to start marking up draft legislation this week. Without the legislative text, many details of the Senate’s proposals remain unclear, but the summary nevertheless provides a helpful overview of and insight into the Senate’s tax reform goals.

Overall, the release of the Senate Summary marks another key milestone on the path towards U.S. tax reform but there are many steps yet to come and many budgetary and political pressure points to be reckoned with. Accordingly, many Canadian businesses and investors will likely continue to monitor these developments and, in many cases, defer major M&A, investment and/or capital allocation decisions pending the resolution of this process. Our objective is to help Canadian businesses and investors navigate through this process confidently with brief summaries of key events and insights into what these changes mean for Canadians.

Key changes in the cross-border area:

As highlighted in our previous update, the House Bill contains provisions limiting interest deductibility and the imposition of an excise tax on certain related party payments that are of particular significance to Canadian companies with U.S. operations and subsidiaries. The Senate Summary contains similar proposals with a number of modifications:

  • Interest deductibility (Part 1): The House proposed to add a new Section 163(n) to the Internal Revenue Code (the Code) that would limit deductible net interest expense based on the U.S. corporation’s earnings before interest, taxes, depreciation and amortization (EBITDA) relative to its global group’s overall EBITDA. The Senate Summary contains a similar proposal, except that the proposal limits the deductibility of interest paid or accrued by U.S. corporations that are members of a worldwide affiliated group by disallowing interest expense to the extent attributable to “excess domestic indebtedness.” In general, excess domestic indebtedness is the amount by which (i) actual U.S. net interest expense exceeds (ii) 110% of debt that would be allocated to the U.S. group if the U.S. group’s total debt-to-equity ratio was proportionate to the worldwide group’s total debt-to-equity ratio (disregarding intragroup debt and equity interests). As with the House Bill, this limitation applies to the U.S. corporation’s net interest expense, whether or not the interest is paid to related or unrelated persons. Unlike the House Bill (which limited carryforwards to five years), interest expense that is disallowed can be carried forward indefinitely under the Senate Summary. This change would be effective for tax years beginning after December 31, 2017.
  • Interest deductibility (Part 2): The Senate Summary replaces current Section 163(j) with a limitation of net interest deductions to 30% of “adjusted taxable income” (similar to EBITDA), regardless of whether the interest is paid to related parties or whether the taxpayer is part of a multinational group. This proposal appears to mirror the House Bill in substance, except that (a) the disallowed interest can be carried forward indefinitely (rather than for five years), and (b) it appears that “adjusted taxable income” under the Senate proposal may be determined in a less taxpayer-friendly manner than the House Bill. The Senate proposal would be effective for tax years beginning after December 31, 2017.
  • Base erosion minimum tax: The House Bill combats base erosion with an innovative proposal to impose a 20% excise tax on “specified payments” (generally, payments made by a U.S. corporation to a foreign affiliate that are deductible, included in COGS or inventory, or included in the tax basis of depreciable/amortizable assets). The Senate Summary takes a different approach and instead operates similar to an “alternative minimum tax” by increasing an offending taxpayer’s regular tax liability by an amount equal to the taxpayer’s “base erosion minimum tax amount.” The tax applies to taxpayers which (a) have average annual gross receipts of at least $500 million for the preceding three tax years and (b) have a “base erosion percentage” of 4% or higher. The “base erosion minimum tax amount” is the excess of 10% (potentially increased to 12.5% by the Senate Modifications for years after 2025 if certain revenue targets are not met) of the “modified taxable income” over the taxpayer’s regular tax liability. In essence, “modified taxable income” is the taxpayer’s taxable income recomputed to exclude (i) base erosion payments paid or accrued to a related foreign party, including amounts paid for acquisitions of depreciable or amortizable assets, and (ii) the “base erosion percentage” of NOL carryforwards. The “base erosion percentage” for a taxpayer in any given tax year is the percentage determined by dividing the total amount of base erosion tax benefits realized by the taxpayer over the total deductions (including deductions for the base erosion tax benefits) for the taxpayer.
    Illustration: Assume a U.S. corporation has gross income of $10,000, total deductions other than base erosion payments of $8,000, and deductions of base erosion payments of $2,000 (none of which are NOL carryforwards) for its 2018 taxable year. The U.S. corporation’s regular tax liability would be $0, but the “modified taxable income” of the U.S. corporation would be $2,000 and as a result, the base erosion minimum tax amount would be $200.

    The provision would be effective for base erosion payments paid or accrued in taxable years beginning after December 31, 2017.

What's new about the Senate proposal?

  • Anti-hybrid rules: The Senate Summary contains a proposal denying a deduction for any interest or royalty payments (i) paid or accrued to a related party pursuant to a hybrid transaction, or (ii) involving a hybrid entity, to the extent that there is no corresponding inclusion to the related party in the other country or if the related party is allowed a deduction for such amount in such country. A transaction (or series of transactions), instrument, or agreement would constitute a “hybrid transaction if one or more payments which are treated as interest or royalties for U.S. federal income tax purposes are not so treated for purposes of the recipient’s country of tax residence. A hybrid entity is any entity which is treated as fiscally transparent in the jurisdiction of the payor and not so treated for purposes of the recipient’s country of tax residence, or vice versa.

    This proposal would appear to cause interest paid under certain common cross-border financing structures to be denied. For example, this proposal would generally deny deductions for interest paid by a U.S. payor to a related party pursuant to a short-term repurchase (i.e., “repo”) arrangement. Very importantly, the proposal grants the Internal Revenue Service (IRS) a broad scope of authority to extend the reach of this provision in ways that could be dramatic. In particular, the Senate would allow the IRS to issue regulations as may be appropriate to carry out the purposes of the proposal, including to disallow interest deductions for interest that is exempt in the hands of the interest recipient by reason of a participation exemption system or other regime which provides for the exclusion of a substantial portion of the interest payment. It appears possible that the extended authority granted to the IRS could be used to deny interest on a broader range of common cross-border financing structures involving lending vehicles formed in third countries.
  • Tax on gain from foreign person’s sale of a partnership interest: A longstanding and controversial IRS ruling, which stated that any income from such sale is treated as income effectively connected to the U.S. to the extent that income is attributable to assets of the partnership used in the U.S. trade or business, was often criticized as flawed, and was effectively overridden by the U.S. Tax Court earlier this year in Grecian Magnesite Mining, Indus. & Shipping Co. v. Commissioner, 149 T.C. No. 3 (2017). The Senate bill would provide a legislative override of this U.S. Tax Court decision, and further impose a withholding tax obligation on the transferee of a partnership interest unless the transferor certifies that they are not a non-resident alien individual or a foreign corporation (and a withholding tax obligation on the partnership itself, if the transferee fails to withhold).
  • Foreign minimum tax: While the House Bill would impose current U.S. taxation on the U.S. parent of a controlled foreign corporation’s (CFC) “high returns,” which would look to all of the CFC’s income, the Senate Summary modifies its purview to so-called “global intangible low-taxed income” (GILTI). The provision would generally result in the U.S. shareholder being currently taxed on the excess of the CFC’s gross income over 10% of the aggregate adjusted bases of the tangible property that is used in the production of that income (but only to which a deduction for depreciation is generally allowed). Broadly put, this effectively results in current U.S. taxation of CFC income streams that exceed a 10% rate of return on tangible depreciable property.

A number of other Senate proposals retain the core concepts of those of the House Bill, including the proposals for a “hybrid territoriality” system, a reduction of the corporate tax rate to 20% (albeit delayed until 2019 in an attempt to satisfy revenue thresholds), indefinite net operating loss carryforwards to offset up to 90% (generally amended to 80% by the Senate Modifications for years after 2023) of taxable income, immediate expensing of qualified property for five years, and a repeal of the alternative minimum tax, and a repeal of Section 956.  Income inclusion of deferred compensation at the time of service-based vesting was originally included in both the House and Senate proposals but subsequently removed from both.

In addition, the Senate Modifications, which amended various proposals related to the NOLs, base erosion minimum tax, and GILTI, also included a repeal of the Affordable Care Act’s individual shared responsibility payment (better known as the “Obamacare individual mandate tax”), which prompted the House to include the same proposal in their bill. It remains to be seen whether the inclusion of this healthcare-related provision will help or hinder passage of the bill in both chambers.

Next Steps

The Senate Finance Committee is expected to begin marking up the bill during the week of November 13. In the meantime, the U.S. House is expected to vote on the House Bill on November 16. As noted in last week’s update, once a bill is passed in both the House and the Senate, there is a conference in which differences in the respective bills will be reconciled to produce a final bill to be voted on in each chamber, and if passed, sent to the President to be signed into law.