Paul Seraganian, Jennifer Lee, Kaleigh Hawkins-Schulz, Jonathan Rhein, Andrew M. Granek, Kevin Colan
Apr 21, 2021
As political pressure mounts in Washington to enact an ambitious infrastructure plan, new details are emerging about the sweeping U.S. tax law changes that may be enacted to help pay for it. On March 31, 2021, the White House released a general overview of the reforms President Biden is proposing for the U.S. tax code (the Biden Plan) alongside its infrastructure plan. Then, in early April, the U.S. Treasury Department published a report (the Treasury Report) providing more details on the Biden Plan, and Senator Ron Wyden (an Oregon Democrat and the chair of the Senate Finance Committee) released a proposal (the Wyden Proposal) from Senate Democrats regarding their vision for U.S. international tax reform. All this has been accompanied by a concerted and persistent public relations campaign by high-ranking administration officials promoting the pressing need for and importance of these dramatic tax changes.
This flurry of tax policy proposals, on the heels of major U.S. tax reform in 2017 under the Trump administration, can be disorienting and difficult to follow, let alone predict. Yet, Canadian businesses, investors and policy-makers, who are deeply invested in the U.S. economy, need to be thoughtful and clear-eyed about these emerging changes in order to assess the likely impact they may have and consider whether any course-correction on their part is advisable. This update is a first installment by Osler to help Canadians navigate through this latest round of fundamental U.S. tax changes.
What are the chances that major U.S. tax changes will be enacted?
As always, predicting what will happen in the U.S. capital is fraught with peril. However, with a majority in the House of Representatives, a bare majority in the Senate and the clunky, yet filibuster-proof legislative process known as “budget reconciliation”, the Democrats do have the means necessary to enact legislation on a purely partisan basis, if they can stay unified.
For more on the current legislative landscape in the United States, see our prior update.
What changes have been proposed that could impact Canadians?
While these are still early days and there is significant political uncertainty hanging over the entire legislative process, certain key factors are becoming apparent. First, it is clear that any tax reform would need to generate significant revenue if it is going to support the bold spending initiatives called for in President Biden’s infrastructure plan while, at the same time, meeting the challenging budgetary strictures of the reconciliation process. Second, considerable amounts of political capital are being expended to advance the infrastructure bill and it is clear that this is a strong legislative priority for Democrats.
Given the close ties between the Canadian and the U.S. economies, Canadian businesses and investors should pay close attention as additional information becomes available.
In the meantime, some of the Biden Plan’s headline changes that we believe are most likely to be relevant to Canadians are:
- Increasing the corporate tax rate to 28% from 21%.
- Imposing a 15% minimum tax on book income of corporations with US$2 billion or more of book income (in lieu of US$100 million mentioned during the campaign). Corporations would pay the greater of their regular corporate income tax or the 15% minimum tax (while still allowing for foreign tax credits and certain other general business credits).
- Replacing the base erosion anti-abuse tax (BEAT) with a rule called Stopping Harmful Inversions and Ending Low-tax Developments (SHIELD), which would deny tax deductions for payments made by multinational U.S. companies to related parties that are subject to a low effective tax rate.
- Strengthening the anti-inversion rules by lowering the continuing ownership threshold to 50% (from 80%) for the rule that treats a non-U.S. acquiring corporation as a domestic U.S. corporation and expanding that rule to apply if the non-U.S. acquiring corporation is managed and controlled in the United States.
- Doubling the tax rate on global intangible low-taxed income (GILTI) earned by foreign subsidiaries of U.S. corporations from 10.5% to 21%.
- Making significant structural modifications to the GILTI regime, including applying GILTI on a country-by-country basis (thereby prohibiting the blending of GILTI computations between high-tax and low-tax jurisdictions, which frequently helps taxpayers reduce GILTI exposure) and eliminating the exemption from GILTI for an amount of income equal to a 10% return on certain qualified business assets.
- Repealing the Trump-era regime that provides a lower tax rate for a portion of a U.S. corporation’s export income characterized as foreign-derived intangible income (FDII) and replacing it with tax credits intended to be more effective at encouraging investment in U.S. R&D.
- Eliminating tax preferences for fossil fuels and expanding incentives/credits for green technology.
- Eliminating preferred capital gains and qualified dividend tax rates for individuals with taxable income over US$1 million and increasing the top marginal rate bracket for individuals from 37% to 39.6% (where it was before the Trump tax reform).
- Increasing the IRS’s enforcement budget to ensure that large corporations (and their shareholders) are held accountable when they underpay their taxes.
What should Canadians expect and watch out for?
The tax proposals in the Biden Plan, Treasury Report and Wyden Proposal are high level summaries and do not provide much in the way of meaningful details, so it is not possible to make meaningful predictions about the precise impact they will have on existing structures and planning. However, we will stay tuned as substantive developments occur and the legislative process unfolds.
In the meantime, here a few key considerations that we think Canadians should watch out for:
1. Potential Impact on Cross-Border Planning
It is likely that the U.S. corporate tax rate will increase above 21%, though the jury is still out on what the new rate will be. An increase in the U.S. corporate tax rate to above 25% could largely reverse the rate advantage that U.S. corporations currently enjoy over Canadian corporations. If that occurs and there is enough of a rate differential, then Canadian companies may once again (as was the case pre-Trump’s tax reform) view it as beneficial to “shift” income from the U.S. to Canada through cross-border planning and intercompany arrangements. However, the strategies used for this before 2017 will likely need to be reworked to be effective under the new U.S. tax rules.
The “base erosion” of the U.S. tax base through related party payments and arrangements is a prime target in the Biden Plan as well as other recent Democratic proposals. The BEAT regime enacted as part of the Trump tax reform targeted base erosion through the imposition of a minimum tax, but its application is limited in several ways: it only applies to corporate taxpayers with average annual gross receipts of at least US$500 million and generally applies only if related party “base erosion” payments exceed 3% of the overall deductions taken by the taxpayer. The Treasury Report indicates that the revenue generated from the BEAT has been materially below the amount forecasted by the Trump tax reform and, in its view, the BEAT has been “largely ineffective at curtailing profit shifting by multinational corporations.” The Biden Plan would repeal the BEAT and replace it with the SHIELD regime, while other U.S. lawmakers have made other proposals that would reform the BEAT instead of replacing it with SHIELD,
While there is little detail regarding the proposed SHIELD regime, an elimination of the BEAT and its replacement with SHIELD could prove to be one of the most consequential reforms included in the proposal for Canadian companies. Based on currently available information, some of the most significant differences between the BEAT and SHIELD regimes are the following:
- As noted above, the BEAT currently only applies to large corporate taxpayers and generally only in years where related party “base erosion” payments exceed 3% of the overall deductions taken by the taxpayer. We do not yet know whether SHIELD would apply to smaller companies, and if it does, what the minimum threshold would be. As such, companies that are not currently subject to the BEAT could potentially become subject to SHIELD.
- The BEAT operates as a minimum tax whereas SHIELD operates as a denial of U.S. tax deductions.
- The BEAT generally applies regardless of whether the payee of the related party payment is subject to tax on the receipt of such amount, whereas SHIELD targets related party payments that are not subject to a minimum effective tax rate. As such, Canadian multinationals that are currently subject to the BEAT could potentially fare better under SHIELD if the relevant related party payments by their U.S. affiliates are paid to Canadian affiliates or, possibly, to non-Canadian affiliates if Canada adopts a global minimum tax.
Finally and importantly, SHIELD could result in a denial of deductions on existing U.S. inbound financing structures to the extent that the interest payments are made by U.S. group members to affiliates or branches in low-tax or territorial taxing jurisdictions. The enactment of the anti-hybrid rules in Section 267A of the Code as part of the Trump tax reform had fundamentally reshaped how Canadian businesses finance their U.S. operations and substantially limited financing structure options that are available that could achieve a deduction/no-inclusion (a deduction in the U.S. without corresponding taxable income inclusion) results. A SHIELD regime could further squeeze cross-border financing structures and, therefore, further increase the after-tax cost to Canadian businesses of financing U.S. activities.
From a policy perspective, the BEAT can be thought of as an “America First” provision that focused entirely on preventing “excessive” erosion of the U.S. tax base, without regard to how the eroding payments were treated outside the United States. By contrast, SHIELD has a much more multilateral orientation and only denies deductions on payments made to related parties subject to low effective rates of tax. The more discriminating SHIELD rule is designed to encourage/coerce other countries to join the new global tax order and adopt a global minimum tax regime or else suffer an increase in the effective U.S. tax rate applicable to their U.S. income (by virtue of losing U.S. tax deductions). Obviously, many more details are needed before any of this is actionable, but Canadian businesses should take notice that the enactment of SHIELD would make it substantially more likely that Canada would itself adopt a global minimum tax and its own SHIELD-like rule. In addition, as noted above, U.S. lawmakers have made several other proposals that would reform the BEAT instead of replacing it with SHIELD, and any such reform could impact cross-border Canadian businesses.
2. Potential Impact on U.S. Investment in Canadian Companies
The changes being proposed to the GILTI regime would generally increase the amount of U.S. taxes imposed on the foreign operations of U.S.-based groups and therefore create a risk of placing U.S.-parented businesses at a competitive disadvantage to foreign-parented businesses and reintroducing incentives for U.S.-parented businesses to repatriate, in particular if agreement is not reached on a global minimum corporate tax pursuant to currently percolating OECD initiatives.
These changes could also have an undesirable effect on U.S. investments in Canadian companies. In particular, Canadian companies in the emerging high growth sector often rely on U.S. capital investment to fund their growth. Since the Trump tax reform, the GILTI regime, together with changes to the controlled foreign corporation (CFC) attribution rules, have led to a proliferation of CFCs and thereby subjected material U.S. investors of many Canadian companies to potential phantom income inclusions under the GILTI regime. Recent regulatory developments in the area have helped reduce these hardships but difficulties remain. The proposed changes to the GILTI regime (which, among other things, raise the rate of tax applicable to GILTI) will likely exacerbate these difficulties and make venture capital financings for Canadian portfolio companies more challenging. Canadian companies that have provided U.S. tax covenants to U.S. investors should follow the developments in this area closely as they may need to re-examine and consider the impact any changes to the GILTI regime may have on the burdens imposed on the company pursuant to such covenants.
3. Potential Impact on Cross-Border Transactions
Currently, if a Canadian company acquires a U.S. corporation, and the U.S. corporation’s shareholders end up owning at least 60% of the combined company, U.S. anti-inversion rules could impose adverse tax consequences on the combined company. If the U.S. ownership percentage is at least 80%, the combined company would be treated as a U.S. corporation for U.S. tax purposes. The Biden Plan would reduce that threshold to 50% from 80% and also would capture companies whose mind and management are in the U.S. There have been proposals to apply the 50% threshold and mind and management test retroactively to acquisitions that occurred after December 22, 2017. However, there is no indication in the Biden Plan or Treasury Report that any new inversion rules would be applied retroactively, and retroactive legislation is uncommon.
Managing the application of inversion rules in cross-border M&A is already a challenging and sometimes thorny process, and this proposal would significantly expand the scope of the inversion rules. Many “conventional” and “innocent” cross-border transactions could become subject to the inversion rules if this proposal is enacted without significant limitations, safe harbors or both. Canadian companies undergoing combination transactions with U.S. companies should review and consider the potential effects of these tighter inversion rules, including the possibility that these rules may be applied on a retroactive basis.
While it is still too early to draw any firm conclusions, it is clear that credible momentum is building in Washington for a bold infrastructure bill. Even though the timetable for this bill is unclear and there will inevitably be unforeseen twists, it seems evident that these proposals would have significant collateral effects on Canadian taxpayers and, possibly, Canadian tax policy. We believe that Canadian businesses and investors with significant U.S. investments should monitor these changes in order to stay ahead of the curve and to navigate change gracefully.
In the meantime, any clients or friends with questions about the potential impact that these U.S. tax changes may have on them should feel free to contact any member of our U.S. tax department.