We describe the Covid-19 outbreak as “unprecedented” while at the same time mentally or digitally flipping calendar pages back through recent experience to find appropriate models for dealing with it. In that regard, the similarly “unprecedented” financial crisis of 2008-2009 is a tempting guide—if one focuses merely on the economic consequences of the pandemic—for possible ways for individuals, companies, and countries to respond to the interruption, if not outright cessation, of commercial activity.
Given all of the uncertainties we face at this time, past experience may be the only reliable guidance available. However, before copying an investment or transactional form that was successful a decade or more ago (or, alternatively, steering clear of an approach that failed miserably during that period), one needs to take into account the obvious and not-so-obvious changes that have occurred in the U.S. tax laws since the financial crisis. In particular, the enactment of Public Law115-97, popularly referred to as the “Tax Cuts and Jobs Act” (TCJA) significantly changed the U.S. tax rules, particularly for cross-border income and investment.
Some of the base-broadening changes made by TCJA bite particularly during economic downturns. For example, for those who may have forgotten about its changes to the treatment of net operating losses (NOLs), limitations on losses of non-corporate taxpayers, and the interest expense limitation rules of Section 163(j), the temporary relief from those provisions provided by the CARES Act (Public Law 116-136) serves as a clear reminder of the effect those provisions would have in the short term.
The changes to the international tax rules in the past 10 or so years, on the other hand, not only lack the reminder of the CARES Act, but their effects are in many cases more subtle. So, before structuring a cross-border loan, contributing equity to (or from) a domestic entity from (or to) a foreign entity, or restructuring the operations or organization of a multinational group, one needs to consider carefully how the new U.S. tax rules may affect attractive measures that worked once before.
- Making a loan to a domestic corporation. The current section 163(j) limitation is a lot broader than the version of section 163(j) that applied a decade or more ago. Even though the 30% limitation of section 163(j)(1)(B) has been increased temporarily to 50%, interest payments still may not be fully deductible in the year of payment or accrual. In addition, if the lender is a related foreign party, the impact of the Base Erosion and Anti-Abuse Tax (BEAT) (Section 59A) has to be taken into account as well.
- Making a loan to a foreign corporation. Section 163(j) affects not only domestic companies but controlled foreign corporations (CFCs) as well. By limiting the amount of interest expense that can be deducted by the CFC, Section 163(j) can result in greater Subpart F income than the same arrangement a decade ago. Similarly, the interest expense limitation can have a series of effects on the determination of GILTI, a concern which no one had to consider in more innocent times.
- Making an equity contribution to a foreign corporation. TCJA made changes to the constructive ownership rules of Section 958(b) and the definition of U.S. shareholder in Section 951(b), making it more likely that a foreign corporation will be a CFC either before or after an equity injection by a U.S. person. Similarly, before TCJA, only owners of voting stock could be U.S. shareholders. Issuance of non-voting stock was an easy way to prevent the contributor from becoming a U.S. shareholder or turning a foreign corporation that was not a CFC into a CFC. Now, a much more careful inquiry is needed to determine whether an existing foreign corporation is a CFC and whether a U.S. person contributing cash or property to the foreign corporation will become a U.S. shareholder.
Due to the repeal of the prohibition on downward attribution (old Section 958(b)(4)) and the expansion of the definition of U.S. shareholder (Section 951(b), as amended by TCJA), a foreign corporation is more likely to be a CFC post-TCJA. Particularly due to the change in the constructive ownership rules, it is not sufficient just to inquire as to the direct and indirect owners of the foreign corporation; one has to examine the entire group to see if there is a domestic corporation turning all foreign members of the group (other than the domestic corporation’s direct and indirect parents) into CFCs. If a foreign corporation is a CFC (or will become a CFC as a result of the new capital contribution), then generally any U.S. person that owns directly, indirectly, or constructively 10% or more of the foreign corporation will be a U.S. shareholder and subject to Subpart F and GILTI inclusions. If the foreign corporation would not be a CFC, but for the new contribution, this change in status could affect not just the new shareholder but existing shareholders as well.
GILTI is so new that we do not have experience with it in an economic downturn. The consequences, however, are likely to be unpleasant for U.S. shareholders. Others have recently pointed out the impact of NOLs and domestic losses on the computation of GILTI, and so I will not repeat those concerns. Still, if a CFC flips from having tested income to having a tested loss for GILTI purposes, its U.S. shareholders lose the ability to count the CFC’s specified tangible property as qualified business asset investment, or QBAI. Of broader concern, however, is the fact that GILTI is unforgiving of timing mismatches involving U.S. and foreign taxes. Reduction in foreign tax liability, either due to losses or deferral of foreign taxes, could result in foreign taxes being in wrong year from a GILTI calculation standpoint and therefore GILTI inclusions on income that is high—taxed—just not in the year the U.S. sees the relevant tested income earned.
Accordingly, before taking a 10% or greater stake in a foreign company, a U.S. person should undertake significant efforts to identify whether the foreign company is, or is likely to become, a CFC. If the investment causes (or may cause) a U.S. person to be a U.S. shareholder in a CFC, then the foreign corporation will need to provide the investor (and any other U.S. shareholder) with significant amounts of detailed information for U.S. tax purposes. The relevant parties may need to negotiate specifically to ensure this information is available; the Form 5471 (Information Return of U.S. Persons With Respect To Certain Foreign Corporations) of a decade ago looks like an executive summary of the Form 5471 now.
- Having a CFC make a loan or contribute cash to a domestic affiliate. Historically, an equity injection or loan by a CFC to a U.S. affiliate could result in adverse U.S. tax consequences to a U.S. shareholder in the CFC due to Section 956. Section 956 may or may not still be relevant to a U.S. shareholder after the recent revisions to Treasury Regulation 1.956-1. In short, Section 956 is still very much a concern for U.S. shareholders who are individuals. Whether it is of concern to a U.S. shareholder that is a domestic corporation depends on the specific circumstances of the CFC and its domestic corporate U.S. shareholder. In any case, one should keep in mind that the temporary rules that applied in 2008-2010 (e.g., Notice 2008-91, extended by Notice 2009-10 and Notice 2010-12) no longer apply.
- Restructuring a multinational group. A hive of new provisions need to be taken into account before following a decade-old blueprint. Among the new issues and concerns:
First, any restructuring or exchange of shares of a member of a multinational group that includes one or more U.S. companies must take into account the U.S. anti-inversion rules, principally Section 7874. Although TCJA made only modest changes regarding the anti-inversion rules, the scope of the regulatory rules has been greatly expanded since 2009. Cross-border transactions are much more likely to implicate these rules than during the last go-around.
Second, there are likely to be U.S. tax costs that did not exist a decade ago. Suppose a U.S. person owns a foreign entity that is disregarded or a partnership for U.S. tax purposes and needs to convert it into a foreign corporation or contribute its operations to a foreign corporation. Pre-TCJA that was much easier to do without causing the transaction to be a taxable transfer to any U.S. owners. After TCJA and its repeal of the old Section 367(a)(3) exception for the active conduct of a foreign trade or business, this component of restructuring is more likely to have a U.S. tax cost to U.S. owners, particularly to the extent that the foreign business has goodwill, going concern value, or other appreciated assets that meet the new definition of “intangible assets” in Section 367(d)(4). Branch losses also now have to be taken into account under Section 91.
Third, hybrid entities and hybrid transactions tend to create problems now, rather than opportunities as they did 10 years ago. Section 267A denies deductions with respect to certain hybrid transactions and hybrid entities, and a lot of other countries have similar laws.
Finally, any strategy that briefly created a CFC has to reconsidered too, in light of TCJA’s repeal of the requirement in Section 951(a)(1) that a CFC exist for 30 days before becoming subject to Subpart F and GILTI.
In times of uncertainty, it is only natural to turn to the familiar. Just make sure that you are as familiar with the new U.S. tax rules as you are with the non-tax problems you are seeking to address. Like a Renaissance artist, you may be inspired by the past but still constrained by norms and practices of the present.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
John L. Harrington is one of the co-leaders of Dentons U.S. tax practice.