U.S. Tax Reform – Significant Changes for Foreign Investors

On December 22, 2017, President Trump signed into law the comprehensive tax reform bill (the “Act”) that had been passed by Congress on December 20. The Act represents the most significant reform of the U.S. Internal Revenue Code in over 30 years. The following is a high-level summary of key features of the Act that may be of particular interest to foreign businesses and individuals investing in the United States. Unless otherwise specified, all changes became effective for tax years beginning on or after January 1, 2018. CORPORATIONSCorporate Tax Rate. The Act permanently reduces the maximum corporate tax rate from 35% to 21%, and repeals of the corporate alternative minimum tax (AMT).Shift from “Worldwide” Taxation to “Territorial” Taxation. With certain exceptions, a U.S. corporation that owns 10% or more of a foreign corporation is entitled to a 100% dividends-received deduction for the foreign-source portion of dividends from these foreign corporations. However, the Subpart F regime (which requires immediate taxation of certain passive or portfolio income of foreign subsidiaries) is largely preserved. This shift to a territorial system does not change the taxation of U.S. corporations that operate abroad through branches, nor does it exempt from taxation gain arising from the sale of shares of subsidiaries (unless they are recharacterized as dividends).Limitation on Business Interest Deductibility.  The Act replaces the traditional “thin-capitalization” rules with new rules that disallow a deduction for net business interest expense of both corporations and flow-through entities (i.e., partnerships and limited liability companies) in excess of 30% of the business’s adjusted taxable income. For taxable years beginning before January 1, 2022, adjusted taxable income is computed without regard to depreciation, amortization and depletion (i.e., similar to EBITDA). Beginning on January 1, 2022, adjusted taxable income will take into account depreciation, amortization and depletion (i.e., similar to EBIT). Disallowed interest deductions may be carried forward indefinitely.Business interest expense is defined as interest paid or accrued on indebtedness. It does not include investment interest within the meaning of Internal Revenue Code section 163(d) for individual taxpayers. For partnerships and other flow-through entities, the net interest expense disallowance is determined at the entity level (e.g., at the partnership level instead of the partner level).  Small businesses with $25 million or less of gross receipts are exempt from this limitation.  There is no grandfathering for preexisting debt.Net Operating Losses. Net operating losses (NOLs) arising after December 31, 2017 are deductible only up to 80% of the taxpayer’s taxable income. NOLs can be carried forward indefinitely, but generally cannot be carried back. ANTI-BASE EROSION AND INCOME SHIFTING PROVISIONS. Base Erosion and Anti-Abuse Tax (BEAT) Applicable to Large Multinationals. The BEAT is designed to keep U.S. corporations from shifting revenues from the U.S. to foreign jurisdictions with a lower tax rate, and affects U.S. subsidiaries with foreign parents. The BEAT is essentially a 10% minimum tax (11% for banks and registered securities dealers) calculated on the taxpayer’s income without tax deductions or other tax benefits arising from “base erosion” payments. A “base erosion payment” is generally an amount paid or accrued by a taxpayer to a related foreign person that is deductible to the taxpayer, but does not include cost of goods sold or qualified derivative payments.The BEAT applies to domestic corporations that (i) are not taxed on a flow-through basis (such as S corporations, regulated investment companies, or real estate investment trusts), (ii) are part of a group with at least $500 million of annual domestic gross receipts over a three-year averaging period, and (iii) have a “base erosion percentage” of 3% or higher for the tax year (or 2% for certain banks and securities dealers). The base erosion percentage means the percentage determined by dividing the corporation’s base erosion tax benefits by the total deductions allowed with respect to the corporation.Limitation on Deduction of Certain Related-Party Payments in Hybrid Transactions or with Hybrid Entities.  The Act disallows a deduction for any disqualified related-party amount paid or accrued in a hybrid transaction, or by, or to, a hybrid entity. A disqualified related-party amount is any interest or royalty paid or accrued to a related party if (i) there is no corresponding income inclusion to the related party under local tax law or (ii) such related party is allowed a deduction with respect to the payment under local tax law. The Treasury Department is given broad authority to issue regulations or other guidance necessary or appropriate to carry out the purposes of the provision.Hybrid transactions are transactions in which payments are treated as interest or royalties for federal income tax purposes but are not so treated for purposes of the tax law of a foreign country. A hybrid entity is one that is treated as fiscally transparent for federal income tax purposes (e.g., a disregarded entity or partnership) but not for purposes of a foreign country, or an entity that is treated as fiscally transparent for foreign tax law purposes but not for federal income tax purposes (reverse hybrid entity).Limitations on Income Shifting through Intangible Property Transfers.  The Act expands the universe of assets that are considered “intangible property” for purposes of outbound transfers to include workforce, goodwill, going-concern value, and “any other item” with a value that is not attributable to tangible property or the services of an individual. This provision makes it more difficult for a U.S. corporation to transfer intangible property abroad without incurring taxes.Repeal of Active Trade or Business Exception for Outbound Transfers. Prior law provided an exception to gain recognition for certain outbound transfers of property for use in foreign corporation’s active trade or business.  The Act repeals this active trade or business exception. As a result, U.S. corporations that transfer assets to a foreign corporation for continued use in an active trade or business will recognize gain on the outbound asset transfer. PASSTHROUGH ENTITIES AND SOLE PROPRIETORSHIPSExpanded S Corporation Shareholders. Previously, only U.S. residents could be shareholders of an S corporation. The Act now permits nonresident aliens to be beneficiaries of an Electing Small Business Trust (“ESBT”) that is a shareholder of an S corporation. The S corporation stock held by the ESBT may not, itself, be distributed to the nonresident alien without terminating the S corporation election. This provision may expand the number of corporations that elect S corporation status, as well as the ability of S corporation shareholders to engage in gift and estate tax planning.Sale of Foreign Partner’s Partnership Interest as ECI. Overturning a recent case decided by the Tax Court, the Act provides that a non-U.S. partner in a partnership recognizes gain or loss treated as “effectively connected” to a U.S. trade or business upon the sale of the partner’s partnership interest, to the extent that the partner would be treated as having effectively connected income in a hypothetical sale of all the assets of the partnership. The transferee in such a transaction must withhold 10% of the amount realized, unless the transferor certifies that it is not a nonresident alien or foreign corporation.Deduction for Passthrough “Qualified Business Income.”  The new law allows an individual taxpayer to deduct 20% of domestic qualified business income (“QBI”) from a partnership, S corporation, or sole proprietorship. This deduction, as other provisions affecting individual taxpayers, sunsets after 2025. The deduction generally would be limited to the greater of: (a) 50% of the W-2 wages paid with respect to the trade or business; or (b) 25% of the W-2 wages paid with respect to the trade or business plus 2.5% of the unadjusted basis of all qualified property. The QBI deduction is not available to most service businesses (e.g. health, law, accounting), but individuals with taxable incomes below certain threshold amounts are not subject to this exclusion, nor the foregoing W-2 limitation. For further information please contact:Maureen R. Monaghan: maureen.monaghan@wg-law.com; (212) 509-6312