An extract from The Corporate Tax Planning Law Review – Edition 3
i Entity selection and business operations
The United States generally imposes tax on the net worldwide income of individual US citizens and permanent residents as well as corporations organised in the United States or any of its political subdivisions.3 The Code generally allows taxpayers to elect the legal form through which they earn income. This chapter focuses on ‘C corporations’,4 namely entities subject to taxation under Subchapter C of the Code, the required classification for business organisations ‘incorporated’ in a political subdivision of the United States and certain non-US entities listed in IRS regulations and a classification available by election to other entity types (general partnerships, limited partnerships, limited liability companies, most non-US entities, etc.).5 The earnings of corporations are generally subject to two levels of tax, while partnerships generally pass their income through to their owners and in accordance with the owners’ agreement (subject to complex tax rules).6 Finally, disregarded entities are ignored for tax purposes.7
The TCJA affected taxpayers’ most fundamental business choices in a few ways. Notably, it limited the deductibility of interest payments, changing the calculus of whether to capitalise an entity with debt or equity, and it provided a new deduction available to non-corporate owners of businesses other than certain service professions.8
Interest deduction limitations: Section 163(j)
Prior to the TCJA, interest paid or accrued by a business was generally deductible, subject to targeted limitations applicable to interest allocable to property held for investment and certain earnings-stripping transactions involving payments by thinly capitalised taxpayers (i.e., with a debt-to-equity ratio exceeding 1.5:1) whose net interest expense to related parties exceeded 50 per cent of their taxable income.9 The TCJA amended Section 163(j) by more significantly limiting the availability of the deduction for interest applicable to a trade or business. Now, the deduction is limited to interest expense that does not exceed 30 per cent (50 per cent for taxable years beginning in 2019 or 2020, under legislation enacted in response to the covid-19 pandemic10) of a business’s ‘adjusted taxable income’, generally, earnings before income tax, depreciation and amortisation for tax years beginning before 1 January 2022, and earnings before income taxes thereafter.11 The limitation does not apply to interest allocable to the trade or business of performing services as an employee, electing real property or farming businesses, or certain utilities.12
In September 2020, the IRS finalised regulations clarifying several key points under Section 163(j). Most significantly, the regulations broadly define ‘interest’, which is not defined in the statute, to include amounts that are typically associated with that term, such as amounts paid for the use of money under the terms of a debt instrument, and amounts that constitute interest under US federal income tax law, such as original issue discount.13 Additionally, the regulations treat certain other amounts as adjustments to interest income, including amounts paid with respect to certain swaps and premium included by a debt issuer, and they include an anti-abuse catch-all treating deductible losses or expenses incurred to secure the use of funds as interest.14
Additional deduction for non-service income earned through a sole proprietorship or flow-through entity
As a result of the TCJA, C corporations are generally subject to a lower rate of tax than individual US taxpayers. Accordingly, depending on liquidity concerns and anticipated rate of return on investment, except in the case of corporations that pay substantial dividends, it may be preferable for individual shareholders to hold their investments in corporate form and to defer shareholder-level tax. However, the TCJA added Section 199A to the Code, complicating this calculus. Under Section 199A, non-corporate taxpayers (including shareholders of S corporations) are entitled to a deduction of up to 20 per cent of the taxpayer’s taxable income. This deduction, which is applied at the sole proprietor, partner, REIT or S corporation shareholder level, is eliminated with respect to income derived from a ‘specified service trade or business’ (SSTB) for single taxpayers with income in excess of US$157,000 or married taxpayers filing jointly with income in excess of US$315,000, in each case, indexed for inflation.15
An SSTB is any trade or business:
- involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services;
- where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners; or
- involving the performance of services that consist of investing and investment management, trading or dealing in securities, partnership interests or commodities.16
Consistent with the general theme of the TCJA, Section 199A is not obviously cohesive. Several of the enumerated professions are service professions, such as law and accounting, but other archetypal service professions (e.g., engineering and architecture) are excluded by the statute,17 and trading or dealing in securities does not necessarily involve the provision of services (except by statutory definition). Moreover, the statute does not distinguish between active and passive owners of an SSTB.
Regulations under Section 199A provide several clarifications to the law, including a de minimis exception providing that a trade or business with US$25 million or less of gross receipts in a taxable year will not be treated as an SSTB if less than 10 per cent of these receipts are attributable to the performance of services in an SSTB (5 per cent in the case of a trade or business with gross receipts of more than US$25 million for a taxable year).18 This exception has a ‘cliff effect’: if a trade or business with gross receipts of greater than US$25 million in a taxable year derives 5.001 per cent of its income from an SSTB, it is ineligible for the Section 199A deduction; accordingly, the availability of the deduction may vary from year to year based on a business’s revenue streams.
Section 199A provides an attractive tax benefit to many taxpayers willing to forego the benefits of deferral of taxation at the level of an owner, and accordingly must be considered when taxpayers elect the form of entity through which they will hold a business. President Biden’s proposal to increase the corporate tax rate to 28 per cent and to tax capital gains and dividends at ordinary income rates for taxpayers with incomes in excess of US$1 million would make the Section 199A deduction even more valuable, particularly for those in the highest income brackets. However, he has also pledged to repeal the TCJA’s tax cuts applicable to individuals with over US$400,000 in income, which may result in phasing out the Section 199A deduction at this level.
ii Common ownership: group structures and intercompany transactions
The structure of the tax code as applied to purely domestic groups of corporations was largely unaffected by the TCJA. Under Section 1501 of the Code, an ‘affiliated group’ of US corporations may file a consolidated tax return. Very generally speaking, affiliated corporations that file a consolidated return are taxed as one taxpayer until a corporation leaves the group, at which point gain or loss from prior intercompany transactions that was deferred during consolidation generally must be recognised.19 Additionally, a US corporation may deduct 100 per cent of the dividend income received from a member of its affiliated group, and 50 per cent of the dividend income from other domestic corporations, provided the required holding period is satisfied.20
Non-US corporations may not be members of a US consolidated group, and prior to the enactment of the TCJA, a deduction in respect of dividends received from a foreign corporate subsidiary was generally available only in respect of the US-source portion of the dividends.21 Through Section 245A, the TCJA removed this incentive to keep cash outside the United States and established a partial participation exemption: the foreign-source portion of dividends received from a 10 per cent-owned foreign subsidiary are now eligible for a 100 per cent deduction, provided the holding period is met.22 The TCJA also included a one-time repatriation tax or ‘toll charge’ on the accumulated earnings and profits since 1986 of a controlled foreign corporation or a foreign corporation with one or more US corporations as shareholders, treating this income as taxable ‘Subpart F income’ (so named for the subpart of the Code imposing this tax) in the taxpayer’s last taxable year beginning before 1 January 2018.23
Subpart F income is generally income from passive sources (dividends, interest, royalties, rents, insurance income, capital gains, etc.), and it, together with investments in US property as defined in Section 956, has long been taxable to US shareholders who own, directly or indirectly (but not constructively),24 stock of ‘controlled foreign corporations’ (CFCs). US shareholders are individual citizens or residents of the United States, as well as entities organised under the laws of the United States, any state or the District of Columbia, who own, directly, indirectly or constructively, 10 per cent of the vote or value of a foreign corporation. A CFC is a foreign corporation 50 per cent or more (by vote or value) or the stock of which is owned, directly, indirectly or constructively by one or more US shareholders.
The TCJA modified corporate tax planning for Subpart F and Section 956 income by changing the definition of US shareholder in two important ways. Prior to amendment, individuals or entities were US shareholders only if they owned 10 per cent of the vote of a foreign corporation; accordingly, shareholders willing to accept low-vote stock could under certain circumstances avoid being subjected to Subpart F and Section 956.25 More significantly, the TCJA greatly expanded the constructive ownership rules for purposes of determining whether a person is a US shareholder,26 with the result that, in any worldwide group of corporations with a common foreign parent and a US subsidiary, virtually all foreign corporations that are direct or indirect subsidiaries of the common parent are likely to be CFCs, significantly expanding the base of Subpart F and Section 956 income. Additionally, under customary terms of credit agreements, guarantees by and pledges of stock of a greater number of foreign corporations have been forbidden.27 Tax planning for Subpart F and Section 956 must shift its focus to avoiding having US shareholders with a direct or indirect stake in a CFC rather than avoiding the creation of CFCs.
International intercompany transactions
Perhaps the most significant challenge in designing incentives to generate and maintain earnings in the United States is the reality that the nation’s economy increasingly depends on the exploitation of intangible assets, which are highly portable as a matter of legal form, and the Code tends to respect the legal form taxpayers choose. The TCJA purports to target the problem of taxing intangible income with a complex and novel two-pronged approach: the ‘carrot’ of a deduction for ‘foreign-derived intangible income’ (FDII) and the stick of a tax on ‘global intangible low-taxed income’ (GILTI). GILTI and FDII sweep more broadly than the word ‘intangible’ implies, and need to be considered by any US corporation that earns income abroad, directly or through subsidiaries.
Under Section 951A of the Code, US shareholders (including individuals) who own, directly or indirectly, stock of a CFC must include GILTI in their income. GILTI is defined as the excess of a US shareholder’s aggregate pro rata share of the net ‘tested income’ of each CFC of which the shareholder is a US shareholder over 10 per cent of the CFC’s ‘qualified business asset investment’ (QBAI), reduced by the interest expense taken into account in calculating the US shareholder’s tested income (to the extent corresponding interest income is not taken into account).28 ‘Tested income’ is the gross income of each CFC, reduced by US-source income effectively connected with the conduct of a trade or business in the United States, Subpart F income, dividends received from certain related persons and deductions properly allocable to such income, in addition to certain other targeted exclusions.29 QBAI is the average of a CFC’s aggregate adjusted basis of depreciable tangible property that gave rise to tested income. While GILTI resists conceptual oversimplification, one way to understand the provision is that Congress subjected income from intangible assets held in CFCs to current taxation and decided to calculate intangible income by providing that all income other than a 10 per cent deemed return on a CFC’s investment in tangible property is derived from intangibles.
The TCJA also introduced two new tax benefits relevant to US corporations calculating GILTI. First, Section 250 allows a deduction of 50 per cent of a corporation’s GILTI (reduced to 37.5 per cent for taxable years beginning after 31 December 2025), meaning that GILTI is effectively taxed to corporations at a 10.5 per cent rate for taxable years beginning before 31 December 2025, after which it will be taxed to corporations at 13.125 per cent. Second, the TCJA amended Section 960 to provide to US corporations a credit for foreign taxes deemed paid in respect of GILTI.30 President Biden has proposed doubling the GILTI rate to 21 per cent and eliminating the exemption for QBAI in order to disincetivise offshore investments.
The amount of the tax credit available in respect of GILTI is limited by Section 904; importantly, GILTI falls in a new foreign tax credit ‘basket’ and, unlike the credits in respect of foreign branch, passive category and general category income, no carry-backs or carry-forwards are allowable in respect of excess credits from tax paid in respect of GILTI.31 When the foreign tax credit in respect of GILTI is taken into account, according to the conference report accompanying the TCJA, the result should be that GILTI is taxed at a minimum combined US and foreign rate that ranges from 10.5 per cent (if the foreign tax rate is zero) to 13.125 per cent if the foreign tax rate equals or exceeds that amount.32 However, the result that the legislative history suggests was intended will not obtain if there are any expenses properly allocable to the GILTI basket. Section 904 requires US corporations to limit their tax credits in each relevant basket for each taxable year by the product of their foreign-source taxable income in the applicable basket for the year and the effective US tax rate on their worldwide income for the year.33 If an item of expense is allocable to the GILTI basket, it will reduce the amount of taxable income offset by the GILTI foreign tax credit, dollar for dollar.34 For this reason, depending on the availability of foreign tax credits allocated to other baskets, a taxpayer may prefer Subpart F income to GILTI even though Subpart F income is taxed at a higher headline rate.
Recently finalised regulations35 provide an electable ‘high-tax exclusion’ that permits taxpayers to omit GILTI subject to non-US tax at a rate of at least 90 per cent of the top marginal US corporate rate. Whether the high-tax exclusion will benefit a particular taxpayer in a particular year will depend on that taxpayer’s own facts and circumstances. For example, excluding highly taxed income from GILTI could reduce QBAI, thereby increasing the tested income that is ultimately subject to tax. Assessing the value of the high-tax exclusion will thus be an important component of US multinational’s corporate tax planning.
FDII is a counterpart to GILTI, and the two concepts operate similarly in certain respects. In addition to the 50 per cent deduction for GILTI, Section 250 now allows a 37.5 per cent deduction in respect of FDII (scheduled to drop to 21.875 per cent for taxable years beginning after 31 December 2025). In the absence of the FDII deduction, it would be more advantageous for US corporations to earn income overseas through CFCs because of the 50 per cent GILTI deduction.36
A US corporation’s FDII equals its ‘deemed intangible income’ multiplied by the ratio of its ‘foreign derived deduction eligible income’ over its total ‘deduction eligible income’. Deemed intangible income is the excess of deduction eligible income over a deemed tangible income return equal to 10 per cent of the corporation’s QBAI (calculated in the same manner as in the GILTI context). Deduction eligible income is the gross income of the corporation (excluding Subpart F and Section 956 income, GILTI, financial services income, dividends from CFCs, domestic oil and gas extraction income and foreign branch income) less deductions, including taxes, properly allocable to such gross income.37 Finally, foreign-derived deduction eligible income is deduction eligible income derived in connection with property sold by the taxpayer to a non-US person and that is established to the satisfaction of the Secretary of the Treasury Department is for a foreign use or in connection with services provided to any person who, it is established to the satisfaction of the Secretary, is located outside the United States or with respect to property located outside the United States.
Notwithstanding the parallels between GILTI and FDII and the IRS’s analysis that ‘(t)he result of the section 250 deduction for both GILTI and FDII is to help neutralize the role that tax considerations play when a domestic corporation chooses the location of intangible income attributable to foreign-market activity’,38 the continued complex calculations of GILTI and FDII and the foreign tax credits available to offset GILTI mean that comprehensive modelling will be required to determine whether a multinational enterprise would prefer to earn intangible income from sources outside the United States directly or indirectly through CFCs. In at least one high-profile instance, a major US corporation (Qualcomm) has determined that the benefits of FDII are significant enough that it has decided to elect to treat many of its former CFCs as disregarded entities, notwithstanding the recognition of income by a domestic corporation upon the liquidation of a foreign corporate subsidiary.39 President Biden has proposed repealing FDII.
iii Third-party transactions
The TCJA has dramatically changed the considerations relevant to taxable sales of CFCs. In particular, the new dividends-received deduction under Section 245A and the GILTI regime have created three tax rates for income that may be realised upon the disposition of stock in a CFC: 21 per cent for Subpart F income and the sale of the CFC’s stock, 10.5 per cent for GILTI (until 31 December 2025, when the rate is scheduled to increase to 13.125 per cent) subject to reduction from foreign tax credits, and zero per cent for dividends (including gain recharactised as a dividend under Section 1248) that satisfy the holding period and other requirements of Section 245A.
One of the principal questions facing parties to a stock sale is whether the purchaser should make (or the seller should contractually forbid the purchaser from making) an election under Section 338(g) with respect to such a sale. Without such an election, the consequences of a sale of a CFC are that the US parent recognises gain to the extent the price of the stock exceeds the parent’s basis in it.40 This gain is treated as a dividend under Section 1248 to the extent of the CFC’s post-1962 accumulated earnings and profits (E&P). If a Section 338(g) election is made (and, absent a contractual agreement to the contrary, a purchaser may make such an election in its discretion), in addition to the stock sale that actually occurs, the transferred corporation (referred to as the ‘old target’) is deemed to sell its assets to a new corporation (referred to as the ‘new target’). As a result, the transferred corporation realises asset-level gain and takes a stepped-up tax basis in its assets. Where the target is a US corporation, the deemed asset sale is treated as occurring after the stock sale, meaning that the acquirer would bear the burden of the asset-level tax;41 however, in the case of a foreign target, the asset sale is treated as having occurred while the seller still owned the target stock,42 resulting in potential GILTI and Subpart F inclusions to the seller in addition to any gain on the stock sale.
The complex interplay of new and old tax rules mean that there is no rule of thumb that making or not making a Section 338(g) election will tend to be better for a seller or a buyer of a CFC. One factor to consider is that, if the US parent satisfies the Section 245A holding period, then to the extent of the CFC’s foreign-source earnings and profits, the gain will be treated as a dividend and eligible for the 100 per cent dividends-received deduction. Although a deemed asset sale would generate E&P, it would also most likely generate Subpart F income and GILTI. Both these kinds of income result in an upward adjustment in the seller’s basis in the target, reducing the gain on the stock sale (and, therefore, the amount of gain treated as a dividend under Section 1248).43 Accordingly, a US owner of a CFC with accumulated E&P may prefer that a buyer not make a Section 338(g) election; however, a US owner of a CFC without E&P may prefer a Section 338(g) election, particularly if the asset-level gain gives rise to GILTI because, although GILTI is effectively taxed at a lower rate than dividends, capital gain and Subpart F, amounts realised in respect of GILTI give rise to a full upward basis adjustment in CFC stock.44