Canada: U.S. Tax Reform For Busy Canadians

The release of H.R. 1, or the Tax Cuts and Jobs Act [PDF], by the U.S. House Committee on Ways and Means on November 2 marks the beginning of what will surely be a raucous and frantic push to enact U.S. tax reform. The draft legislation would usher in sweeping changes and shift paradigms that have shaped cross-border tax planning for decades. Many of the changes proposed in the bill were anticipated; others were not. Overall, if enacted, this bill would have a deep impact on Canadian businesses and investors with U.S. operations or assets. While there are many details to unpack in this 429-page document, two clear overarching themes emerge from this bill that Canadian businesses should take note of:

  1. Outside the U.S., many American companies will become more formidable competitors in the international marketplace (see, e.g., the new 20% corporate rate and the introduction of a territorial tax system);
  2. Within the U.S., a battery of anti-base erosion provisions would re-level the tax playing field, making it significantly more difficult for non-U.S. based companies to strip or shift income out of the United States (see, e.g., BEPS-style interest deductibility limitations and excise taxes on certain cross-border payments).

While this bill is a vital step forward and reveals key details, it is important to note that this is only a step in a longer process. With the more challenging budgetary and political constraints in the Senate, it is possible that the bill could be modified dramatically before it is finalized, or not passed at all.

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

  • Interest deductibility (Part 1): The bill would introduce new Section 163(n) to the Code. Broadly speaking, this rule (which is similar to the OECD's BEPS Action Four) would limit deductible net interest expense of a U.S. corporation within an "international financial reporting group" to 110% of its "allocable share" of the group's net interest expense. The U.S. corporation's allocable share of the group's net interest expense is determined by reference to the U.S. corporation's earnings before interest, taxes, depreciation and amortization (EBITDA) relative to the group EBITDA. This limitation applies to the U.S. corporation's net interest expense, whether or not the interest is paid to related or unrelated persons. Disallowed interest could be carried forward for five years.

    Illustration: assume (1) the U.S. member of a multinational group has $500 net interest expense, (2) the group as a whole has $3000 net interest expense, and (3) the ratio of the U.S. member's EBITDA to the group's EBITDA is 10%. In this case, the U.S. member's net interest expense for such year would be limited to $330 (110% of its allocable share of the net interest expense, $300 [10% x $3000]), and $170 of its interest deduction would be disallowed.
    This change would be effective for tax years beginning after December 31, 2017, and the bill allows for no grandfathering of existing debt. It is expected that this measure would increase U.S. tax revenues by $34.2 billion over the 10-year budget window.
  • Interest deductibility (Part 2): The bill would also repeal current Section 163(j) and replace it with a more rigorous version. The new Section 163(j) would limit net interest deductions of any taxpayer to 30% of "adjusted taxable income" (similar to EBITDA). As modified, new Section 163(j) would be a general limitation on interest deductibility, applicable to all interest expense whether or not paid to related persons and whether or not the taxpayer is part of a multinational group. Disallowed interest could be carried forward for five years. There is no grandfathering of existing debt and these changes are effective for tax years beginning after December 31, 2017. This provision is scored to generate $172 billion over the 10-year budget window.
  • New tax on certain cross-border payments: This rule represents an aggressive and potentially disruptive approach to combatting U.S. base erosion. Under this provision, cross-border payments made by a U.S. corporation to a foreign affiliate that are deductible, included in cost of goods sold or inventory, or included in the tax basis of depreciable/amortizable assets, are ring-fenced as "specified payments." The gross amount of these "specified payments" would be subject to a 20% excise tax in the hands of the payor. As an alternative, the foreign payee may elect to have the specified payment subjected to tax in its hands as effectively connected income (generally subject to taxation on a net basis at regular corporate rates – 20% for corporations), with net taxable income for such purposes determined by reference to the group's profit margins for the relevant product line. "Specified payments" do not include interest, intercompany services charged at cost and certain commodity transactions.
    • This provision was unexpected and would represent an extraordinary unilateral expansion of U.S. taxing jurisdiction. This tax appears to override U.S. tax treaties and bears some conceptual resemblance to the much-maligned " border adjustment tax." Notably, this rule would apply automatically in that it is not dependent on there being any tax avoidance motive or purpose on the part of the taxpayers involved.
    • For cross-border businesses with large amounts of intercompany services, royalties or similar charges, this provision could be a game-changer.

The provision would be effective for amounts paid or accrued after December 31, 2018, and would apply to international financial reporting groups for which payments from U.S. corporations to foreign affiliates total at least $100 million annually on average. This provision is scored to increase revenue by $154.5 billion over the 10-year budget window.

  • "Hybrid" territoriality: One of the major paradigm shifts in the House Bill is a transition from a "worldwide" to a "hybrid" territorial system for the taxation of foreign earnings. The mechanic for effecting this change is to introduce a dividend, or "participation," exemption for 100% of foreign-sourced dividends paid by a foreign corporation to a U.S. corporation that owns at least 10% of the foreign corporation. There would be no foreign tax credit (or deduction) for any foreign withholding or other taxes imposed on the inbound dividend.
    • Importantly, the bill does not appear to provide for any parallel U.S. tax exemption for gain from the sale of shares of a 10% owned direct or indirect foreign subsidiary.
    • This type of territoriality is referred to as a "hybrid" because (a) core elements of the U.S. subpart F regime are retained, and (b) more importantly, a new "foreign minimum tax" is included (see discussion of "foreign high returns" below).
    • As a transition rule, currently accumulated offshore earnings (determined as of November 2, 2017 or December 31, 2017 – whichever is higher) will be deemed to be repatriated for U.S. tax purposes. Those earnings held as cash and other liquid assets would be subject to a 12% tax rate, while noncash assets would be taxed at a 5% rate. A taxpayer may elect to pay this tax liability over an eight-year period in equal annual installments.
    • While the proposed participation exemption is expected to reduce revenues by $205 billion over the 10-year budget window, the transitional deemed repatriation rule is expected to increase revenues by $223 billion over the same period.
  • Foreign minimum tax – Current taxation of "Foreign high returns": Under this provision, a U.S. parent corporation would be subject to current U.S. taxation (at the new 20% rate) on 50% of its controlled foreign corporations' (CFCs') "high returns." Tax would be required to be paid on these imputed income streams regardless of whether the corresponding earnings were actually distributed to the U.S. parent. "Foreign high returns" are the excess of the CFC's net income over a baseline return (7% plus the federal short-term rate) on the CFC's adjusted tax bases in depreciable tangible property, reduced by interest expense included in the CFC's net income. "Foreign high returns" would be defined to exclude certain types of income (including "effectively connected income," income from the disposition of commodities produced or extracted by the taxpayer, and income subject to tax at an effective rate of at least 18%). This provision, which cuts against the theory of a "pure" territorial tax system, was designed to counterbalance incentives that may otherwise linger for U.S. companies to locate high return generating assets/activities (like intangible property) in offshore locations.

Key domestic tax changes

  • Reduction in corporate tax rate: The headline U.S. federal corporate income tax is set at a flat 20% under the bill (25% for personal services corporations). This replaces the present bracketed corporate tax rates ranging from 15% to 35%. This amendment alone is expected to result in a $1.5-trillion loss of revenues over the next 10 years. This proposal is not phased in, and is set to be effective for tax years beginning in 2018.
  • Indefinite NOL carryforwards to offset up to 90% of taxable income: The bill proposes allowing taxpayers to carry forward indefinitely the NOLs generated in tax years beginning after 2017, which can be used to offset 90%of their taxable income. It also proposes the repeal of NOL carrybacks for most situations. Carryforward amounts would be increased annually by an interest factor in order to avoid time-value erosion of their value.
  • Immediate expensing for five years: The bill enables taxpayers to fully and immediately expense 100% of the cost of qualified property acquired and first placed in service after September 27, 2017 and before January 1, 2023, in lieu of the currently available first-year 50% "bonus" depreciation. "Qualified property" is expanded by repealing the requirement that the original use of the property begin with the taxpayer.
  • Repeal of Alternative Minimum Tax: The bill repeals the Alternative Minimum Tax in its entirety for both individuals and corporations, beginning in 2018. This amendment is expected to result in a loss of $735 billion in revenues over the next 10 years.

Other proposals Canadians should watch

  • Changes coming for Canadian governmental entities? The House Bill contains a provision that subjects U.S. state and local governments to the "unrelated business taxable income" (UBTI) provisions of the Code that are generally applicable to U.S. tax-exempt entities such as charities. Under these provisions, income derived by a tax-exempt organization from (i) a trade or business that is unrelated to the organization's exempt purpose, or (ii) debt-financed passive assets, are subject to tax at regular corporate tax rates.
    • In many ways, the treatment of foreign governmental entities under Section 892 of the Code parallels treatment of U.S. domestic governmental entities under the Code. To the extent that U.S. governmental entities are subject to these UBTI rules, it is possible that corresponding changes may be made to similarly subject Section 892 governmental entities to these rules. If this were to happen, this could have an adverse impact on Canadian governmental pension funds that borrow to acquire assets (or that invest in partnerships that borrow to acquire assets).
  • Section 956 Repeal: Under current law, Section 956 of the Code limits the ability of foreign CFC subsidiaries of a U.S. parent to (i) invest in U.S. property, or (ii) provide guarantees or other forms of credit support to the U.S. parent. If a CFC subsidiary engages in these activities, Section 956 triggers a deemed dividend from the CFC to its U.S. parent. As a result of the introduction of a territorial tax system, in which dividends paid by a CFC subsidiary to a U.S. parent are generally excluded from U.S. taxation, Section 956 is no longer needed to guard against "covert" repatriations and, accordingly, would be repealed. The Section 956 restriction on guarantees is frequently an issue in structuring credit support for cross-border lending facilities. The repeal of Section 956 would eliminate these restrictions and allow affected borrower groups to offer their lenders more expansive credit support.
  • Executive compensation: Under existing U.S. tax rules, employers and employees are able to defer taxation on many forms of compensation (such as SERPS, stock options and stock appreciation rights, restricted stock units and deferred share units) until such amounts are actually or constructively received by the employee, subject to compliance with complex rules under Section 409A of the Code. The House Bill would essentially repeal 409A and introduce new Section 409B. New 409B would effectively end deferred compensation as we know it in the U.S. by requiring deferred compensation to be included in income at the time service-based vesting conditions are satisfied. The definition of deferred compensation under Section 409B does not contain an exemption for stock options, which would result in a significant change in how stock options are taxed in the U.S. – instead of employees recognizing income at the time of exercise, they would now be required to include the value of the option in income at the time of vesting (presumably using the "in-the-money" amount or some Black-Scholes methodology to determine option value).
    • Under this rule, the timing of income inclusion for options would differ between Canada and the U.S., which could create unintended ripple effects for cross-border compensation arrangements. Also, it is common for directors of Canadian publicly traded companies to receive a portion of their fees in the form of fully vested deferred share units. If, under the new rule, the value of the deferred share units is included in income at the time of vesting, this form of compensation would almost surely be eliminated for directors who are U.S. taxpayers.

Next steps in the tax reform process: When thinking about this bill and its potential impact, it is important to keep in mind the broader context of the U.S. tax reform process. The House Bill is a big step forward but in many ways represents an opening bid. There will likely be many changes as the process hurtles forward. Changes to the bill have already begun to emerge – a chairman's mark [PDF] was released Friday (which left the original proposal largely intact with the exception of one provision relating to limitation on treaty benefits) [PDF]. Early this week, the House will begin to markup the bill with a view to passing a final bill by U.S. Thanksgiving. Separately, there have already been rumblings of discontent with the House Bill among Senators. The U.S. Senate Finance Committee is expected to propose its own version of a tax reform bill soon, perhaps as early as this week. The Senate presents a more complicated budgetary and political calculus for tax reform. From a budgetary standpoint, the so-called "Byrd" rule (applicable to revenue law enacted via the reconciliation process) requires that tax reform be deficit-neutral over the 10-year budget window. The House Bill (not constrained by the Byrd rule) appears to be significantly offside this rule, leaving the Senate Bill with few good options – i.e., doing a complete rewrite of the tax reform bill, imposing a 10-year sunset on certain provisions, and/or introducing significant new revenue-raising provisions. From a political perspective, Republican leadership can afford to lose the votes of only two Republican senators. All of this suggests that there are likely to be significant differences between the House and Senate bills. Once a bill is passed in both the House and the Senate, there will be conference in which differences between the respective bills will be reconciled to produce a final bill to be voted on in each of the House and Senate and, if passed, sent to the President to be signed into law. Republican leadership continues to say its goal is to have the bill enacted into law before December 31, 2017.

A detailed section-by-section summary of the bill prepared by the House Committee on Ways and Means can be found here. As noted above, we will provide updates as the bill progresses in the House and when the Senate produces its own proposed bill on tax reform.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
Davies Ward Phillips & Vineberg
Osler, Hoskin & Harcourt LLP
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Davies Ward Phillips & Vineberg
Osler, Hoskin & Harcourt LLP
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions