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:
- 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);
- 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
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
- 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
- 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.