Welcome to the September edition of the Proskauer UK Tax Round Up. This month has seen a number of interesting tax cases and some clarity on the meaning of ordinary share capital.
On September 6, the Internal Revenue Service (“IRS”) released Revenue Procedure 2018-47 (the “RIC Rev Proc”), which provides that a repatriation deemed to have been received by a registered investment company (a “RIC”) under Section 965 (enacted as part of the 2017 tax reform act, commonly known as the “Tax Cuts and Jobs Act” or “TCJA”) is treated as a “specified gain.” As a result, the amount of the deemed repatriation need not be distributed by the RIC until 2018 in order for the RIC to avoid the 4 percent excise tax imposed under Section 4982(a).
On September 13, the IRS released Revenue Procedure 2018-48, which provides that “global intangible low-taxed income” (“GILTI”), Subpart F income and “passive foreign investment company” (“PFIC”) inclusions of a real estate investment trust (a “REIT”) are treated as qualifying income for purposes of the 95 percent gross income test, and that certain REIT foreign exchange gains relating to distributions of previously taxed earnings and profits (“PTI”) are not included in gross income for purposes of the 95 percent gross income test.
Read further for additional background and more detail on these developments.
The Internal Revenue Service has published Notice 2018-68 (the “Notice”), which provides long awaited, but limited guidance on the recent amendments to Section 162(m) of the Internal Revenue Code (“Section 162(m)”) by the Tax Cuts and Jobs Act of 2017 (the “TCJA”). Specifically, the Notice provides guidance regarding the identification of a “covered employee” and the grandfathering rules governing written and binding arrangements in effect on November 2, 2017. The Notice applies to any taxable year ending on or after September 10, 2018. This post summarizes the key points of the Notice and the likely impact of the Notice on publicly held corporations.
Background. Section 162(m) limits the deductibility of remuneration to “covered employees” of certain publicly held corporations to the extent the remuneration for a taxable year exceeds $1 million. The TCJA made significant changes to Section 162(m) as follows: (1) expanded the definition of covered employees; (2) expanded the definition of “publicly held corporations” subject to Section 162(m); (3) eliminated exceptions to the Section 162(m) deduction limitations for commission and qualified performance-based compensation; and (4) established transition rules for certain outstanding arrangements (i.e., grandfathering rules). The TCJA applies to taxable years beginning on or after January 1, 2018. For more information on the TCJA’s amendments to Section 162(m), please see Proskauer’s previous post related to the passage of the TCJA.
Covered Employees. Amended Section 162(m) provides that the term “covered employee” includes (1) any employee who was the principal executive officer (“PEO”) or principal financial officer (“PFO”) of the publicly held corporation any time during the taxable year and (2) any employee whose total compensation for the taxable year is required to be reported to shareholders under the Securities Exchange Act of 1934 by reason of such employee being among the three highest compensated officers for the taxable year (other than the PEO or PFO). The Notice provides that officers do not need to be serving with the publicly held corporation at the end of the taxable year in order to be covered employees.
The Notice further clarifies that executives may be covered employees if their compensation is not required to be disclosed by the applicable publicly held corporation even under the Securities and Exchange Commission (the “SEC”) rules. For example, covered employees of smaller reporting companies and emerging growth companies are determined in the same manner as other publicly held corporations, regardless of whether the disclosure of their compensation is required under the less expansive disclosure requirements applicable to such companies under the SEC rules.
Based on the Notice, there may be a difference between the executives reported on a publicly held corporation’s summary compensation table and the executives who are treated as covered employees for purposes of Section 162(m). Publicly held corporations should separately identify and track their covered employees for Section 162(m) purposes.
Grandfathering Rules. The amendments made to Section 162(m) by the TCJA do not apply to remuneration payable under a written binding contract which was in effect on, and not materially modified after, November 2, 2017. A contract is considered binding only to the extent that a corporation is obligated under applicable law (e.g., state contract law) to pay the remuneration if the employee performs services or satisfies any applicable vesting conditions.
Renewal. A contract that is terminable or cancelable by the corporation without the consent of the employee is not grandfathered under the rules. In addition, contracts that are renewed after November 2, 2017 are not grandfathered under the rules, unless that renewal is in the sole discretion of the employee. However, the Notice provides that a contract is not considered terminable or cancelable by the corporation if it can be terminated or canceled only by terminating the employment of the employee.
Negative discretion. One of the areas of guidance most awaited by practitioners was whether negative discretion on the part of the corporation to reduce or eliminate compensation otherwise payable pursuant to an otherwise grandfathered contract affected the grandfathering provisions under the TCJA. The Notice contains several examples that illustrate the guidance. While the body of the Notice does not directly address the effect of negative discretion on grandfathering, one of the key examples (Example 3 under Material Modification) illustrates the effect. The example implies that the ability of a corporation to exercise discretion to reduce the amount payable to a covered employee eliminates grandfathering for the amount the corporation had the ability to reduce. In the example, a PEO participates in a bonus plan that would otherwise be qualified performance-based compensation before the TCJA amendments. The example provides that the amount that is not subject to negative discretion by the corporation is grandfathered. The remainder of the bonus in the example is subject to the Section 162(m) limitations even though the bonus is otherwise earned under the terms of the bonus plan and negative discretion is not exercised by the corporation.
Material modification. If a written binding contract is materially modified after November 2, 2017, it is treated as a new contract. The Notice provides that a modification that increases compensation above a reasonable cost of living increase is generally considered material. Likewise, accelerations of compensation may be viewed as material unless the accelerated amount is discounted to reflect the time value of money. Deferrals of compensation are not material modifications if the increase (or decrease) in the amount deferred is based on a reasonable rate of interest or a predetermined actual investment (although actual investment is not required).
Supplemental Payments. An agreement to provide increased or additional compensation is treated as a material modification of the underlying contract if the facts and circumstances demonstrate that the increased or additional compensation is paid on the basis of substantially the same elements or conditions as the compensation that is otherwise paid pursuant to the contract. For example, an increase in an executive’s base salary that is higher than provided in the executive’s employment contract (and greater than a cost of living increase) would be viewed as a material modification to the employment contract.
Further requests for comment. Further guidance on Section 162(m) is expected from the Treasury Department and the IRS. In particular, the Notice did not address and the Treasury Department and IRS requested further comment on the application of Section 162(m) to newly public corporations.
 Presently, Section 162(m) provides relief for newly public corporations whereby, generally, compensation paid (and, in certain limited cases, equity-linked compensation granted) during a limited period following the corporation’s initial public offering pursuant to a plan or agreement that exists prior to the corporation becoming public, and that is disclosed in connection with the initial public offering of the corporation’s securities, is not subject to the deduction limitation of Section 162(m).
Welcome to the August edition of the Proskauer UK Tax Round Up. Not unexpectedly, August has been a quiet month with just a couple of interesting developments.
A number of states have recently proposed or passed new laws related to state-level taxation, some of which are taxpayer-friendly and some of which are expected to impose additional tax burdens on taxpayers. They vary in subject from efforts by states to mitigate the new federal limitation on the deductibility of state and local taxes to proposed changes to state income taxation of “carried interest.” This update reflects some of those recent proposals and laws.
The proposed amendment to entrepreneurs’ relief (“ER”) in Finance Bill 2019 is designed to address one of the outstanding issues with the current law when dilution of a company results in the loss of ER. Under the current rules, a shareholder who has held, for at least 12 months prior to disposal, at least 5% of both the ordinary shares and 5% of the voting rights in a trading company (or holding company of a trading group) and is also an officer or employee of the relevant company can benefit from a lower rate of capital gains tax (10%) on the chargeable gain at time of disposal.
However, an issue of new shares, usually upon a new investment into the company, can reduce an individual’s percentage shareholding below the required 5% holding threshold. If this occurs, the individual would lose any ER completely, even in respect of the gain which accrued when the required threshold was satisfied. This consequence has been seen as a barrier to growth for companies.
The proposed amendment will allow individuals, where an issue of shares will lower their holding below the 5% threshold, to elect to crystallise a gain by deeming a disposal and reacquisition of their shares or securities at market value immediately before an issue of shares. Any gain that has accrued up until that point will still qualify for the lower, 10% rate of capital gains tax. The individual can also elect to carry forward the gain, retaining the 10% ER rate, to a time when the individual actually sells the shares to avoid a dry tax charge. Further gains which accrue after the issue of shares will be taxed at the standard 20% CGT rate.
The new proposals will only apply where the share issue which creates the dilution is made wholly in cash, for genuine commercial reasons and not to secure a tax advantage. The new rules will apply for share issues which occur on or after 6 April 2019.
On 6 July 2018 the UK Finance Bill 2019 was published by the UK Government. The draft Finance Bill contains the details of the new regime on taxation of non-UK resident investors in UK real estate that had been proposed in a consultation by HMRC following the November 2017 Budget (see Proskauer Tax Talks blog entry of 22 November, here). The rules will come into force on 6 April 2019 and, for the first time, the charge to UK capital gains tax will be extended to include gains made by non-UK investors in UK commercial property and in certain “property-rich” vehicles.
In general, the structure of the new regime will be as proposed in the November consultation with a few amendments. One of the key changes from the consultation is the inclusion in the draft legislation of an exception from the scope of the new charge for trading entities (described in more detail below).
Alongside direct disposals of UK land, disposals of “property-rich” assets will be caught by the new legislation (such as shares in a company) that derive at least 75% of their value from UK land. Where a number of companies or other entities are disposed of in a single arrangement, the assets of all of the entities will be aggregated in order to establish whether this 75% test is satisfied. Indirect disposals will be within the charge to tax where the investor holds at the date of the disposal, or has held within two years prior to disposal, a 25% or more interest in a property-rich asset (either directly or through a series of entities). This test has been relaxed from the consultation, as the draft Finance Bill reduces the look-back period from five years to two, and includes an additional exception allowing an investor to disregard a holding of 25% or more during the two years prior to a disposal if the holding was only greater than 25% for an insignificant proportion of the total length of the holding period.
Under the revised proposals in the Finance Bill, an offshore investor will be exempt from UK tax on any gain on disposal of a property-rich company if the investor can reasonably conclude that the underlying UK land is, to all but an insignificant extent, used in the course of a trade carried on by the company or a person connected to the company. The trade must have been ongoing for 12 months prior to the disposal, and must be expected to continue. How this exemption will be applied in practice remains to be seen, but this could be an important development for investors in companies carrying on UK businesses such as hotels and some retail businesses.
The rebasing rules as proposed in the consultation have also been relaxed in the draft Finance Bill:
- Investors will now be able to rebase their holding in indirect assets to April 2019 market value – this is something that had been lobbied for by the industry and is a helpful change. Previously rebasing was only going to be possible for direct disposals of UK property.
- Non-UK resident companies which become UK resident after April 2019 will also now be able to elect to rebase to the April 2019 value.
Disappointingly, the application of the new law to collective investment vehicles, in particular real estate funds, will be the subject of further consultation by HMRC.