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Impact of Proposed Regulations under Section 956 on Lending Arrangements Involving U.S. Corporate Borrowers


On October 31, 2018, the U.S. Treasury Department (“Treasury”) and the Internal Revenue Service (the “IRS”) proposed new regulations (the “Proposed Regulations”)[1] that are likely to allow many controlled foreign corporations (“CFCs”)[2] of U.S. multi-national borrowers to guarantee the debt of their parents and to allow the U.S. parent to pledge more than 66 2/3% of the voting stock of the CFC (and to have the CFC provide negative covenants), all without causing the U.S parent to recognize deemed dividend income under Section 956 of the Code.[3] Specifically, the Proposed Regulations will exempt a corporate “United States shareholder”[4] of a CFC from including its pro rata share of a CFC’s earnings attributable to an “investment in United States property” (a “Section 956 deemed dividend”) as income to the extent that such deemed dividend would be excluded from income if it was paid as an actual dividend under Section 245A.  However, there will remain certain situations where Section 956 will still trigger deemed dividends.[5]  Although the Proposed Regulations are proposed only (and may be amended before being finalized), corporate U.S. borrowers may rely on them so long as the borrower and all parties related to the borrower apply them consistently with respect to all CFCs of which they are United States shareholders.[6]

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Summary of the Opportunity Zone Program

The Tax Cuts and Jobs Act enacted section 1400Z-2 of the Internal Revenue Code, which created the qualified opportunity zone program. The program is designed to encourage investment in distressed communities designated as “qualified opportunity zones” by providing tax incentives to invest in “qualified opportunity funds” (“opportunity funds”) that, in turn, invest directly or indirectly in the opportunity zones.

The qualified opportunity zone program generally offers three potential tax benefits to investors:

First, a taxpayer may elect to defer tax on capital gain from the sale or exchange of property with an unrelated person by investing the gain as equity in an opportunity fund within 180 days after the sale or exchange.  The deferral ends on December 31, 2026, or sooner if the taxpayer sells its interest in the opportunity fund, and at that time the taxpayer must recognize the gain (and pay tax) with respect to the original property.

Second, if the taxpayer holds its interest in an opportunity fund for five years, it can step up its basis in the opportunity fund by an amount equal to 10% of the deferred gain with respect to the original property and, if the taxpayer holds its interest in the opportunity fund for seven years, it can step up its basis in the opportunity fund by an amount equal to an additional 5% of the deferred gain with respect to the original property (for a total of 15%). The stepped up basis reduces the amount of gain recognized by the taxpayer at the end of the deferral period.

Finally, if the taxpayer holds its interest in the opportunity fund for at least 10 years, it can step up its basis in its interest in the opportunity fund to the fair market value of the interest on the date the interest is sold (enabling the taxpayer to eliminate income tax on any post-acquisition capital gain in its opportunity fund interest, including any capital gain attributable to leverage incurred by the fund).

An in depth discussion of the opportunity zone program and the proposed regulations can be found here:

UK Budget – Some Key Changes

The UK Budget took place on 29th October. The Chancellor, Philip Hammond, took the opportunity to make a series of targeted changes to the UK’s tax system, some of which had already been announced, but several of which were new and surprising. We have summarized here of the most eye-catching changes that will be of interest to our corporate and international client base. Please contact any member of our UK tax group if you have any queries about how this year’s Budget will affect your business.

Immediate restriction on eligibility for entrepreneurs’ relief

Entrepreneurs’ relief (ER) is a longstanding relief which allows, amongst others, certain manager shareholders in private fund backed businesses to pay capital gains tax at 10% rather than 20% on up to £10 million of lifetime gains realised when they sell their shares in the company that they manage. The most significant change announced in the Budget that will affect private fund-backed businesses was the immediate change to the conditions required for shareholders to be able to claim ER, which means that many management shareholders who would have qualified for ER on a future sale of the shares that they hold currently will now not qualify. While changes to the ER rules have been anticipated for a while, it is surprising that the changes have been introduced with no consultation, immediate effect and application to existing shareholdings on the basis, as stated by the Treasury, that the measure is to “address an identified abuse of the current rules”.

In order to be able to claim ER on shares, the share issuing company has to be the individual shareholder’s “personal company”. As well as some employment requirements, this required that the individual held “ordinary shares” which entitled them to at least 5% of the issuing company’s “ordinary share capital” and 5% of the votes. The ordinary share capital test is a technical one, so that the only substantive requirement was for the ER shares to carry 5% of the votes. A private fund backer of a business would generally be willing to give management as a whole 20% of the votes so that they retained 75% plus control of the company.

The change to the rules has introduced two new economic rights tests, so that in addition to the share capital and voting rights, an individual now has to be entitled to at least 5% of the profits available to equity holders and 5% of the assets available to equity holders in a winding up of the company. These tests have to be satisfied at all times through the 12 months before the disposal (being increased to 24 months from 6 April 2019). It will be extremely difficult for any portfolio company manager receiving shares as part of an equity incentive arrangement from a private fund backed business to satisfy these 5% economic tests.

As we mention above, it is not particularly surprising that these changes have been made to the rules, particularly given the Resolution Foundation’s (the political think tank) report in August pointing out just how much ER has cost the Exchequer in the 10 years since its introduction and who has benefited from it. What is unfortunate, however, in a period when it is particularly important for the UK to appear an attractive jurisdiction for inward investment, is that the changes have been introduced with immediate, and effective retrospective, effect by removing a large number of existing management shares from ER without warning when the share terms were designed to comply fully with the clear and well understood requirements in place when the shares were issued. The government’s claim that the change is addressing an abuse of the rules, along with the immediate effect of them, will add to the feeling of the investment management industry that they are not welcome in the UK and undermine further the UK’s reputation for having a stable and certain tax regime. For these reasons, the manner in which the change has been introduced is more concerning than the change itself.

Digital Sales Tax

It was also announced at the UK Budget that the UK will introduce a new digital services tax (DST).  The DST will apply from April 2020 and is intended to address the rise of the digital economy and the challenges it poses to traditional tax regimes by ensuring that digital businesses pay UK tax that reflects the value generated from UK customers.

The tax will be levied at 2% of revenues generated from UK customers by search engines, social media platforms and online marketplaces. Only businesses that meet a “double threshold” will fall within the scope of the tax, meaning that they must generate at least £500m of revenue globally and the first £25m of UK revenue will not be taxable.  A safe harbour will be included for businesses that are loss-making or have very low profit margins, the details of which will be subject to consultation.

The introduction of the DST makes the UK a front runner in tackling tax for the digital economy, although it is acknowledged that it may be repealed in the future as international solutions for effective taxation of the digital economy are progressed and implemented.

Offshore Intangibles Regime

New rules are to be published, which will have effect from 6 April 2019, to directly tax non-resident companies that realise intangible property income in low-tax jurisdictions that derives from UK sales. The measure will include embedded royalties and income from the indirect exploitation of intangible property in the UK market through unrelated parties.

The Government gives the example of a non-UK entity receiving income from the sale of goods or services in the UK, and that entity making a payment to the holder of intangible property in a low tax jurisdiction. A charge will arise under the new rules to the extent that the income receivable in the low tax jurisdiction is referable to the sale of goods or services in the UK.

This tax replaces the previously proposed withholding tax proposed in Budget 2017 to capture similar revenues. How this new tax will be collected and enforced remains to be seen, although the proposals do include joint and several liability for connected parties if the non-resident entity does not pay. There will be a £10m de minimis UK sales threshold and other exemptions where income that is taxed at appropriate levels and/or supported by local substance. In addition, non–UK resident companies located in countries with which the UK has a double tax agreement containing a non-discrimination article will not be affected.

UK Tax Round Up: October 2018

Welcome to the October edition of the Proskauer UK Tax Round Up. It has been a reasonably busy month, with a number of interesting UK cases being reported as well as further clarity from the CJEU in relation to VAT. The Autumn Budget will be presented later today and the Finance Bill 2019 will be published on 7 November.

Please view this month’s issue of the UK Tax Round Up.

New Repatriation Tax Relief for RICs and Foreign Income Guidance for REITs

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.

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IRS Releases Preliminary Guidance on Certain Aspects of the Amended Section 162(m) Provisions

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.[1]




[1] 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).