Corporate Taxation

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On October 2, 2019, the Internal Revenue Service (“IRS”) and the U.S. Department of the Treasury (the “Treasury”) issued Revenue Produce 2019-40 (the “Revenue Procedure”) and proposed regulations (the “Proposed Regulations”) that provide guidance on issues that have arisen as a result of the repeal of section 958(b)(4) by the tax reform act of 2017.[1] The repeal of section 958(b)(4) was intended to prevent certain taxpayers from “de-controlling” their controlled foreign corporations (“CFCs”) and avoid paying current tax on earnings of those CFCs. However, the repeal has inadvertently caused a number of foreign corporations to be treated as CFCs for U.S. federal income tax purposes. As a result, U.S. persons who directly or indirectly own between 10% and 50% of the voting stock or value of foreign corporations that are now treated as CFCs are subject to tax on income (“subpart F income”) and 951A (globally intangible low-taxed income, or “GILTI”). The repeal has had other unintended consequences. For example, if a foreign corporation receives U.S.-source interest from a related person, the repeal of section 958(b)(4) may cause the interest to be subject to U.S. withholding tax (i.e., the interest would fail to qualify for the “portfolio interest exemption”).[2]

The Proposed Regulations “turn off” certain special rules that arise solely as a result of the repeal of section 958(b)(4). However, the Proposed Regulations do not prevent foreign corporations from being treated as CFCs as a result of the repeal of section 958(b)(4), do not limit the subpart F or GILTI income required to be reported as a result of the repeal of section 958(b)(4), and do not reinstate the portfolio interest exemption for foreign corporations affected by the repeal of section 958(b)(4).

The Revenue Procedure provides safe harbors for certain U.S. persons to determine whether they own stock in a CFC and to use alternative information to determine their taxable income with respect to foreign corporations that are CFCs solely as a result of the repeal of section 958(b)(4) if they are unable to obtain information to report these amounts with more accuracy.

The Proposed Regulations are generally proposed to apply on or after October 1, 2019. However, a taxpayer may rely on the Proposed Regulations for taxable years prior to the date they are finalized. The Revenue Procedure is effective for the last taxable year of a foreign corporation beginning before January 1, 2019.

On September 10, 2019, the Internal Revenue Service (“IRS”) and the U.S. Department of the Treasury (the “Treasury”) issued proposed regulations (the “Proposed Regulations”) on calculation of built-in gains and losses under Section 382(h) of the Internal Revenue Code of 1986, as amended.[1] In general, the Proposed Regulations replace the existing guidance on the calculation of net unrealized built-in gains (“NUBIG”), net unrealized built-in losses (“NUBIL”), realized built-in gains (“RBIG”) and realized built-in losses (“RBIL”) under Section 382(h). This guidance had largely taken the form of Notice 2003-65[2] (the “Notice”), which had been the key authority relied upon by taxpayers for purposes of the various calculations required under Section 382(h).

By eliminating the Notice’s 338 Approach and by making certain other changes, the Proposed Regulations, if finalized in their current form, could significantly cut back on a loss corporation’s ability to use pre-change losses and therefore could substantially diminish the valuation of this tax asset in M&A transactions and could hamper reorganizations of distressed companies. In fact, these proposed changes could put more pressure on companies in bankruptcy to attempt to qualify for the benefits of Section 382(l)(5) or to engage in a “Brunos-like” taxable restructuring transaction, and, when those options are not available, could lead to more liquidations rather than restructurings.

The Proposed Regulations are another factor in a series of changes and circumstances that affect the value of tax assets such as net operating losses for corporations. Both the current low applicable federal long-term tax-exempt rate (1.77% for October 2019)—which creates relatively small Section 382 limitations—and the new rule from the 2017 tax reform that limits the usability of net operating losses arising in tax years beginning after December 31, 2017 to 80% of taxable income are developments that, in conjunction with the Proposed Regulations, put downward pressure on the expected value of this tax asset.

The Proposed Regulations are not effective until they are adopted as final regulations and published in the Federal Register, and will apply only with respect to ownership changes occurring after their finalization. Until that happens, taxpayers may continue to rely on the Notice for calculations of NUBIG, NUBIL, RBIG and RBIL.

Implements 2018 Proposed Regulations, ending most limitations on investments in U.S. property, as well as pledges and guarantees by CFCs wholly-owned by U.S. corporations – also provides PTI guidance for CFC shareholders.

EXECUTIVE SUMMARY

In anticipated and important guidance, the U.S. tax authorities have issued final regulations under I.R.C. Section 956 (the “New 956 Regulations”).[1] The New 956 Regulations are intended to eliminate, in most situations, the “deemed-dividend” issue with respect to controlled foreign corporations (“CFCs”) that are subsidiaries of U.S. corporations, including where the U.S. domestic corporation is a partner in a partnership.

The New 956 Regulations achieve this result by generally giving a U.S. corporation’s income inclusions under Section 956 the same benefit of the U.S.’s limited participation exemption[2] that is otherwise available to actual dividends received from a CFC. The impact of Section 956 on noncorporate U.S. entities (which generally do not benefit from the participation exemption), including where the noncorporate entity is a partner in a partnership, is generally unchanged by the New 956 Regulations. The New 956 Regulations finalize, with limited but important changes, proposed regulations from November 2018.

An immediate impact of the New 956 Regulations will be on the use of non-U.S. subsidiaries to secure borrowings by U.S. corporations. A U.S. borrower generally should now be able to grant lenders complete pledges of stock of CFCs and provide full security interests in the assets of CFCs (and so-called CFC Holdcos — i.e. borrower subsidiaries that hold CFC stock) as long as the CFCs are directly or ultimately owned, in whole, by U.S. domestic corporations and partnerships where all of the direct and indirect partners are either U.S. domestic corporations or entities not subject to U.S. income tax (e.g., tax-exempts, foreign investors) without negative U.S. federal income tax consequences. Under existing Section 956 regulations, the effective limit to avoid phantom dividend income was a pledge of 65% of the voting stock in the CFC, with no guarantee by the CFC. The New 956 Regulations should end the position that new loan agreements must include the old, limited 65% voting stock pledge to protect U.S. corporate borrowers – which was an arguable residual concern while the regulations were still proposed.

The New 956 Regulations also provide a welcome change for multinationals with substantial previously taxed income (“PTI”) under the CFC rules relating to certain hypothetical distributions under the ordering rules for PTI.

These final regulations were issued and became effective on May 23, 2019 (with lookback effectiveness to taxable years beginning after December 31, 2017 in certain circumstances).

Please contact any Proskauer tax lawyer, or your usual Proskauer contact, for further information about the New 956 Regulations and their effect on shareholders of CFCs, as well as lenders and borrowers in structures with non-U.S. subsidiaries or operations. A detailed description of the New 956 Regulations, along with background, a description of the U.S. tax authorities’ explanation of the provisions and discussion of differences from the proposed regulations, continues below.

Introduction

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]

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.

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.

This post outlines at a high-level certain provisions under the recently enacted 2017 tax legislation (Pub. L. 115-97, the “Tax Act”) that may affect M&A Transactions.  Some of these rules are very complex, particularly in cross-border transactions, and this post describes them in general terms without all of their fine details.  The discussion of foreign corporations below is in the context of foreign subsidiaries of U.S. groups.

Multiple Lower Effective Corporate Tax Rates

There are now multiple effective corporate tax rates and the much-despised corporate alternative minimum tax has been repealed.  Because all of them are substantially below 35 percent, they may contribute to an increase in asset prices.  In addition, tax benefits now may be less valuable to corporate purchasers than to non-corporate buyers.

Base Corporate Income Tax Rate—21 percent tax rate (effective for taxable years beginning after December 31, 2017).  No sunset provision.

Certain Foreign Source Income Earned from the U.S (“FDII”).—Intended to attract cross-border business back to the U.S., a tax rate lower than 21 percent is now imposed on certain excess returns earned by a U.S. corporation on the sale, license or lease of property or the provision of services to an unrelated foreign party for foreign use or consumption.  (Additional rules apply when the transaction is with a related party.)  In broad terms, the lower rate applies to the foreign source income from these transactions in excess of 10 percent of the corporation’s allocable depreciable tangible property basis.

On Friday, December 15, the U.S. House of Representative and Senate conferees reached agreement on the Tax Cuts and Jobs Act (H.R. 1) (the “Final Bill”), and released legislative text, an explanation, and the Joint Committee on Taxation estimated budget effects (commonly referred to as the “score”).  Next week the House and Senate are each expected to pass the bill, and it is expected to be sent to the President for signature the following week.  As the conferees actually signed the conference text, changes (even of a limited and/or technical nature) are extremely unlikely at this point.

The Final Bill largely follows the Senate bill, but with certain important differences.  We outline some of the most significant differences between the Final Bill, the earlier House bill, and the Senate bill.  We then discuss in detail some of the most significant provisions of the Final Bill.  The provisions discussed are generally proposed to apply to tax years beginning after December 31, 2017, subject to certain exceptions (only some of which are noted below).  While we discuss some of these provisions in detail, we do not address all restrictions, exclusions, and various other nuances applicable to any given provision.

Under both the House and Senate versions of the Tax Cuts and Jobs Act, Internal Revenue Code Section 162(m) would be modified to expand the scope of companies and executive officers subject to the limitation on deductibility of compensation over $1 million, as well as to eliminate the exception to non-deductibility under Section 162(m) for qualified performance-based compensation. The changes would be effective for tax years after 2017, but under the Senate bill, binding contracts in effect on November 2, 2017 would be grandfathered if not materially modified on or after that date).  Each version of the Tax Cuts and Jobs Act would also generally lower the corporate tax rate to 20%.  The House bill reduces the corporate tax rate beginning in 2018 and the Senate reduces it beginning in 2019.