13 June 2018
On December 18, 2015 President Obama signed into law H.R. 2029, which incorporated both the “Protecting Americans from Tax Hikes Act of 2015” (PATH) and the Consolidated Appropriations Act, 2016. In what has been unusual fashion of late, the measures passed the House and Senate and were signed into law relatively quickly. From an international corporate tax perspective, the new law finally gives taxpayers some certainty with respect to the US tax impact on their international operations.
The new law makes a number of tax extenders permanent, while extending others for 5 years and some for two years. Specifically, US taxpayers who are owners of controlled foreign corporations (“CFC”) have faced uncertainty over the past several years with respect to certain exceptions under the Subpart F regime. The Subpart F regime deals with the US taxation of certain income earned by CFCs.
In general, US taxpayers who are 10 percent or greater shareholders in a CFC must include in their annual income their pro rata share of the CFC's Subpart F income. This results in current US taxation on certain income of a non-US corporation regardless of whether the income is actually repatriated to the US. This anti-deferral regime is intended to prevent US taxpayers from artificially shifting portfolio/passive income offshore to lower tax jurisdictions in order to avoid or delay the US tax cost. There are several categories of Subpart F income and the definitions contain a number of exceptions. Two of these exceptions are the so-called CFC look-through exception of IRC §954©(6) and the active finance exception of IRC §954(h).
The CFC look-through exception excludes from Subpart F income dividends, interest, rents, or royalties received by one CFC from a related CFC to the extent the dividends, interest, rents, or royalties are attributable or properly allocable to non-Subpart-F income (or income effectively connected with a US trade or business, “ECI”). This exception takes into account the movement of cash predicated by business needs, as opposed to shifting for perceived tax reasons. The imposition of current US tax these tax movements would inhibit US multi-national corporations (“MNCs”) from redeploying active revenue to continue business growth in other jurisdictions. This important exception has applied for tax years beginning after December 31, 2005, and when originally enacted, was set to expire at the end of 2008. However, Congress has passed several extensions with the most recent one expiring at the end of 2014. Congress has not always acted timely and has let the extension expire only to revive it with retroactive effect, which has led to tremendous uncertainty for taxpayers from both a planning and reporting perspective. US MNCs often employ complex and multi-layered global structures and constant uncertainty around this exception has led some to delay intercompany cash movements and required others to borrow from third parties to satisfy cash needs. Furthermore, US reporting rules require corporations to calculate earnings using the law in force at the time, resulting in a Subpart F inclusion that must then be reversed when Congress retroactively extended the exception.
The new law extends the CFC look-through exception to tax years of foreign corporations beginning before January 1, 2020 (i.e., through 2019 for calendar year corporations). This will give US MNCs a longer window within which to plan their business operations and has been welcome news to CFOs, VPs of tax, tax directors and tax professionals alike. However, further extension of items not made permanent may prove more difficult for permanent planning in the long run.
The active finance exception excludes from Subpart F income certain qualified banking or financing income of an eligible CFC. This exception has a complex history; in its prior form it was abolished and reinstated by President Clinton and the Supreme Court, respectively. In 1998, Congress re-wrote the rules in the current form and provided an extension for one year. Since then, IRC §954(h) has been extended for various terms with intermittent proposals for permanent enactment, the last of which has now finally been adopted.
The active finance exception is vitally important for US MNCs predominantly involved in the banking or financing business. As taxpayers have been uncomfortable with the state of flux of the active finance exception over the past several years, less has been done in the planning context as compared with CFC look-through planning. The primary reason for this is that the active finance exception is more focused on unrelated customer dealings, leaving less opportunity for intercompany planning unlike the CFC look-through exception. Nevertheless, US MNCs in these qualifying businesses can now manage their multinational structure with a longer term plan and greater certainty regarding their US tax costs.
Finally, in an unrelated and unexpected development, the new law increases the US withholding tax on disposition of US real property interests from 10 percent to 15 percent. While this change does not alter the substantive tax rules related to dispositions of US real property, it will impact the economics both when non-US investors consider exiting their current US real estate investments and as they consider investing in the US real estate market in the future.
Overall, H.R. 2029 is a significant win for taxpayers compared to legislative tax actions over the previous few years. While overall tax reform is still a major goal for Congress, the new rules at least give taxpayers several years of stability with respect to previously uncertain areas.