A previous Holland & Knight alert provided an overview of corporate and individual income tax increases as detailed in the U.S. Department of the Treasury May 2021 "Green Book." (See "Biden Administration's FY 2022 Budget and Its Tax Increases for Corporations, Wealthy," June 3, 2021.)
This alert provides more details as to selected international tax proposals relating to 1) The Global Minimum Tax Regime, 2) The Stopping Harmful Inversions and Ending Low-Tax Developments (SHIELD), 3) Repeal Taxation of Foreign Fossil Fuel Income, 4) Repeal the Deduction for Foreign Derived Intangible Income (FDII), 5) Limit Foreign Tax Credits from Sales of Hybrid Entities, 6) Restrict Deductions of Excessive Interest of Members of Financial Reporting Groups for Disproportionate Borrowings in the United States, and 7) Provide Tax Incentives for Locating Jobs and Business Activity in the United States and Remove Deductions for Shipping Jobs Overseas.
Introductory Comments
In evaluating the proposals discussed herein, several general observations can be made:
First, the proposed changes are consistent with President Joe Biden's key campaign proposals.
Second, if these proposals were to be enacted, they would significantly narrow the Tax Cuts and Jobs Act (TCJA) quasi-territorial system in favor of a worldwide taxation system through the repeal of 1) the 10 percent return on qualified business asset investment (QBAI), 2) the exclusion of foreign oil and gas extraction income (FOGEI), from Global Intangible Low-Taxed Income (GILTI) and 3) the repeal of the high-tax exemption under GILTI and Subpart F.
Third, added complexity will result through the country-by-country approach for computation of GILTI and foreign branch income, the use of financial reporting information for purposes of the SHIELD and the proposed new interest limitation, and the expansive new anti-inversion provisions (as well as increasing traps for the unwary).
Global Minimum Tax Regime
This proposal has three constituent elements: 1) modifications to the GILTI regime, 2) disallowance of deductions attributable to exempt income, and 3) substantial expansion of the provisions to limit inversions.
Modifications to GILTI Regime
The Biden Administration proposed three principal changes to the GILTI rules that were enacted under the Tax Cuts and Jobs Act of 2017 (TCJA).
First, the proposal would eliminate the concept of QBAI under the GILTI rules. Under the TCJA, a U.S. shareholder is taxed on a GILTI inclusion only to the extent that the shareholder's tested income of its controlled foreign corporations (CFCs) exceeds a 10 percent return on certain foreign tangible property eligible for depreciation (i.e., QBAI). The proposal to eliminate QBAI would therefore increase the base of CFC income subject to GILTI and substantially circumscribes the foreign -source earnings of a CFC eligible for a Section 245A deduction. The Green Book concludes that the elimination of QBAI would eliminate the incentive for U.S. multinational companies to invest in tangible assets abroad rather than domestically.
Second, the proposal would reduce the deduction under Section 250 that applies to U.S. corporations for a global minimum tax inclusion from 50 percent to 25 percent. Under TCJA, a 50 percent deduction against GILTI has the effect of imposing a 10.5 percent minimum tax (i.e., $100 GILTI less a $50 Section 250 deduction times 21 percent corporate tax rate), assuming that the taxable income limitation requirement is otherwise satisfied. The net effect of the Green Book proposal to reduce the Section 250 deduction would be to increase the global minimum tax on foreign earnings of CFCs from 10.5 percent to 21 percent, which is 75 percent of the proposed 28 percent corporate tax rate.1
Third, the method for calculating a U.S. shareholder's global minimum tax would be determined on a country-by-country basis. In contrast to the existing global-blending approach (whereby tested income and loss of all CFCs are netted), a U.S. shareholder's GILTI inclusion and corresponding U.S. tax liability would be determined separately for each foreign jurisdiction in which its CFCs have operations. That would eliminate the ability to cross-credit foreign taxes paid in higher jurisdictions against income earned in lower-taxed jurisdictions. The Green Book for the same reason also would apply this same country-by-country approach to foreign branch income. The Green Book does not propose a country-by-country approach to Subpart F income, although that does not mean it will not be examined further by the Treasury Department.
The Green Book lacks detail regarding the operation of the country-by-country system for computing both GILTI and foreign tax credit limitations. Although it appears that the 80 percent GILTI foreign tax credit haircut will be retained, there are numerous open questions, including how to assign income and taxes to a particular jurisdiction (likely to be based on the current proposed regulations under Section 1.861-20), base and timing issues, whether a tested loss in one country can reduce tested income in another country (likely not), whether foreign tax credits should be denied for all tested loss CFCs, and whether carryover of foreign tax credits will continue to be denied. Suffice it to say, until these and other issues are flushed out, it will be challenging for multinational businesses to estimate the impact of this proposal.
Finally, the Biden Administration proposes to repeal the high tax exemption to Subpart F income and GILTI inclusions. Although this proposal is generally set forth in the context of corporate tax reforms, there is no mention or clear indication that the repeal would be limited to corporate U.S. shareholders. If not, individual U.S. shareholders of CFCs could be significantly adversely affected by a repeal of the high tax exemption due to an inability to claim indirect foreign tax credits.2 For multinational businesses, this set of proposals would move the United States from a quasi-territorial system to a worldwide system (without deferral), with two rates of tax and systems for computing how income is determined. If these changes were to be enacted, commentators have suggested that the GILTI and Subpart F rules should be integrated into one section, but that likely is a project for another day.
Effective Date: Tax years after Dec. 31, 2021.
Disallowance of Deductions Attributable to Exempt or Preferentially Taxed Income
The Biden Administration proposes to disallow any deductions that are attributable to a class of foreign income that is exempt from U.S. tax or taxed at a preferential rate through a deduction. In illustration, dividends received from a foreign corporation may be entirely offset by a deduction under Section 245A. Similarly, amounts subject to tax as a GILTI inclusion may be partially offset by the deduction provided in Section 250. Because such amounts are entirely or partially exempt from U.S. tax, to the extent taxpayer deductions are claimed for expenses allocable to exempt amounts, the Green Book concludes that the United States is providing a tax subsidy for foreign investment. Therefore, the proposal would seek to disallow deductions allocable to the wholly or partially exempt income.
The Green Book does not address how the allocation of deductions to exempt income would be accomplished. Existing rules under Section 861 regulations presumably could serve as the allocation methodology. The Green Book acknowledges that rules would be provided for determining the amount of disallowed deductions when only a partial deduction is allowed under Section 245A or Section 250 with respect to dividends and global minimum tax inclusions, respectively.
Corresponding to the disallowance of deductions attributable to exempt or preferentially taxed income, the proposal, as outlined in the Green Book, would also repeal Section 904(b)(4), which applies to disregard (solely for purposes of the foreign tax credit limitation) deductions allocable to income for foreign stock3 other than global minimum tax or Subpart F income inclusions, for purposes of determining a taxpayer's foreign tax credit limitation.
Effective Date: Tax years after Dec. 31, 2021.
Further Limit Ability of Domestic Corporations to Expatriate
Over many years, statutory and regulatory provisions have been enacted or adopted to limit a U.S. taxpayer's ability to escape the U.S. tax net by way of expatriating or executing inversion transactions. Under existing rules contained in Section 7874, the foreign-acquiring corporation of a U.S. entity that undergoes an inversion transaction will be treated as a domestic corporation if at least 80 percent (by vote or value) of its interests are held by former shareholders of the U.S. company prior to the inversion transaction. If at least 60 percent (but less than 80 percent) of the foreign-acquiring corporation interests are held by former shareholders of the U.S. entity, the foreign-acquiring entity is respected as a foreign entity but full U.S. tax must be paid on certain income or gain recognized by the expatriated U.S. entity and its affiliates for a 10-year period following the inversion. An inversion also results from acquisitions of "substantially all of the properties constituting a trade or business" of a domestic partnership. There is an exception if after the acquisition, the expanded affiliated group that includes the foreign acquiring corporation does not meet a "substantial business activities" test in the country in which the entity is created or organized.
The Biden Administration proposes to further restrict the ability of U.S. entities to engage in inversion transactions without remaining fully subject to U.S. taxing jurisdiction. Under the proposed change:
- The definition of an inversion transaction would be broadened by replacing the 80 percent test with a greater than 50 percent test and eliminating the 60 percent test.
- Significantly, even if a company were able to avoid the lower ownership threshold, an inversion transaction would be deemed to have occurred (i.e., to treat the foreign entity as a domestic entity) if 1) immediately prior to the acquisition the fair market value of the U.S. entity was greater than that of the foreign acquirer prior, 2) following the acquisition, the expanded affiliated group is managed and controlled in the U.S., and 3) the expanded affiliated group does not conduct substantial business activities in the country in which the foreign acquiring corporation is created or organized. Concern has been raised that this new rule may impact normal inbound merger and acquisition (M&A) transactions.
- The scope of the direct or indirect acquisitions rule within Section 7874 currently includes 1) substantially all of the properties held directly or indirectly by a domestic corporation and 2) substantially all of the properties constituting a trade or business of a domestic partnership. These rules would be expanded to include acquisitions of substantially all of 1) the assets of a U.S. company constituting a trade or business; 2) the assets of a domestic partnership; or 3) the U.S. trade or business assets of a foreign partnership.
- Further, a distribution of stock of a foreign corporation by a domestic corporation or partnership that represents either substantially all of the assets or substantially all of the assets constituting a trade or business of the distributing corporation or partnership would be treated as a direct or indirect acquisition of substantially all of the assets or trade or business assets, respectively, of the distributing corporation or partnership.
Any business contemplating a cross-border transaction will need to carefully review the tests to ensure that the resulting business is not an inverted company. Otherwise, the consequences are disastrous – the merged company could be taxed in full by both the U.S. and the foreign country in which the entity is resident. Unlike proposals by Sen. Dick Durbin (D-Ill.) and Rep. Lloyd Doggett (D-Texas), the Green Book does not seek to apply these changes to transactions as far back as 2014.
Effective Date: Transactions after date of enactment.
The Stopping Harmful Inversions and Ending Low-Tax Developments (SHIELD)
The SHIELD is a new provision that would replace the base erosion and anti-abuse tax (BEAT). The BEAT subjects certain taxpayers to a base erosion minimum tax equal to the excess of 10 percent of taxable income determined without the benefit of amounts paid or accrued that are deductible from payments to foreign-related parties or includible in the basis of a depreciable or amortizable asset purchased from a foreign-related party, over the regular tax liability reduced by tax credits other than specified tax credits. The BEAT focuses on the payment and is agnostic as to the effective tax rate of the foreign payee; a deduction paid to a foreign-related party is treated as a base-eroding payment, even if the foreign payee's effective tax rate exceeds the U.S. corporate income tax rate.
The SHIELD would apply to any financial reporting group (i.e., a group that prepares consolidated financial statements)4 that includes at least one U.S. corporation or U.S. branch with effectively connected income, with global annual revenues in excess of $500 million. It focuses on the U.S. taxation of low-taxed earnings.
The SHIELD looks to the effective tax rate of the foreign payee (determined on a jurisdiction-by-jurisdiction basis) and, if the rate is below a specified level, then the deduction for federal income tax purposes would be denied to a U.S. corporation or a U.S. branch of a foreign entity with a U.S. trade or business.
In applying SHIELD, both direct payments and indirect payments to a low-taxed member would be subject to disallowance. However, unlike BEAT, the disallowance is not determined solely by looking at the payments, but rather looking at the overall low-tax profits generated in the financial reporting group.
Payments made directly to a low-taxed jurisdiction would be subject to the SHIELD as follows: payments giving rise to deductions would be denied in their entirety, while payments for cost of goods sold (COGS) and third-party payments would be "disallowed up to the amount of the payment." To avoid Sixteenth Amendment5 concerns, other deductions would be reduced in an amount equal to COGS paid to the low-tax jurisdiction.
Also, the Biden Administration is concerned about indirect payments to entities in high-tax jurisdictions, which. In turn, make payments to low-tax jurisdictions. To address these concerns, the SHIELD would partially deny deductions based on the aggregate ratio of the financial group's low-tax profits to its total profits, based on consolidated financial statements.
The effective tax rate would be set in a multilateral agreement. If the SHIELD were to be implemented prior to agreement of a multilateral agreement, the effective tax rate would be the GILTI rate, or possibly 21 percent. It is likely that the Treasury Department is using this leverage to force the OECD Inclusive Framework to reach consensus before the SHIELD becomes law.
Payments to 1) financial groups that (on a jurisdiction-by jurisdiction basis) meet a minimum effective rate of taxation and 2) investment funds, pension funds, international organizations and nonprofits would be exempted. Importantly, the Treasury Secretary would be given authority to address book/tax differences and to provide rules to account for net operating losses (NOLs) in a jurisdiction.
The BEAT would be repealed and replaced with the SHIELD effective for taxable years beginning on or after Jan. 1, 2023. The replacement of the BEAT with the SHIELD would raise $390 billion over 10 years.
The SHIELD operates akin to a CFC regime – it is the U.S., operating as a market country, attempting to impose tax on a greater share of the system profits. Additionally, the SHIELD appears to be inconsistent with the undertaxed payments rule (UTPR) proposed in Pillar 2, which is designed to operate as a top-up tax. The SHIELD imposes a cliff. If a taxpayer makes a deductible payment to a foreign-related party with an effective rate of 20.9 percent, it would lose the full deduction, imposing the U.S. full income tax rate to the payment. In contrast, the UTPR would impose incremental tax to top up the rate to 21 percent.
The SHIELD primarily would apply to foreign-parented groups, as it does not appear to apply to entities subject to GILTI or Subpart F, to the extent that the payment is taken into account in determining a U.S. shareholder's share of income. An open question is how SHIELD would apply to "sandwich" structures, where a foreign corporation owns a U.S. corporation that has CFCs below the U.S.?
Finally, the SHIELD would place significant reliance on financial statements for purposes of computing low-tax income. It would also require multinational groups to create country-by-country financial statements. Congress and the Treasury Department (through its regulatory authority) will need to consider how to assign income to jurisdictions and address book/tax and other computational issues.
Effective Date: Tax years after Dec. 31, 2022.
Repeal Exemption from GILTI for Foreign Oil and Gas Extraction Income
The Biden Administration proposes to repeal the exemption from GILTI for foreign oil and gas extraction income (FOGEI). Currently, FOGEI is excluded from a CFC's gross tested income under the GILTI rules. The Green Book recognizes that a CFC's FOGEI is generally exempt from U.S. tax based on the dividends received deduction under Section 245A. The proposal is presumably intended to achieve parity with FOGEI earned through a foreign branch, which is subject to full U.S. taxation, subject to foreign tax credits. As part of the proposal, the definition of FOGEI as well as foreign oil related income (FORI) would be amended to include income derived from shale oil and tar sands activity.
The Green Book further outlines a proposal to limit the amount of a levy that would qualify as a creditable foreign tax in the context of a "dual capacity taxpayer" who is subject to high levies imposed by foreign governments that arguably constitute royalty equivalents (e.g., oil and gas producers subject to a foreign levy who also receive specific economic benefit, such as concessions for developing foreign natural resources). The proposal would codify, subject to treaty obligations, the safe harbor included in the Treasury Department regulations for determining the portion of the levy that is paid in exchange for a specific economic benefit, and would make the safe harbor the sole method for determining the creditable portion of the levy.
Effective Date: Tax years after Dec. 31, 2021.
Repeal of the Deduction for Foreign-Derived Intangible Income
A proposal is made to repeal the deduction for foreign-derived intangible income (FDII) provided under Section 250. The Biden Administration determined that FDII favors multinational companies over domestic producers by offering tax incentives only to companies with high export sales, as opposed to those with largely domestic sales. Further, companies are incentivized to offshore plant and equipment in order to maximize the tax deduction under FDII. For these stated reasons, the deduction enacted less than four years ago as part of the TCJA would be repealed under the administration's proposal. The Green Book states that the revenue from the repeal would be "used to encourage R&D." There is no additional detail regarding how the U.S. would further encourage research and development.
Effective Date. Tax years after December 31, 2021.
Limit Foreign Tax Credits from Sales of Hybrid Entities
A proposal is made to apply the principles of Section 338(h)(16) to certain transactions that currently do not fall within the scope of the statutory provision. In the context of stock sales that are treated as asset dispositions under Section 338 or 336(e), Section 338(h)(16) prevents the earnings generated from the deemed asset sale from changing the character of the gain from capital to ordinary and thereby enabling the use of foreign tax credits to reduce or eliminate residual U.S. tax on the stock gain.
The Biden Administration has determined that the same foreign tax credit concerns addressed by transactions subject to Section 338(h)(16) exist in certain hybrid entity transactions; for example, sales of an entity classified as a partnership or disregarded entity for U.S. tax purposes but treated as a corporation for foreign tax purposes, or deemed transactions pursuant to entity classification elections that are not respected by the foreign jurisdiction's tax authority. To ensure that the foreign tax credit concerns are addressed, the Green Book states that the "principles of section 338(h)(16)" would apply to determine the source and character of any item recognized in connection with a direct or indirect disposition of an interest in a specified hybrid entity and to a change in entity classification that is not recognized for foreign tax purposes. Under the proposal, the Treasury Department would be granted authority to issue implementing regulations and set parameters for the scope of such rules.
Effective Date: Transactions after date of enactment.
Restrict Interest Deductions for Disproportionate Borrowing in the U.S.
In a new approach to limit interest expense deductions, the Biden Administration proposes to disallow a financial reporting group member's deduction for interest expense if the U.S. member has net interest expense for financial reporting purposes (computed on a separate company basis) that exceeds the member's proportionate share of the financial reporting group's net interest expense reported on consolidated financial statements, based on EBITDA.
The reason for this new proposed limitation is that the existing interest expense limitation under Section 163(j) does not consider the leverage of a multinational group's U.S. operations relative to the leverage of the group's worldwide operations.
This new provision would apply in addition to the limitation contained in current Section 163(j) and the disallowance would be based on whichever provision imposes a lower limitation. If a U.S. member's interest expense were less than its proportionate share reported on the consolidated financial statements, the excess limitation could be carried forward indefinitely.
A taxpayer would be permitted to compute the interest limitation under either 1) a proportionate share approach, or 2) a 10 percent alternative. Under the proportionate share approach, a member's excess net interest expense would equal the member's net interest expense for U.S. tax purposes multiplied by the ratio of the member's excess financial statement net interest expense to the member's net interest expense for financial reporting purposes. Alternatively, at the election of the member or if the member fails to substantiate its proportionate share of the group's net interest expense for financial reporting purposes, the member's interest deduction would be limited to the member's interest income plus 10 percent of the member's adjusted taxable income (as defined in Section 163(j)). Regardless of the method used to compute the interest limitation, any disallowed interest expense could be carried forward indefinitely.
U.S. subgroups6 would be treated as a single member of the financial reporting group for purposes of applying the proposal, and certain entities would be excluded (e.g., financial services entities). Moreover, the proposal would not apply unless the financial reporting group would otherwise report net interest expense of at least $5 million on one or more U.S. income tax returns for a taxable year.
This new proposal would appear to apply only to U.S. inbound structures and is intended to prevent U.S. base erosion.
Effective Date: Transactions after Dec. 31, 2021.
Incentivize U.S. Onshoring and Disincentivize Offshoring
To incentivize U.S. employers to bring offshore jobs and investments to the United States, the Biden Administration sets forth a two-prong proposal with a carrot-and-stick approach.
First, the proposal would create a new general business credit equal to 10 percent of the eligible expenses paid or incurred in connection with onshoring a U.S. trade or business.
Second, the proposal would disallow deductions for expenses paid or incurred in connection with offshoring a U.S. trade or business. The Green Book states that a U.S. shareholder would be denied deductions for any expenses paid or incurred in connection with moving a U.S. trade or business outside the United States in connection with determining GILTI or Subpart F income.
For purposes of the proposal, onshoring/offshoring expenses are limited solely to expenses associated with the relocation of the trade or business and do not include capital expenditures or costs for severance pay and other assistance to displaced workers.
In practice, it will be very difficult for a taxpayer to demonstrate it is entitled to the credit, or that it did not offshore jobs.
Effective Date: Expenses paid or incurred after enactment.
Conclusion and Takeaways
The Green Book represents a policy statement by the Treasury Department on the Biden Administration's revenue proposals and should be viewed as an opening bid in negotiations with Congress. Changes are likely, particularly because of the close margins by which the Democrats control the House and Senate, and also because of the views of some of the more moderate Democratic members in the Senate. Prospects for ultimate enactment by the Congress of any or all of the proposed international tax changes or variations is uncertain and many open questions would need to be addressed in connection with the enactment or implementation of these proposals.
Notes
1 Separate from proposed international tax changes, the Green Book proposes to increase the U.S. corporate income tax rate to 28 percent, thereby resulting in a new effective tax rate for GILTI of 21 percent (i.e., ($100 - $25) x .28 = $21). As has been reported in the media, at least one, and perhaps more than one, Senate Democrat would not support a 28 percent rate, suggesting that the rate might only be increased to 25 percent. Note, no Republicans support any of the international tax proposals discussed herein.
2 Individual U.S. shareholders of CFCs had no certainty of the ability to claim high-tax relief against GILTI until Treasury and the IRS issued regulations last year. See T.D. 9902 (July 20, 2020).
3 In other words, dividends (and the underlying assets related thereto) eligible for the Section 245A deduction are not treated as exempt income or as exempt assets
4 It should be noted that the definition of a financial reporting group is essentially identical to the definition of financial reporting group for purpose of the proposal to limit deductions for disproportionate U.S. borrowings, discussed herein.
5 The Sixteenth Amendment allows Congress to levy a tax on income from any source without apportioning it among the states and without regard to the census.
6 A U.S. subgroup is any U.S. entity that is not owned directly or indirectly by another U.S. entity, and all members (domestic or foreign) that are owned directly or indirectly by such entity, to include CFCs.
