Main Effects of U.S. Tax Reform on Foreign Taxpayers

by Holland & Knight LLP
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President Donald Trump signed the U.S. tax reform bill previously entitled the Tax Cuts and Jobs Act into law on December 22, 2017, enacting comprehensive U.S. tax reform with most provisions becoming effective starting on January 1, 2018 (generally until 2025).

The summary below describes, in general terms, the principal effects of the tax reform bill on foreign taxpayers investing or operating in the United States, including the following:

  1. Reduction of the U.S. federal corporate income tax rate from 35 percent to 21 percent
  2. Minimum 10 percent U.S. federal corporate income tax on foreign related-party payments by certain large U.S. corporations or non-U.S. corporations with U.S. business income (aka the Base Erosion Anti-Abuse Tax or BEAT)
  3. New anti-hybrid rule denying deductions for certain interest and royalties paid or accrued to foreign related persons
  4. Reduction from 39.6 percent to 37 percent of the maximum U.S. federal income tax rate on ordinary income (including real property income) derived by individuals and persons such as trusts that are taxed as individuals, directly or through "pass-through" entities
  5. Up to 20 percent additional deduction for ordinary income (including real property income) derived by individuals directly or through "pass-through" entities
  6. "Carried Interest" long-term capital gain tax rate not eliminated but requires a more-than three-year holding period
  7. Interest deductions limited to 30 percent of earnings before interest, taxes, depreciation and amortization (EBITDA) or 30 percent of earnings before interest and taxes (EBIT) starting in 2022
  8. Net operating loss deductions become limited to 80 percent of taxable income
  9. Reversal of the recent U.S. Tax Court decision in Grecian Magnesite vs. Commissioner of Internal Revenue regarding taxation of gain upon a sale by a foreign person of an interest in a "pass-through" entity that owns a U.S. business

I. Foreign Persons Operating or Investing in a U.S. Business or U.S. Real Property Through a U.S. Subsidiary

1. Reduction of the U.S. federal corporate income tax rate from 35 percent to 21 percent

  • Starting in 2018, U.S. corporations are subject to U.S. federal corporate income tax of 21 percent on their taxable income or gains instead of 35 percent under current law.

2. No change to the U.S. withholding tax on dividends from U.S. corporations to foreign shareholders

  • As under current law, dividends from U.S. corporations to foreign shareholders are generally subject to a U.S. withholding tax of 30 percent (or a reduced treaty rate, if applicable).
    • This results in a combined U.S. federal income tax of up to 44.7 percent for non-U.S. shareholders with respect to a U.S. corporation's income or gain that is distributed to the foreign shareholder, instead of up to 54.5 percent under current law.

3. Minimum 10 percent U.S. federal corporate income tax on foreign related-party payments by certain large U.S. corporations (aka the Base Erosion Anti-Abuse Tax or BEAT)

a) Starting in 2018, subject to the exceptions described below, U.S. corporations that are part of a controlled group of corporations with an average annual gross receipts of at least $500 million for the three-taxable-year period ending with the preceding taxable year and that have foreign related-party payments in excess of certain threshold percentages, are required to pay a minimum 10 percent (minimum 5 percent for the first taxable year beginning during 2018) U.S. federal corporate income tax on their taxable income without taking into account deductions for payments made to foreign related parties (such as interest, royalties, service fees with a markup above cost, acquisitions of depreciable property from the foreign related party, etc.).

  • This is in fact an alternative minimum tax. The regular tax liability on the U.S. corporation's regular taxable income applies if it is higher than the 10 percent minimum tax.

b) Exceptions

(i) This rule does not apply to Regulated Investment Companies (RICs), Real Estate Investment Trusts (REITs) or S corporations.

(ii) Payments to a foreign related party of cost of goods sold are not subject to this rule.

(iii) Payments to a foreign related party of service fees at cost (i.e., with no markup) are not subject to this rule.

(iv) Payments that are subject to a full 30 percent U.S. withholding tax are not subject to this rule (the rule applies on a proportionate basis to payments that are subject to a reduced U.S. withholding tax by operation of an income tax treaty).

4. New anti-hybrid rule denying deductions for certain interest and royalties paid or accrued to foreign related persons

a) In order to target perceived exploitation of legal differences across jurisdictions to escape taxation, starting in 2018, a new rule denies a deduction for any interest or royalty paid or accrued to a foreign related party if there is no corresponding inclusion in income to the related party under the tax law of its country or the related party is allowed a deduction with respect to the payment under the tax law of its country.

  • This rule applies if the payor or payee entity or the payment itself are treated differently for tax purposes in the United States and in the country of the payee.
  • This rule is consistent with recommendations set forth in the OECD's Base Erosion and Profit Shifting (BEPS) Project.

5. Interest deductions limited to 30 percent of EBITDA (or 30 percent of EBIT starting 2022)

a) Subject to the Small Business Exception or Electing Real Property Trade or Business (ERPTOB) Exception described below, starting in 2018, deductions of any net interest expense for the year, whether paid to a related party or not, are limited to 30 percent of "Adjusted Taxable Income" of the taxpayer, which is intended to resemble EBITDA until 2021 and EBIT from 2022.

b) Amounts of disallowed interest deductions are carried forward (indefinitely) and treated as interest expense in succeeding taxable years.

  • This limitation on interest deductions replaces the limitation on interest deductions under the old Section 163(j) of the tax code that applied to limit deductions only for interest payments by U.S. corporations to foreign affiliates and only if the U.S. corporation's debt-to-equity ratio exceeded 1.5 to 1. 
  • This limitation on interest deductions makes borrowing at the U.S. subsidiary level less beneficial from a tax perspective. Financing structures should be re-examined to take into account this new interest deduction limitation.

c) Small Businesses Exception – The limitation on interest deductions does not apply to businesses with average gross revenue of $25 million or less for the past three years.

d) Electing Real Property Trade or Business (ERPTOB) Exception – U.S. corporations holding U.S. real property may elect to be exempt from the limitation on interest deductions if they elect to depreciate their residential rental real property over 30 years using the straight-line method (instead of 27.5 years) or their commercial real property over 40 years using the straight-line method (instead of 39 years).

6. Net operating loss deductions become limited to 80 percent of taxable income

  • Starting in 2018, net operating losses of U.S. corporations are only allowed to offset up to 80 percent of taxable income for the year.

7. Sale of U.S. subsidiary by a foreign shareholder

a) As under current law, non-U.S. individuals or corporations are generally not subject to U.S. federal income tax or U.S. federal corporate income tax upon the sale of stock in a U.S. corporation unless the U.S. corporation constitutes a "U.S. real property holding corporation" (aka the FIRPTA tax).

  • Note that a sale of stock does not provide the buyer with a "step-up" in basis in the underlying assets of the U.S. corporation and this may adversely affect the value of the stock being sold.
  • As under current law, the U.S. "branch profits" tax does not apply to gain from a sale by a non-U.S. corporation of stock in a U.S. real property holding corporation.

II. Foreign Corporations Operating or Investing in a U.S. Business or U.S. Real Property Directly or Through "Pass-Through" Entities

1. Reduction of the U.S. federal corporate income tax rate from 35 percent to 21 percent

  • Starting in 2018, non-U.S. corporations that derive U.S. business income and gains, including U.S. real property income or gains that are taxed to them as U.S. business income (or U.S. permanent establishment income or gains where an income tax treaty applies) are subject to U.S. federal corporate income tax of 21 percent on such U.S. business income or gains, instead of 35 percent under current law.
    • This applies to U.S. business income or gains derived by the non-U.S. corporation directly or through "pass-through" entities such as a partnerships or U.S. limited liability companies.

2. No change to the U.S. "branch profits" tax for non-U.S. corporations

a) As under current law, non-U.S. corporations are generally also subject to a U.S. "branch profits" tax of 30 percent (or a reduced treaty rate, if applicable) on their after-tax U.S. business or gains (irrespective of distributions), including their after-tax U.S. real property income or gains that are taxed to them as U.S. business income.

  • This results in a combined U.S. federal income tax of up to 44.7 percent for non-U.S. corporations with respect to their U.S. business income or gains, instead of 54.5 percent under current law.
  • This applies to U.S. business income derived by the non-U.S. corporation directly or through "pass-through" entities such as partnerships or U.S. limited liability companies.

3. Minimum 10 percent U.S. federal corporate income tax on foreign related-party payments by non-U.S. corporations (aka the Base Erosion Anti-Abuse Tax or BEAT)

a) Starting in 2018, the 10 percent minimum Base Erosion Anti-Abuse Tax (BEAT) described in Section I.3. above also applies to non-U.S. corporations that derive U.S. business income or gains, including U.S. real property income or gains that are taxed to them as U.S. business income (or U.S. permanent establishment income or gains where an income tax treaty applies) except that in the case of non-U.S. corporations, only gross receipts from U.S. business income are taken into account in determining whether the corporation is subject to this rule under the $500 million gross receipt threshold.

4. Interest deductions limited to 30 percent of EBITDA (or 30 percent of EBIT starting 2022)

a) Starting in 2018, the new interest deduction limitation described in Section I.5. above also applies to non-U.S. corporations that derive U.S. business income or gains, including U.S. real property income or gains that are taxed to them as U.S. business income (or U.S. permanent establishment income or gains where an income tax treaty applies).

  • This applies to U.S. business income derived by the non-U.S. corporation directly or through "pass-through" entities such as partnerships or U.S. limited liability companies.

5. Sale of an interest in a "pass-through" entity that owns a U.S. business or U.S. real property

a) As under current law, non-U.S. corporations are generally subject to U.S. federal corporate income tax and "branch profits" tax on gain from a sale or other disposition of an interest in a "pass-through" entity (such as a partnership or limited liability company) that is attributable to U.S. real property held by the "pass-through" entity.

  • 15 percent withholding tax requirement: The purchaser is generally required to withhold and remit to the IRS 15 percent of the purchase price for the interest in the "pass-through" entity as an advance tax payment of the non-U.S. seller.

b) The U.S. tax reform bill provides that non-U.S. corporations are subject to U.S. federal corporate income tax and "branch profits" tax (where applicable) on gain from a sale or other disposition on or after November 27, 2017, of an interest in a "pass-through" entity (such as a partnership or limited liability company) that is attributable to a U.S. trade or business held by the "pass-through" entity, thereby reversing the recent U.S. Tax Court decision in Grecian Magnesite vs. Commissioner of Internal Revenue.

  • 10 percent withholding tax requirement: The purchaser is generally required to withhold and remit to the IRS 10 percent of the purchase price for the interest in the "pass-through" entity as an advance tax payment of the non-U.S. seller.

III. Foreign Individuals Investing in a U.S. Business or U.S. Real Property Directly or Through "Pass-Through" Entities

1. Reduction from 39.6 percent to 37 percent of the maximum U.S. federal income tax rate on U.S. business income derived by individuals directly or through "pass-through" entities

a) Starting in 2018, non-U.S. individuals who derive U.S. business income, including U.S. real property income that is taxed to them as U.S. business income (or U.S. permanent establishment income where an income tax treaty applies) are subject to U.S. federal income tax on such U.S. business income at new graduated tax rates with a maximum tax rate of 37 percent instead of a maximum tax rate of 39.6 percent under current law.

  • This applies to U.S. business income derived by the non-U.S. individual directly or through "pass-through" entities such as partnerships or U.S. limited liability companies.

2. Up to 20 percent additional deduction for ordinary income derived by individuals directly or through "pass-through" entities

a) Starting in 2018, individual taxpayers are eligible for an additional special deduction of up to 20 percent against their U.S. business income, including U.S. real property income that is taxed to non-U.S. individuals as U.S. business income.

  • This would in effect reduce the maximum U.S. federal income tax rate on such income down to 29.6 percent (i.e., 37 percent multiplied by 80 percent, assuming that the full 20 percent deduction is available to the taxpayer – see below).
  • This applies to U.S. business income or U.S. real property income derived by the non-U.S. individual directly or through "pass-through" entities such as partnerships or U.S. limited liability companies.

b) The 20 percent deduction is capped by the higher of the following:

(i) 50 percent of W-2 wages paid by the business to employees; or

(ii) 25 percent of W-2 wages paid by the business to employees plus 2.5 percent of the acquisition cost of depreciable property (including depreciable real property) used in the business that has not been fully depreciated for U.S. federal income tax purposes.

  • This means that the full 20 percent deduction is allowed if the business has sufficient W-2 income payable to employees and/or sufficient depreciable property (including depreciable real property).

3. Interest deductions limited to 30 percent of EBITDA (or 30 percent of EBIT starting 2022)

a) Starting in 2018, the new interest limitation described in Section I.5. above also applies to non-U.S. individuals that derive U.S. business income or gains, including U.S. real property income or gains that are taxed to them U.S. business income (or U.S. permanent establishment income or gains where an income tax treaty applies).

  • This applies to U.S. business income or U.S. real property income derived by the non-U.S. individual directly or through "pass-through" entities such as partnerships or U.S. limited liability companies.

4. Maximum long-term capital gains tax rate remains 20 percent for individuals

a) As under current law, non-U.S. individuals are subject to U.S. income tax on gain from the sale of a U.S. real property interest, including gain from the sale of stock of a "U.S. real property holding corporation" (aka the FIRPTA tax).

b) There is no change to the maximum 20 percent U.S. federal income tax rate on long-term capital gain derived by foreign individuals upon the sale of stock of a "U.S. real property holding corporation" or upon the sale of any other U.S. real property interest.

c) Change to "carried Interest" long-term capital gain definition: As under current law, long-term capital gain is gain from a sale of the capital asset after a holding period of at least one year, except that, starting in 2018, capital gains allocated to a "carried interest" in a partnership (or in another "pass-through" entity or fund) that is held by an individual is eligible to the 20 percent long-term capital gain tax rate only if the underlying asset was sold by the partnership (or other "pass-through" entity or fund) after a holding period of more than three years.

5. Sale of an interest in a "pass-through" entity that owns a U.S. business or U.S. real property

a) As under current law, non-U.S. individuals are generally subject to U.S. federal income tax on gain from a sale of an interest in a "pass-through" entity (such as a partnership or limited liability company) that is attributable to U.S. real property held by the "pass-through" entity.

  • 15 percent withholding tax requirement: The purchaser is generally required to withhold and remit to the IRS 15 percent of the purchase price for the interest in the "pass-through" entity as an advance tax payment of the non-U.S. seller.

b) The U.S. tax reform bill provides that non-U.S. individuals are subject to U.S. federal income tax on gain from a sale or other disposition on or after November 27, 2017, of an interest in a "pass-through" entity (such as a partnership or limited liability company) that is attributable to a U.S. trade or business held by the "pass-through" entity, thereby reversing the recent U.S. Tax Court decision in Grecian Magnesite vs. Commissioner of Internal Revenue.

  • 10 percent withholding tax requirement: The purchaser is generally required to withhold and remit to the IRS 10 percent of the purchase price for the interest in the "pass-through" entity as an advance tax payment of the non-U.S. seller.

IV. No Change to U.S. Estate Tax Exposure for Non-U.S. Individuals

  • Non-U.S. individuals remain subject to the 40 percent U.S. estate tax upon death or 40 percent U.S. gift tax upon lifetime gifts with respect to
    "U.S.-situs property" having a value of more than $60,000.
    • Note that the reduction in the U.S. federal corporate income tax rate from 35 percent to 21 percent makes non-U.S. corporations a much more attractive vehicle to hold "U.S.-situs property" thereby avoiding the exposure to the U.S. estate tax.

Note: This publication does not address the U.S. tax reform changes with respect to investments in U.S. real property through real estate investment trusts (REITs) or other regulated investment companies.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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