Most of the attention surrounding the international aspects of Public Law No. 115-97, formerly known as the Tax Cuts and Jobs Act (the “Tax Reform Act”), has understandably focused on outbound provisions, including Section 951A (GILTI), Section 250 (FDII), Section 965 (deemed repatriation tax), and Section 245A (dividends received deduction).[1]  The scope of the implications of inbound changes under the Tax Reform Act, however, particularly in the context of inbound financing structures, will catch many international practitioners by surprise.

The repeal of Section 958(b)(4), which contained a limitation on the inbound attribution of stock in the context of determining whether a foreign corporation is a controlled foreign corporation (CFC) for U.S. federal income tax purposes, may cause many innocuous inbound financing structures to fail to qualify for the portfolio interest exemption.  The introduction of new Section 267A and modifications to Section 163(j) create further complexity and ambiguity, and will prevent deductions of U.S.-source interest payments in some situations where there does not appear to be any abuse.  The new “base erosion and anti-abuse tax” (BEAT) tax under Section 59A may have further implications, although for purposes of this blog, we will assume the relevant taxpayers realize gross receipts below the $500 million threshold such that the BEAT provisions should not be applicable.

Basic Inbound Financing Example

In a typical inbound structure (prior to the Tax Reform Act), assume two unrelated foreign individuals who are tax resident in Brazil (FI1 and FI2) each own 50% of a Cayman Islands limited liability company that is treated as a corporation for U.S. federal income tax purposes (“FC”).  FC in turn owns 100% of the non-voting interests, and substantially all of the economic rights, in a U.S. LLC that has elected to be treated as a corporation for U.S. tax purposes (“USB”).  The voting shares of USB (which carry little or no economic rights) are held by an unrelated hotel management company. USB in turn owns a 50% interest in a joint venture, operated through a U.S. LLC taxed as a partnership (“USP”), with an unrelated U.S. hotel company as the second member of the LLC.  USP owns and operates a large, luxury hotel in Miami Beach.

FC invests in USB using a combination of equity and debt, for example investing 80% of its capital in USB as debt, and 20% as equity.  The debt is evidenced by a promissory note that is in registered form and pays fixed interest to FC annually.  Prior to the Tax Reform Act, the fixed interest payments on the note generally were deductible by USB, subject to the limitations under former Section 163(j).[2]  Additionally, the interest payments were characterized as “portfolio interest” for purposes of Section 881(c) and thus were exempt from U.S. withholding tax.[3]  Lastly, FC acted as an effective estate tax blocker from the U.S. perspective for FI1 and FI2, each of whom would otherwise be subject to U.S. estate tax at a rate of 40% to the extent the value of his U.S.-situs assets exceeded $60,000 at death.

 

Illustration

Changes under the Tax Reform Act

The Tax Reform Act repealed Section 958(b)(4), which used to prevent the attribution, under Section 318(a)(3), of stock owned by a foreign person to a U.S. person for purposes of determining whether a foreign corporation was a CFC. This repeal was intended to combat certain post-inversion transactions, but as explained below, may have a much more expansive impact on inbound financing structures generally.

As noted above, assume FI1 and FI2 own FC, which owns substantially all of the economic interests in USB.  Without Section 958(b)(4), FC is now, technically, a CFC (but see discussion below pertaining to Rev. Rul. 74-605).  As a result, any interest payments made by USB to FC may no longer be eligible for the portfolio interest exemption.  This is because interest payments received by a CFC from a related person are carved out from the portfolio interest exemption.[4]  The repeal of Section 958(b)(4) was made retroactive to tax year 2017.[5]  Therefore, any planning to alleviate the adverse tax consequences arising from the provision’s repeal also would need to be made retroactive to 2017.  Otherwise, the U.S. payor, as withholding agent, will be liable for U.S. federal income tax on any interest payments made during the 2017 tax year that were not properly withheld upon.

The classification of FC as a CFC results from the following series of attribution rules.  First, Section 958(b) refers to Section 318 for determining constructive ownership for CFC purposes.[6]  Under Section 318(a)(2)(C), if 50% or more in value of the stock of a corporation is owned (directly or indirectly) by a person, that person is deemed to own a pro rata portion of the stock owned by the corporation.  Based on this rule, 50% of FC’s shares in USB are attributed upward to each of FI1 and FI2, so FI1 is treated as actually owning 50% of USB (by value), and FI2 is treated as actually owning the remaining 50% of USB (by value).

Then, under Section 318(a)(3)(C), if 50% or more of the value of a corporation’s stock is owned (directly or indirectly) by a person, the other stock owned by the person (with respect to other corporations) is attributed downward to the corporation.  Section 318(a)(2)(C) caused each of FI1 and FI2 to be treated as actually owning 50% of the USB shares by value.[7]  As a result, the other shares owned by FI1 and FI2 (i.e. the shares of FC) must be further attributed down to USB under Section 318(a)(3)(C).  Therefore, USB is treated as owning 100% of FC, which causes FC to be a CFC.[8]

While the repeal of Section 958(b)(4), as just described, does thus technically cause FC to be characterized as a CFC, the question is whether the IRS would actually challenge the eligibility of USB’s interest payments on the note for the portfolio interest exemption in this situation.  In Rev. Rul. 74-605,[9] the IRS ruled that, for Section 304 purposes, a wholly-owned subsidiary should not be treated as being in control of its parent, as this would cause the subsidiary to be treated as owning its own stock under Section 318(a)(2), which is prohibited under Regulation Section 1.318-1(b)(1).  Logically, there does not appear to be any reason why this rationale should not be extended beyond Section 304 transactions to other provisions of the Code (such as Sections 958(b) and 881(c)).

In GCM 35414 (July 25, 1973), which provides the supporting rationale behind Rev. Rul. 74-605, the IRS noted that Treasury Regulation Section 1.318-1(b)(1) first was added to the proposed Section 318 regulations to address the “faultily drafted” Section 304 and concerns of any overlap between Section 304(a)(1) “brother-sister” transactions and Section 304(a)(2) “parent-subsidiary” transactions.  The GCM takes the view that the drafters intended that “Section 318(a) should not be applied (especially in a Code Section 304 case) to reach a result that is both unrealistic and unreasonable, such as a subsidiary owning or controlling its parent corporation.” It is not clear how much weight the parenthetical statement should be given, or how broadly this reasoning should extend.  As a result of the uncertain effect and scope of this IRS guidance, which is now more than 40 years old, it simply is not clear whether Rev. Rul. 74-605 addresses the above inbound financing fact pattern or not.  Thus, while it certainly is possible that the IRS would rely on Rev. Rul. 74-605 for the proposition that FC should not be recharacterized as a CFC in the above situation, the issue is not entirely free from doubt, particularly given that the IRS has on occasion taken positions that are contrary to its own published guidance.

Section 267A Implications

To avoid any potential arguments for treating FC as a CFC in this situation, a simple solution would seem to be causing FC (assuming it is not a per se corporation) to file a check-the-box election to be treated as a partnership for U.S. tax purposes.[10]  Assuming FC is a corporate entity under local law, however, (for example, a limited liability company, as opposed to a limited partnership), this U.S. partnership treatment would implicate other issues, such as the new anti-hybrid rules under 267A, which were effective as of January 1, 2018.[11]

Under these new provisions, no deduction would be allowed for any “disqualified related party amount” paid or accrued by or to a “hybrid entity.”[12]  A disqualified related party amount means any interest or royalties paid or accrued to a related party if (i) such amount is not included in the income of such related party under the tax law of the country of which such related party is a resident for tax purposes or is subject to tax, or (ii) such related party is allowed a deduction with respect to such payment under the tax law of such country.

A hybrid entity is an entity that either is treated as fiscally transparent in the United States but not in its home country, or is treated as fiscally transparent in its home country but not in the United States.  For this purpose, a related party means a related person as defined in Section 954(d)(3) (i.e., more than 50 percent vote or value standard).  Importantly, any payment that is made to a CFC and included in the gross income of a 10% U.S. shareholder under Section 951(a) is not subject to Section 267A.

In the fact pattern described above, where the payment is made to an entity resident in a country that does not have an income tax (e.g., the Cayman Islands), it is hard to identify any potential for abuse, irrespective of whether the recipient entity is a hybrid or not.  Either way, it will not be subject to any local income tax on, or entitled to a deduction for, the amounts it receives.

In fact, Section 267A is drafted so broadly that it could apply even to situations in which the amounts paid are subject to tax in the jurisdiction where the hybrid entity is resident.  For example, assume FC is a U.K. limited liability partnership (LLP) that defaults into a corporation for U.S. federal income tax purposes under the check-the-box regulations.  Further assume that all partners of the U.K. LLP are U.K. residents subject to tax on their share of the LLP’s income.  Section 267A would apply to any U.S.-source interest payments made to the U.K. LLP even though such amounts are fully taxable in the U.K. in the hands of the U.K. resident partners.  This alternative situation does not appear to create any potential for abuse that these rules should logically seek to address.  While the statute indicates that Treasury may issue regulatory or other guidance dealing with exceptions to the anti-hybrid rules where the payment is taxed under the laws of another foreign country, the statute does not specifically direct Treasury to address situations involving taxation in the same country but as to a different taxpayer (such as the U.K. limited partners).

In an analogous area, Section 894(c) and its accompanying regulations clearly permit treaty benefits to be claimed where the relevant payment is made to a fiscally transparent entity if the income is “derived” by either the entity or its interest holders.  Section 894(c) thus properly focuses on whether the income is subject to tax in the entity’s residence country, regardless of whether that tax is imposed on the entity or on its owners.[13]  Section 267A should have a similar focus in these cases.[14]

In addition, although Section 267A does provide limited relief for certain payments made to CFCs, this relief only is available if the amount is included in the gross income of a U.S. shareholder as Subpart F income (under Section 951(a)).  In the above case, if FC is characterized as a CFC, no amount of the payment is included in the gross income of a U.S. shareholder under Section 951(a) (because U.S. shareholders are not required to include income arising from constructive ownership of CFC stock),[15] and therefore, no relief would be available to USB under that provision.

Impact of New Section 163(j)

In addition to the potential disallowance of interest deductions under Section 267A, new Section 163(j) may present an additional hurdle for many inbound structures.  While the prior version of Section 163(j) focused on the payor’s debt-to-equity ratio, whether the payor and payee were related, and whether the interest payment was subject to U.S. federal income tax in the hands of the payee, the new version of Section 163(j) is not dependent on any of these issues.  Instead, all interest payments potentially are subject to limitation under new Section 163(j).[16]

The amount allowed as a deduction under new Section 163(j) for any taxable year for a taxpayer’s “business interest” cannot exceed the sum of (1) the “business interest” income of the taxpayer for such taxable year, [17] (2) 30 percent of the “adjusted taxable income” of such taxpayer for such taxable year, and (3) the floor plan financing interest of such taxpayer for such taxable year.[18]

Special rules apply under Section 163(j) in the case of partnerships.  Section 163(j) explicitly provides that it is to be applied at the partnership level, and that any deduction for business interest is taken into account in determining the non-separately stated taxable income or loss of the partnership.[19]  The statute also provides that the adjusted taxable income of each partner of the partnership (i) is determined without regard to such partner’s distributive share of any items of income, gain, deduction, or loss of the partnership; and (ii) is increased by a partner’s distributive share of a partnership’s “excess taxable income.” This formula essentially allows the partnership to pass its excess, unused Section 163(j) limitation up to its partners pro rata, and in that sense, treats the partnership as an aggregate (rather than as a separate entity).

For example, assume USP generates $200 of non-interest income and its only expense is $40 of business interest.  Under Section 163(j), the deduction for business interest is limited to 30% of adjusted taxable income, i.e., 30 percent x $200 = $60.  Thus, after applying its $40 business interest against this cap, USP has $20 of excess, unused Section 163(j) limitation that it can pass on to its partners.   USP deducts $40 of business interest and reports ordinary business income of $160.  USB’s distributive share of the ordinary business income of USP is $80.  Assume that USB has no other taxable income from any other operations but it has interest expense of $25 on the loan from FC.  While USB cannot include the $80 distributive share of the non-separately stated income of USP in its adjusted taxable income, it can include 50% of the excess, unused Section 163(j) limitation of USP (50% x $20) in its adjusted taxable income.  Therefore, USB can deduct $10 of its $25 of interest expense.  The remaining $15 of business interest is not currently deductible.

What is not clear is how this partnership mechanism works when a partnership avails itself of the “electing real property trade or business” exception to Section 163(j).[20]  In such cases, the partnership itself clearly has an unlimited deduction, but there is no excess, unused Section 163(j) limitation to be passed through to the partner.  This is because the partnership that makes the election will have zero “adjusted taxable income,” as this amount is computed without regard to any item that “is not properly allocable to a trade or business.”  Electing real property trades or business are specifically not treated as trades or businesses for this purpose.[21]  Thus, unless the partner may also elect out of Section 163(j) under the real property trade or business exception, or is deemed to do so as a result of the partnership’s election (or unless the partner has significant “adjusted taxable income” from other sources, which is highly unlikely in most cases involving a U.S. blocker corporation), the partner may find that it is not able to deduct any interest at all.

In the fact pattern described above, it is clear that USP may make the electing real property trade or business exception and, as a result, should have an unlimited interest deduction, to the extent it has any debt of its own.  But unless USB also may make the election based on its ownership interest in USP (or is deemed to do so), its adjusted taxable income will be zero for Section 163(j) purposes.  Accordingly, USB will be prohibited from deducting any amount of its interest payments made to FC.  Therefore, whether USB is deemed to be engaged in the same business of USP, such that it may elect out of Section 163(j), is an all or nothing proposition that is of great significance to many inbound financing structures.

Conclusion

With the repeal of Section 958(b)(4), many inbound structures will become outbound structures, and where these inbound investments are leveraged, portfolio interest treatment may no longer be available.  As noted above, attempting to resolve these issues with check-the-box planning may lead to additional problems under Section 267A, which may disallow interest deductions completely.  Finally, even if the foregoing issues can be avoided, new Section 163(j) may separately limit or prevent the deduction of interest by a U.S. blocker corporation that is a partner in a real estate (or other business carved out from Section 163(j)) partnership.  Taxpayers operating in this space, and their advisors, should therefore carefully plan their inbound financing activities and structures going forward, and should closely monitor future guidance on these issues.

[1] All references to “Section” refer to Sections of the Internal Revenue Code of 1986 (the “Code”), as amended, and the Treasury Regulations promulgated thereunder.

[2] Under the rules of former Section 163(j), deductibility of interest was limited when paid by corporate taxpayers to related borrowers, if the payor’s debt-to-equity ratio exceeded 1.5-to-1, the payor’s net interest expense exceeded 50% of its adjusted taxable income figure, and the related recipients paid no U.S. tax on the interest (e.g. because it was exempt portfolio interest).

[3] Portfolio interest treatment was available because FC did not own 10% or more of the voting shares of USB, the note was in registered form, and the note paid fixed % interest.

[4] Section 881(c)(3)(C).  FC and USB are related for this purpose under Sections 864(d)(4) and 267(b) because FC directly owns 100%, by value, of the stock of US.

[5] See Section 14213 of The Tax Reform Act.

[6] Section 958(b) modifies Section 318 for this purpose in a number of respects.  In relevant part, the same shares are not attributed sideways more than once among family members.  In addition, for purposes of upward attribution under Section 318(a)(2)(C), 10% is substituted for 50%.  Otherwise, constructive ownership generally is treated as actual ownership for purposes of again applying the relevant rules. Section 318(c)(5)(A).

[7] Note that a similar issue would arise even if the corporation had multiple owners, none of whom owned 50% or more directly, if they are related for purposes of Section 318(a)(1).

[8] Notably, there is no prohibition on first attributing shares upward under Section 318(a)(2)(C), and then further attributing the shares downward under Section 318(a)(3)(C).  Section 318(a)(5)(C).

[9] 1974-2 C.B. 97.

[10] Taxpayers should be aware of potential FIRPTA implications of the deemed liquidation that would result from such a check-the-box election if the underlying assets consist of U.S. real property interests.

[11] Note that if FC is formed as a partnership under local law, no hybrid entity will result for purposes of these rules if the entity is treated as partnership for U.S. purposes as well. Query the U.S. estate tax exposure that may exist as a result of this U.S. partnership classification.

[12] The provision also applies to payments made with respect to “hybrid transactions.”

[13] Treas. Reg. Section 1.894-1(d)(1).

[14] Note that because Section 894(c) deals with treaty country residents, the issues relating to the initial Cayman example set out above would not arise in the context of this provision, as our treaty partners do impose income tax.

[15] Section 951(a)(1).

[16] An exception to new Section 163(j) is provided for any taxpayer whose average annual gross receipts for the three-taxable-year period ending with the prior taxable year does not exceed $25 million.  Aggregation rules apply for this purpose under Sections 52 and 414.

[17] For this purpose, “business interest” means any interest paid or accrued on debt properly allocable to a trade or business, and “business interest income” means the amount of interest includible in the gross income of the taxpayer for the taxable year which is properly allocable to a trade or business.  Section 163(j)(5) and (j)(6).

[18] Adjusted taxable income for this purpose is computed without regard to, e.g., deductions for depreciation, amortization or depletion (before Jan 1, 2022), NOLs, and Section 199A deduction.  Section 163(j)(8).

[19] Section 163(j)(4).

[20] Section 163(j)(7).  If a taxpayer makes this election, any interest allocable to that business is not “business interest” subject to Section 163(j) but instead interest that is deductible in full under Section 163(a).  For purposes of the election, “real property trade or business” is defined by reference to Section 469(c)(7), and means any real property development, redevelopment, construction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.

[21] Section 163(j)(8).

Reprinted with permission of Tax Analysts.