The Emerging Impact of Tax Reform on Domestic and Cross...

The Emerging Impact of Tax Reform on

Domestic and Cross-Border M&AUnderstanding New Deal Structure Considerations and Avoiding Traps for the Unwary

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THURSDAY, APRIL 18, 2019

Presenting a live 90-minute webinar with interactive Q&A

Russell A. Daniel, Partner, Grant Thornton, Charlotte, N.C.

Pamela A. Fuller, Of Counsel, Tully Rinckey PLLC & Royse Law, New York & San Francisco

David Strong, Partner, Morrison & Foerster, Denver

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The Emerging Impact of Tax Reform on

Domestic and Cross-Border M&A:

Understanding New Deal Structure Considerations and

Avoiding Traps for the Unwary

April 18th, 2019Strafford Webinar

Presented by:

Russ Daniel Pamela Fuller David StrongPartner Of Counsel PartnerGrant Thornton Tulley Rinckey PLLC Co-Chair Federal Tax [email protected]& Royse Law Morrison& Foerster, LLP

[email protected] [email protected]

DAVID B. STRONG

PARTNER

DIRECT PHONE:

(303) 592-2241 (Denver)

(212) 336-4191 (New York)

E-MAIL: [email protected]

David Strong (Dave) is co-chair of the Federal Tax Practice Group and the Tax Department at Morrison & Foerster. Dave is also the managing partner of the firm’s Denver office and he works closely with transaction teams across the firm, including teamslocated in Los Angeles, New York, Palo Alto, San Francisco, Tokyo and Washington D.C.

Dave’s nationally-recognized areas of expertise include mergers and acquisitions, joint ventures, private equity and venture capital investments, restructurings, distressed situations, and initial public offerings and other types of capital markets transactions. Throughout his career, Dave has worked on transactions across a broad range of industries, including consumer,health care, manufacturing and industrial services, media and entertainment, mining and natural resources, real estate, technology, and internet and telecommunications.

Dave is the past chair of the Corporate Tax Committee of the Tax Section of the American Bar Association and a frequent speaker on corporate and other tax matters at local, regional, and national seminars and continuing legal education programs. Dave is afellow of the American College of Tax Counsel and also an adjunct professor and member of the faculty at The University of Denver Law School (Graduate Tax Program), where he teaches a class on corporate reorganizations, spin-offs, recapitalizations, and restructurings.

Dave received his J.D. from Stanford Law School and his LL.M. in Taxation from New York University. Prior to moving to Denver, Dave worked as both a transactional tax attorney and as an investment banker in New York City.

David Strong – Professional Biography

6

http://www.mofo.com/David-Blair-Strong

mailto:[email protected]

These materials have been prepared in connection with a continuing legal education program and solely for the purpose of enhancing

practitioners’ professional knowledge on federal tax matters.

No part of these materials constitutes written tax advice that may be either used or relied upon by any person for any purpose.

Disclaimer

7

8

1. Background / TCJA Headline Areas of Change

2. Choice of Entity Considerations

3. Section 168(k) / 100% Asset Expensing

4. Section 172 / NOL Limitations

5. Section 163(j) / Interest Expense Limitations

6. International Provisions

Agenda

1. Background /TCJA Headline Areas of Change

10

• Reduction in the corporate graduated rate structure (with a maximum rate of 35%) to a flat rate of 21%

• Elimination of the corporate alternative minimum tax

• Creates a top marginal tax rate of 29.6% for investors in certain types of qualifying “pass-through” businesses (partnerships, LLCs taxed as partnerships, and electing Subchapter “S” corporations)

• Retains 20% individual income tax rate on long-term capital gain, including qualifying “carried interest” allocations, provided a three-year holding period is satisfied for any gains derived from certain investment assets (including securities, commodities, or real estate held for rental or investment)

Tax Rates

11

Tax Deductions / Preferences / Attributes

• Section 168(k) – Allowance for 100% immediate expensing for the full cost of certain new and used business assets (in general, includes most tangible assets but excludes intangibles)

• Section 163(j) – Limitation on the deductibility of interest on indebtedness to 30% of “EBITDA” (as defined in the Act) until 2021, and to 30% of “EBIT” (again, as defined in the Act) for 2022 and thereafter

• Section 172 – Prohibition on the carryback of NOLs and limitation on the use of NOLs generated in 2018 and thereafter to 80% of taxable income

12

International Provisions

Expansion of Subpart F / CFC Rules (“downward attribution”)

Section 951A (“GILTI”)

Section 250 (“FDII”)

Section 59A (“BEAT”)

Withholding on partnership interests

2. Choice of Entity Considerations

14

General COE Considerations

Formation◦ Section 721 (pass-throughs)

◦ Section 351 (corporations)

◦ Other tax and non-tax considerations

Operation◦ Investor base / UBTI

◦ Number of owners / administrative considerations

◦ Anticipated level of profitability / use of losses / deductions

◦ Use of operational cash flow / distributions

◦ Other tax and non-tax considerations

Exit◦ Potential for asset step-up for buyer?

◦ Section 1202

◦ Section 368

15

Section 1202 – General Benefits

In general, Section 1202 allows a non-corporate taxpayer to potentially exclude up to 100% of a substantial portion (or possibly all) of the gain realized from the sale or exchange of qualified small business (“QSB”) stock held for more than five years.

Section 1202(b)(1) provides that the aggregate amount of excludable “eligible gain” effectively allowable under Section 1202(a) equals the greater of:

◦ (i) $10 million (reduced by the aggregate amount of any “eligible gain” previously excluded by the taxpayer for prior taxable years as a result of dispositions of QSB stock issued by the corporation); or

◦ (ii) 10 times the aggregate adjusted bases of QSB stock issued by the corporation and disposed of by the taxpayer during the taxable year.

In addition, Section 1045 allows a taxpayer to potentially roll-over gain from the sale of QSB stock that has been held for more than 6 months.

16

Section 1202 – Primary Requirements

There are four main requirements that must be satisfied before gain on the sale of stock is potentially eligible for the exclusion under Section 1202.

(1) Stock of a C-corporation acquired at “original issuance”

(2) Qualified small business requirement ($50 million test)

(3) Active business requirement (non-service businesses)

(4) Five-year holding period

17

Case Study – PE Fund Conversions

• Ares Management was the first “publicly traded partnership” / PE firm to convert to a “C” corporation (February 2018)

• Ares shares immediately went up 12% (but have since settled)

• Drivers include: the elimination of the need for “lumpy” cash distributions to investors, consistent dividend story, lower administrative burden, lower effective tax rate on fee income, and access to wider range of potential investors (enhancing liquidity)

• KKR followed Ares and converted to a C corporation (July 2018) and shares also initially traded up substantially (but have also since settled)

• Blackstone, Apollo, and Carlyle still holding as PTPs (for now)

18

Case Study – PE Platforms

Basic Facts:◦ Some investors are tax-exempt and have UBTI concerns

◦ Some individual investors taxed at high rates (federal plus state)

◦ Operational cash-flow will be reinvested in the business

◦ Business generally expected to qualify for benefits under Section 1202

◦ Management would like to receive incentives similar to profits interests

◦ Exit horizon expected to be 5 years or more

COE Analysis:◦ On balance, seems like a very strong candidate for C-corp Holdco

◦ Corporate tax rate of 21% (federal) presents lower operational drag

◦ Tax-exempt investor does not need to invest through blocker

◦ Section 1202 benefits could be significant on exit (and more than offset loss of potential premium for asset step-up)

◦ Management “profits interests” could be replicated through a “common strip” (common stock that sits under preferred from investors)

3. Section 168(k) / 100% Asset Expensing

20

Section 168(k) – Overview

The Act allows taxpayers to take a bonus depreciation deduction equal to 100% of the adjusted basis of “qualified property” acquired and placed in service after September 27, 2017 and before January 1, 2023.

The term “qualified property” is generally defined as (i) tangible personal property with a depreciation recovery period of 20 years or less, (ii) certain limited types of computer software, and (iii) property used in qualified film, television, and theatrical productions.

The deduction is available for both new and used property, and the deduction percentage will be reduced annually for purchases of property between January 1, 2023, through December 31, 2026, and will not be available after 2026.

There are certain requirements regarding what acquisitions of used property can qualify for the additional allowance for depreciation under section 168(k). Section 168(k)(2)(E)(ii), as amended by the TCJA, provides that an acquisition of property meets these requirements if – (I) such property was not used by the taxpayer at any time prior to such acquisition (the “no prior use requirement”), and (II) the acquisition of such property meets the requirements of paragraphs (2)(A), (2)(B), (2)(C), and (3) of section 179(d) (the “unrelated purchase requirement”).

Proposed Regulations under Section 168(k) were issued on August 3, 2018

21

Trap for the Unwary / The “No Prior Use Requirement”

Prop. Reg. § 1.168(k)-2(b)(3)(vi), Ex. (20):

Parent owns all of the stock of D Corporation and E Corporation. Parent, D Corporation, and E Corporation are all members of the Parent consolidated group. D Corporation has a depreciable interest in Equipment #2. No other members of the Parent consolidated group ever had a depreciable interest in Equipment #2.

During 2018, D Corporation sells Equipment #2 to BA, a person not related, within the meaning of section 179(d)(2)(A) or (B) and Regulation section 1.179-4(c), to any member of the Parent consolidated group.

In an unrelated transaction during 2019, E Corporation acquires Equipment #2 from BA or another person not related to any member of the Parent consolidated group within the meaning of section 179(d)(2)(A) or (B) and Regulation section 1.179-4(c).

22

Trap for the Unwary / The “No Prior Use Requirement”

In the case of the Example, the Proposed Regulations conclude that E Corporation is treated as previously having a depreciable interest in Equipment #2 because E Corporation is a member of the Parent consolidated group, and D Corporation, while a member of the Parent consolidated group, had a depreciable interest in Equipment #2.

As a result, E Corporation’s acquisition of Equipment #2 would not satisfy the “no prior use requirement” and therefore would not be eligible for additional first year depreciation.

The results would be the same if D Corporation had ceased to be a member of the Parent consolidated group prior to E Corporation’s acquisition of Equipment #2.

23

Deal Structure / Stock v. Assets

Basic Facts:◦ Target C corporation has assets worth $100 (no liabilities and pre-tax)

◦ Target has $25 basis in its assets

◦ Target has $35.5 of NOLs

◦ $50 of Target property is eligible for Section 168(k) expensing

◦ Target has one shareholder with zero basis in stock worth $100

◦ Acqurior is a C corpration subject to tax at 21% federal rate

Deal Structure Analysis:◦ Simplified facts reveal a breakeven as between stock and asset deal,

assuming Acquiror would be willing to pay $10.5 for the value of $50 worth of immediate Section 168(k) asset expensing

◦ After-tax stock proceeds = $80 ($100 x (1-.20))

◦ After-tax asset proceeds = $80 (($110.5 –($50x.21))x(1-.20))

4. Section 172 / NOL Limitations

25

NOL Limitations – Overview

Beginning in the 2018 tax year (and for subsequent tax years), the TCJA eliminated NOL carrybacks

Following the TCJA, NOL carryforwards must also be separately tracked in two separate “pools”: (i) pre-2018 NOLs (which can fully offset taxable income and which are ordered first); and (ii) NOLs generated in 2018 or after (which can only offset 80% of taxable income and are ordered second)

As a result of the changes, NOL tracking (and valuation) has become more complex (coupled with the new 21% corporate tax rate)

In addition, due to the elimination of NOL carrybacks, the typical deal dynamic in relation to “transaction tax deductions” (“TTDs”) has changed somewhat

26

TTDs – What are they?

In general, “TTDs” are transaction-related expense items that give rise to a tax deduction in the pre-closing period

Common examples of TTDs include:

◦ Option cancellation payments;

◦ Sale bonuses, change-in-control payments, retention payments;

◦ Fees, expenses, and interest incurred in connection any target indebtedness; and

◦ Fees, costs and expenses incurred in connection with the acquisition, including, to the extent deductible, any legal, accounting and investment banking fees, costs and expenses

27


In the case of a corporate target, TTDs can create a valuable tax shield on the “inside” of the entity being acquired (by offsetting corporate-level taxable income)

In the case of a pass-through target, TTDs can effectively create a valuable tax shield for the selling equity owners on the “outside” of the entity being acquired (due to the flow-through of net taxable income)

In the corporate context, the allocation of the potential value associated with TTDs is typically negotiated and TTDs can affect pre-closing tax returns, post-closing tax returns, and net working capital calculations

In the pass-through context, certain aspects of TTDs are also sometimes addressed in the acquisition agreement, but sellers generally obtain the benefit of TTDs by default (due to the flow-through of net taxable income to the selling equity owners in respect of the final pre-closing period)

28


In the corporate context, prior to 2018 (and the elimination of NOL carrybacks) the value of TTDs historically arose in 3 ways:

◦ (i) deductions that would offset taxable income in the final pre-closing period;

◦ (ii) excess deductions that could be carried back as an NOL to prior taxable years, and that would generate a tax refund; and

◦ (iii) excess deductions that could be carried forward as an NOL to future taxable years, and that would potentially offset future taxable income.

Beginning in the 2018 tax year (and for subsequent tax years), the value of TTDs can no longer be realized through an NOL carryback to a prior taxable year (due to the elimination of NOL carrybacks under the TCJA)

Following the TCJA, NOL carryforwards must also be separately tracked in two separate “pools”: (i) pre-2018 NOLs (which can fully offset taxable income and which are ordered first); and (ii) NOLs generated in 2018 or after (which can only offset 80% of taxable income and are ordered second)

29

LSVC Holdings – Basic Facts

LSVC / seller

Court Square / buyer

Approximately $6-$7 million worth of TTDs were subject to specific back-and-forth negotiations during the deal

The transaction closed on December 27, 2012

Prior to closing, on December 17, 2012, LSVC caused the target to make an estimated 4th Quarter tax payment to the IRS in respect of the 2012 tax year that took 100% of the TTDs into account (thereby effectively reducing the required estimated tax payment by $6-$7 million)

30


However, following the closing, Court Square claimed that the value of the TTDs should not have been applied to reduce the final pre-closing estimated tax payment (and that the TTDs should have instead been applied post-closing to generate a refund in respect of the 2012 taxable year)

During the course of the negotiations, the parties had apparently verbally agreed to “split the value of the TTDs 50%/50%,” but only to the extent that any benefits were effectively realized in the post-closing period (with respect to the 2012 taxable year)

Following the verbal agreement, the documentation was then drafted and executed with provisions that did not clearly require the benefit of the TTDs to be claimed by the seller / LSVC in the post-closing period

31


Instead, the literal language of the agreement allowed LSVC to claim the benefit of the TTDs in the pre-closing period (i.e., in connection with the December 17th, 2012 4th quarter estimated tax payment, which was made prior to closing)

As a result, based on LSVC’s use of all TTDs in the pre-closing period, there were no TTDs that could be used in a post-closing period and split 50%/50%, such that LSVC effectively obtained 100% of the economic benefit of the TTDs (presumably, through post-closing net working capital)

Although there was a provision that required Court Square to potentially pay 50% of any post-closing benefits back to LSVC, there was no provision requiring LSVC to pay 50% of any pre-closing benefits to Court Square

The value of the TTDs was also not explicitly addressed in the net working capital provisions of the agreement (such that normal principles applied)

32

LSVC Holdings – Opinion

The DE Chancery Court found that extrinsic evidence could be considered because the acquisition agreement was potentially subject to more than one reasonable interpretation

The Court then recounted all of the factual details of the extensive back and forth negotiations between LSVC and Court Square and their respective legal advisors

In the end, the court was most persuaded by LSVC’s interpretation, primarily because LSVC’s reading:

◦ (i) was consistent with the plain language of the document (which allowed LSVC to account for 100% of the TTDs when it made the pre-closing estimated tax payment); and

◦ (ii) did not require LSVC to do something that was not required by the agreement (i.e., make a payment of 50% of the benefit of the TTDs back to Court Square)

33

Key Takeaways / Best Practices

Identify potential value associated with TTDs early in the process

Consider adding desired approach to TTDs to the LOI / term sheet

Once an agreement is reached, ensure that the various provisions of the agreement operate in conjunction to effect the desired result

In particular, in a corporate acquisition agreement:

◦ (i) make sure that the nature and scope of TTDs is well defined;

◦ (ii) review the tax covenants / tax return preparation provisions to ensure that the intended timing / use of TTDs is clear;

◦ (iii) confirm that the working capital provisions are consistent with the business deal (e.g., that the net working capital target is set so that the seller (or buyer) will effectively obtain the desired economic benefit associated with any TTDs); and

◦ (iv) if the buyer agrees to pay for any future benefits associated with an NOL carryforward, make sure that the methodology for computing such benefits is clear in the agreement (e.g., current year losses ordered first, then NOL carryforwards, etc.)

5. Section 163(j) / Interest Deduction Limitations

Section 163(j)

Russell A. [email protected]

© 2019 Grant Thornton LLP | All rights reserved | U.S. member firm of Grant Thornton International Ltd

Overview

36

• Section 163(j) provides that the amount allowed as a deduction for business interest

expense may not exceed the sum of:

‒ business interest income for a taxable year;

‒ floor plan financing interest for such taxable year; and

‒ 30 percent of "adjusted taxable income" for such taxable year.

• Any disallowed business interest is carried forward and treated as business interest

paid or accrued in the succeeding taxable year subject to section 163(j).

• Exemption for certain small businesses that meet the gross receipts test of section

448(c).


Overview

37

• Adjusted Taxable Income (ATI) means the taxable income of a taxpayer computed

without regard to:

‒ income, gain, deduction, or loss not properly allocable to a trade or

business;

‒ business interest expense and business interest income;

‒ net operating loss deduction under section 172;

‒ the deduction under section 199A (for qualified business income); and

‒ depreciation, amortization, or depletion for taxable years beginning before

January 1, 2022.

• Other adjustments to ATI have been provided in regulations.


Overview

38

• The carryover of disallowed business interest is an attribute of a corporation under

section 381.

• A pre-change loss of a corporation under section 382 includes any carryover of

disallowed business interest.

• Special rules apply for the application to partnerships and S corporations under

section 163(j)(4).


Overview

39

• The proposed regulations are not effective until final.

• However, taxpayers and their related parties (under sections 267(b) and 707(b)(1))

may apply the proposed regulations:

"so long as the taxpayers and their related parties consistently apply the

rules of the section 163(j) regulations, and if applicable, §§ 1.263A-9,

1.381(c)(20)-1, 1.382-6, 1.383-1, 1.469-9, 1.882-5, 1.1502-13, 1.1502-21,

1.1502-36, 1.1502-79, 1.1502-91 through 1.1502-99, (to the extent they

effectuate the rules of §§ 1.382-6 and 1.383-1), and 1.1504-4 to those

taxable years." [Emphasis added] (Excerpt from Prop. Reg. 1.163(j)-1(c)).


Key Definitions and General RulesInterest

40

1. Compensation for the use or forbearance of money.

• includes OID, qualified stated interest, repurchase premium, market discount, and

imputed interest.

2. Swaps with significant non-periodic payments.

• time-value component of non-cleared swap with significant non-periodic payments.

3. Other amounts treated as interest.

• premium, substitute interest payments, gain under section 1258, amounts from a

derivative that alters effective cost of borrowing or effective yield, certain commitment

fees, debt issuance costs, guaranteed payments for the use of capital under section

707(c), and factoring income.

4. Any expense or loss in a transaction (or a series of related transactions) in which the

taxpayer secures the use of funds for a period of time if the expense or loss is

predominantly associated with the time value of money.


Key Definitions and General RulesAdjusted Taxable Income (ATI)

41

• ATI is defined as taxable income with specified adjustments (see next page).

• For this purpose, taxable income means the definition in section 63 (computed without regard to

section 163(j)).

• A deduction under section 250(a)(1) is determined without regard to the taxable income

limitation in section 250(a)(2) and without regard to section 163(j).

• The preamble acknowledges the need for ordering rules to apply other provisions based on, or

limited to, taxable income.

• Additional rules apply for determining ATI with respect to specific types of taxpayer (e.g., C

corporations, RICs and REITs, S corporations, partnerships, etc.).



42

Additions:

• business interest expense;

• net operating loss deduction;

• deduction under section 199A;

• deduction for capital loss carryback or carryover;

• deduction or loss not properly allocable to a non-

excepted trade or business; and

• For years beginning before January 1, 2022:

‒ depreciation under sections 167 or 168;*

‒ amortization of intangibles under sections 167 or 197;

‒ other amortized expenditures (section 195(b)(1)(B), 248, or

1245(a)(2)(C)); and

‒ depletion under section 611.

Observations:

• Note that expenses capitalized under Section 263A

are not depreciation, amortization, or depletion, and

therefore are not added back.

• Consider revisiting UNICAP methods to assess

whether they are still correct after 25 years since

original elections. For example, has amortization of

Sec. 197 intangibles been properly included when

related to production related assets (i.e. patent,

technology, knowhow)?

• Under old law, this would be a timing

difference only. Due to the nature of 163(j)

disallowance, it could be treated as

permanent once valuation allowances are

considered.



43

Observations:

Recapture provisions are not easy to implement, nor are

they particularly fair.

• In a pure asset sale, it operates similar to Sec.

1245, but in a bulk sale you will need a detailed

purchase price allocation on

depreciable/amortizable assets.

• In the sale of a consolidated subsidiary, the rule

seems on the face to function similar to the asset

sale rule above, but will end up with a larger

subtraction since the regs don't provide a look-

through to the underlying assets. (See example on

next page.)

Subtractions:

• business interest income;

• floor plan financing interest expense;

• the lesser of: (1) any gain recognized on the sale or

other disposition of property; and (2) depreciation,

amortization, or depletion for taxable years after

December 31,2017 and before January 1, 2022, with

respect to such property;

• certain investment adjustments under Reg. § 1.1502-

32 attributable to depreciation, amortization, and

depletion upon the sale or other disposition of the

stock of a member of a consolidated group;

• the taxpayer's distributive share of certain deductions

of depreciation, amortization, and depletion allowable

under section 704(d) upon the sale or other

disposition of a partnership interest; and

• income or gain that is not properly allocable to a non-

excepted trade or business.


Key Definitions and General RulesExample

44

• In 2018, Sub acquires a depreciable asset for

$1,000 for use in its larger business. Sub

depreciates the asset over 10 years (assume

straight-line method).

• In 2025, Sub sells the asset (basis of $300) for

$400, recognizing a $100 gain.

Parent

Sub

Outcome:

• From 2018-2021, Sub adds back $400 of

depreciation to determine ATI.

• From 2022-2024, Sub does NOT add back any of

the $300 of depreciation to determine ATI.

• In 2025, the ATI subtraction is the lesser of:

• $100 gain recognized, or

• $400 of depreciation previously added

back.

• Note that there is no allocation of that subtraction to

post-2021 depreciation recapture.

• If sale proceeds were $800, the ATI subtraction

would be $400 – full recapture of previously added-

back income.

• May cause some taxpayers to forego bonus

depreciation in 2019-2021.


Key Definitions and General RulesExample - Modified

45

• In 2018, Sub acquires a depreciable asset for

$1,000 for use in its larger business. Sub

depreciates the asset over 10 years (assume

straight-line method).

• In 2025, Sub still holds the asset with basis of $300,

but the asset has minimal value to a third party

buyer.

• In 2025, Parent sells Sub for $1 million, recognizing

a gain of $200,000.

Parent

Sub

Outcome:

• From 2018-2021, Sub adds back $400 of

depreciation to determine ATI.

• From 2022-2024, Sub does NOT add back any of

the $300 of depreciation to determine ATI.

• In 2025, the ATI subtraction is the investment

adjustments under 1.1502-32 "attributable to

deductions described in paragraph (b)(1)(ii)(C) of

this section," or $400.

• Note that there is no consideration given to the fact

that the asset wouldn't trigger a gain on its own,

since it has no value.


Key Definitions and General RulesSmall Business Exemption

46

• Section 163(j) limitation does not apply to any

taxpayer, other than a tax shelter defined in

section 448(d)(3), if average annual gross

receipts does not exceed $25 million under

section 448(c).

• Note that "tax shelter" includes more than

typical tax shelters; a "syndicate" under section

1256(e)(3) qualifies as a tax shelter.

• Generally applies to non-C corp

entities

• Over 35% of losses flow to limited

partners or similar owners

This can apply to any type of business,

even where there's no tax planning at all.

• Note that this restriction also applies to use of

the cash method.

Observations:

• Complex related party rules for purposes of

applying the gross receipts test

• The "syndicate" definition is its own animal –

similar to 469 rules but not by any means the

same.

• Also note that a company can be a syndicate one

year (by losing money) but not the next (when it

makes money.

© 2019 Grant Thornton LLP | All rights reserved | U.S. member firm of Grant Thornton International Ltd 47

• Generally, a consolidated group has a single section 163(j) limitation.

• Relevant taxable income in computing the group’s ATI is the group’s consolidated taxable

income determined under Reg. § 1.1502-11 without regard to any carryforwards or

disallowances under section 163(j).

• Intercompany items and corresponding items are disregarded to the extent that they offset in

amount for purposes of calculating the consolidated group's ATI.

• Intercompany obligations are disregarded for purposes of determining a member’s current-year

interest expense and interest income and the consolidated group’s ATI.

• Cross references Reg. § 1.1502-32(b) to provide that if a member has current-year interest

expense for which a deduction is disallowed in the current taxable year under section 163(j),

basis in the member’s stock would be adjusted in a later taxable year when the expense is

absorbed by the group.

Consolidated Section 163(j)


Observations:

• Note that the rules apply on a consolidated level, but not at a controlled group level. Two US

companies directly owned by a foreign parent would each have their own limitation, potentially

with possibly terrible results if one lends to the other.

• Intercompany items generally excluded, but separate company state filings may require

modified computations (with potentially similar results as noted above)

• Consider impact of deferred 163(j) deductions in year where a company leaves the group. Gain

on deconsolidation/sale may free up substantial deferred deductions in the group – which could

result in complex circular basis issues under 1.1502-11.




49

Example:

• Parent owns Sub1 and Sub2. Sub1 owns Sub3.

• Sub1 borrows from a third party Bank and then

subsequently loans the proceeds to Sub2. Sub2

bears the economic cost of the interest, since

Sub1 is simply passing it through to the Bank.

• Assume $10 of the interest to Bank is disallowed

by 163(j).

• Because the intercompany loan is ignored for

163(j) purposes, the deferred interest actually

sits at Sub1, even though it had no net interest

expense of its own.

Observations:

• Careful planning could allow taxpayers to "designate"

163(j) limitations to the entity of their choice.

• Note that state tax answer may be much different, as

the intercompany loan may not be disregarded for state

income tax purposes.


Interaction of Sections 163(j) and 382

50

• Under section 382, if a loss corporation undergoes

an ownership change, section 382 limits the amount

of the loss corporation’s taxable income that can be

offset by pre-change losses to the product of the loss

corporation’s value x the long-term tax-exempt rate.

• New section 382(d)(3) provides that, for purposes of

section 382, the term “pre-change loss” includes

carryovers of disallowed interest expense under

section 163(j).

• For purposes of determining the portion of

disallowed interest expense attributable to the pre-

change period, Prop. Reg. § 1.382-2 requires that

disallowed interest expense be ratably allocated on a

daily basis, regardless of whether the loss

corporation makes a closing-of-the-books election

under Reg. § 1.382-6(b)(2) with regard to allocating

its other taxable items.

Observations:

• Ratable allocation will adversely affect leveraged

acquisitions (where the target corporation incurs debt

as part of the acquisition) by allocating a

disproportionate amount of post-acquisition interest to

the pre-change period and subjecting it to section 382.

• Does not override default closing-of-the-books rule of

Reg. § 1.1502-76(b) if loss corporation enters or leaves

a consolidated group.

• Possible solution: consider always using a new parent

corporation to form a new consolidated group to force a

cut-off if planning to lever up the company.

• Remember that the corporate contraction rules of

Section 382 will also drive the 382 limitation down

when borrowing at target company.



Acquired

May 26, 2019

Facts:

• On May 26, 2019, Target is acquired by Acquiring, an unrelated partnership, resulting in a section 382 ownership change.

• For calendar year 2019, Target pays $100 interest (all of which is incurred for new borrowing incurred in the acquisition) and has

an $81 section 163(j) limitation.

Analysis:

• Regardless of whether Target makes a closing-of-the-books election under Reg. § 1.382-6(b)(2), Target’s interest expense

deduction is ratably allocated between the pre-change and post-change periods.

• For calendar year 2019, Target may deduct $81 of interest expense, of which $32.40 ($81 x (146 days/365 days)) is allocable to

the pre-change period. The remaining $19 of interest that was paid in 2019 is disallowed, of which $7.60 ($19 x (146 days/365

days)) is allocable to the pre-change period. The $7.60 of disallowed business interest expense is treated as a section 382

disallowed interest carryforward, and thus is a pre-change loss within the meaning of Reg. § 1.382-2(a)(2).

• Note that P/S could elect to be taxed as a corporation and file a consolidated return to avoid this result, since Target's pre-change

return would cut off at closing.

Target $81 section 163(j) limitation

P/S

$100 interestBank



52

Value restoration under Section 382(m)(5)

• Consider impact of 382(m)(5) when GILTI computations are involved.

• Section 382(m)(5) and regulations provide a mechanism to properly allocate value between legal entities when it

would otherwise be double counted.

• Example:

• US Parent (value $1,000, NOL c/f of $300) owns 100% of Foreign Sub (value $200, 163(j) limited

interest of $10). Note that the value of US Parent is $800 without regard to Foreign Sub.

• US Parent has an ownership change. Assume 382 rate is 2%, and there is no NUBIG or NUBIL.

• The default result is that $200 of value in Foreign Sub is "deemed elected" to be restored to US

Parent under Reg. 1.382-8(h)(1).

• Outcome:

• USP 382 limit is ($1,000 x 2%) $20 and all NOLs will be used over 15 years.

• FS 382 limit is $0 ($0 x 2%) and 163(j) limited interest will never be deductible.



53

Value restoration under Section 382(m)(5)

• Same facts as prior example, but assume

that USP elects to not restore value of $100

from FS.

• Outcome:

• FS has 382 limit of $2 ($100 x

2%), so will free up $10 of

interest over 5 years

• USP has 382 limit of $18 ($900 x

2%), so will use $18 of NOLs for

approx. 17 years

Observations:

• Modeling will be needed to determine the optimal

solution when not all attributes can be used.

• Note that this election must be made in the year of

the ownership change, so waiting to perform a 382

study brings new risks.

• Each foreign sub will need its own 382 computation,

including NUBIG/NUBIL.

• Query whether a GILTI deduction is more or less

valuable than a direct deduction in the US?

• Fun fact: the election in this case is to elect OUT of

a deemed election to restore value.


S Corporations

54

• The section 163(j) limitation is applied at the S corporation level, and any deduction allowed for

business interest expense is taken into account in non-separately stated taxable income or loss.

• Deductible interest expense is not subject to section 163(j) at the shareholder-level but retains

its character as business interest expense for other purposes (e.g., section 469).

• For purposes of determining the S corporation's ATI, the taxable income of the S corporation is

determined under section 1363(b).

• Note that Section 382 applies to S corps, so any 163(j) carryover can be limited following an

ownership change for the S corp.

The Emerging Impact of Tax Reform on Domestic and Cross-Border M&A

International Tax Considerations in Structuring M&As

After the 2017 Tax Act (TCJA)

Pamela A. Fuller, Esq.Royse Law FirmOf CounselNew York, NY, San Francisco, CASilicon Valley, [email protected]

Tully Rinckey PLLC777 Third Ave, 22nd FloorNew York, [email protected]

Thursday - April 18, 2019

Emerging Impact of US Tax Reform on Cross-Border M&A -- Pamela A. Fuller

Tully Rinckey - Royse Law

http://www.rroyselaw.com/

International Tax Considerations

AgendaA. Overview: International Tax Provisions adopted by 2017 TCJA

1. Drastic change in how US shareholders are taxed on foreign-source income earned by their foreign subs/controlled corporations

2. Partial elimination of the historic “Deferral Privilege” exception to taxing US shareholders on their worldwide income

3. Cross-border structures that still can enjoy the “tax deferral privilege” post TCJA

B. Expansion of Subpart F rules applicable to “controlled foreign corporations” (CFCs)1. Expanded definition of “US Shareholder” - amended § 951(b)2. The many unintended bad & ugly (and a couple good) consequences of §958(b)(4)’s repeal:

a. “Pop-up CFCs”;b. Lost US Portfolio Interest Exemption,c. Heavier compliance burdens, d. But fewer PFICs

3. New § 951A’s GILTI’s relationship to Subpart F rules (a back-up, minimum tax)

C. New IRC § 951A - “Global Intangible Low Taxed Income” tax (GILTI): M&A planning considerations1. Overview of GILTI’s underlying congressional intent and mechanics – (“the stick”)2. Foreign entity selection in light of the new GILTI tax3. When it makes sense to avoid GILTI, and when it makes sense to plan into GILTI 4. Rules of thumb before you spend the money to model 5. §338(g) elections: huge trap for unwary in post TCJA world

D. Foreign Derived Intangible Income – FDII (“the carrot”)1. Qualification for the deduction2. Negotiating & Pricing M&A in light of FDII deduction

56Emerging Impact of US Tax Reform on

Cross-Border M&A -- Pamela A. Fuller Tully Rinckey - Royse Law

International Tax Considerations

Agenda (cont.)E. Acquiring or Selling/Disposing of a US-owned foreign subsidiary – planning considerations

1. Assets Deal or Stock Deal in cross-border transaction? An overview of tax Stakes2. Taxable or tax deferred? Effects of TCJA on this analysis 3. § 902 “Indirect Credit” repealed4. New § 245A – a very limited “participation exemption”5. Surprising effects of new § 1248(j)6. “Check & Sell Transactions” post TCJA7. New §1248(j) and § 964(e)8. Purchaser Considerations in deciding whether to elect § 338(g)9. Seller’s increased stakes 10. Due diligence and deal terms

F. Use of Hybrid Arrangements (entities and instruments) in M&A 1. The perceived abuse in hybrid arrangements2. Limitations imposed by TCJA - §267A’s disallows deductions for “disqualified related party amounts”3. How much tax arbitrage is still tolerated? 4. Other countries’ restrictions on the use of hybrid arrangements in M&A5. Recommendations of OECD’s BEPS Action 2 6. “Hybrid dividends” and new § 245A DRD

G. New § 59A – Base Erosion Anti-Abuse Tax (“BEAT”)1. Overview and congressional purpose2. Mechanics3. Strategies to Manage BEAT exposure if your client (or counterparty) is impacted4. Structuring, pricing, and negotiating M&A in light of BEAT tax exposures (of any party)

H. Dispositions by Foreign Partners of Interests in Partnerships “Engaged in a US Trade or Business”1. New §864(c)(8) 2. New §1446(f) Transferee Withholding3. IRS Notice 2018-29 57

Overview:How the 2017 Tax Cuts and Jobs Act

fundamentally changed US Tax Stakes in Cross-Border M&A

---------

“New” U.S. International Tax Provisions



Spectrum of Entity Selection – Often the first consideration in structuring tax consequences of M&A (what have you got?)

US C-Corp

ControlledForeign Corp

(CFC)

General Rule: When a foreign venture rises to the level of “permanent establishment” status, then foreign entity selection becomes more relevant, and a choice needs to be made. Traditionally, choice was between “foreign E&P deferral” or “no deferral.”

U.S.

ForeignJurisdiction

59

Dividend

Foreign P/S

Disregarded Entity

Unincorporated Branch

(“PE” status?)

Un-Controlled Foreign Corp

Non-US persons own > 50%

Other partners US or foreign

US P/S (or LLC)

US Individual S-Corp (and

other types of US biz entities)



The 2017 Tax Act (formerly known as TCJA) Drastically Changes How Foreign Subsidiary Income of US Corporations is taxed

US C-Corp

ForeignCorp

BEFORE 2017 US Tax Act

• General Rule: United States generally taxes US corporations on a “worldwide”

basis—i.e., US corporations taxed currently on both US-source income and foreign source income they receive. (Contrast with a pure “territorial jurisdiction,” which taxes its resident corporations only on income earned within its borders—not on foreign-source dividends and other foreign income ).

• Policy for Worldwide (“Residence-Based”) System: Belief that capital is

allocated more efficiently when investors’ choices about where to invest are not distorted by tax considerations. Economists believe it is more efficient if investments are made on the basis of pure economic fundamentals.

• Deferral “Privilege” Exception: If a FOREIGN corporate Sub (of US corporate

parent- as per diagram) earns foreign-source income, US corporate tax is not imposed on the foreign Sub’s income unless and until it is repatriated to the US—in an actual or deemed dividend. (Indefinite tax deferral is tantamount to a complete tax exemption due to time-value of money.)

• Policy Rationale: US-owned foreign Subs need a “level playing field” to compete

and should not have to pay both foreign and US taxes when their competitors do not. Thus, U.S. tax deferral is allowed so long as the foreign Sub can be viewed as truly competing in an active trade/business in its relevant market abroad. However, to the extent the foreign Sub receives income that is either “passive” or looks like “conduit income” (i.e., earned through an low-tax branch/tax haven), the deferral “privilege” ends w/respect to that income, which is then taxed currently to its US shareholder(s) under one of several statutory anti-abuse regimes. Rationale: Foreign Sub is just there for tax advantages—not to compete in a foreign trade/business (i.e., “capital import neutrality” policy objective no longer being served).

• Foreign Tax Credits: The corporate income taxes imposed by U.S. upon actual or

deemed repatriation of a foreign Sub’s E&P may generally be offset with the foreign taxes already paid on that E&P via a tax credit (to extent it eliminates double juridical taxation).

U.S.

ForeignJurisdiction

Foreign-source income

60

Dividend

The 2017 Tax Act Drastically Changes How Foreign Sub Income is Taxed:No More Deferral—Sub’s E&P is either taxed currently or exempted

US C-Corp

ForeignCorp

AFTER 2017 US Tax Act • General Rule: United States still generally taxes its US corporations on a “worldwide”

basis—but at a much lower rate—i.e., 21% (down from 35%). However, the corporate tax base is broader with more foreign Subs’ E&P subject to US tax. Also, there is some foreign-source income that is completely exempt from U.S. corporate taxation . Thus, new system is still a “hybrid system” exhibiting attributes of both a residence-based AND territorial system.

• “Deferral Privilege” Exception is formally eliminated: Now, all income

of a foreign subsidiary owned by a U.S. corporation will be either:

• Taxed currently by US (either under one of the pre-existing anti-abuse

regimes (PFIC or expanded Subpart F ) OR under the new very broad category of §951A “GILTI” income (Global Intangible Low-Taxed Income), which functions as a minimum tax , which can reach a foreign Sub’s income even if it’s not passive or

conduit income; OR

•EXEMPT from U.S. corporate taxation (forever).

Three categories of foreign-source income of foreign Subs are now EXEMPT . But these may not amount to much due to the breadth of the new GILTI minimum tax. They include:

1. CFC’s earnings attributable to the 10% notional return in the GILTI regime (QBAI), which

qualifies for the § 245A DRD when repatriated:

2. Income of 10% corporate “US Shareholders” of foreign Subs that do not qualify as CFCs

(but do qualify as “specified foreign corporations” and so get the § 245A DRD); and

3. Pre-1987 E&P accumulated by foreign Subs, but only to extent of the pro rata share

owned by 10% U.S. CORPORATE shareholders, since the §965 Transition Tax does not

apply to those earnings and the §245A DRD applies when repatriated.

• In Sum: U.S. still has a “hybrid system” –i.e., part Residence-based (perhaps more so

now) and part Territorial. Despite its new territorial attributes, the purview of US corporate tax is probably greatly expanded… but at a much LOWER rate—21% (vs. the former 35% ).

U.S.

ForeignJurisdiction

Foreign-source income

61

Dividend

Expanded Reach of theSubpart F-CFC Rules

Post TCJA

An important tax factor in structuring, negotiating, and documenting

Cross-Border M&A



Expanded Reach of Subpart F- CFC Rules Post-TCJA

Six ways the 2017 Act broadened Subpart F’s application

1. § 951(b) definition of “US shareholder” was broadened to include a value test -(after TCJA, the test for “US shldr” is a US person owning at least 10% of EITHER vote OR 10% of value of a foreign corporation (directly, indirectly through foreign entities, or constructively through modified § 318 attribution rules).

2. Amended § 951(b) to provide that the new definition of “U.S. shareholder” applies “for purposes of this title,” – (i.e., Title 26—the whole U.S. Internal Revenue Code)—instead of just for purposes of Subpart F as under pre-TCJA law.

3. Repealed IRC § 958(b)(4), which had (prior to repeal) turned-off the downward stock attributionrules of § 318(a)(3)(A) through (C) for purposes of imputing stock owned by a foreign person to a US person (in identifying US shldrs and CFCs).

4. Eliminated from § 951’s income inclusion rule the requirement that a foreign corporation must be a CFC for at least “an uninterrupted period of 30 days” during any taxable year in order for a US shldr to be taxed. (Now a foreign corporation need only be a CFC for 1 day.)

5. Added a broad new category of income to Subpart F—i.e., § 951A “Global Intangible Low Taxed Income” (GILTI). Although § 951A GILTI is not technically within § 952’s definition of “Subpart F Income,” GILTI is part of Subpart F, and GILTI’s application thresholds are basically the same (i.e., only “US shlders” in a “CFC” are taxed on GILTI inclusions, as that new residual category is defined).

6. Added , to very end of Subpart F, new § 965 --“Treatment of deferred foreign income upon transition to participation exemption system of taxation” (i.e., the “Transition Tax”)




Basically, when does Subpart F regime apply?

• Subpart F regime can potentially apply whenever there is a “controlled foreign corporation” (CFC).

• CFC is defined in § 958(a) as “any foreign corporation if > 50% of the total voting power OR > 50% of total value is owned by 10% “US shareholders” on any 1 day.

• For purposes of identifying “US shldrs” and testing for “CFC” status, stock ownership can be direct, indirect through foreign entities, or constructive. (Attribution rules of § 318 are incorporated by reference in Subpart F, but with modifications.)

• Beware of control premiums and value discounts (“drag along” & “tag along” rights)

• With respect to voting power, courts have looked to power to control board of directors. See Framatome v. Cir. 118 TC (2002) (because the veto powers and supermajority requirements prevented US shldr from exercising powers over Japanese corp ordinarily exercised by a domestic board of directors, US shareholder did not have > 50% voting power. Court relied on Alumax v. Cir., 109 TC 133 (1997), aff’d 11th

Cir.

ForeignCorp = CFC

ForeignCorp

US P/S or LLC

US Individual

45% value; 45 vote

35% value; 35% vote

20% vote & value

Foreign Corp is a “CFC” because the “US shareholders” (i.e., the US LLC and the US individual together own > 50% of the vote (and here, also 55% of the value). IF US individual owned only 5%, then there would be no CFC.

64


Definition of “US shareholder” broadened to include 10% of vote OR VALUE

• “US shareholder” was historically defined in § 951(b) as a “US person” that owns at least 10% of the foreign corporation’s VOTING stock . VALUE WAS IGNORED.

• The 2017 Tax Act amended § 951(b) to add a value test….so that a U.S. shareholder is now defined as any “US person” that owns (directly, indirectly, or constructively) at least 10 % of foreign corp’s voting stock OR 10 % of foreign corp’s VALUE.

• Value test is likely to import all the judicial and administrative IRS authority regarding control premiums, minority discounts, and in some instances, “drag-along” and “tag along” rights, valuation of beneficial ownership—making process of identifying “US shldrs” in complex family trust and/or corporate arrangement more complex.

• Effective date of new “US shldr” definition is prospective: Applies to CFC tax years beginning after 12/31/2017,and for taxable years of US shldrs in which or with which the CFC’s year ends. Sec. 14214(b), TCJA.

• “US person” includes US citizens, US residents, US C- corp, S Corps, partnerships formed in the US, Estates taxable in the U.S., and non-foreign trust

• For § 951(b) purposes (defining “US Shareholder”), stock ownership has always been computed, and continues to be computed, using the “direct” and “indirect through foreign entities” of § 958(a) AND the constructive attribution rules of § 958(b) (which incorporate § 318, but modifies them in significant ways)

• Although constructive ownership rules are used to identify “US shareholders” and “CFCs,” income is included in proportion to each US shldr’s direct and/or indirect ownership only! US shldrs are never subject to tax based on shares they own only constructively. See flush language of § 958,and confirmed in House Report and 2018 Notices.

– § 965: While constructive ownership can cause § 965 to apply, only the E&P of foreign corporations attributable to shares actually owned (directly and indirect) are deemed repatriated.

– § 951A: While constructive ownership can cause § 951A to apply, inclusion is based on shares of the CFC owned directly and indirectly (not constructively).




“US shareholder” broadened to include 10% of vote OR VALUE

• PRE- TCJA law: “US shareholder” defined as a US person owning stock representing 10% or more of the total voting power of all stock of the foreign corporation. § 951(b). (Ownership could be direct, indirect, or constructive.)

• Thus, a US person holding nonvoting preferred shares representing 10% of the VALUE was not treated as a “US shlder.” That US person could not be counted for purposes of determining whether a foreign corporation was a CFC. And, if it was a CFC, such shldr would not be subject to US taxation under Subpart F.

• POST-TCJA Law: TCJA expanded definition of “US shareholder” to include a US person owning shares representing 10% or more of the VALUE of all shares of the foreign corporation (regardless of the shareholder’s voting power).

• RIGHT: US individual qualifies as a “US shareholder” of the Foreign Corp because she owns stock representing at least 10% of the foreign corporation’s value.

• But IF the value of US individual’s shares is only 9% of the Foreign Corp’s total value, then US individual is not a “US shareholder” and her shares can not be counted to determine if Foreign Corp is a CFC. (Note that she also only owns 9% of vote.)

• Here, value of US individual’s shares is critical. If the value of her shares is only 9%, then Foreign Corp is not a CFC because US LLC does not own > 50% of vote or value. IF US individual’s shares can be counted (because she has at least 10% of total value, then her ownership counts, and together US LLC and US individual own shares totaling > 50% of the total value of Foreign Corp.


Tully Rinckey - Royse Law 66

Foreign Corp

US individual

Foreign persons

❖ Voting Common• 9 % vote• 6% value

❖ Nonvoting Preferred• 4% value of ForCorp

US LLC ❖ Voting Common• 41 % vote• 41% value


Attribution rules of § 958 (a) & (b)–different rules and different purposes

§ 958 contains the rules for determining stock ownership. Subsections (a) and (b) serve different purposes, and contain distinct rules.

§ 958(a)(1) - General Rule: For purposes of Subpart F (other than § 960(a)(1)), stock owned means—

• § 958(a)(1) and (2):

– stock owned directly (§ 958(a)(1) and

– Stock owned indirectly through foreign entities, including a foreign corporation, foreign partnership, foreign trust, or foreign estate. § 958(a)(2). (Do not attribute up through domestic entities.)

• US shlds are taxed only on their direct and indirect ownership as determined under §958(a)(1) & (2)—not on their constructive ownership.

• § 958(b) defines “constructive ownership” of stock, for purposes of identifying a

– “US shareholder” defined in § 951(b);

– “CFC” defined in § 957;

– “related person” as defined in § 954(d)(3); and

– US shldr(s) that has “invested in US property” under through domestic corporations, pursuant to §956(c)(2).

• § 958(b) expressly incorporates the familiar attribution rules of § 318(a), but modifies them in important ways with respect to attribution thresholds.



BEFORE the 2017 TCJA: How did § 958(b) modify the § 318(a) attribution rules, which § 958(b) expressly incorporates ?

PRE-TCJA:Section 958(b): Constructive attribution rules, for purposes of Subpart F, incorporate the

attribution rules of § 318, but modify them as follows:

1) NO NRA to US individual stock attribution: In applying § 318(a)(1)(A), no stock of a non-resident alien is to be attributed to a US citizen or a US resident alien for purposes of making the US individual a “US shareholder” or § 954(d)(3) “related person” or identifying a CFC;

2) Upward Attribution (i.e., up TO owners of entities from the entities): In applying §318(a)(2)(A) – (C), if a partnership, estate, trust, or corporation owns, directly or indirectly, more than 50 % of the total combined voting power of all classes of stock entitled to vote of a corporation, it shall be considered as owning ALL the stock entitled to vote. (Policy: effective control is assumed.)

3) In applying § 318(a)(2)(C), the phrase “10 percent” shall be substituted for the phrase “50 percent” used in subparagraph (C).

4) Downward Attribution rules of 318(a)(3)(A) –(C) are turned OFF: Such rules can never be applied so as attribute stock owned by a foreign person to a US person (e.g., to make the US person a US shareholder).




Repealed § 958(b)(4)’s limit on downward attribution

• The 2017 Act repealed IRC § 958(b)(4)…..RETROACTIVELY.

• This change is applicable to the last year of the foreign corporation that begins before Jan. 1, 2018 (and the taxable years of its US shareholders that end with or within the CFC’s taxable year). This means that for calendar year taxpayers, the repeal of § 958(b)(4) applies retroactively—i.e., to taxable years ending in 2017.

• Before its deletion from the US Tax Code, § 958(b)(4) provided:“ Subparagraphs (A), (B), and (C) of Section 318(a)(3) shall not be applied so as to consider a United States person as owning stock which is owned by a person who is not a United States person.”

– § 318(a)(3)(A) provides for downward attribution of stock ownership TO partnerships and estates . (The partnership/estate is treated as owning whatever the partner or estate owns.)

– § 318(a)(3)(B) provides for downward attribution of stock ownership TO trusts (exception for “remote contingent interests” in which case there is no downward attribution to the trust).

– § 318(a)(3)(C) provides for downward attribution of stock ownership TO corporations:

“If 50 percent or more in value of the stock in a corporation is owned, directly or indirectly, by or for any person, such corporation shall be considered as owning the stock owned, directly or indirectly, by or for such person.” *

* Note that the relevant threshold under § 318(a)(3)(C) is “AT LEAST 50%” of the value…



Repeal of § 958(b)(4) – Myriad Collateral Effects:“Pop-Up CFCs” & real, substantive Subpart F tax exposure\\\ IRC § 958(b)(4) and the Expanded Definition of a CFC

Foreign Parent(Non- CFC)

US ShareholderForeign

Shareholders10%

vote or value 90%

Foreign Sub1 Foreign Sub2 Foreign Sub3US Sub

• Prior to the TCJA, Foreign Subs 1, 2 and 3 were not CFCs

• Because Foreign Parent Co owns US Sub stock w/at least 50% total value, § 318(a)(3)(C) is triggered. Thus, ALL the stock owned by Foreign

Parent is treated as owned by US Sub--making US Sub both a § 951(b) “US shlr” and Foreign Subs 1, 2, and 3 “CFCs.”

• US Sub not taxed on constructive ownership (which is all it owns in this diagram).

• BUT the 10% US shlder (at the top) owns 10% of the CFC indirectly (through Foreign Corps) and thus IS taxed on its pro rata share of all Subpart

F earnings of Foreign Subs 1, 2, 3. Also, the indirect US Shldr could also have tax under §§ 956 (Earnings invested in US Property); §951A

(GILTI; § 965 Transition Tax (even though none of the foreign corps are “controlled” directly or indirectly by US shs.

• Here, advisors should review income and earnings of each CFC. Also, need to review loan documentation requiring guarantees

(because under of § 956 Investment in US Property, any CFC guarantee of a U.S. obligation could trigger a deemed dividend).

Borrower Guarantor Guarantor Guarantor

318(a)(3)(C): For Co owns at least 50% of US Sub by value…



Congress’ Repeal of § 958(b)(4): Myriad Collateral Damage – (intended or not?)

• The TCJA repealed a limitation on downward attribution of stock ownership to an entity from its owner

• This change applies beginning in the last taxable year of a foreign corporation that begins before Jan. 1, 2018 (and the taxable

years of its US shlders that end with or within the corporation’s taxable year). This means that for calendar year taxpayers,

the repeal of § 958(b)(4) applies retroactively—i.e., to taxable years ending in 2017.

• This is not just an outbound issue for U.S. shareholders.

• Without the old restriction of § 958(b)(4), a U.S. sub of a foreign parent company may be considered a U.S. shareholder of a

non-U.S. sister subsidiary of the foreign parent.

• Myriad Implications of this repeal, which were likely NOT intended by Congress:

– If foreign parent has a 10% direct or indirect U.S. direct or indirect shareholder (not constructive) such shareholder

could have Subpart F, §951AGILTI, IRC § 956, or other “phantom” income (not within the scope of the post-

inversion decontrol-of-CFC transactions;

– Foreign investors in U.S. corporations may cause their non-U.S. subsidiaries to become CFCs;

– Qualification for U.S. portfolio interest exemption for withholding may be implicated (i.e., lost! -- the foreign corporate

recipient of the US-source “portfolio interest” cannot qualify for the exemption if it is a CFC receiving interest from a

related person).

– Will often wreak havoc with PFIC/CFC overlap rules.

– Happily may cause the PFIC rules to not apply with respect to new § 951(b) “US shareholders”

– May cause § 1248 to apply, triggering “dividends” that qualify for the new § 245A DRD.



Effect of repeal of § 954(b)(4):

Obligation to file IRS Form 5471 • Repeal of § 958(b)(4) dramatically increases the number of US shareholders who are now required to file Form 5471.

• IRC § 6038: If any foreign corporation is treated as a CFC for any purpose under subpart F, the Secretary of Treasury may require any US person treated as a US shareholder (or officer or director) of such corporation to file an information return on Form 5471, providing information about the entity.

• IRS Form 5471, entitled “Information Return of US Persons with respect to Certain Foreign Corporations” is normally required to be filed with the US shareholder’s tax return. The US persons required to file, and the extent of the information they are required to provide on Form 5471, varied based on the person’s filing “category” (e.g., Category 2, 3, 4, or 5.)

• Under Category 5, a Form 5471 is required to be filed for each CFC with respect to which the US person is a “US shareholder.” (Form 5471 Instructions).

• Stiff Penalties for Failure to Timely File Form 5471: $10,000 for each annual accounting period (for each missing Form 5471). If any failure continues for more than 90 days after the day on which the Secretary mails notice of such failure to the United States person, such person shall pay [increased penalties] not exceeding $50,000 (for each foreign corp for which a Form 5471 was due). IRC § 6038(c).

• Failure to file a Form 5471 can also result in decreased foreign tax credits. IRC § 6038(c).

• Repeal of 958(b)(4), as well as expanded definition of “US shareholder” dramatically increases the number of CFCs and US shldrs, and therefore the obligation to file Forms 5471 (many being obligated with respect to their 2017 taxable years). But see “group filing exception” below.

• Fairness Concerns: US shldrs and US subs could get hit with substantial penalties for not reporting on the operations of foreign corporations over which they have no control and from which they will never be entitled to receive income (because their ownership is only constructive). The “Category 5” filing obligation can apply even when a US shldr is not otherwise subject to tax under subpart F.



Increased Obligation to file IRS Form 5471:

Notice 2018-13 provides limited relief

• General Rule: Notice 2018-13 provides limited relief for “constructive US shldrs” from obligation to file a Form 5471 but only with respect to “constructive” CFCs

• Specifically, in section 5.02 of the Notice (and echoed in Preamble or the Proposed 965 Regs) IRS announced its intent to “amend the Instructions for Form 5471 to provide an exception from Category 5 filing for a US person that is a US shareholder with respect to a CFC if:

(1) “no US shareholder (including such US person) owns, within the meaning of §958(a), stock (directly or indirectly) in such CFC, and

(2) the foreign corporation is a CFC solely because such US person is considered to own the stock of the CFC owned by a foreign person under § 318(a)(3).”

• Thus, a very limited exception! Basically, it is a “but for” test. If the foreign corp would not be a CFC but for the constructive ownership of the US shareholder (who owns no stock directly or indirectly), then a Form 5471 may not need to be filed. Also, it appears from language in the Notice, that no other US shareholder may hold ANY stock directly or indirectly. So…use caution when trying to fit within this narrow exception.

• Group filing exception to filing Form 5471: To alleviate redundant filings, a joint ownership exception generally allows one U.S. person to file a joint 5471 on behalf of other persons required to file the same information for the same CFC. Example: Only one Form 5471 for a CFC may need to be filed by a consolidated group even when there multiple Category 5 US shldrs due to expanded § 958(b) constructive ownership rules.

• When a U.S. person files a Form 5471 on behalf of a person that is not in its consolidated return group, the person relying on the exception must attach to its return a statement that identifies the filer and provides certain other information.

• Look for updated Instructions to Form 5471. Anticipate more guidance on Form 5471 filing obligations from IRS.



Repeal of § 958(b)(4):

Increases exposure to § 951(a), as well as§ 956, § 951A GILTI, and § 965 Transition Tax

• Not only can classification of the foreign sub as a CFC under § 318(a)(3)(C) increase exposure to taxation under § 951(a) (Foreign Personal Holding Company Income, Foreign Base Company Sale & Services Income and other categories of § 951(a) “Subpart F Income,” it can also trigger the application of many other tax provisions in the Code. For example:

• § 956 Earning Invested in U.S. Property: Where a foreign corp suddenly becomes a “CFC,” many types of transactions can be characterized as “deemed repatriations” under § 956 (e.g., loans, pledges of stock).

• GILTI Exposure under § 951A: applies to §951(b) “US shareholder” of a “CFC,” using the same exact same definitions and ownership thresholds. But as under § 951(a), § 951A GILTI tax is computed on with respect to shares actually owned (i.e., directly and indirectly).

• § 965 Transition Tax: The mandatory repatriation rules of 965 apply to “US shareholders” of “specified foreign corporations” (SPF) that have post-1986 E&P that was not previously taxed (or repatriated). A SPF is defined as a CFC or any foreign corporation that has at least one domestic C-Corp that is a § 951(b).

• §245A participation exemption: The DRD is denied with respect to “hybrid dividends” in certain tiered CFC structures.

• Many other provisions can be triggered, even though the underlying policy reasons for the application of those provisions is often not present.



Repeal of §958(b)(4):

Impact on application of §965 Transition Tax

• US Sub directly owns 9% of Foreign Sub, and, under revised section § 958(b), constructively owns the remaining 91% of Foreign Sub as a result of “downward attribution” of Foreign Parent’s ownership of Foreign Sub. US Sub is treated as wholly owning Foreign Sub, and Foreign Sub is an SFC for purposes of § 965.

• Thus, US Sub would have to include in income its pro rata share of Foreign Sub’s post-86 E&P under the mandatory repatriation rules of §965, although the amount of the inclusion would be based solely on its direct and indirect ownership (9%) of Foreign Sub, and only take into account E&P earned by Foreign Sub during periods Foreign Sub qualified as an “SFC.”

• FTCs: foreign income taxes paid or accrued by Foreign Sub would not be attributed to US Sub’s mandatory repatriation inclusion because US Sub owns < 10% of Foreign Sub’s voting stock (as determined under the relevant rules).



Foreign Parent

US Sub

Foreign Sub

100%

91% 9%

Repeal of § 958(b)(4) – Collateral Effects:

Could Disqualify Foreign Corporate Recipient from Eligibility for US Portfolio Interest Exemption

• A CFC cannot qualify for the all important US Portfolio Interest Exemption if it received interest from a “related person.” § 881(c)(3)(C).

• Excluded from the definition of “portfolio interest” is interest “received by a CFC from a related person” (within meaning of §864(d)(4)/ § 267(b), (f).

• Because TCJA repealed §958(b)(4), the downward attribution rules of §318(a)(3) are no longer “turned off,” and are operative beginning with foreign corporation’s tax years beginning before 12/31/2018.

• Because Foreign Partnership owns at least 50% of the value in US Portfolio Corporate Fund, such Fund is deemed to own all the stock that Foreign P/S owns. (Same rule would apply if F-1 owned at 50% of the value). Therefore, under §318(a)(2), US Portfolio Fund constructively owns 60% of F-2, making it a “US shldr” and making F-2 a CFC.

• Suddenly, F-2 (a CFC) cannot qualify for the US Portfolio interest exemption because F-2 is a CFC receiving the interest from a “related person” within the meaning of §267(b), (f)

• A lot of restructuring has been (or must be) done to get around this sudden loss of the US Portfolio Interest Exemption…(lost retroactively for taxable year beginning before 2018).



F-1

US Portfolio

FUNDF-2

loan

Interest payments (often

exempted from US 30% withholding tax if they qualify as “portfolio interest”)

P/S owns 55% of US Portfolio Fund

ForeignP/S

60%

F-1

Repeal of § 958(b)(4) – Collateral Effects:

Could wreak havoc with PFIC/CFC overlap rules

• TCJA’s removal of § 958(b)(4) from the Internal Revenue Code will cause some PFICs to become “CFCs” and subject to CFC rules, instead of the dreaded PFIC rules. (A “good thing” usually…)

• § 1297(d): a foreign corporation that is a CFC as to any U.S. inclusion shareholder cannot be a PFIC. Many may find this is a happy consequence of the repeal of §958(b)(4) since it may help some avoid the horrid PFIC rules. (Some may have even tried to qualify for the CFC regime instead of the PFIC regime but failed. Application of 318(a)(3) can help in that instance.)

• Eligibility for §245A Deduction. Dividends from a PFIC do not qualify for the §245A deduction, but dividends from a CFC do. (Thus, where repeal of §958(b)(4) causes a foreign corp that would have been a PFIC to become a CFC, a US shlder that is a “corporation” will be allowed the deduction.

• Pop-Up PFICs: A foreign corporation can be a PFIC with respect to non 951(b) shldrs (owning < 10%) and a CFC with respect to § 951(b) shldrs. Under §1297(e)(2), if the foreign corporation is a CFC (and not publicly traded), it is required to apply the PFIC asset test of §1297(a)(2) by reference to the adjusted basis, rather the fair market value, of its assets. This will often cause the corporation to be treated as a PFIC when it would not have otherwise qualified had the FMV test applied.

• PFIC Parent, CFC Sub. Recall the simplest example of a “faux CFC” (i.e., foreign sub of a foreign parent that happens to own a US sub). Although the results in such a case might merely be annoying, like having to file Form 5471, there is a possibility that foreign parent in such a case might be a PFIC as to some U.S. shareholders, with very strange results since a PFIC would then own a “faux CFC.” *

• * See K. Blanchard, Top Ten Reasons to Limit 958(b)(4) Repeal, 47:6 TAX MNGMT, INT’L J. (2018)




More unintended consequences of § 958(b)(4)’s repeal (a non-exclusive list)

• Qualifying for the 245A Participation Exemption: US shareholder that sells stock in a “faux CFC” may have a §1248 “dividend” that can qualify for the §245A DRD. (“A good thing.”)

• Basis bump-ups and more PTI: Inclusions of any extra Subpart F and/or GILTI income can give rise to positive basis adjustments under §961 and create PTI for purposes of §959 and §965. (“A good thing.”)

• Portfolio Interest Exemption: Section 881(c)(3)(C) and §881(c)(5) limit the availability of the US Portfolio Interest Exemption as applied to interest paid to CFCs by “related persons.” Clearly, the policy underlying these restrictions is not implicated in the case of a faux CFC.

• Expatriations: §877 provides punitive tax rules for US citizens or long-term green card holders who expatriate. §877(d)(1)(C) and §877(d)(4) punish expatriates who own or form CFCs (apparently including these “faux CFCs” that pop-up due to the repeal of § 958(b)(4).

• Subpart F Insurance Income. Repeal of § 958(b)(4) makes it easier to create income under § 953, which was already sweepingly broad. A US tax-exempt org may be subject to the UBIT (Unrelated Business Income Tax) if it is a shareholder of a faux CFC that has insurance income. §512(b)(17).

• Downward E&P adjustments under § 312(m). § 312(m) prohibits a downward adjustment to E&P of a foreign corporation that pays interest on an obligation that fails to meet the registration requirements of §163(f). This punitive rule does not apply to a foreign corporation that is not a CFC and does not have a tax-avoidance purpose. However, if a foreign corporation is a CFC, it will be subject to the punitive rule, regardless of its purpose.

• International Shipping & Aircraft Income. § 883 generally exempts income earned by foreign corps from intern’l ships and aircraft so long as the foreign corp is not “treaty shopping” and resides in a country granting US carriers an similar exemption. § 883(c)(2) turns off the treaty shopping restriction for CFCs.



https://www.bloomberglaw.com/product/tax/bc/W1siRG9jdW1lbnQiLCIvcHJvZHVjdC90YXgvZG9jdW1lbnQvWDdUOVRPVTAwMDAwMDA_ZG9jX2lkPVg3VDlUT1UwMDAwMDAwJmRvY190eXBlPUxBV19SRVBPUlRTJnJlbW92ZV9qcz1mYWxzZSJdXQ--f546a29010a819f4ad47d1cdb13dee763b4f8f2f/document/1?citation=26%20usc%20881(c)(3)(c)&summary=yes


Repeal of “uninterrupted 30-day ownership” test

• PRE- TCJA: Income earned by a foreign corporation that would otherwise qualify as Subpart F income of a CFC was not subject to U.S. tax if the foreign corporation was not a “CFC” for an uninterrupted period of at least 30 days. § 951(a).

– Example: Assume a foreign corporation with one class of stock and a December 31st year end met qualified as a “CFC” during its last month because a US person acquired more than 50% of its stock on Dec. 3rd. Because the foreign corporation would not have qualified as a CFC for an uninterrupted period of 30 days during its taxable year, the US shareholder will not have any inclusion under 951(a) for the year of the acquisition.

• TCJA repealed this 30-day rule. Sec. 14215(a), TCJA.

• POST-TCJA: Now, a US shldr will be taxed on its pro rata share of Subpart F income even if the foreign corporation qualifies as a “CFC” for only ONE DAY, provided the US owns the CFC on the last day of the CFC’s tax year.

• New rule is effective prospectively: Repeal of the 30-day rule is effective for tax years of foreign corporations beginning after December 31, 2017, and taxable years of U.S. Shareholders in which or with which those taxable years of a foreign corporation end.



New § 951A “Global Intangible Low Taxed Income”

(GILTI)-----------

Basic M&A Planning Considerations



New § 951A Global Intangible Low Taxed Income - “GILTI”• New “GILTI” tax under § 951A: Although not technically a new category of Subpart F income, new

§951A taxes “US shs” of a CFC on a sweeping new basis, functioning as sort of a residual “minimum tax.”

• Specifically, new § 951A imposes US tax on 10% (or greater) US shldrs (as defined in amended § 951(b)) on “tested income” of their CFCs.

• ‘Tested income’’ is: all gross income, less allocable expenses, other than income already taxed as (i) ECI, (ii) Subpart F income, (iii) income excluded from Subpart F by virtue of the high-taxed “kick out” exception, (iv) dividends from §954(d)(3) “related persons,” and (v) any foreign oil & gas extraction income. (Thus, tested income is likely to comprise a large portion of the operating income of many CFCs.)

• GILTI may be taxed at a lower 10.5% rate (lower than capital gains of C Corps): “US shldrs” (10%) that are “C -Corporations,” can deduct 50% of their GILTI inclusions under new § 250, which can result in a rate of approximately 10.5% .

• Foreign Tax Credits: As with Subpart F income or actual repatriation under pre-TCJA law, an indirect FTC is available on GILTI for foreign income taxes imposed at the CFC level on its tested income. § 960(d). However, all foreign taxes on GILTI income can get no more than an 80% FTC (20% is disallowed), and placed in a separate § 904 FTC basket with no carrybacks/carryforwards. Thus, obtaining full utilization of the FTCs associated with GILTI will be more difficult that under prior law. See discussion of “Affirmative Subpart F Planning” below.

• GILTI inclusion = CFCs’ “net tested income” (measured at shldr level and less losses in the same tested income category) that exceeds a fictional deemed return on investment which is basically 10% of a CFC’s aggregate tax basis in tangible property used by the CFC in producing tested income. §951A(d)(1). This type of income that can be exempted is based on QBAI (“qualified business asset investment”). This sliver of QBAI—the notional net deemed 10% return on tangible assets– is essentially never subject to US tax, even when actually repatriated.



New § 951A GILTI kills the “Check & Sell (Assets) Deals

Dover makes a retroactive Check-the-Box Election to be treated as selling assets (not stock) for US tax purposes

Assumed facts: • U.S. parent, Dover, owns CFC1 (Dover UK), which owns

CFC 2, the foreign target.

• Dover U.K contracts to sell Target STOCK to Foreign Buyer. The gain on the stock sale is likely to be “foreign personal holding company income” under Sec. 954(c) and thus taxable under Subpart F. When Dover realizes this, it makes a retroactive Check-the-Box election (after the sale closes!!) to treat the Target as a tax transparent entity for U.S. tax purposes. This election causes (1) a deemed liquidation of the Target, and (2) a deemed sale of its ASSETS (even though the stock is what is actually being sold , and the UK sees it as a stock sale.)

• Under pre-TCJA law, a deemed sale of CFC2’s assets used in its trade or business generally escapes Subpart F income (due to an exception for sales of active trade/business assets).

• But post-TCJA, even though the deemed asset sale escapes immediate taxation under Subpart F, the gain will likely constitute “tested income” for GILTI purposes.

• Thus, the U.S. parent would include the gain from the deemed sale of assets in GILTI. (Check-and-Sell deal’s benefits are nullified.)See Dover v. Commissioner, 122 TC 324 (2004).



Dover U.S.

Dover U.K

(CFC-1)

Foreign Target

(CFC-2)

Foreign Buyer

(1) Dover agrees to sell

Target’s STOCK

(2)Deemed liquidation, as a result of check-the-box election. Thus, actual stock sale is treated as a deemed sale of ASSETS for US tax purposes.

§ 951A – M&A strategy: Consider planning “into” Subpart F to avoid GILTI• To the extent a CFC’s income is included as “Subpart F income,” it cannot be GILTI income (by

definition)

• Advantages of Subpart F income (as compared to GILTI)

– “Excess foreign tax credits” can be utilized (with a 10-year carry forward). Unused GILTI FTCs cannot be carried back or forward to other years (they are just lost)

– Foreign tax credits associated with Subpart F income are not stuck in the “GILTI FTC basket” but can be cross-credited against other “general basket income, and are otherwise subject to the 10-year carryforward.

• Alternatively, elect the “high tax exception” to Subpart F under § 954(b)(4).

• How to get a “true territorial” result ?

– Take advantage of the “High Tax Exception”: Taxpayers may elect to exclude income from Subpart F IF the income is subject to a foreign tax rate of > 90% of the maximum US rate (i.e., > 18.9%). §954(b)(4); Regs. §1.954-1(d).

– Income excluded under the Subpart F “High Tax Kick-out Exception” is NOT subject to EITHER Subpart F or GILTI. § 951A(c)(2)(A)(i)(III).

– Thus, the income will enjoy DEFERRAL from U.S. taxation….AND it is eligible for the “participation exemption” (i.e., the 100% DRD) under new §245A !

• Section 904(b)(4) may apply to any allocable shareholder – level expenses.



Comparing US statutory tax rates & limits on FTC utilization

§245ADRD

§951(a)Subpart F

§951AGILTI

Foreign branch

§956 Invest US property

§250 FDII

Non-FDII

Effective rates (%)

0 21 10.5 21 21 13.125 21

Foreign tax credits (%)

None 100% 80% 100% 100% 100% 100%

FTCCarryforward

None 10-yrs None 10-yrs 10-yrs 10-yrs 10-yrs

Other Creates exempt income/partially exempt asset

For corps, PTI generally means little 245A

GL or passive

Separate Basket

Separate Basket

Converts Exempt Income

Multiple year FTCs?

Most income U.S. source – no FTCs

Most income U.S. source –no FTCs

Avoid/get in FDII

Offshore Onshore



Some Post 2017-Tax Act Strategies to consider using the Check-the-Box Election

• Consider converting the U.S. investor making an investment abroad into a a C-Corporation if it will have CFCs (But caution: election could trigger tax under §7874 and/or § 367(a) or (d) (now almost impossible to transfer intangibles outside US without tax due to amendments to § 367).

• Consider “planning into” Subpart F. (Why??? --to avoid GILTI as the results under GILTI could be worse, due to foreign tax credit limitations,despite lower, preferential tax rate! It is easy to plan into Subpart F – e.g., create a branch to have services performed outside the CFC’s cy of incorporation.)

• Check-the-box to flow-through status to combine QBAI in a chain of CFCd where one CFC is an “income CFC” and another is a “loss CFC” (more QBAI means less GILTI exposure)

• Check-and-Sell Transactions (Remember, tax stakes are changed because a §1248 “dividend” is eligible for the § 245A DRD.



New § 951A GILTI – Key M&A Take Aways

• M&A Take Away: Although “tested income” is likely to comprise a big percentage of many CFC’s operating income, GILTI can only be earned by a CFC—not a 10/50 corporation. Thus, in disposing of a foreign corporation, this may raise planning opportunities (could dispose of shares or assets in a 10/50 corporation without triggering GILTI).

• M&A Take Away: Although modeling and running the numbers will usually be needed in more complex transactions, there are a few rules of thumb on when it may be wise to “plan into” GILTI and when to avoid GILTI:

– Avoid if US shareholder of the CFC is NOT a C Corporation (and cannot become one, or cannot make a Sec. 962 election). Reason: cannot qualify for the 50% deduction under §250, so could have a LOT of phantom income at full marginal rates (not 10.5% rate). Also, may want to avoid GILTI if US shareholder has a lot of excess foreign tax credits.

– Maybe “plan into” GILTI (or don’t fear it if) the CFCs in question own a lot of tangible, depreciable trade-and-biz assets, which can generate a lot of QBAI (qualified business asset investment), which is exempt from U.S. tax, even when repatriated.

• M&A Take Away: Deemed asset sales, even if the gain is exempted from Subpart F, are likely to produce more total gain in the form of GILTI under new § 951A. This factor will greatly impact both “check-& -sell-assets” transactions and §338(g) deemed asset sales—both of which formerly often escaped current US taxation when T was a CFC due to exceptions for sales of T/Biz assets in Subpart F Regs.)

• M&A Take-Away: However, because GILTI is often taxed to corporate US shareholders at effective rates as low as 10.5%, GILTI can effectively reduce the overall tax to the Seller depending on the facts.



Acquiring or Selling/Disposing of a U.S.-owned foreign subsidiary:

Tax Considerations



- Overview of Stakes –

Stock Deal or Assets Deal?

Taxable (or tax-deferred)?

Under U.S. tax law, there are 4 principal ways to acquire a target company:

• Taxable purchase of target corp’s stock

• Taxable purchase of target’s corp’s assets

• “Tax free” acquisition of stock in a qualified corporate reorganization exchange

• “Tax free” acquisition of assets in a qualified corporate reorganization exchange

In any M&A analysis of a desired acquisition, there are at least 2 fundamental threshold TAX questions that need to be asked up, front apart from the overall business objectives of the client:

(1) Should it be an “assets deal” or “stock deal”?

(2) Should US tax be deferred (if that’s possible), or does client want the transaction to be regarded as currently recognized for US tax purposes?

Section 338 election--including the basic §338(g) election and the more popular §338(h)(10) election--involve acquisitions that are currently “recognized” for US tax purposes—i.e., “taxable”—not just realized, but “tax deferred” through the mechanism of a carry-over tax basis to the Acquiror. § § 362(b), 334(b). If the acquisition is taxable, the Acquiror generally gets a “cost basis.” § 1012.



- Overview of Stakes –

Purchaser’s Basic Business & Tax Considerations

• From business, legal, and administrative perspective, the purchaser (“P”) of a corporate business often prefers buying a corporation’s STOCK rather than assets because

– A stock purchase is much easier to accomplish

– A stock purchase usually avoids disruption of Target’s contractual & other relationships regarding the assets (e.g., leases).

• But from tax perspective, a corporate P often prefers to buy T’s assets because, among many factors:– P can obtain a higher “cost” basis in assets, which is valuable due to present value of

depreciation/amortization deductions. And, post 2017 TCJA, a higher depreciable basis in tangible assets provides a QBAI cushion against imposition of the new GILTI tax under § 951A…(see in-depth analysis of this and other factors, with examples below)

• In general: If certain requirements are met, a § 338 election affords a corporate P the business & legal convenience of a stock purchase, but with the tax benefits of an asset purchase by allowing the P to elect to treat the stock purchase as an asset purchase for federal income tax purposes.



The § 338(g) Election Mechanism (p.1)

• A corporation that purchases at least 80%, by vote and value, of the stock of a Target corporation (excluding certain nonvoting preferred) within a 12-month period (i.e., a “qualified stock purchase” or “QSP”) can elect irrevocably to treat the stock purchase as an asset acquisition.

• Deemed Asset Sale: If the § 338(g) election is made, the Target Corp (“Old T”) is treated (for tax purposes only) as if it sold all of its assets to itself (i.e., “New Target”) at the close of the first day on which the Purchaser has acquired 80% of Old Target's stock (i.e., the “acquisition date”).

• The Target is then treated as a new corporation (i.e., “New T”), unrelated to Old T, that purchases, on the day after the “acquisition date,” Old T’s assets at a price that reflects the price paid for T’s stock, adjusted for the Target's liabilities and other items.

• Stepped Up Asset Basis: Thus, a principal effect of this deemed asset sale is that New Target's acquires an aggregate basis in its assets that is “stepped up” (or down) under §1012 to the FMV price that the unrelated Purchaser actually paid for Old Target's stock (adjusted for assumed liabilities and other items).

• Allocation of Basis Required: New T is required to allocate the deemed purchase price among its assets according to a prescribed “residual method” under IRC §1060, which can get complicated… (Must compute “adjusted grossed Up Basis”).

• Old Target’s tax attributes are extinguished, and New Target starts a new life with a clean slate of tax attributes. (Note that PTI accounts are wiped clean in a 338(g) election, which may not be good for Purchaser if there were huge PTI accounts.)




• Price for Purchaser’s Stepped Up Asset Basis: Two levels of tax recognized transactions:

(1) the stock sale is taxable (indeed, it is required to be a “qualified stock PURCHASE”), and

(2) the deemed asset sale is fully recognized for US tax purposes.

• The deemed asset sale is treated as though it were a fully taxable transaction to the Target Corporation, although the gains may be offset by Target’s tax attributes (e.g., NOLs). (Deemed asset sale not visible to the foreign jurisdiction...which prior to 2010 Hire Act created opportunity to hype FTCs. But see § 901(m)).

• Thus, unless a § 338(h)(10) election is made (and § 338(h)(10) election is NEVER available for a non-US target) the price for New T’s basis step-up is a doubly tax recognized transaction: one level of tax incurred by S on the sale of the Target stock and another level or tax Old T’s deemed sale of its assets.

• Why can’t parties elect § 338(h)(10) for a foreign target? Because a §338(h)(1)election can only be made if Target is:

(i) a domestic corporation that is a subsidiary member of a consolidated group,

(ii) a domestic corporation that is a subsidiary member of an affiliated group not filing a consolidated return, or

(iii) an S corporation (as defined in § 1361). Reg. §1.338(h)(10)-1(c)(1).




• Which party is really bearing the US Tax Burden of a § 338(g) Election?? (It depends…but new provisions of TCJA are likely to create more gain…)

• If T is a CFC, Old Target’s deemed asset sale often qualify for exceptions to Subpart F income—for example, the exception to § 954(c) “Foreign Personal Holding Company Income” set forth in Reg. §1.954-2(e)(3) for depreciable T/biz assets. (Need to also test under § 954(d) for FBC Sales income.) And this is why § 338(g) elections and “Check & Sell” transactions were often used prior to the 2017 TCJA.

• But after the 2017 TCJA, the deemed asset sale will likely give rise to GILTI income--i.e., more actual GAIN even if Subpart F inclusions are avoided. GILTI income is currently recognized to §951(b) “US Shldrs”) under new § 951A…with other ramifications analyzed below.

• Seller is responsible for any tax liability arising from the stock sale. The deemed asset sale triggered in a § 338(g) election occurs on the “acquisition date,” and any tax liability resulting from the deemed asset sale is Old Target's (Old T’s) liability (i.e., from the US tax perspective…Obviously, the deemed asset sale is not recognized for foreign law purposes!)

• But, absent contractual provisions to the contrary, the US income tax liability resulting from the deemed fictional asset sale could be borne economically by Purchaser because it is the owner of New Target and New T inherits Old T's tax liabilities.

• NOTE: the Purchaser makes the § 338(g) unilaterally, and yet it can have a huge effect on the Seller (who may never have agreed to it)! Thus, it is very important for parties (especially Seller who doesn’t have the power under the Code to make the 338(g) election unilaterally) to have contractual provisions in the M&A documents, and on the M&A checklist. Parties need to agree on whether the §388(g) election will be made…



§ 338(g) Mechanism - (p.4)

• Purchasing Corp must make a “qualified stock purchase” (QSP), defined as transaction (or series of transactions) where 1 corp acquires by “purchase” 80% control of Target’s stock during the 12-month “acquisition period.”

• 80% control means at least 80% voting power and value

• Share acquisitions may be over 12 months, but must be by “purchase” (thus excluding shares acquired by gift, inheritance, tax-free reorgs, and certain related-person transfers, etc.).

• Purchaser must be a corporation, and cannot be an individual or a partnership.

• However, neither Purchasing Corp nor Target need be US corporations. See IRS Chief Counsel Advice 2007-006.

• Purchasing Corp. may elect s338(g) unilaterally without the consent of the Seller or Target (unless contractually bound to get consent, which should always be on Seller’s M&A checklist).

• Deadline: Must elect no later than 15th day of 9th

month beginning after the month in which the “acquisition date” occurs (which is the day within the 12-month period on which 80% control was acquired. (Example:

• The § 338(g) election is irrevocable.

• Procedure for late § 338 elections. 93

Non-US Target Corp.

Non-US Shrhldrs

Cash

Target Stock

Purchaser US Corp.

Appreciated Assets(Value > a/b)



Paradigm example of § 338(g) Election with CFC Target

(1) Initial Structure (2) T Acquisition (July 1st)

94

PurchaserUS Corp.

SellerUS shldr

Foreign T(CFC)

PurchaserUS Corp.

SellerUS shldr

Foreign T(CFC)

Cash

Assumed Facts:• P elects 338(g) unilaterally.

• Where T is a CFC, results of the deemed asset sale generally affect the SELLER. Reg. §1.338-9(b)(2).

• If Seller does not want those effects, should so specify in the SPA, requiring at minimum, S’s consent.



Paradigm example of §338(g) Election with CFC Target (cont.)

(3) Deemed Asset Sale

(at close of Day, July 1st)

(4) Deemed Asset Purchase

(Beginning of July 2nd)

95

SellerUS shldr

Old Target(CFC)

PurchaserUS Corp.

Seller US shldr

New Target (CFC)

Fictitious Buyer

(“New T”)

Old T deemed to “SELL” all of its assets to New T in a FICTIONAL ASSET SALE for cash.

• Potential “deemed dividends” of Subpart F income (and GILTI) from deemed asset sale by T. § 951(a), § 951A GILTI

• Gain recognized by S may be wholly or partially characterized as OI by S under §1248…and thus eligible for § 245A DRD. § 1248(j)

• Before this recharacterization takes place, however, S may recognize Sub-F income, and/or GILTI on the deemed sale, which will increase the “1248 amount” as defined.

• Gain recognized will affect S’s basis in the stock for purposes of determining total amount of gain to be recognized.

FictitiousSeller

(“Old T”)New T deemed to “PURCHASE” all of Old T’s assets for cash at FMVEmerging Impact of US Tax Reform on


Paradigm example of §338(g) Election with CFC Target (cont.)

(5) After Transaction

96

PurchaserUS Corp.

Seller US shldr

New Target (CFC)

• New Target has “stepped up basis” in the acquired assets through the fictional asset sale.• Tax attributes are purged.

S has CASH from the QSP.



(All this “deeming” seems dumb!)

Why is the § 338(g) Election so crazy and illogical?

• How did a real stock sale come to be treated as a deemed asset sale?

• Why on earth would a Purchaser want to elect §338(g)--and how could P get S to agree to the § 338(g)election in the M&A docs-- and pay TWO levels of tax up front in a transaction, when P&S could pay just one level of tax between them? (How could the present value of any depreciation & amortization deductions be worth that much?)

• ANSWER: The deductions probably aren’t worth that much (i.e., unless some of the taxes are sheltered by tax attributes) …and the origin of § 338’s “fictional, deemed asset sale” is found, as so often the case in tax law, in the HISTORY of § 338!



§ 338(g) Election – Historical Evolution of how a

Stock Sale came to be treated as a Deemed Asset Sale• Pre 1954 Tax Act: US Courts applied an elusive “intent standard.”

• 1950 seminal case (no longer the law): Kimbell-Diamond Milling Co. v. CIR, 14 T.C. 74 (1950), affd. 287 F.2d 718 (5th Cir. 1951). Milling company (KD) purchased stock of a another milling company (“target” or “T”) after its own plant was destroyed by fire. KD argued it should acquire a carryover basis in T’s assets, since it bought T’s stock. IRS argued transaction should be treated, in substance, as an asset deal—with KD getting only a “cost basis” in the assets equal to what it paid for the stock. Tax Court agreed with IRS, finding KD’s sole intent was to acquire T’s assets (KD liquidated T 3 days after stock purchase). HELD: KD (Buyer) should be treated as directly acquiring T’s assets as the stock purchase was merely a transitory step in the asset acquisition. Thus, KD must take “cost basis” in the assets equal to what it paid for T’s stock.

• Kimbell-Diamond doctrine codified in 1954 as (former) §334(b)(2) in 1954 Tax Act to replace elusive “intent test” with ostensibly more “objective test.” Thus, old §334(b)(2) allowed a Parent Corp to step up basis of its sub’s assets if Parent (a) acquired at least 80% of the Sub’s stock in fully taxable purchase during a 12-month period and (b) caused Sub to liquidate pursuant to a plan of LQ adopted w/in 2 yrs of purchase. Sub recognized gain on LQ as if it had sold its assets, and its tax attributes were extinguished. Purchaser was treated as if it purchased assets—taking a cost basis approximately equal to what it paid for the T stock (rather than a transferred basis, which usually results from a complete liquidation of controlled T Sub). Old §334(b)(2) was criticized as being very complex w/pitfalls.

• 1982: § 338 (election) enacted (with policy goal of simplification) allowing Purchasing Corp to ELECT to treat certain 80% stock purchases as asset purchases, in order to allow Purchasing Corp to take a higher, depreciable tax basis in those assets…(if certain requirements were met, which were borrowed from KD doctrine).



§ 338(g) Election – Historical Evolution (Cont’d)

• Originally, § 338(g) election triggered only ONE level of tax: Between 1982 and 1986, §338 functioned in the context of the Gen. Utilities doctrine, as codified by (former) §337. Under old §337, a corp generally recognized no gain or loss on sale of its assets after adopting a Plan of Liquidation.

• Nonrecognition was subject to certain exceptions, the most significant of which were depreciation recapture under §1245 and §1250 and investment tax credit recapture.

• Thus, until General Utilities repeal in the 1986 Act, a sale of a target's assets followed by a LQ of Target generally resulted in only ONE level of federal income tax—i.e., the tax incurred by T shldrs on their exchange of their shares for LQ proceeds (plus target-level recapture income).

• Combined effect of §338(g) election in context of old 337 meant that Purchaser could acquire a §1012 step-up in T’s asset bases, at cost of a single layer of fed income tax imposed on T’s shldrs.

• Repeal of Gen Utilities doctrine in 1986 Act radically altered the impact of §338 and introduced distortions, particularly in the consistency rules.

• After 1986 Act, §338 meant double taxation (absent a §338(h)(10) election), and so 338(g) elections generally became undesirable in purely domestic context. § 338(h)(10) elections became the common tool planning tool in domestic context.

• But § 388(g) elections were and are still viable in cross-border context—in purchases of foreign corporations (CFCs). Recall that § 338(h)(10) cannot be elected where the Target is foreign.

• In a 338(g) election, neither Purchasing Corp nor Target need be US corporations—both can be foreign. See IRS Chief Counsel Advice 2007-006.



Mechanics of Electing § 338(g) – Must have a “QSP”

• P must make a QSP: Purchasing Corp must make a

“qualified stock purchase” defined as transaction (or series of

transactions) where 1 corp acquires by “purchase” 80%

control of Target’s stock during the 12-month “acquisition

period.”

• 80% control means at least 80% voting power and value

• Share acquisitions may be over 12 months, but must be by

“purchase” (thus excluding shares acquired by gift,

inheritance, tax-free reorgs, and certain related-person

transfers, etc.).

• Purchaser must be a corporation, and cannot be an

individual or a partnership.

• However, neither Purchasing Corp nor Target need be

US corporations. See IRS Chief Counsel Advice 2007-

006.

• Purchasing Corp. may elect s338(g) unilaterally without

the consent of the Seller or Target (unless contractually

bound to get consent, which should always be on Seller’s

M&A checklist).

• Deadline: Must elect no later than 15th day of 9th month

beginning after the month in which the “acquisition date”

occurs (which is the day within the 12-month period on

which 80% control was acquired.

• Use IRS Form 8023 to make the § 338(g) election.

• The § 338(g) election is irrevocable.

• § 9100 Relief for LATE § 338 elections: Rev. Proc. 2003-33 provides that in accordance with § 301.9100-3, an extension of 12 months from the date of discovery of the failure to file a timely § 338 election is automatically granted to any person described therein. 100

Non-US Target Corp.

Non-US Shrhldrs

Cash

Target Stock

US Purchaser

Corp.

Appreciated Assets (Value> tax basis)



New TCJA provisions & factors in the § 338(g) analysis• New lower 21% US corporate tax rate: For post-2017 tax years, the top federal corporate income tax rate was

lowered 14 points.

• New “GILTI” tax under § 951A: Although not technically a new category of Subpart F income, it taxes “US shs” of CFC on a sweeping new basis, functioning as sort of a residual “minimum tax.” Specifically, new § 951A imposes US tax on 10% (or greater) US shldrs (as defined in amended § 951(b)) on “tested income” of their CFCs.

• § 902 Indirect Credit Repealed: Prior to its repeal, § 902 allowed US Shs of CFCs that received an “dividend” to credit the foreign taxes paid on the CFC’s earnings out of which the dividend was paid (or deemed paid). Deemed “dividends” under 1248 were also allowed a § 902 indirect credit. The § 902 credit was replaced by the § 245A DRD. The indirect § 960 FTC (for Subpart F deemed divs) was retained, but amended.

• New § 245A - a limited “participation exemption”: “US shareholders” (as defined in 951(b)) that are C Corps, can deduct 100% of “dividends” received from their CFCs or “specified foreign corporations” is a one-year holding period is satisfied. (HP is 1year within the 2-yr period surrounding ex-dividend date). A “specified foreign corp” is defined as any foreign corporation that has at least one 10% corporate shlder that would qualify as a § 951(b) shldr if the foreign corporation were a CFC.

• § 245A can be material factor for CFCs with large amounts of exempt QBAI. (Indeed, § 245A can work as an incentive for Purchasers to get higher-bases depreciable tangible assets that generate QBAI, because that sliver of notional income can be repatriated tax free.

• Because the § 245A DRD is available to Corporate shareholders (owning at least 10%) of so-called 10/50 corporations, and such non-CFCs cannot generate GILTI, a greater percentage of such 10/50 corporations’ earnings may be eligible for the § 245A DRD.



New 2017 Tax Act provisions & considerations (cont’d)

• § 1248 retained: Under §1248, gain on the Sale/Exchg stock of a foreign corporation (FC)--whether or not a CFC at time of sale--by a person who was a 10% U.S. shldr” at any time during the preceding 5 years while the FC was a CFC, is recharacterized as a dividend to the extent of the post-1962 accumulated E&P of the FC “attributable” to such stock and only for periods during which the 10% US shldr held the stock while the FC was a CFC. The E&P so computed is called “the 1248 amount” in the Regs.

– Prior to elimination of the Capital Gains preference for corporations in 1986, § 1248 functioned as an anti-abuse provision to prevent Tps from turning capital gains into OI.

– After 1986, and before the 2017 Tax Act, § 1248 was used as a vehicle to bring up indirect foreign tax credits under § 902.

• New § 1248(j): “In the case of a sale or exchange by a domestic corporation of stock in a foreign corporation held for 1 year or more, any amount received by a domestic corporation…treated as a dividend by reason of this section shall [be eligible] for the section 245A [100% DRD].”

• New § 964(e): It extends the 100% DRD of 245A to sales of lower-tier CFC stock by upper-tier CFCs where the application of 1248 and 964(e) results in a deemed dividend. (Prior to the 2017 Act, this CFC-to CFC dividend would have been excluded under 954(c)(6).) The HP requirements for 245A DRD apply, so CFC-to-CFC dividends may result in Subpart F income.



Results of CFC purchase WITHOUT a 338(g) Election

Assume a US shareholder is selling its interest in a CFC -

Results with NO § 338(g) Election:

Gain recognized by a US corporation on its sale of CFC stock is recharacterized as a dividend

under §1248 to the extent of the previously untaxed post-1962 E&P of the CFC and its subs

(i.e., the “§ 1248 amount”).

• The § 1248 “dividend” is eligible” for the 100% DRD under new § 245A (holding period

requirement must be satisfied).

• Any remaining capital gain is subject to a 21% tax rate.

• Taxable year of Target does not close for US tax purposes.

• Thus, a domestic Purchaser (rather than the Seller) generally is subject to tax on any Subpart F income and GILTI of the CFC for the entire year of sale, but reduced by the amount of current year earnings treated as a dividend distributed to Seller, including any amount recharacterized as a dividend under § 1248.



Results of CFC purchase WITH a 338(g) Election

Assume a US shareholder is selling its interest in a CFC ---

Results with WITH a § 338(g) Election:

• Target CFC is deemed to sell its all its assets to New Target. Old T recognizes any gain (and losses) resulting from the deemed asset sale.

• If Seller is a US corporation, the CFC Target’s gain on non-trade/bizs may be Subpart F income; any other gains would likely be “tested income” for GILTI purposes and taxed at 10.5%.

• CFC Target’s tax year closes.

• Target’s Subpart F income and GILTI through the date of sale is includible in gross income of the US Seller (rather than the Buyer), absent contractual provisions to the contrary.

• Basis-bump up for purposes of actual stock sale: US seller will also be taxed on any gains realized on the sale of the CFC-Target’s stock, with the basis of such stock first increased for the amount of any inclusions under Subpart F and GILTI for the year--including the Subpart F and GILTI income generated by the deemed asset sale.

• Subject to holding period requirements, the stock gain will be recharacterized as a deductible dividend under sections §1248 and § 245A to the extent of the CFC’s post-1962 accumulated untaxed E&P (i.e., the “1248 amount” that are not Subpart F income or tested income), as well as earnings arising from gain on the deemed sale of assets that are not subject to Subpart F or GILTI.



Purchaser Considerations in Deciding whether to Elect § 338(g)

Potential Advantages (and possible disadvantages) to Purchaser of Electing § 338(g):

• Advantage -- Complete Elimination of Target’s tax attributes: (This factor can actually cut both ways.)

– On one hand, because the historic E&P accounts are wiped clean, P is able to calculate more easily (and cheaply) the character of future distributions.

– P need not rely on historic financial records to determine source & character of pre-acquisition earnings and amounts of foreign taxes paid in pre-acquisition years.

– P is also not at risk for audit adjustments for pre-closing periods if election is made. Further, a clean tax attribute slate removes need for cumbersome computations of accounting adjustments needed to convert statutory retained earnings of foreign T to US GAAP as required by 1.964-1(b)(1), and to convert US GAAP retained earnings to accumulated E&P.

• Disadvantage - Complete Elimination of Target’s tax attributes: – The elimination of historic E&P pursuant to a §338 election can prevents P from receiving distributions of PTI free of tax (unless

the 245A DRD is available).

– If FT becomes a CFC at a time when it already had an “investment in US property,” P’s § 338(g) election would destroy any benefit from § 956(b)(2).

– The “1248 amount” account of New T is eliminated if there is a 338(g) election. Thus, if P later decides to sell New Target, there will be much less/no post-1962 accumulated 1248 E&P to be characterized as a “dividend” eligible for the 100% DRD under §245A.





• Basis Step-up in Assets of New Target: (This can cut both ways too.)

– The step-up gives Purchaser of FT greater depreciation/amortization deductions for U.S. tax purposes, and reduced gain on assets sold post-acquisition. (FT’s future income and E&P for U.S. tax purposes are reduced, which also reduces FT's E&P for dividend and FTC purposes. Although this has the effect of reducing future subpart F inclusions, FT will likely still be subject to GILTI.

– Having a higher depreciable asset basis provides more QBAI, and thus a cushion against the imposition of GILTI due to having a higher net deemed tangible income return.

– But if FT pays little or no foreign tax on its future earnings, P has less dividend income should FT ever distribute earnings. If, however, the FT pays foreign tax at a high rate, then a §338 election could increase the FT’s excess FTCs because the basis step-up is not likely to be effective under the tax laws of countries in which the target operates. (This mismatch increases the effective rate of foreign tax paid by the foreign target relative to its E&P for U.S. tax purposes. Prior to enactment of §901(m), the increase in the effective foreign tax rate could generate excess FTCs when earnings were distributed or deemed distributed. Since 2010, §901(m) restricts the prior FTC benefit of making a §338(g) election for a foreign target, although in many circumstances it may remain beneficial.





• Election may facilitate Post-Acquisition Restructuring: A § 338(g) election made for a first-tier CFC would increase the basis in that Target CFC’s assets—i.e., its bases in its own subsidiaries. In one fact pattern, Foreign T owned a US corp, the stock basis of which was stepped up to FMV with a § 338(g) election. This enables New Foreign Target to sell the domestic sub’s stock up the ownership chain free of gain that would otherwise apply. See. Rev. Rul. 74-605.

• Election may impair Post-Acquisition Transactions: Because a § 338(g) election eliminates the accumulated E&P and §1238 amount accounts, PTI may not be able to be distributed tax-free to the US shareholder.



US individual Seller of CFC with and without a § 338(g) Election

With NO § 338(g) Election:• Seller A has a § 1248 dividend for any E&P, which is taxed

as a “qualified dividend” assuming conditions are satisfied (15%).

• The § 245A DRD is not available because A is not a US C Corporation.

• Residual tax is “capital gain” taxed at 23.8% (20% + 3.8% net investment tax rate)

With § 338(g) Election: Drastic difference!

• Seller has GILTI income on Target CFC’s deemed asset sale, but the 50% deduction under § 250 is not available for individuals (nor for funds or pass-through entities).

• Seller has GILTI inclusion, which gives Seller a stock basis bump-up, so she has less gain on the stock sale, which would have been taxed at preferable capital gain rates (23.8%).

• Effect of 338(g) election: Converts capital gains into ordinary income, taxable at 40.8 % (i.e., 37% + 3.8%)

• Individuals and pass-through Sellers will usually want contractual protections to prevent Purchaser from electing § 338(g) (regardless of whether Purchaser is US or foreign).



108

US Individual

“A”

TargetCFC

Purchaser

A sells 100% of CFC stock in QSP

§ 338 Election Scenarios –(Cheat Sheet)

(1) Domestic corporate seller and Purchaser and Target• § 338(g) election: Usually not done unless the target had net operating losses (NOLs) because it does not

make sense to pay tax today for depreciation on the same amount to be deducted tomorrow; the gain falls on the buyer’s side in a one day year of target, although the target generally can use its historic NOLs. However, now the buyer (new target, the next day) may expense part of the purchase price. Depending on the amount of expensing and the portion of the gain currently taxed, the election might make sense for the buyer.

• § 338(h)(10) election: Usually done unless the asset gain is much greater than the seller’s stock gain. Expensing the benefit will fall on the buyer’s side and make the election more favorable.

(2) U.S. corporation sells U.S. sub to a foreign corporation• § 338(g) election: Same as (1) above.

• § 338(h)(10) election: Same as (1) above.

(3) U.S. corporation sells stock of a controlled foreign corporation (CFC) to a U.S. corporation• § 338(g) election: Deemed asset sale can produce Subpart F income and global intangible low-taxed income

(GILTI), which will be taxable to the seller as if the CFC’s year closed on the day of the deemed sale. That inclusion will increase the seller’s stock basis and create previously taxed income (PTI) for the seller, and the seller will recognize stock sale gain, Section 1248 will apply, and the dividend created will be eligible for a 245A dividends received deduction (DRD).

• § 338(h)(10) election: N/A§

• No § 338 election: Section § 1248 gain and dividend created will be eligible for a § 245A DRD; seller will not have Subpart F or GILTI inclusion for the year because the CFC year will not close on sale.



§ 338 Election Scenarios –(Cheat Sheet)

(4) U.S. corporation sells stock of CFC to a foreign purchaser• § 338(g) election: Deemed asset sale can produce Subpart F income and GILTI, which will be taxable to the seller as

if the CFC’s year closed on the day of the deemed sale. That inclusion will increase the seller’s stock basis and create PTI, the seller will recognize stock sale gain, and Section 1248 will apply and 245A will apply to the dividend.

• § 338(h)(10) election: N/A

• No § 338 election: Section 1248 gain, 245A will apply to dividend; seller will have Subpart F or GILTI inclusion for the year because the CFC year will close on sale unless the foreign buyer has U.S. subs and CFC status continues.

(5) Foreign corporation sells U.S. sub to a U.S. corporation• § 338(g) election: Same as (1) above.

• § 338(h)(10) election: N/A

(6) Foreign corporation sells foreign sub to a U.S. corporation• § 338(g) election: I f the target was not a CFC, the deemed asset sale cannot produce Subpart F income and GILTI; if

it was a CFC, those income items would not be taxable except to the target’s U.S. shareholder.

• § 338(h)(10) election: N/A

(7) CFC sells CFC• Section 338(g) election: U.S. shareholder of the seller CFC will include Subpart F income and GILTI generated by

deemed asset sale.

• 338(h)(10) election: N/A



Current Restrictions on Hybrid Arrangements

After2017 US Tax Act and Other Countries’

Implementation of BEPS Action 2



The Perceived Abuse in Hybrid Arrangements

• Hybrid arrangements, such as those involving hybrid entities or hybrid instruments are viewed as abusive because their use can erode the tax bases of both jurisdictions involved in a transaction.

• A “hybrid entity” is one that is viewed as tax transparent in one country, but as a separate corporate taxpayer in another country. The use of hybrid entities can result in income that is not taxed in any country because, for example, each country views the item as not being received by a person taxable within its own jurisdiction or, alternatively, the item is eligible for some beneficial treatment.

• A “hybrid instrument” can result in an income deduction in the country viewing the instrument as “debt” and in no income inclusion (or beneficial treatment) in the country that treats the same payment as “equity.”

• Hybrid arrangements typically involve:

– A payment in one country where the payor resides, with no corresponding income inclusion where the recipient resides (or a favorable rate of taxation). This is called “Deduction—No Inclusion” (“D/NI”) in BEPS speak)

– A double deduction for the same expense. This is called “Double Deduction” (“DD”) in BEPS speak); OR

– Multiple claims of foreign tax credit relief for the same foreign tax paid.



Classic Example of Hybrid Instrument

113

F-Co

US Sub

Assumed Facts:

• F-Co contributes money to US Sub, in exchange for a an instrument, which is in legal “form” under the laws of F-Co’s country, a contribution in exchange for US Sub’s stock.

• Country F views the F-Co as holding “equity” in US Sub.

• The U.S. views the same transaction, in substance, as a “debt instrument” creating a debtor-creditor relationship, and “loan” for tax purposes.

• Because at least two countries relevant to the transaction view the instrument inconsistently, it is a “hybrid instrument.”

• Absent special rules, the U.S would allow US Sub to deduct the “interest” payments on its U.S. tax return.

• At the same time, because Country F views the payments as “dividends” on equity, Country F would (absent special rules) allow F-Co to exempt them under any available special tax regime (e.g., a repatriation deduction or credit).

• Thus, the payments result in deductions in one jurisdiction (the U.S.), with no taxation of the full amounts in the country where the recipient resides. (i.e., “Deduction-No Inclusion” or “D/NI” in BEPS speak.)

• Traditionally, the U.S. has had no “bright-line” test for distinguishing “debt” from “equity,” but has applied substance-over-form principles. Unlike the U.S., many other countries look to the legal form of the instrument to determine its tax treatment, resulting in myriad opportunities for creating hybrid instruments and tax arbitrage.

Payments are “interest in US; “dividends” in Country F

F-Co invests in US Sub as “shareholder” under F’s law; but “creditor” in US



Classic Example of Hybrid Entity

SC is a Hybrid Entity

NL

SpanishSC

ETVE/OpCo

Spanish Financing Structure –“Sociedad Colectiva”

• Assume Netherlands views the SC (a Sociedad Colectiva) as tax transparent—i.e., a disregarded branch.

• Assume Spain treats the SC as a corporate taxpayer—i.e., a regarded entity for tax purposes.

• The SC is a “hybrid entity” because the two countries relevant to the transaction classify the SC differently for tax purposes.

• Result:

• Netherlands does not tax NL on the receipt of interest because it views NL as having made a loan to itself.

• Under Spanish tax law, SC may deduct the interest it pays against the income of its tax group formed by SC and the ETVE (75% participation exemption). In addition, there may no w/h tax or (a preferential rate) under the Netherlands-Spain treaty.

• The payment is deductible from income in Spain, but not included in income of the recipient the Residence country– resulting in a “deduction—no inclusion” (“DD/NI” in BEPS speak).

• Results under EU law—ATAD II? EU Parent-Sub Directive ?

Loan Interest payments



Common Hybrid Structures - #1Traditional Use of Hybrids to Disregard Loan

(and avoid Subpart F income – may not work anymore!)

Loan Interest

• Assume U.S. views U.S. Parent and Entity A in Country X as tax opaque corporations.

• Assume U.S. views Entity B in Country Y as a tax transparent “disregarded entity” (or branch of its corporate parent in Country X).

• Assume Country X views Entity A as a tax opaque corporation.

• Assume Country Y views Entity B as a tax opaque corporation—not merely a branch of Entity A.

• Conclusion: B is a “regular hybrid” entity because the U.S. views it as disregarded entity (branch) while another relevant jurisdiction (Country Y) views B inconsistently as a corporation.

• Tax Result ? For purposes of Subpart F, U.S. disregards the A-B loan because it sees it as a transaction occurring purely within Foreign Corp A.

• Meanwhile, Country X allows A to deduct the interest payments (reducing its Entity’s A’s E&P, which could be taxed at a high rate), and Country Y imposes little or no tax on the receipt of the interest payments.

• Isn’t this is the kind of income shifting that is supposed to be targeted by Subpart F. See IRS Notice 98-11 (Ex. 2), but withdrawn by Notice 98-35.

115

US Parent Corp.

Foreign Entity A

(Country X)

Foreign Entity B

(Country Y – a tax haven)



Common Hybrid Structures- #2Using Hybrids to Fit within “Same Country Exception” to

IRC § 954(c) – (Foreign Base Company Income)

Loan

Interest

• Assume same facts except U.S. views U.S. Parent and Entities A and C in Country X as tax opaque corporations.

• U.S. views Entity B in Country Y as a tax transparent “disregarded entity” (or branch of its corporate parent in Country X).

• Country X views Entity A as a tax opaque corporation.• Country Y views Entity B as a tax opaque corporation—not

merely a branch of Entity A.

• Conclusion: B is a “regular hybrid” entity because the U.S. views it as disregarded entity (branch) while other relevant jurisdictions (Countries X and Y) view B inconsistently as a corporation.

• Tax Result ? For Subpart F purposes, U.S. views the B-C loan as occurring between Entity C and Entity A (Not B) because U.S. seems B as a mere branch of Entity A. Thus, because the U.S. views the interest payments as received by a 954(d)(3) “related person” to Entity C, but because both CFCs are organized in the same country, the payments are not 954(c) FBCI—i.e., within an exception to Subpart F income!

• Meanwhile, Country X allows C to deduct the interest payments (reducing Entity’s C’s E&P, which could be taxed at a high rate), and Country Y, which sees B as a corporation, imposes little or no tax on the receipt of the interest payments.

• Thus, earnings are being stripped out of CFC C, without any inclusion under Subpart F, and very little or not tax imposed on the income anywhere. See IRS Notice 98-11 (Ex. 1), but withdrawn by Notice 98-35. See also the OECD BEPS- Action 2 Hybrid Arrangements; U.K. Hybrid Mismatch Rules (effective 1/1/2017).

116

US Parent Corp.

Foreign Entity A

(Country X)

Foreign Entity B

(Country Y – a tax haven)

Foreign Entity C

(Country X)



Nails in the “Hybrid Coffin” -Escalating Limits on Hybrid Arrangements in Last 20 Years

A. IRC § 894 and Reg. § 1.894-1(d)(2)(ii) – Domestic law limits tax benefits of arrangements using domestic reverse hybrids

B. IRS Notice 98-11, but soon withdrawn by Notice 98-35.

C. U.S. Model Tax Treaty (going back to at the 1996 US Model Treaty): U.S. negotiating position has been to ensure that treaty benefits are limited when “fiscally transparent entities” are used to achieve double non-taxation. Stricter and broader anti-hybrid provisions in 2016 US Model Tax Treaty.

D. OECD’s Partnership Report of 1999 – “The Application of the OECD Model Tax Convention to Partnerships”

E. OECD/G20’s “BEPS” initiative – (Base Erosion Profit Shifting report, Action 2 “Neutralising the Effects of Hybrid Mismatch Arrangements”

1. Oct. 2015: Final Report on Action 2 issued (expands on Sept. 2014 Interim Report)

2. Aug. 22, 2016: “Branch Mismatch Structures” discussion draft released (detailed )

3. OECD recommends changes to domestic law and OECD Model Tax Treaty.

4. OECD’s Multilateral Instrument signed (containing anti-hybrid provisions)

F. “Fruit of BEPS”: Implementation of Action 2 in an increasing number of countries’ domestic law (and EU)

G. EU’s Anti-Tax-Abuse Directive (ATA Directive), Article 9 (ATAD I and ATAD II) and EU’s Amendment to Parent-Sub Directive

H. Unilateral limits imposed by other countries (independent from OECD’s BEPS): UK’s “Hybrid Mismatch Rules” effective Jan. 1, 2017 (BREXIT?); Netherlands; Germany; France; Australian proposal

I. USA: Obama Proposals; 2016 Model Tax Treaty restrictions; US Congress asked to fix “hybrid problem,” and finally, in 2017, US Congress enacts IRC § 267A (GOP Senate’s provision was enacted--very similar to Obama proposal!)



New IRC Section 267A (Pub. L. 115–97, title I, § 14222(a), Dec. 22, 2017, 131 Stat. 2219.)

• § 267A disallows U.S. tax deductions for any “disqualified related party amount,” which is interest and royalties paid or accrued to a “related party” in a “hybrid transaction,” or paid to or by a “hybrid entity.” §267A(a).

• “Related party” for § 267A purposes is defined by reference to “related person” in § 954(d)(3) (substituting the payor for the CFC). Thus, related party includes an individual, corporation, partnership, trust or estate that controls, is controlled by, the payor, or where both payor and recipient of the interest or royalty are “controlled” by same person(s). Control means >50% ownership (by vote or value). Ownership can be direct, indirect, or constructive through labyrinthine attribution rules. See § 958(a), (b). (And, consider the scope of application given repeal of § 958(b)(4)).

• “Hybrid Transaction” defined broadly as “any transaction, series of transactions, agreement, or instrument one of more payments of which are treated as interest or royalties” for U.S. tax purposes and which are not so treated for purposes of the tax law of the recipient’s foreign country. (E.g., Otherwise deductible interest payments that are considered dividends, subject to preferential treatment like participation exemption for foreign tax purposes.)

• “Hybrid Entity” is an entity treated as fiscally transparent in the U.S., but not for purposes of the tax law of the foreign country where the recipient is resident, or vice versa.

• “Disqualified Related Party Amount” is any interest or royalty paid or accrued to the extent that the payment:

-- Is not included in the income of the related foreign party under the tax law of the country in which the related party isresident or subject to tax OR

-- The related party will (also) be allowed a deduction with respect to the amount under the tax law of the foreign country

-- Exception: to extent such payment is included in income of a US shareholder under § 951(a) (Subpart F).

• § 267A(e) grants IRS/ Treasury Dept. broad regulatory authority to write rules carrying out purposes of § 267A(a), including its application to conduit arrangements, branches, structured transactions, and for treating a “tax preference” as an “incomeexclusion” if the preference reduces the applicable statutory rate by 25%. Regs may also provide exceptions where an interest payment or royalty is taxed in a third country, or in cases that do not present a risk of tax base erosion.

• Observation: As drafted, and in the absence of liberalizing regulations, § 267A may literally disallow interest and royalty payments in common “Check-the-Box” structures involving eligible entities—e.g., payments to a related GmbH and Co. KG, viewed as tax transparent by Germany, but which could be treated as an opaque corporation for U.S. tax purposes.



How new § 267A targets “Hybrid” Finance Structures: “Repos”

“Repo” Financing of Canadian acquisition of US Subsidiary

119

CanCo

US HoldCo

US OpCos

US Target

Bank

Bank Loan $$“Sale” of Sub

preferred shares” to Canco w/forward contract, requiring US HoldCo to repurchase them from CanCo at fixed price w/time-value-of money component. (“Hybrid instrument” due to conflicting debt-equity classifications)

Assumed Facts: CanCo borrows from 3rd party bank, using loan proceeds

to “purchase” US HoldCo common stock. US HoldCo contributes the cash to US OpCos for common and preferred, and then “sells” the preferred Sub shares to Canco, but simultaneously enters into a forward contract to “repurchase” them on fixed date (or on demand) at fixed price + interest component. US OpCos use proceeds of subscription to acquire US Target.

US Tax Results (PRE 2017 Tax Act): If properly structured, and

although in form a share “purchase,” US views the sale & “repurchase” as a “secured loan” in substance, with CanCo merely holding title to the preferred shares as collateral. Thus, when US Opcos pay dividends to Canco on the preferred “repo shares” Canco holds, US has (in past) allowed those interest payments to be deducted against income of US consolidated group.

Canadian Tax Results: Canada sees the arrangement as “equity.” Thus,

dividends paid to Canco on the repo shares of the OpCos (or on HoldCo’scommon) are dividends out of “exempt surplus” (because derived in active US business) and not taxed to Canco. No FTC available in Canada for the 5% W/H tax on any dividends from Holdco. However, no US W/H tax on the dividends on the repo shares (as they are recharacterized as “interest” in the US).

US Result under new IRC §267A: To the extent that the interest

payments qualify as “disqualified related party amounts” § 267A will DENY the interest deductions since paid to a related foreign party, resident in a foreign jurisdiction where such payments are not taxed as income. Effective date: Taxable years beginning after 12/31/2017.

(Note that the interest is not “recharacterized” as equity. If the controversial US Debt-Equity regulations under § 385 apply, debt issuances of a US obligor to a related party could be recharacterized as “stock per se” for all US income tax purposes. The § 385 Regulations have not been withdrawn.)

Cascading share subscriptions to US Subs--“purchases” in form.

US Group files consolidated tax return.



Structures that new IRC § 267A does not target

§ 267A , as drafted, apparently does not disallow the double deduction in this case because there is no “related party.” But other countries’ “hybrid mismatch rules” may apply. Does the grant of regulatory authority in §267A (e ) givethe U.S. Treasury latitude to address this structure in Regs? (i.e., imputing some kind of “related foreign party”?)

▪ Assumed Facts: Countries A and B classify B-Co inconsistently for tax purposes. Country A views B-Co as a tax transparent branch; Country B views Bco as opaque.

▪ Thus, B Co is a hybrid entity.

▪ Country A deducts the interest payments made by its transparent foreign branch.

▪ B-Co, as borrower, also deducts the same interest payments to on its Country B tax return. (Alternatively, such deductions in B-Co may increase the B Co’s losses, which may offset profits under a tax consolidation regime.

▪ If Country B is the United States, § 267A will not disallow the interest deductions because they are not being made to a “related [foreign] party.” (If Country A is the United States, the US dual consolidated loss rules will generally disallow any net loss of the B-Co group.)

▪ Still, but for a special rule, a “double deduction” would result (“double dip” or double deduction –”DD” in BEPS speak).

▪ Note: Obama proposal would have denied interest or royalty deductions arising from certain hybrid arrangements involving unrelated parties in appropriate circumstances, such as structured transactions.

▪ BEPS Action 2: – Primary rule: to the extent a payment gives rise to a DD outcome,

deny the deduction at the parent level– Defensive rule: If A-Co Parent takes the deduction, then the tax

law in Country B should deny the deduction at payor level (i.e., inCountry B).



OECD’s BEPS Action 2: Neutralising the Effects of Hybrid Mismatch Arrangements”

• The 2015 Report on Action 2 makes recommendations for domestic legal rules to neutralize “mismatches” in tax outcomes that arise in respect of “hybrid mismatch arrangements” (HMA)

• “Hybrid Mismatch Arrangement” (HMA): “exploit differences in the tax treatment of an entity or instrument under the laws of two or more tax jurisdictions to achieve double non-taxation, including long-term deferral.

• Action 2 addresses inconsistencies caused both by hybrid entities and hybrid instruments.

• With respect to hybrid entities, Action 2 targets payments made by or to a hybrid entity that give rise to one of three types of mismatches:

a. deduction / no inclusion (D/NI) outcomes, where the payment is deductible under the rules of the payer jurisdiction but not included in the ordinary income of the payee;

b. double deduction (DD) outcomes, where the payment triggers two deductions in respect of the same payment; and

c. indirect deduction / no inclusion (indirect D/NI) outcomes, where the income from a deductible payment is set-off by the payee against a deduction under a hybrid mismatch arrangement.



OECD’s Recommended “Fix”: Adopt “Primary” and “Defensive” Rules▪ In the Deduction/No Inclusion (“D/NI”) situation:

– Primary rule: to the extent a payment gives rise to a D/NI outcome, domestic law shoulddeny a deduction for such payment in the payer’s jurisdiction

– Defensive rule: But if such deduction is not denied (or taken anyway), domestic lawshould require such payment to be included as ordinary income in the payee jurisdiction

– Recommended Application: D/NI rule applies to (i) related party or control grouptransactions and (ii) structured arrangements

– Recommendation: Participation exemption and similar dividend relief should not applyto the payee if payment is deductible by the payer, whether or not parties are related.(However, if the payment is treated as “tax exempt” income in and of itself in payeejurisdiction, that will not create a D/NI situation. See Interim Report 9/2014.

• In the Double Deduction (“DD”) situation:

– Primary rule: to the extent a payment gives rise to a DD outcome, deny the deduction atthe parent level

– Defensive rule: deny the deduction at the payer level

– Application: DD rule has broader application



EU Directive (ATAD 2) now addresses hybrid mismatches with 3rd (non-EU) countries

• May 2017: Council of European Union adopted a directive amending the original “Anti-Tax Avoidance Directive” (ATAD). This “ATAD 2” extends scope of ATAD to hybrid mismatches involving non-EU countries.

• ATAD 2 sets minimum rules that neutralize hybrid mismatches, where at least one of the parties involved is a corporate taxpayer in an EU Member State.

• In addition to expanding the territorial scope of the ATAD to third countries, ATAD 2 also expands the scope to address

– hybrid permanent establishment (PE) mismatches, hybrid transfers, imported mismatches,

– reverse hybrid mismatches and dual resident mismatches.

• ATAD 2 explicitly states that Member States should use the applicable explanations and examples outlined in Action 2 of the OECD’s BEPS reports as a source of illustration or interpretation to the extent that they are consistent with the provisions of the ATAD 2 and EU Law.

• Deadline for implementation by Member States: Jan. 1, 2020 (to transpose the Directive into national laws and regulations) and Jan. 1, 2022 for the implementation of reverse hybrid mismatches).

• Implications: expected to have a significant effect on tax planning by multinational companies operating in the EU.

• AND the “MULTILATERAL INSTRUMENT: An historic multilateral tax treaty (explicitly binding) signed by 68 countries in June 2017, as result of OECD’s BEPS initiative) also includes anti-hybrid mismatch rules—most of which were opted into by the signatory countries.



• § 245A(e): DRD is not available for hybrid dividends paid by CFC to a US shareholder

• Hybrid dividends also do not qualify for any FTC on the E&P being distributed, or a deduction for taxes imposed on such dividend

• “Hybrid dividend” defined: a dividend to which § 245A would apply, and for which the CFC receives a deduction “or other tax benefit” for foreign tax purposes

• Unlike § 267A (see above), US tax treatment at payor level is not relevant for §245A

• § 245A is relevant only after PTI account has been distributed including for current year (since PTI is not taxable when distributed).

• Hybrid dividend received by one CFC from another CFC with common corporate US shareholder is treated as subpart F income (taxable at 21% rate) “notwithstanding any other provision of this title” (so apparently overrides § 954(c)(6)!)

• New § 245A includes grant of regulatory authority (awaiting guidance from Treasury)

§ 245A DRD (repatriation DRD) is disallowed if the payment constitutes a “Hybrid Dividend”

Check-the-Box Elections for Foreign Subs Pamela A. Fuller, Esq.

Tully Rinckey - Royse Law Firm

Planning Point: Avoid “hybrid entities” (and instruments) to prevent disallowance of the § 245A DRD !!

USP

Low-Tax CFC 1

Straight Loan

CFC 2

InterestPECS/ORA orStraight LoanWith DE

USCo

CFC 1

DRE

The §245A repatriation DRD would be disallowed in this situation because the dividend is a “hybrid dividend”

If CFC 2 deducts the interest in its (pink) jurisdiction, and there is no inclusion in CFC-1’s jurisdiction (gree), would a dividend paid out of that interest income be a “hybrid dividend” disqualified for the § 245A DRD by 245A(e)?



BASE EROSION ANTI-ABUSE TAX (“BEAT”)New IRC Section 59A:



Overview of BEAT

• IRC § 59A – official name in Code: “Tax on base erosion payments of taxpayers with substantial gross receipts”

• § 59A(a): “There is hereby imposed on each applicable taxpayer for any taxable year a tax equal to the base erosion minimum tax amount for the taxable year. Such tax shall be in addition to any other tax imposed by this subtitle.”

• Intended as disincentive to large corporate taxpayers (US or foreign) to “erode” the US tax base by making deductible payments (e.g., interest, royalties) to “related” foreign (non-US) persons.

• Applies only to Large Corporations (US or Foreign) earning annual average gross receipts of at least $500MM and with a “base erosion percentage” of at least 3% (2% for certain banks) during the 3-year period immediately preceding the taxable year.

• If BEAT applies, it is a minimum tax imposed in addition to the TP’s other tax liability (not in lieu of).

• Annual Test: Large corporate taxpayers must test for BEAT liability every year.



Overview of BEAT continued…

• The BEAT can apply to large US corporations (other than a RIC, REIT, or S-Corp) and to large foreign corporations with a US branch(es) or a US affiliate(s)

– Special aggregation rules apply to determine if two conjunctive application prerequisites are met: (1) whether the $500M average-annual-gross-receipts threshold is satisfied; and (2) whether the “base erosion percentage” is at least 3% (2% for certain banks)

• IF the two-part application test is met, then BEAT imposes a minimum federal income tax (in addition to the corporate TP’s regular tax liability) of:

– 5% of “modified taxable income” for TY 2018

– 10% for TYs 2019-2025

– 12% for TYs 2026 and beyond

– BEAT rate is 1% higher for certain financial groups (banks/broker-dealers)

• § 59A(f) – Grants IRS broad regulatory authority as necessary and appropriate to prevent avoidance of §59A’s purposes

• Little or no effect on US State Corporate Tax Bases: Because the BEAT is a new federal corporate tax on a base that is distinct from the corporate income tax base, it presumably does not impact the determination of the US corporate income tax base that serves as the starting point for determining many U.S. states’ corporate income tax returns.

– Most commentators expect that no (or very few) states will pass tax laws to conform conforming state tax laws to IRC § 59A BEAT.



BEAT’s Policy and Seeming Inconsistency with Treaty Obligations

• Dual Congressional Purpose: (1) Anti-Base-Erosion and (2) a Minimum Tax: Because the BEAT appears to impose tax on payments that are already taxed as Subpart F income and Effectively Connected Income (ECI), it also functions as a “minimum tax”—not just an anti-earning stripping mechanism.

• To increase international competitiveness of US companies: The BEAT arguably serves this objective by reducing base erosion opportunities that have previously allowed foreign-controlled US corps to operate in USA at lower effective tax rates than their US competitors.

– See Unified Framework for Fixing Our Broken Tax Code (Sept. 27, 2017), https://www.treasury.gov/press-center/press-releases/Documents/Tax-Framework.pdf

– US-tax-base erosion by foreign-controlled US corps had caused US businesses to be more valuable on an after-tax basis to a foreign acquiror than to a US acquiror-- a principal incentive for US corporate inversions.

• Caveat: While the BEAT reduces base-eroding opportunities, it also inhibits the full deductibility of payments, which is arguably inconsistent with the international “arm’s length standard” for transfer pricing. Thus, BEAT could conflict with existing APAs and accepted transfer pricing principles, established by the OECD.

• Violates US Tax Treaty and Trade Treaty Commitments? BEAT is arguably not consistent with:– Art. 24 (5), Non-Discrimination, US Model Tax Treaty (2016)– Art. 7, attribution of profits to a US permanent establishment– Art. 23, double tax relief– Art. 25, Mutual Agreement Procedure– Could also conflict with existing APAs (advance pricing agreements); WTO Trade - GAT and GATS



IRC § 59A - Key Definitions and Terms of Art

• A simple way to think about BEAT’s application is to focus on its two-part application test in § 59A. In general, the BEAT will apply if:

(1) An “applicable taxpayer” makes “base eroding tax payments” to a “related foreign person,” but

(2) Only to extent the tentative BEAT tax liability exceeds TP’s regular tax liability.

• Thus, in determining whether any large corporate taxpayer has a BEAT liability, the following must be identified and/or computed:

– “Applicable Taxpayer” - defined in § 59A(e) (note the aggregation rules in par. (3))

– “Base Erosion Minimum Tax Amount” - This is essentially the BEAT, defined in § 59A(b) by reference to:

– “Modified Taxable Income” - defined in 59A(c)(1) by reference to:

• “Base Erosion Tax Benefit” - defined in § 59A(c)(2)

• “Base Erosion Tax Payment” - defined in § 59A(d)(1)

• “Base Erosion Percentage” - defined in § 59A(d)(1)

– “Related Party” - defined in § 59A(g) (incorporates definitions in §§ 267(b), 707(b)(1) and 482)

– “Foreign Person” - defined in § 59A(f)



BEAT only applies to “Applicable Taxpayers”

• § 59A(e): “Applicable taxpayer” means, with respect to any taxable year, a taxpayer—– (1)(A): that is a corporation (foreign or US but not a RIC, REIT, or S-Corp);– (1)(B): has average annual “gross receipts” of at least $500M for the 3-yr period ending with the preceding tax year; AND– (1)(C): has a “bare erosion percentage” for the taxable year of 3% or higher (2 % for certain banks and financial institutions).

• Aggregation Rules apply only for purposes of:

– Determining whether the $500M avg. annual gross receipts test is met, and

– Determining whether the 3% “base erosion percentage” threshold is met (2% for certain financial institutions)

– §59A(e)(3) treats all members of an aggregated group as one person, but only for purposes of (1) testing whether the $500M avg. gross receipts threshold is met, and (2) whether the base erosion percentage is at least 3% (2% for certain financial institutions).

– The BEAT aggregation rule refers to the “single employer rule” of § 52(a), which in turn incorporates the controlled group rules of §1563(a), but substituting “more than 50 percent” for “at least 80 percent” where it appears in §1563(a)(1).

– Although §1563(b)(2)(B) generally excludes “foreign corporations” from the definition of “controlled group,” new §59A(e)(3) turns off that exclusion. Thus, US companies that are owned > 50% by a foreign corporation are treated as one person for purposes of applying the $500M gross receipts test and the “base erosion percentage.”

– §59A(e)(2): For non-US corporations, “gross receipts” includes only those used to determine ECI under § 864(c).

– RESULT: count only gross receipts of any US controlled group, together with any ECI of the foreign parented group, to test whether group has $500M gross receipts.

– Drafting error? If statute were applied literally, all intergroup payments could be ignored—both inbound and outbound. Arguably, payments to US group members and to US branches by foreign group members should be ignored in calculating the single employer group for purposes of the BEAT because they are obviously not base eroding. (This issue is likely to be clarified in forthcoming Treasury regulations.)



BEAT Aggregation Rules – Illustration



Foreign

Parent

USParent #1

ForeignSub

USParent #2

USSub

Foreign Sub

100%

80%

100%

100%

100%

Foreign Sub

100%

Foreign Sub

20%

US Branch

IRC §59A(e)(3) aggregation rule treats all corporations (US or foreign) that are members of the same aggregated group (as defined) as one person for two purposes only: (1) to determine whether the $500M gross receipts test is met, and (2) whether the base erosion percentage is 3% (2% for financial institutions).

Count gross receipts of foreign members, but only to extent of their gross receipts related to effectively connected income (ECI).

Implicit Rule in 59A: For purposes of actually calculating the BEAT liability, do NOT apply the aggregation rules of §59A(e)(3). Rather, look to “taxpayer filer” status—i.e., US consolidated groups calculate their BEAT liability on a consolidated basis. Stand alone, non-consolidated entities calculate their BEAT liability separately.

USParent #3

USSub

50%

100%

10%

Foreign Sub

BEAT’s Application in the Partnership Context

• § 59A is silent on its application to partnerships: Looking only at statute, intended treatment is unclear, and will depend on forthcoming guidance from Treasury and the IRS, which may be retroactive.

– Guidance may be retroactive

• Calculation of $500M gross receipts threshold, base erosion payments, and base erosion percentage are all likely to be affected by how payments by, to, and through partnerships are viewed (i.e., whether the payments are viewed as being paid to/by the entity itself, or to/by its partners).

• Seems rational that Treasury’s administrative guidance will take position that BEAT applies at the partner level (i.e., applying aggregate-of-partners approach, as opposed to “entity” approach)

– In absence of guidance, note that § 59A treats a partnership as a “person” both in defining “foreign person” (§ 59A(f)) and “related party” (§ 59A(g)).

– If BEAT applies at partner level, TPs might try to manipulate BEAT’s application through “special allocations” of items to avoid § 59A’s application thresholds and character of payments, but §704(b) requires such allocations to have “substantial economic effect” apart from their tax consequences. So, §704(b) should be able to police potential abuse.



• zz • zz

Forthcoming regulations might take an aggregate approach,testing for BEAT’s application at the partner level

Payments by P/S likely to be treated as deducted at partner level. (So, each partner would be tested for “applicable taxpayer” status.)

Payments to a US P/S with foreign partners may be treated as paid to the partners for §59A purposes; thus, could be “base erosion payments” w/in BEAT.



• zz

US FCUS US US FC FC

US FP

US

US$$ $$$$

Payment to foreign P/S with only US partners is not likely to be treated as payment to a foreign person under §59A…so outside of BEAT.

Overview of BEAT Calculation

• Step one: Determine if there is an “Applicable TP” not within either 1 of 2 safeharbors—i.e., < $500M three-year annual gross receipts OR has a “base erosion percentage” of < 3%. (If annual gross receipts are > $500M, then must analyze other tests to see if BEAT applies.)

• Step Two: Determine “Base Erosion Percentage” under § 59A(c)(4) (i.e., “Base Erosion Tax Benefits” divided by Total Deductions for the year, other than §172 NOL dd; §245A participation dd; §250 dds for GILTI/FDII; and dds not treated as “base erosion payments” because they are either “qualified derivative paymts” or within services cost method safe harbor of Reg. § 1.482-9).

– If Base Erosion Percentage is < 3%, stop--because BEAT does not apply. (The base erosion percentage must be < 2% for certain financials to escape BEAT.)

• Step Three: Determine “Modified Taxable Income” (i.e., Taxable income + “Base Erosion Tax Benefits” + [Base Erosion % x NOL dd for the tested year])

• Step Four: Calculate the § 59A(c)(4) floor, which is TP’s “Regular Tax Liability” (§ 26(b)) reduced by all allowable credits for the taxable year (TY) other than the R&E credits, and 80% of the allowable §38 credits. (NOTE: Huge debate before TCJA was signed because in draft statute, the §38 “general business credit” was drafted to reduce “regular tax liability” in BEAT calculation, meaning the laundry list of various credits listed in §38(b) would, in effect, increase a TP’s BEAT liability, many of those credits relate to politically sensitive industries (e.g.., alternative energy, low income housing). Note: FTCs are subtracted to compute “Regular Tax Liability”—WHY?

• Step Five: Determine BEAT Liability for the year. BASIC FORMULA:

“Base Erosion Minimum Tax Amount” = Excess of [Modified Taxable Income X 10%*] OVER [21% rate X TP’s Net US Tax liability, less the “allowable tax credits” (but disregarding R&E credit and 80% of TP’s applicable § 38 credit)].

– * Substitute 5% of modified taxable income for TY 2018; 10% for TYs 2019-2025, 12% for TYs 2026 & beyond

• Step Six: Determine TP’s Total US Corporate Income Tax Liability (i.e., [TP’s regular tax liability minus credits] + BEAT Liability)

• This is an annual test.Emerging Impact of US Tax Reform on


135

Indentifying “Base Erosion Payments” for BEAT purposes

• § 59A(d)(1) defines “Base Erosion Payment” as “any amount paid or accrued by the taxpayer to a foreign person which is a related party of the taxpayer and with respect to which a deduction is allowable under this chapter.”

• Base Erosion Payments may include:

– Royalties

– Interest (Ordering rule: interest disallowed under new §163(j) is allocated first to payments that are “unrelated” for BEAT purposes, thus increasing chances that the payment will be a base eroding payment and added back to “modified taxable income”).

– Payments for acquisition of depreciable or amortizable property acquired from a foreign related person (property must generate depreciation/amortization dds).

– Payments for services (But note exception for some intercompany services at cost)

– Insurance Premiums or other consideration for any reinsurance payments (§§803(a)(1)(B), 832(b)(4)(A)).



“Bare Erosion Payments” do NOT include:

• Payments that reduce “gross receipts” (e.g., payments included in “cost of goods sold” of inventory (COGS) rather than being deductible, unless the recipient foreign affiliate is a post -11/9/2017 inverted company, or a member of such entity’s “expanded affiliated group” as defined in § 7874.

• Payments to the extent they are already subject to the US 30% withholding tax under §871 or §881. Example: If a royalty payment is eligible for a treaty-reduced W/H tax of 5% (instead of US 30% statutory rate), then 5/6ths of the actual royalty payment is treated as a base erosion payment because the royalty is subject to only 1/6th of the US 30% W/H tax. Cf., treatment of Subpt F Income & ECI, which are not exempt from BEAT.

• “Qualified Derivative Payments” (as defined in § 59A(h)(2))

– Taxpayer under mark-to-market; treats gain or loss as “ordinary”; and treats character of all items w/respect to payment pursuant to the derivative as “ordinary.” Exceptions for split derivatives.

• Intercompany services payments eligible for “services cost method” in Reg. §1.482-9(b) (but determined without regard to either any “mark-up” or requirement that such services not contribute significantly to the fundamental risks of the business.

– Rev. Proc. 2007-13 lists 101 qualifying services assumed to be low-value;

– Activities excluded from the Reg. §1.482-9 safe harbor (which could thus be base erosion service payments for BEAT purposes) include: mftg, production, reselling, distribution services, sales agency, commissionaire, R&D/R&E, engineering, scientific, financial transactions (including guarantees).

– Activities likely to be “covered services” w/in Reg. §1.482-9 safe harbor include: services not specifically “excluded” and for which adequate books/records are maintained. These are often “support services” common across the taxpayer’s industry sectors, and which do not have a significant mark-up component, such as data entry, recruiting, credit analysis, data verification, legal services, and other common support services.



“Foreign Person” and “Related Party” are broadly defined in BEAT

• For § 59A BEAT purposes, a “foreign person” may be a corporation, partnership, or other entity.

– §59A(f) defines “foreign person” by reference to § 6038A(c)(3), to include entities that are not US domestic entities

• For § 59A BEAT purposes, “related party” means, with respect to any applicable taxpayer,

– (A): any 25-percent owner of the taxpayer (vote or value);

– (B): any person that is related to either the taxpayer or to any 25-percent owner of the taxpayer within the meaning of §§267(b) or 707(b)(1) (generally a >50% control standard); and

– (C): “any other person who is related (within the meaning of section 482 to the taxpayer.”

• Thus, § 59A provides a very broad standard for related party. Under § 482, the IRS may determine that two parties are “related” by virtue of them “acting in concert” or having a common purpose, even if there one party owns no equity in the other.

• Some commentators have interpreted § 59A as imposing a 25% “related” threshold, but not clear from the statute whether 25% ownership is the intended threshold in all cases because such interpretation would make (B) superfluous. “Any 25% owner” is not defined, and could be limited to direct 25% owners).

• § 318 attribution rules apply for purposes of the first two prongs:

– “10 percent” is substituted for “50 percent” in § 318(a)(2)(C) (i.e., attribution threshold from a corp to a SH).



BEAT Calculation – Basic Example

Assumed Facts for US Group:

• Avg. annual gross receipts 2016 through 2019 is > $500M

• 2019 Taxable Income = $100M

• $5M Tax Credits (with $2M = R&D credits)

• “Related Person” payments:

– $35M interest paid to Non-US parent by US Group (Assume $5M is limited under new §163(j))

– $85M royalties to Foreign IP-Co

– $5M shared services fees paid by US Group to Non-US Parent (qualifying for Services Cost Method (SCM) under Reg. § 1.482-9, no mark-up)

– $10M service fee paid to CFC (not SCM eligible)

– Total deductible expenses = $625 M

– Assume Non-US Parent and IP-Co are US tax treaty eligible and no there is no US Group depreciation or amortization in connection w/property acquired from a foreign related person in post-2017 period.

Inbound Licensing Structure



IP-Co(Non-US)

Non-USParent

US Group

CFC

$85M royalties paid by US group to IP-Co

License

Sales to 3rd party customers

$10M service fee (not SMC eligible)

$35M interest &$5M service fee

(§ 482 SCM eligible)

BEAT Calculation – Basic Example (continued)

• Step One: $500M annual avg. gross receipts test is met. (Given facts assume that…so this safe harbor is flunked)

• Step Two: Determine “Base Erosion Percentage.”(Here, it’s 20%)

Deductions attributable to “base erosion paymts”

All deductions for year (other than §172 NOL, §245A, §250 GILTI/FDII, etc.)

$30M + $85M + $10M$625M EQUALS 20 %, which is > 3% (So, this test also flunked.)

• Step Three: Determine “Modified Taxable Income”

MTI = Taxable income + base erosion benefits

MTI = $100M + $125 = $225M

• Step Four: Calculate TP’s “Regular Tax Liability” but REDUCED by all allowable credits other than R&E credits and 80% of §38 credits, etc. (i.e., the floor described in §59A(b)(1)(B)).

21% rate X Taxable Income LESS regular tax credits (other than R&D, etc.)

$21M LESS ($5M credits - $2M R&D Credit) = $18M Floor

• Step Five: Determine BEAT liability for TY.10%(MTI) – TP’s Regular Tax Liability less credits (i.e., subtract the “floor” described in 59A(b)(1)(B))

10% ($225M) - $18M Floor = $4.5M BEAT Liability

• Step Six: TP’s Total US Corporate Tax = Regular Tax Liability (less credits) + BEAT Liability

[($100M TI x 21% US corporate tax rate) -$5M credits] + $4.5M BEAT = $20.5M



Strategies to Manage BEAT Exposure

• Modeling, monitoring, and specific BEAT “management” will be needed to stay under the 3% “base erosion percentage” (which operates as a cliff) (2% for certain financial institutions)

– Statutory requirement (§59A(b)) that certain credits be subtracted in calculating the BEAT can easily result in a low “regular tax liability” which offsets “Modified Taxable Income” in the BEAT calculation.

• Possible strategies:

– Financings: Refinance intercompany debt into third-party loans

– Manufacturers: Evaluate whether certain payments could be included in COGS (or structure them that way—e.g., Think about whether royalties paid for distribution could be restructure so that they become production costs of the inventory; marketing costs v. internal costs that reduce gross receipts)

– Services:

• Find payments eligible for the “services cost method” under Reg. §1.482-9 (exception to base erosion payment)

• Distinguish cost-based services from cost reimbursements

• Replace global services contracts (US general contractor, foreign subcontractors) with local contracts to eliminate payments from US affiliates to related foreign persons



Procurement Transaction - § 59A BEAT Implications

Assumed Facts:

• USP purchases finished goods from unrelated Chinese clothing manufacturer• USP relies on a Hong Kong affiliate to procure the goods from third-party mftrs in China.• USP pays HK Sub a “procurement fee,” which UPS deducts from its gross income.

The §59A BEAT Issue: The procurement fees, otherwise deductible, are being paid to a foreign “related person” under § 59A and thus could be “base erosion payments” for BEAT purposes if USP’s avg annual aggregated gross receipts > $500M and its “base erosion % > 3%.

Alternative Structure ?Revise contract with HK Co., making it a “buy-sell”

procurement arrangement, rather than fee-based. This would effectively replace the deductible BEAT payment with a non-deductible “cost” item for the inventory, thus reducing USP’s gross receipts (and thus, outside of BEAT definition of “base erosion payment”).

Caveats and Considerations:

• Practical & legal ability to amend the contract • Transfer pricing (would TP Regs require comp for giving up valuable contract?)• Customs & Trade: Must compare customs cost of importing from related HK affiliate to non-related China corp.• Subpart F. HK Co is a CFC, and would have §954(d)(1) FBC “sales income” unless an exception (K-mftg ?) applies. If not Subpart F income, would it be GILTI?• BEAT’s grant of regulatory authority to US Treasury to write anti-avoidance rules for the BEAT? Emerging Impact of US Tax Reform on


142

USP, Inc.

HK Sourcing Subsidiary

(CFC)

China Mnftr.

Sales of inventory to USP

Procurement fees paid by USP under a procurement contract

Cost Sharing Payments - § 59A BEAT Implications

Assumed Facts:

• USP is a technology company, incorporated in the US as a C-Corp.• USP has a cost-sharing agreement (CSA) with an Irish subsidiary, which provides that IP rights are split geographically—i.e., US IP to be exploited by USP and non-US IP to be exploited by Ireland Co.• USP’s “reasonably anticipated benefits” (RAB) = 50%; Ireland Co’s RAB = 50%. • Another Sub, Dutch Co., performs R&D for USP’s group. Under terms of the original billing arrangement, Ireland Co. makes payments to USP for its 50% RAB. Then USP compensates Dutch Co. for 100% of Dutch Co’s R&D services.

The § 59A BEAT Issue: The entire service fee paid by USP to Dutch Co. could be a “base erosion payment” for §59A BEAT purposes (outside of service cost method safe harbor) ,assuming such paymt is otherwise deductible and assuming USP’s avg annual aggregated gross receipts for past 3 years > $500M and its “base erosion % > 3%.

Alternative Structure ? Revise billing procedures to have Dutch Co. directly bill Ireland Co. for 100%

its R&D services so that USP is no longer making that outbound payment for those costs to a related foreign person. USP will then have to make a CSA payment to Ireland Co. based on USP’s RAB. Although that CSA payment may be a “base erosion payment,” it will likely be less than the prior payment to Dutch Co. Under the new arrangement, “base erosion payments” within purview of the BEAT would be reduced.

Caveats and Considerations:

• Practical costs of amending billing procedures

• Transfer pricing? (Also, BEPS considerations for this structure—location of DEMPE functions…)

• Congress’ grant of regulatory authority in §59A to US Treasury to write anti-avoidance rules for the BEAT? Should this “fix” be a prohibited BEAT avoidance technique under forthcoming Regs? Emerging Impact of US Tax Reform on


143

USP, Inc.

Ireland Co.Dutch Co.(R&D)

Originally, USP pays all Dutch Co’s contract R&D costs, deducting them.

Under revised arrangement, Ireland Co. pays Dutch Co. for all its R&D services.

Under revised arrangement, USP makes CSA payments to Ireland Co.

• .

BEAT - New Reporting Requirements and Penalties

• The 2017 Tax Act amended §6038--the current reporting regime for 25%-foreign-owned corporations, IRS Form 5472--by adding new subsection (b)(2) imposing additional reporting requirements related to the BEAT.

• The additional reporting require TPs to disclose info necessary to determine:

– Base erosion payments;

– Base erosion tax benefits; and

– Base erosion minimum tax amount for the taxable year.

• The IRS is expected to guidance on the new reporting requirements.

• Penalties for failure to report this information have been increased from $10,000 to $25,000 per form, with $25k penalties accruing every 30 days after failure to report for 90-day period and after official notification.

– See §6038A (d). There is a “reasonable cause” exception for such failures.



New § 59A BEAT - Key Take-Aways

• BEAT was intended by Congress to serve as disincentive to large corporate taxpayers (US or foreign) to “erode” the US tax base by making deductible payments to “related” foreign persons.

• BEAT potentially applies only to Large Corporations (US or Foreign) earning annual average aggregated-group gross receipts of $500MM, and with a “base erosion percentage” of at least 3% (2% for certain banks) during prior 3-year period. (Aggregation rules apply for purposes of these two tests.)

• If BEAT applies, it is imposed in addition to TP’s other tax liability.

• As a general rule, BEAT will only be imposed on a large US corporation (or US branch of a foreign corp) if TPs “base erosion tax benefits” reduce its US taxable income by more than 52%, or if approximately 52% of TP’s US tax is offset by applicable tax credits (or combo of the two).

• BEAT will have a disproportionate effect on non-US multinational enterprises (MNEs) that have US affiliates or US branches that are funded with foreign related-party debt or that make royalty payments to related (by 25% ) foreign persons, where the US entity or branch also lacks a sufficient level of non-base-eroding deductible payments (like COGS or payroll expenses) to fall below the statutory application thresholds.

• Common practice of US MNEs to deploy non-US affiliates to serve as recipients of deductible payments of royalties and interest within the group (e.g., FinCos and License-Cos) should be evaluated to determine whether BEAT can be avoided or mitigated by structuring direct 3rd-party arrangements instead.

• BEAT could disproportionately impact US Subs of “expatriated entities” (because COGS is treated as a base eroding payment if paid in respect of a member of an expatriated group, which is not the rule for non-expatriated foreign recipients of these payments).

• BEAT requires CEOs, CFOs, and their companies’ tax advisors to participate in on-going Management and Monitoring—both to avoid or mitigate BEAT exposures and to comply with strict new BEAT-related reporting requirements under § 6038A.

• Whether BEAT constitutes a violation of US Tax Treaty or WTO Trade Treaty obligations (non-discrimination principles)—stay tuned.

• In meantime, Applicable Corporate Taxpayers with potential § 59A BEAT exposures, should make sure they are in compliance with the new §6038A BEAT reporting requirements to avoid multiple $25k-per-form penalties.

• Expect more (and final) guidance from US Treasury/IRS in form of regulations clarifies BEAT calculation, application of BEAT in partnership context, application of aggregation rules, definition of “related person,” and other areas of uncertainty in statutory language of new IRC §59A.



Dispositions by Foreign Partners of Interests in Partnerships

Engaged in a US Trade or Business

146

New IRC § 864(c)(8)and IRC § 1446(f)



Foreign Partner’s Disposition of Interest in a Partnership w/a US Trade/Biz: BACKGROUND

• Rev. Rule 91-32: IRS rules that a foreign partner who sells an interest in a P/S is subject to US taxation if that P/S is engaged in a US trade/biz through a US office, to the extent the gain is attributable to property of the P/S which was used to produce “effectively connected income” (ECI).

– Many US taxpayers tried to ignore this Revenue Ruling, arguing any gain should be capital gain—not taxable in US.

– Obama Administration, in its proposed budget, recommended codifying Rev. Rul. 91-32 and adding a withholding obligation.

• Grecian Magnesite v. CIR, 149 T.C. (2017): US Tax Court rejected Rev. Rule 91-32, holding that gain or loss recognized by a foreign partner disposing of a P/S interest is generally not considered ECI (or effectively connected loss) with respect to any US trade/biz that partnership may be conducting.

• New IRC § 864(c)(8): Enacted as part of the 2017 TCJA. Treats as ECI the foreign partner’s “distributive share of the amount of gain (or loss) which would have been ECI if the partnership entity has sold all of its assets at FMV just prior to the foreign partner’s disposition (but reduced for any gain already subject to the FRPTA regime).

– § 864(c)(8) effectively reverses the result obtained in Grecian Magnesite court opinion, issued earlier in the year 2017.

Non-US Partner

P/S

US Trade/Biz

#2 (ECI assets)

US Trade/ Biz #1 (no ECI)

147

Partner

3rd Party Buyer

Sale of P/S Interest

US Group

Issue: To what extent, if any, should Foreign Partner’s sale proceeds be treated as ECI (taxable in US) or as capital gain (generally not taxable in US)?



IRC § 864(c)(8) – What it does

• Reverses holding in Grecian Magnesite (retroactively to November 27, 2017), so that foreign partners will be taxed on the sale/exchange of their interests in partnerships (US or foreign) that are conducting a trade or business in the United States.

• § 864(c)(8)(A) provides: Notwithstanding any other provision of subtitle A (Income Taxes) of the Code, gain or loss of a nonresident alien individual or foreign corporation from the sale, exchange, or other disposition of a "directly or indirectly”* held partnership interest shall be treated as effectively connected to the extent that such gain or loss does not exceed the gain or loss such person would have recognized as effectively connected gain or loss had the partnership sold all of its assets at their fair market value as of the date of the transfer.

– * Applies to tiered P/S structures: Conference Report makes clear that interests in a partnership that holds ECI assets, and that is held by a partner indirectly through other partnerships, is subject to new 864(c)(8). the provision.

• Tax recognition of the outside gain the foreign partner realizes on sale its partnership interest is limited to the disposing partner’s share of gain inherent in any ECI assets held by the partnership. ECI gain and loss is apparently netted to arrive at net ECI gain or net ECI loss.

• Coordination with the FRPTA rules to avoid double taxation: Subpar. (C) of §864(c)(8) provides that the amount of gain or loss on the sale, exchange or other disposition of the partnership interest that is treated as ECI under subparagraph (A) shall be reduced by the amount of gain or loss on such disposition that is treated as effectively connected under §897 (i.e., the FIRPTA rules).

– The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) authorizes the US to tax foreign persons on dispositions of “U.S. real property interests.” When a foreign person disposes of a U.S. real property interest in a sale, exchange, or transactions that normally would be a non-recognition transactions, FIRPTA treats such gains as “effectively connected income” (ECI), and imposes withholding obligations under § 1445.

• § 864(c)(8)(E) grants regulatory authority to Treasury to promulgate Regs or other appropriate guidance for the applying §864(c)(8), including with respect to various corporate non-recognition provisions.

– Example: If a P/S interest is contributed by a non-US partner to a corporation, should the non-recognition rule of §351 be turned off? Section 864(c)(8) does not purport to override any non-recognition provisions.



IRC § 864(c)(8) – What it says

(c)(8) Gain or loss of foreign persons from sale or exchange of certain partnership interests (A) In general . Notwithstanding any other provision of this subtitle, if a nonresident alien individual or foreign corporation

owns, directly or indirectly, an interest in a partnership which is engaged in any trade or business within the United States, gain or loss on the sale or exchange of all (or any portion of) such interest shall be treated as effectively connected with the conduct of such trade or business to the extent such gain or loss does not exceed the amount determined under subparagraph (B).

(B) Amount treated as effectively connected . The amount determined under this subparagraph with respect to any partnership interest sold or exchanged—

(i) in the case of any gain on the sale or exchange of the partnership interest, is—(I) the portion of the partner’s distributive share of the amount of gain which would have been effectively connected with the conduct of a trade or business within the United States if the partnership had sold all of its assets at their fair market value as of the date of the sale or exchange of such interest, or(II) zero if no gain on such deemed sale would have been so effectively connected, and

(ii) in the case of any loss on the sale or exchange of the partnership interest, is—(I) the portion of the partner’s distributive share of the amount of loss on the deemed sale described in

clause (i)(I) which would have been so effectively connected, or(II) zero if no loss on such deemed sale would be have been so effectively connected.For purposes of this subparagraph, a partner’s distributive share of gain or loss on the deemed sale shall be determined in the same manner as such partner’s distributive share of the non-separately stated taxable income or loss of such partnership.

(C) Coordination with United States real property interests. If a partnership described in subparagraph (A) holds any United States real property interest (as defined in section 897(c)) at the time of the sale or exchange of the partnership interest, then the gain or loss treated as effectively connected income under subparagraph (A) shall be reduced by the amount so treated with respect to such United States real property interest under section 897.

(D) Sale or exchange. For purposes of this paragraph, the term “sale or exchange” means any sale, exchange, or other disposition.

(E) Secretarial authority. The Secretary shall prescribe such regulations or other guidance as the Secretary determines appropriate for the application of this paragraph, including with respect to exchanges described in section 332, 351, 354, 355, 356, or 361.



New §1446(f) Transferee Withholding

• As part of the 2017 US Tax Act, Congress also enacted a new withholding requirement—IRC section 1446(f).

• Section 1446(f) provides that, if the portion of the gain (if any) on a disposition of an interest in a partnership would be treated under § 864(c)(8) as income effectively connected with the conduct of a trade or business within the U.S. ("ECI"), the transferee of the partnership interest [i.e., Buyer] must withhold tax equal to 10% of the amount realized on the disposition.

– The withholding is applied to the entire “amount realized” as determined under §1001(b), and does appear to be limited to ECI on the deemed sale of the partnership’s ECI assets. Regulatory authority is granted to provide for reduced withholding in some situations. See new Notice 2018-29 (below).

– If transferee fails to withhold on the “amount realized,” partnership is required to withhold on distributions to the transferee partner in the amount the transferee failed to withhold (plus interest). But see Notice 2018-29.

• Different effective dates: Although § 864(c)(8) applies to dispositions of partnership interests occurring on or after November 27, 2017, §1446(f) applies only to dispositions occurring after Dec. 31, 2017.

• IRS Notice 2018-8: Suspends, temporarily, application of 1446(f) withholding to dispositions of interests in publicly traded partnerships (PTPs), and promises that future guidance (Regs) will be prospective and will include transition rules to allow sufficient time to prepare systems and processes for compliance with the new W/H requirements. (IRS later announced in Notice 2018-29 that this suspension does not apply to non-publicly traded partnerships, which are to generally follow the withholding procedures under §1445, applicable to FIRPTA.)



IRS Notice 2018-29:

• Notice 2018-29 provides guidance with respect to the new withholding provision IRC §1446(f), enacted in connection with new § 864(c)(8). Although it does not suspend the W/H requirement for non-publicly traded partnerships, it provides helpful rules and a few safe harbors.

• Notice directs transferees to apply § 1445 principles and forms for reporting and paying withholding tax until specific guidance and forms are issued under § 1446(f). (See, e.g., § Reg. 1.1445-1(c).)

• Form 8288, U.S. Withholding Tax Return for Dispositions by Foreign Persons of U.S. Real Property Interests

• Form 8288-A, Statement of Withholding on Dispositions by Foreign Persons of U.S. Real Property Interests.

• Include statement "Section 1446(f)(1) withholding" at the top of relevant forms; enter amount subject to withholding under § 1446(f)(1) on line 5b of Part I of Form 8288 and on line 3 of Form 8288-A. Enter the amount actually withheld on line 6 of Part I of Form 8288 and on line 2 of Form 8288-A. At this time, the IRS will not issue W/H certificates under section 1446(f)(3).

• Provides interim guidance on how to determine liabilities in calculating the “amount realized” (implementing Crane & Tufts, and IRC § 752)

– In a few situations, withholding is limited to amounts of cash and property transferred (e.g., where most of amount realized is debt relief).

• Provides guidance on coordinating withholding rules of § 1446(f) with FIRPTA’s withholding regime (FIRPTA does not generally exempt non-recognition transactions, while § 864(c)(8) apparently does.)

• Provides guidance on application of withholding in the context of tiered partnerships

• Provides guidance on partnership’s backup withholding on distributions to the new transferee partner.

• Provides guidance on complete redemptions of a foreign partner’s P/S interest.



IRS Notice 2018-29 (cont.)

• Notice provides LIMITED EXCEPTIONS from duty to withhold (which may be temporary).

Pending further guidance, Transferee of P/S interest is NOT required to withhold in any of the following circumstances:

– Transferor furnishes affidavit to transferee signed under penalty of perjury, that it/she/he is not a “foreign person” and transferor has no reason to believe otherwise;

– Transferee receives a certification, signed under penalties of perjury by transferor with a US TIN, that transfer of P/S interest will result in zero realized gain;

– 1st de minimis rule: Transferee receives a certification that Transferor’s allocable share of ECI was < 25 % of its distributive share of income for each of the three prior taxable years in which Transferor was a partner (for the entire year). A transferor that did not have a distributive share of income in any of its three immediately prior taxable years during which the partnership had ECI cannot provide this certification. A transferee is not relieved from withholding if it has actual knowledge that the certification is false. When a partnership is a transferee by reason of making a distribution, this rule does not apply. Notice says these thresholds will be reduced when further guidance is issued.

– 2nd de minimis rule – ECI would be < 25% of total gain on the deemed sale: Transferee receives a certification from the P/S stating that if the P/S had sold all its assets at their FMV, amount of gain that would have been effectively connected with a US Trade/Biz would be < 25% of the total gain. (May be difficult to get P/S to cooperate.) Notice says the < 25% threshold will be reduced in forthcoming Regs.

– Non-Recognition Transactions: Until further guidance is issued, Notice provides that Transferee is not required to withhold 10% of the amount realized on a transfer in which the Transferor is not required to recognized any gain or loss by reason of a non-recognition provision. (E.g., § 351 incorporating transactions.)



Example: Disposition of P/S Interest (with US Trade/Biz) by Foreign Partner

• Facts: Foreign Co. sells its 30% interest in US P/S to an unrelated party on Feb. 14, 2018, realizing a $450 gain. Is any of it subject to US tax as “ECI”?

• Analysis:• Under §864(c)(8), For Co’s $450 realized gain is treated as income “effectively connected with the conduct of a US trade/business to extent such gain does not exceed its distributive share of gain that would be ECI had the P/S sold all of its assets at FMV as of date of sale/exchange of such interest (but reduced by real property gains that would already be separately taxed as ECI under the FIRPTA regime).

• Hypothetical sale of all of P/S’s assets would result in $600 US Real Property gain, and $300 ECI gain in personal property assets, for a total of $900 ECI gain. (NOTE: FIRPTA gains are treated as ECI under that tax law.)

• § 864(c)(8) provides that the amount treated as ECI in the hypothetical asset sale is reduced by the amount that would already be taxed as ECI under the § 896(g) of the FIRPTA regime—here $600.

• Thus, 30% of the inherent $600 FIRPTA gain (i.e., $180) is allowed to first offset For Co.’s OUTSIDE gain on the sale of its P/S interest--($450 realized gain less $180 = $270. How much of the remaining outside gain is treated as ECI to For Co?

• For Co.’s 30% distributive share of the $900 total ECI gains = $270. That $270, representing For Co’s share of total ECI gain is also offset by 30% of the FIRPTA gain: ($270 - $180 =$90).

• Thus, under § 864(c), $90 of For. Co.’s realized gain on the sale of its P/S interest is treated as ECI—and taxed in the U.S. (This makes sense as $90 equals For Co.'s 30% distributive share of the ECI gains on the personal property held by the P/S , which assets are effectively connected with a US Trade or Business.)

153

Non-USP/S

US Trade/Biz

For Co. Non-US

3rd party Non-US

70% 30%

US

For Co. 1 SELLS its 30% P/S interest for $500

For Co.’s 30% P/S InterestFMV $600Basis $150

US Real Property Personal ECI PropertyFMV $1000 FMV $1000Basis $ 400 Basis $ 700



Example continued: Disposition of P/S Interest (with US Trade/Biz) by Foreign Partner

• Facts: Foreign Co. sells its 30% interest in US P/S to an unrelated party on Feb. 14, 2018, realizing a $450 gain. Is any of it subject to US tax as “ECI”?

• Analysis of transferee withholding duty under §1446(f) and Notice 2018-29:

• §1446(f) became effective Jan. 1, 2018, and it applies to this sale of For Co’s P/S interest which occurred on Feb. 14, 2018.

• Section 10 of Notice 2018-29 provides that if a transferee is required to withhold on an “amount realized” under §1446(e)(5) or Reg. § 1.1445-11T(d) only FIRPTA withholding applies.

• However, there is no FIRPTA withholding in this example because the P/S assets are not 90% US Real Property Interests and cash. Thus, withholding under new 1446(f) conceivably applies to the ENTIRE amount realized—i.e., 10% w/h X $600 = $60.

154

Non-USP/S

US Trade/Biz

For Co. Non-US

3rd party Non-US

70% 30%

US

For Co. 1 SELLS its 30% P/S interest for $500

For Co.’s 30% P/S InterestFMV $600Basis $150

US Real Property Personal ECI PropertyFMV $1000 FMV $1000Basis $ 400 Basis $ 700



Some Post 2017-Tax Act Strategies to consider using the Check-the-Box Election

• For an individual investing in a high-tax jurisdiction with a US treaty: remember to consider electing pass-through treatment for the non-US operations. Why?

• Consider converting the U.S. investor making an investment abroad a C-Corporation if it will have CFCs

• Consider “planning into” Subpart F. Why?--to avoid GILTI as the results under GILTI could be worse! (Eg., create a branch to have services performed outside the CFC’s cy of incorporation)

• Check-the-box to flow-through status to combine QBAI in a chain of CFCdwhere one CFC is an “income CFC” and another is a “loss CFC” (more QBAI means less GILTI exposure)

• Check-and-Sell Transactions (changed stakes because a § 1248 “dividend” is eligible for the § 245A DRD!

• Consider using foreign entity selection to avoid foreign “base erosion payments” to a “related foreign person” for § 59A BEAT purposes (a payment of interest to an unincorporated foreign branch may not be a “base-eroding payment” to a related foreign person for BEAT purposes- cannot pay off a loan to yourself)



Impact of US Tax Reform on Crossborder M&A Deals

A Few “Big Picture” Take-Aways: • The choice of entity calculation starts with whether to use a US corporation to make the outbound investment (as opposed to an S-corp, or

pass-through entity (LLC taxed as a partnership), or an individual)

• There is no “one size fits all” structure

• CFC status will impose more compliance costs (especially due to new GILTI regime under Section 951A)

• There is essentially no more deferral . Call it a “quasi-territorial regime” but emphasis is on QUASI (very quasi)

• Foreign tax credit analysis is even more difficult today, given interaction between Subpart F and GILTI!!

• Avoiding § 951(a) Subpart F income will still usually be cost effective because it is taxed at a higher rate (21%) as opposed to GILTI (10.5% for lucky corporations) —but not always!

• Occasionally, because of limited FTCs with the GILTI regime, results under the longtime Subpart F regime may be better!

• Just like foreign entity selection was used for decades to avoid Subpart F income, same techniques may be used to plan “into” Subpart F

• Foreign entity selection may be used to avoid the application of the Subpart F, GILTI, and even the BEAT, and careful modeling with the right foreign entity selection can mitigate the impact of these taxes (even if you cannot avoid them)

• Hybrid mismatches (entities and instruments) are under attack globally! Be aware of the US and increasing codification of BEPS-inspired anti-hybrid rules that effectively neutralize the former tax advantages of using hybrid entities.

• No § 245A DRD for hybrid dividends (also no FTC or deduction or 78 gross-up)!

• Hybrid mismatches are often impossible to avoid; they arise organically--and can still be benign.

• Consider using foreign entity selection to avoid foreign “base erosion payments” to a “related foreign person” for § 59A BEAT purposes (a payment of interest to an unincorporated foreign branch may not be a “base-eroding payment” to a related foreign person for BEAT purposes-cannot pay off a loan to yourself)

• Determining the optimal corporate structure requires more thought than in the past (and a little “betting”)

• Until the US Treasury Department tells us otherwise, in some cases the law doesn't seem to work the way it should, or the way Congress apparently thought it would.

• Expect much administrative guidance and new regulations from the U.S. Treasury Department

• And finally: Not every outbound structure needs to be changed, but every outbound structure should be reexamined (in light of 2017 US Tax Act and other global tax law changes) !!





Thank you for your time.

Questions and/or Comments?

Pamela A. Fuller, [email protected]

[email protected]



Ms. Fuller advises a wide range of clients--including private and public companies, joint ventures, private equity funds, individuals, C-Suite executives, “start-ups,” and government entities--on transactional, investment, and supply-chain strategies to achieve optimal tax and business results. As a seasoned practitioner and tax technician, Ms. Fuller is accustomed to handling nuanced matters involving highly technical questions of law, policy, and procedure at the federal, state, local, and international levels. She provides sophisticated tax planning services across most industry sectors, including software & emerging digital technologies, financial services, real estate development, healthcare, pharmaceutical, construction & engineering, infrastructure, oil & energy, and retail.

Ms. Fuller is also an effective taxpayer advocate, with nearly two decades of experience resolving U.S. federal, state, and foreign tax controversies, as well as asserted tax penalties. Some of the controversies Ms. Fuller has handled have involved novel questions of law. She also has significant experience with complex transfer pricing issues--skills Ms. Fuller first acquired when she clerked for the United States Tax Court, serving three consecutive 2-year terms as Attorney Advisor to that court’s Chief Judge immediately following graduation with her Juris Doctorate (U.S.) degree.

Ms. Fuller holds an LL.M. in Tax Law from New York University School of Law, where she served as Graduate Editor of that school’s international law review and completed post-LL.M. studies in international business law; a J.D. from Seattle University where she was a member of the moot court team; and a B.A. from the University of Washington, where she was a varsity athlete and double majored in the honors program. She is admitted to practice law in several U.S. state jurisdictions and multiple federal courts, including the United States Tax Court where she clerked.

Ms. Fuller frequently publishes in the areas of international tax planning, dispute resolution, capital markets, and comparative securities law in peer-reviewed journals like "The International Lawyer," among others. She is a regular Session Reporter for the International Bar Association’s Taxes Committee, and has published substantive reports and extended commentaries on how to structure cross-border transactions for optimal tax and business effects.

Prior to becoming an attorney, Ms. Fuller was a business news reporter and anchor for a highly regarded NBC News affiliate in Seattle, Washington, covering national and international business, and geo-political developments.

Pamela A. FullerTax Counsel Tully Rinckey PLLC New York, [email protected]: +917 589 5697

Pamela A. Fuller, J.D., LL.M. (Tax)

Royse Law FirmSan Francisco, CA; Silicon Valley, [email protected]: + 917-589-5697

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