US Inbound: Obama Administration issues Green Book
The Obama Administration issued its Green Book, which contains the details of the President's tax proposals for his 2015 Budget. Three of the new proposals could materially affect inbound investment into the US The first would significantly change the rules for deductibility of interest under Section 163(j). Under the proposal, a group member's US interest expense deduction generally would be limited to the member's interest income plus the member's proportionate share of the financial reporting group's net interest expense computed under US income tax principles. A member's proportionate share of the financial reporting group's net interest expense would be determined based on the member's proportionate share of the group's earnings (computed by adding back net interest expense, taxes, depreciation, and amortisation) reflected in the group's financial statements.
The proposal would apply to an entity that is a member of a group that prepares consolidated financial statements in accordance with US generally accepted accounting principles, international financial reporting standards, or other methods authorised by the IRS under regulations. A member of a financial reporting group that is subject to the proposed rules would be exempt from the application of present-law Section 163(j).
If a member fails to substantiate the member's proportionate share of the group's net interest expense, or a member so elects, the member's interest deduction would be limited to 10% of the member's adjusted taxable income (as defined under Section 163(j)). Disallowed interest could be carried forward indefinitely and any excess limitation for a year could be carried forward to the three subsequent tax years.
This is a significant change from existing rules (which continue to apply to those taxpayers who are not subject to the proposed rule). The existing rules, unless a 1.5:1 debt-to-equity safe harbour applies, generally limit a US corporation's interest deduction to 50% of its adjusted taxable income (as defined under Section 163(j)) without regard to the corporation's share of the group's net interest expense.
US subgroups would be treated as a single member of the financial reporting group for purposes of the proposal. A US subgroup is defined as any US entity that is not directly or indirectly owned by another US entity, and all members (domestic or foreign) that are owned directly or indirectly by that entity. If a US member of a US subgroup owns stock of one or more foreign corporations, this proposal would apply before the administration's proposal that defers the deduction of interest expense allocable to deferred foreign earnings. The US subgroup's interest expense that remains currently deductible after the application of the proposal would then be subject to deferral to the extent the remaining US interest expense is allocable to deferred foreign earnings.
The proposal would not apply to financial services entities. The proposal also would not apply to financial reporting groups that would otherwise report less than $5 million of net interest expense, in the aggregate, on one or more US income tax returns for a taxable year.
As noted above, entities that are exempt from this proposal would remain subject to present-law Section 163(j). The proposal would be effective for taxable years beginning after December 31 2014.
Under the second of the three inbound proposals, deductions would be denied for interest and royalty payments made to related parties under certain circumstances involving hybrid arrangements. The proposal would deny a deduction in the US when the taxpayer makes an interest or royalty payment to a related party and either (1) as a result of the hybrid arrangement, there is no corresponding inclusion to the recipient in the foreign jurisdiction, or (2) a hybrid arrangement would permit the taxpayer to claim an additional deduction for the same payment in another jurisdiction.
The Green Book's explanation describes the relevant hybrid structures as including hybrid entities, hybrid instruments, and hybrid transfers (such as a sale-repurchase or repo transaction) in which the parties take inconsistent positions in respect of the ownership of the same property.
The IRS would be granted authority to write regulations, including regulations that could apply the rules in situations involving conduit arrangements in which there is a hybrid arrangement between at least two of the parties to the arrangement, structured transactions, and interest or royalty payments that, as a result of the hybrid arrangement, are subject to inclusion in the recipient's jurisdiction pursuant to a preferential regime that has the effect of reducing the generally applicable statutory rate by at least 25%. The proposal would be effective for taxable years beginning after December 31 2014.
The third major inbound proposal involves the Section 7874 "expatriation" rules. We discussed certain new regulations under those rules last month, and considered their potential impact on inbound acquisitions. The new proposal would broaden the definition of an inversion transaction by reducing the 80% test to a greater than 50% test. In other words, a foreign acquirer that is not at least as valuable as its US target would be treated as a US corporation under the proposal since persons previously owning stock in target would own more than 50% of the acquiring entity thereafter.
Significantly, the proposal would also add a rule under which, regardless of the level of shareholder continuity, the foreign acquirer would be deemed to be a US corporation if the affiliated group that includes the foreign acquirer has substantial business activities in the US and the foreign corporation is primarily managed and controlled in the US.
This could materially affect, for example, the acquisition by a large foreign multinational of a much smaller US target company. It apparently would cause the large foreign parent company to be treated as a US corporation for US tax purposes, even in the case of a 100% cash acquisition, if the foreign parent was "primarily managed and controlled" in the US.
Primary management and control is different from the European concept of management and control. While the proposal does not offer further detail on the amount or type of US primary management and control that would trigger the rule, it likely would be defined in accordance with the provision the US has recently added in a number of treaties. "Primary place of management and control" in those recent treaties applies if executive officers and senior management employees exercise day-to-day responsibility for more of the strategic, financial and operational policy decisions for managing the company, including its direct and indirect subsidiaries, in a particular country (the US under the proposed Section 7874 change) than in any other country and the staff employees of those persons conduct more of the day-to-day activities necessary for preparing and making those decisions in that country than in any other country.
As explained by the Treasury technical explanations to a number of these treaties, it is necessary to determine the persons considered "executive officers and senior management employees". In most cases, the technical explanations states it will not be necessary to look beyond the executives who are members of the board of directors (the "inside directors"). It further states this will not always be the case, however. In fact, the relevant persons may be employees of subsidiaries if those persons make the strategic, financial and operational policy decisions.
The proposal is stated to be effective for transactions occurring after December 31 2014.
Jim Fuller (firstname.lastname@example.org)
Tel: +1 650 335 7205
David Forst (email@example.com)
Tel: +1 650 335 7274
Fenwick & West