In the US, the 2017 Tax Cuts and Jobs Act (2017 Act) did not make significant changes to laws surrounding mergers and acquisitions (M&A). Consequently, one might believe that US tax advisory for international M&A has remained the same post-tax reform. However, the reality is very different. The overhaul of basic US tax rules in 2017 significantly alters US tax advisory considerations in cross-border M&A transactions. This article examines a few of the prominent issues facing US sellers and US buyers of foreign corporations and business assets.
US seller considerations
Before the 2017 Act, US corporate sellers of controlled foreign corporations (CFCs) generally held their operating CFCs through a CFC holding company. These CFCs were sold using the check-and-sell technique, as seen in the US Tax Court's opinion in Dover Corp. v. Commissioner (122 TC 324, 2004).
According to this model, the target CFC would 'check a box' in order to be treated as a disregarded entity for US tax purposes. The CFC's holding company would then sell the target's stock to the buyer. This sale would then be treated as an asset sale for US tax purposes, and with limited exceptions, would not generate Subpart F income. Consequently, the sale would not have any immediate US tax consequences.
After the 2017 Act, the check-and-sell approach still produces non-Subpart F income gains on the asset sale, as it did before the Act, but the gain will be treated as tested income that forms part of the US parent company's calculation in its global intangible low-taxed income (GILTI).
Global intangible low-taxed income
The effect of having a higher GILTI-tested income will depend on the amount of income earned by the US parent company's CFCs in the year of sale, as well as the foreign taxes paid on the combined income.
For instance, a US company whose CFCs pay foreign tax at a blended rate of 20% might suffer no tax consequences, while a US company whose CFCs pay foreign tax at a blended rate of 5% might be subject to an immediate US tax on the additional income, at the 10.5% effective rate for GILTI.
An alternative to the check-and-sell approach would be to sell the target CFC's stock, without first making them 'check the box'.
In general, a stock sale would produce Subpart F income for the CFC holding company, which is subject to an immediate 21% US corporate tax rate. This Subpart F income could be offset by an equivalent dividends deduction under §§ 964(e)(4) and 245A of the code, but only to the extent the appreciation in the target CFC's stock is attributable to earnings and profits (E&P) not previously subject to US tax as Subpart F income or GILTI.
Following US tax reform, it will not be easy for CFCs to accumulate material amounts of non-taxed E&P. From 2019, most CFCs and their E&P will be taxed as either Subpart F income or GILTI. In either case, it will be subject to an immediate US tax.
Taxpayers have considered resorting to self-help in this regard. The US seller could contractually enforce a foreign buyer to engage in a Section 338(g) election, which would treat the target CFC as selling all of its assets prior to the sale of its stock to the buyer. The election could be considered helpful to the US seller but have no impact on the foreign buyer. The election-triggered asset sale would produce an asset gain and E&P in the target CFC, which generally would be subject to US tax as GILTI-tested income.
Both a Section 338(g) election and a check-and-sell transaction would see the US seller's gains be taxed at a lower rate. Additionally, the inclusion of GILTI would see a spike in the target CFC's stock immediately prior to the stock sale. As a result, the CFC holding company would recognise a smaller gain (or loss) on a sale.
A capital loss generated in this manner might be more beneficial in situations where the target CFC is directly owned by a US parent company. The capital loss would then arise in the US tax return and this could be used to offset US capital gains.
In the case of a Section 338(g) election, it might not be possible to offset the US's 10.5% tax on the GILTI generated by the election with excess credits. The uncertainty arises from § 338(h)(16) of the Tax Code, an obscure provision from the 1986 Tax Reform Act that was designed for a more limited purpose.
In cases where the target CFC remains a CFC in the hands of the buyer, the allocation of the target CFC's GILTI-tested income in the year-of-sale raises novel questions. This situation could also arise in the case of a sale to a US buyer or in the sale to a foreign buyer with one or more US subsidiaries.
Overall, the 2017 Act's repeal of § 958(b)(4) allows for a 'downward attribution' of stock ownership from a foreign parent company to its US subsidiaries. As a result, a CFC could technically remain a CFC after a sale to a foreign multinational buyer. However, the earnings of such a CFC would generally not be taxable by a US subsidiary treated as its owner by attribution.
It should be noted that the tax technical corrections bill introduced by Representative Kevin Brady in January 2019 would reinstate § 958(b)(4), and would introduce in its place a more limited version of 'downward attribution'. These changes are proposed to be retroactive, as if they were included in the 2017 Act.
Private equity and venture capital
CFCs owned by non-corporate investors (such as venture capital or private equity) will face significant issues on exit. If a buyer were to make a Section 338(g) election, the sellers' anticipated capital gain on sale (which is already taxed at a 20% rate), would be converted to GILTI ordinary income and taxed at a 37% rate.
The proposed § 250 regulations issued in March 2019 have helpfully extended the 50% GILTI deduction to individuals electing under § 962 to be taxed like corporations on their GILTI. However, in these circumstances, the § 962 election would not provide a higher value for sale. Furthermore, the election is only available to 10% US shareholders who are deemed individuals.
US buyer considerations
Prior to the 2017 Tax Act, US buyers of foreign target companies routinely made Section 338(g) elections to obtain a higher value in the target's assets. After the Act, US buyers will continue to have incentives to make the election. The higher value will increase depreciation and amortisation deductions, resulting in reduced amounts of GILTI-tested income.
Qualified business asset investment
The higher value will also materially increase the amount of qualified business asset investment (QBAI) if the target has substantial tangible property, which will result in a reduced GILTI inclusion for the US parent company. GILTI is generally calculated as the net tested income of all CFCs, minus the 10% return on the QBAI of all CFCs with tested income.
As is the case with US sellers, the importance of reducing GILTI may vary depending on the US buyer's circumstances. A US buyer that sees their CFC earn a substantial tested income at a blended foreign tax rate of 5% will be strongly incentivised to limit further GILTI inclusions.
However, for a US buyer that sees their CFC earn tested income that is taxed at a higher foreign rate of 20%, the incentive to reduce GILTI will remain, but will not be as strong. In this case, the higher foreign taxes might offset the impact of the increased GILTI inclusion.
Unlike other foreign tax credit baskets, excess credits in the GILTI basket cannot be carried back or forward to other tax years. Reducing the GILTI in these circumstances might only produce marginal US tax benefits by reducing expense allocations to GILTI basket income.
In certain cases, enhanced depreciation and amortisation deductions resulting from a Section 338(g) election could push the acquired CFC into a tested loss. This tested loss would favourably reduce GILTI inclusions by offsetting other CFCs' tested income, but it also would result in a loss of QBAI and possibly a loss of foreign tax credits.
Only the QBAI of a CFC with tested income is taken into account in the 10% return calculation for GILTI. Similarly, only foreign taxes of a CFC with tested income are taken into account as foreign tax credits in the GILTI calculation, already after reducing them by the 20% haircut of § 960(d).
As discussed above, US sellers may have incentives to prevent buyers from making a Section 338(g) election. In situations where a transaction involves the sale of a CFC by a US seller to a US buyer, there could be substantial negotiations around making the Section 338(g) election. Without a special provision in the purchase agreement, the election is at the unilateral option of the buyer.
Base erosion and anti-abuse tax
Another material issue for certain US buyers is the special payment rule in the proposed BEAT regulations. The preamble expresses the view that a tax-free § 332 liquidation of a CFC into its US corporate parent gives rise to a BEAT payment.
The US parent, which surrenders its stock in the CFC during the liquidation, is deemed to have made payment for the CFC's assets in liquidation. This extension seems farfetched, and it is hoped that the final regulation will take a more measured view of the scope of an outbound payment.
US tax reform implications for M&A
While taxpayers await clarification on final BEAT regulations, US buyers may wish to reconsider traditional acquisition methods involving the purchase of a foreign target, and enlisting both a Section 338(g) election and a check-the-box election for the target.
Prior to the 2017 Tax Act, the aforementioned techniques allowed US buyers to amortise the purchase price of the acquisition against US taxable income, but at the expense of bringing all of the target's intangible assets into the US-taxed jurisdiction.
Until the BEAT regulations become final, US buyers might consider alternative acquisition structures that achieve the same effect without raising potential BEAT issues.
Financing issues will also take on a different character and tone. The 2017 Act imposed numerous disincentives regarding interest deductions on hybrid debt. Between US tax rules and the EU rules under the Anti-Tax Avoidance Directive II (ATAD II), hybrid debt is more likely to create issues than to solve them.
After 2017, it should be less important to use foreign cash to fund foreign acquisitions than it was before. In theory, the 2017 Act allows for tax-free repatriation of foreign cash, either under the new § 245A dividends received deduction, or as previously taxed earnings and profits (PTEP).
However, PTEP gives rise to currency gains or losses during repatriation under Code § 986(c). This may also create basis issues as it is distributed through a chain of foreign ownership.
US borrowings could still be used to achieve US and foreign tax deductions, but at the cost of an increased tax basis in CFC stock. This would also see a possible limitation under the new § 163(j) rules, particularly after 2022 when adjusted taxable income will be reduced by depreciation and amortisation so that it resembles earnings before interest and tax (EBIT) rather than earnings before interest, tax, depreciation and amortisation (EBITDA). The Treasury and the IRS have also indicated a possible concern with this kind of double-dip in the pre-amble to hybrid debt regulations.
US buyers of partnership interests should also be mindful of the new withholding rule under Section 1446(f). Unless it receives certain certifications, the buyer of a partnership interest may be required to withhold and pay 10% of the purchase price to the IRS if the partnership is engaged in a US business. The partnership can also be held liable if the buyer fails to withhold.
This article was written by Adam Halpern and William Skinner of Fenwick & West.
Chair, tax group
Tel: +1 650 335 7111
Adam is a lecturer in law at Stanford Law School, teaching classes in international tax, and is a frequent speaker at the Tax Executives Institute (TEI) and Practising Law Institute (PLI).
Adam is recognised as a leading tax lawyer by Euromoney's World's Leading Tax Advisors, International Tax Review and Chambers USA. He also appears in ITR's Tax Controversy Leaders guide.
The Fenwick & West tax group has advised over 100 Fortune 500 companies on tax matters, and has served as counsel in more than 150 large-corporate IRS Appeals proceedings and more than 75 federal court tax cases. Recent published cases include Analog Devices, Inc. v. Commissioner, 147 T.C. No. 15 (2016), CBS Corp. v. United States, 2012-1 U.S.T.C. ¶50,346 (Fed. Cl.), and the landmark Xilinx, Inc. v. Commissioner, 125 T.C. 37 (2005), aff'd, 598 F.3d 1191 (9th Cir. 2010), described by the Wall Street Journal as "the biggest tax case in the last 20 years".
Fenwick has been named San Francisco Tax Firm of the Year and US Tax Litigation Firm of the Year numerous times by International Tax Review.
Adam graduated summa cum laude from the University of California, Hastings College of the Law, and has an AB in philosophy from Princeton University.
He is a member of the State Bar of California.
Partner, tax group
Tel: +1 650 335 7669
In his tax planning practice, he develops and stress-tests customised tax planning to meet client objectives. He has significant experience representing both outbound and inbound taxpayers, and regularly deals with international tax issues such as Subpart F, foreign tax credits, transfer pricing (TP) and international M&A/restructurings. He regularly represents corporations in IRS audits, appeals and other tax controversies (including litigation).
In his transactional tax practice, Will has experience advising on a wide range of sophisticated corporate transactions, such as M&A, tax-free reorganisations, financings and restructurings.
Will has been recognised by California Super Lawyers and in Euromoney's expert guide as one of the World's Leading Tax Advisors. He regularly presents at industry educational programmes, such as Bloomberg BNA, Strafford, TEI and IFA events. He has taught international tax at San Jose State University and at the University of California, Berkeley, School of Law. A prolific writer, Will has published numerous articles, including in the Journal of Taxation, Journal of Corporate Taxation, International Tax Journal and Practicing Law Institute's Corporate Tax Practice Series. He is the author of a treatise on cross-border spin-offs for RIA's Checkpoint Catalyst.
Will graduated with a juris doctor, with distinction, from Stanford Law School in 2005, where he was a member of the Stanford Law Review. He received a BA in history in 2001 from the University of California, Berkeley.
Will is a member of the State Bar of California.