US President Joe Biden’s tax proposals could bring dramatic changes to mergers and acquisitions (M&A) activity and investment into and out of the US. Biden’s tax plan would raise US taxes on the earnings of domestic corporations and controlled foreign corporations (CFCs), tighten limits on the deductibility of interest, and erect higher barriers to foreign-parented business combinations of US and foreign entities under revisions to the anti-inversion rules of Section 7874.
To enact his proposals, the Biden administration will need to obtain passage of his legislation through a deadlocked Senate, which creates uncertainty as to what form any tax legislation will take. Whatever the ultimate details, it seems likely that the US corporate tax rate will go up, thereby decreasing the attractiveness of investment into US corporations and leading to more investments overseas. So would Biden’s proposed repeal of the deduction for US corporations’ foreign-derived intangible income (FDII), a deduction that has encouraged US corporations to locate intangible property rights at home.
Changes to outbound investment or acquisitions by US companies
The 2017 Tax Cuts and Jobs Act (TCJA) significantly increased the attractiveness of a US corporation as a vehicle for holding both US and foreign assets, as compared to alternatives such as a foreign-parented structure or a pass-through entity. In addition, for US-based multinational corporations, the global intangible low-taxed income (GILTI) and FDII rules decreased the potential difference in tax rate for earning foreign income through the US parent corporation or a controlled foreign corporation (CFC) from as much as 35% in 2017 to as little as 2.5% today. These changes decreased the incentives to acquire businesses under a foreign parent and made acquisition of intangible property in the US more attractive.
In addition to raising the mainline corporate tax rate from 21% to 28% (a figure that one Democratic senator has said is 3 percentage points too high), the Biden administration proposals would repeal the FDII deduction, subjecting all income earned by a US corporation to full US corporate tax, and increase the rate of tax on GILTI from 10.5% to 21%. This would increase the ‘spread’ between owning foreign intellectual property (IP) in a CFC versus directly in the US parent to 7%, instead of the current 2.5% or less. This could renew incentives for offshoring intangible property and, in an asset purchase, make it less likely that a US buyer would want to acquire foreign assets at home. Asset dispositions by US companies to foreign buyers would no longer enjoy the reduced rates of tax on FDII.
The Biden proposals would enact two new restrictions on deductibility of interest expense that could significantly affect the tax treatment of a leveraged acquisition of foreign assets by a US parent corporation. First, in a proposal that resurrects a provision from the 2017 tax bill passed by the House of Representatives but not included in the final TCJA legislation, interest expense of a US member of a financial reporting group would be limited to that member’s proportionate share of the group’s net interest expense. The member’s proportionate share of net interest expense would be equal to the member’s contribution to the group’s worldwide earnings on a financial reporting basis before interest, depreciation, amortisation, and taxes.
This provision would limit interest deductibility more stringently than current §163(j) by preventing ‘overleveraging’ the US group relative to foreign members of the group. It would also introduce significant complexity in assigning the financial reporting group’s earnings for financial statement purposes geographically within the group. Alternatively, a US member of a financial reporting group could elect to limit its interest deductions to 10% of the adjusted taxable income of the US member. Section 163(j) would not be repealed but would coexist with this groupwide interest limitation.
Second, after applying the groupwide interest expense allocation described above, the proposed legislation would also disallow the deduction for any interest expense of a US parent that is allocable under §861 to CFC stock that produces GILTI subject to a reduced rate of tax. This proposal recalls similar proposals made during the early part of the Obama administration to disallow interest expense deductions related to a US group’s deferred foreign earnings.
Here, however, the interest expense would be disallowed to the extent related to the portion of GILTI that is eligible for a reduced rate of tax. For example, if the GILTI rate is 21% and the regular US corporate rate is 28%, then one-quarter of the taxpayer’s interest expense related to foreign source income would be disallowed as a deduction.
It is unclear how this new disallowance of foreign-allocable interest expense would coordinate with the foreign tax credit limitation, although §904(b)(4) would be repealed. This provision would have a major impact on US taxpayers who borrow at home and own CFCs subject to a low rate of foreign tax, because it would limit the value of US-based interest deductions that are supported by the taxpayer’s foreign assets to the GILTI rate.
US companies and planning for foreign dispositions
The proposed changes in the corporate rates and GILTI rates will also, of course, affect the tax consequences of asset sales, carve-outs, and other dispositions of foreign assets by US taxpayers.
To the extent that the selling US group has unrecovered stock basis in a target company, the decreased spread between the GILTI rate and the regular corporate tax rate would incentivise stock sales rather than asset sales. Under the TCJA, if a US corporation intends to sell a CFC, the sale could be structured as a stock sale without a §338 election, which would generally be subject to 21% corporate tax (except to the extent of any §1248 amount that is eligible for the participation exemption of §245A), or as a sale of assets that, to the extent those assets do not give rise to subpart F income, would be eligible for a 10.5% tax rate. Depending on how the asset sale is structured, the tested income so generated might also be eligible for offset against excess foreign tax credits in the GILTI basket.
The Biden proposal’s increase in the GILTI rate relative to the increase in the corporate rate will change the calculus again. Further, the Biden plan would bar taxpayers from using excess foreign tax credits to shelter the US tax on gain from the sale of a hybrid entity via a ‘check-the-box’ election. Under current law, §338(h)(16) provides that a deemed asset sale by virtue of a §338 election is disregarded for purposes of determining the source of income and the foreign tax credit limitation. Other deemed asset sales, such as from the sale of a disregarded entity, currently enjoy more favourable foreign tax credit limitation treatment. The Biden proposal would eliminate this difference and treat all sales of a hybrid entity as if they were sales of CFC stock for purposes of determining the source and §904 basket of the taxpayer’s gain.
In addition to the corporate tax treatment of a disposition, the Biden proposals would significantly increase non-corporate shareholder taxes on capital gains and dividend income. To the extent those proposals were enacted, the new rules would tend to favour a tax-free spin-off as a method of disposition of foreign (or US) assets to return value to shareholders.
Inbound investment into the US
Although some of the effects of an increase in the US corporate tax rate may be mitigated by the establishment of a worldwide minimum corporate tax rate of at least 15%, as recently agreed to by the vast majority of the countries in the OECD’s Inclusive Framework, a higher US corporate tax rate will nonetheless decrease investment in US corporations.
Furthermore, the Biden plan includes a provision aimed at penalising multinationals with greater than $500 million in global annual revenues that make deductible payments to affiliates in low-tax jurisdictions despite the global minimum tax envisioned under the OECD’s pillar two. Under the provision, known as SHIELD (stopping harmful inversions and ending low-tax developments), a deduction would be disallowed to a US corporation or US branch of a foreign corporation by reference to gross payments that are made or deemed made to any financial reporting group member that is subject to an effective tax rate below the designated minimum tax rate under the OECD’s pillar two.
The deductions for payments made to an affiliate subject to a low rate of tax would be disallowed in their entirety. Thus, for example, if a foreign multinational holds IP in a low-tax jurisdiction, the multinational’s US business would be denied any deduction or recovery of expense as costs of goods sold with respect to royalty payments made to the IP owner in the low-taxed jurisdiction. Note that this deduction disallowance would be all or nothing; an effective tax rate that is 50% of the statutory minimum tax rate would result in a 100% disallowance, not a 50% disallowance.
In addition, even if the US group members do not make payments to any low-taxed member of the financial reporting group, there would be a partial deduction disallowance with respect to payments from the US business to any foreign member of the financial reporting group to the extent that other financial reporting group members are subject to an effective tax rate less than the designated minimum.
In a rule even broader than the ‘hybrid mismatch’ rules that were part of the EU’s anti–tax avoidance directive, the US business would be treated as having paid a portion of its related-party payments to low-taxed members of the financial reporting group based on the aggregate ratio of the group’s low-taxed profits to its total profits, as reflected on the financial reporting group’s consolidated financial statements. Thus, the SHIELD rule would penalise a foreign group’s US business for profits earned by the group in low-tax jurisdictions, even if the only connection between the US business and the low-tax jurisdiction business is that the group does business in both locations.
If SHIELD is enacted, multinationals with more than $500 million in global annual revenues are likely to seek to avoid organisational structures under which their US businesses make inter-company payments. One consequence could be more use of US corporations as sales and marketing agents and contract research and development service providers rather than as principals. To the extent that a group cannot eliminate or minimise payments from its US businesses, the compliance burdens could be onerous. SHIELD is proposed to be effective for taxable years beginning after December 31 2022, perhaps to allow time for coordination with pillar two and global enactment of minimum taxes that conform to the pillar two requirements.
In a reversal of developments seen after the TCJA, the Biden tax plan may prompt parties in cross-border acquisitions to structure M&A activity under a foreign parent company rather than under a US parent company. At the same time, the Biden plan’s new anti-inversion proposals would make such combinations more difficult to achieve. Under current law, the anti-inversion rules of §7874 tax the new foreign entity as a US tax resident corporation if there is 80% or more continuity of ownership by former holders of stock of the US combining entity (as determined for §7874 purposes), and less punitive results apply if there is 60% or more continuity of ownership.
The Biden plan would tighten the rules by lowering the 80% test to a 50% test, so that the new foreign parent in a combination in which owners of the US combining entity retain a 50% or greater interest would be deemed to be a US tax resident corporation. (The 60% test would be eliminated.) The Biden plan would also tax the combined entity as a US corporation unless (i) immediately before the combination, the fair market value of the US entity is less than or equal to the fair market value of the non-US entity; (ii) after the combination, the combined entity is primarily managed and controlled outside of the US; and (iii) the combined entity (directly or through its subsidiaries) conducts substantial business activities in the country in which the combined entity is organised. Other technical changes to the anti-inversion rules involving partnerships, asset acquisitions, and tax-free spin-offs are also proposed.
If these proposed changes became law, foreign acquirers would need to carefully consider the potential inversion impact of any acquisition of a US corporation in which the foreign company uses its stock as consideration.
Will Skinner is a partner at Fenwick, who focuses on tax-efficient structuring of business transactions and corporate tax planning initiatives, particularly in the cross-border area. He supports US inbound and outbound clients in solving critical tax issues, ranging from Fortune 500 companies to venture-backed and other closely held companies. He brings both significant tax planning and tax controversy experience to bear in developing and implementing defensible solutions to client problems.
During his years of tax practice, Will has led the tax structuring and execution of numerous high-stakes corporate transactions, ranging from representing publicly traded corporations on M&A, divestitures and joint ventures, planning for legal entity rationalisations and other internal restructurings, helping US multinationals optimise their foreign tax credit or subpart F positions, and advising companies and founders of non-US companies on CFC and passive foreign investment company (PFIC) issues.
Will is a graduate of the University of California, Berkeley, and later completed his JD from Stanford Law School. He regularly presents at industry educational programmes and has taught international tax at San José State University and UC Berkeley School of Law.
Mike Knobler is an associate at Fenwick whose practice focuses on international and domestic corporate and partnership tax planning, M&A issues, and controversies.
Prior to joining Fenwick, Mike was an associate in the Washington DC office of a global law firm, where he worked on issues arising in all areas of the firm’s international corporate tax practice.
Mike is a graduate of Harvard University and earned his JD from Yale Law School.
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