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Senate Wins on Base Erosion, Interest Limitation Drops

Posted on December 18, 2017 by Andrew Velarde

Congress is abandoning the separate limitation on deductibility of interest for multinationals in its tax reform bill, just one of the international developments from a conference committee report that includes a substantial endorsement of several Senate provisions related to anti-base-erosion and mobile income.

The final version of the Tax Cuts and Jobs Act (H.R. 1) no longer contemplates what would have been newly created interest limitations under section 163(n) for international financial reporting groups, although other new limitations remain in the bill.

Both the House and Senate had created a “worst of” rule for international financial reporting groups, each operating slightly differently. The House would have limited interest expense to the lesser of 30 percent of earnings before interest, taxes, depreciation, and amortization or, for worldwide groups, 110 percent of the U.S. corporation’s share (allocated by EBITDA) of net interest expense. The Senate would have limited interest to the lesser of 30 percent of earnings before interest and taxes or, for worldwide groups, expense on 110 percent of the amount of debt the U.S. member would hold if its debt-to-equity ratio were proportionate to worldwide debt. The worst of rule was met with stiff opposition from practitioners, both for its draconian application when compared with other countries, and for administrability difficulties it would cause.

Need for Revenue

The final bill generally follows earlier proposals to move to territoriality through a participation exemption system with a 100 percent dividends received deduction (DRD). "Dividends received" is interpreted broadly, including allowing the DRD for a corporation that indirectly owns stock of a foreign corporation through a partnership. The DRD would not be available to regulated investment companies or real estate investment trusts.

The melded legislation also underwent tinkering with the rate for deemed repatriation of accumulated offshore earnings. Transition to the participation system would tax illiquid assets at 8 percent and liquid assets at 15.5 percent. The House and Senate earlier envisioned a tax on cash assets of 14 percent and 14.5 percent, respectively, and noncash assets of 7 percent and 7.5 percent, respectively. That rate was already higher than what businesses had anticipated, but in Congress's search for more revenue, it has been dialed up further in the final bill. It is now estimated to raise $338.8 billion over 10 years.

To avoid double counting or non-counting of earnings, Treasury would be instructed to provide guidance, including potentially by adjusting a deductible payment from one foreign corporation to another between measurement dates. Antiabuse rules are also expected to address situations in which taxpayers may have engaged in strategies such as a change in entity classification, accounting method, taxable year, or intragroup transactions to reduce earnings and profits.

The need for revenue for other parts of the bill was not lost on John L. Harrington of Dentons. “Although the international provisions generally follow the Senate’s approach . . . the conference report also seems to have made choices based on how much revenue the provision raised,” Harrington said. “In that regard, there were some surprises, such as the fact that the conference report retains section 956 for domestic corporations even though both bills would have repealed it. The result is a set of international tax rules that are even more complicated than current law, and that are very harsh except for domestic corporations that qualify for the dividend exemption.” He added that the statement of managers does include greater detail on how the provisions work, which would be needed by taxpayers, given that most provisions would be implemented immediately or nearly so.

Both the House and the Senate anticipated instituting several anti-base-erosion measures, though those measures differed significantly in operation. The final legislation closely follows several previous Senate base erosion proposals. The bill calls for inclusion of global intangible low-taxed income with an allowable deduction. Such income is defined as the excess of a shareholder’s net controlled foreign corporation-tested income over net deemed tangible income return.

The final bill would allow a deduction for foreign-derived intangible income, also envisioned by the Senate, which permits domestic corporations a 37.5 percent deduction for such income. It abandons, however, a Senate provision designed to encourage migration back to the United States of previously transferred intangibles. That provision would have allowed the transfers of intangible property from CFCs to U.S. shareholders with the fair market value to be treated as not exceeding adjusted basis.

The combined bill also favors the Senate’s inbound base erosion antiabuse tax over the blunter House excise tax. The antiabuse tax serves as a 10 percent minimum tax (12.5 percent after 2025) on U.S. entities’ payments to foreign affiliates. It is calculated by disallowing some deductible amounts paid to related parties, but it does not include costs of goods sold in that disallowance. That has led some practitioners to speculate that the provision could provide companies with planning opportunities through the allocation of profits into costs of goods sold. Some observers have also argued that both the House and Senate provisions violate WTO rules.