The House tax bill released last week includes two measures that limit the ability of multinational groups to reduce their U.S. taxes. First, the bill would provide for a foreign minimum tax in the form of a high-profit foreign subsidiaries tax. We discussed that change in detail here.
Second, the bill would impose a 20% excise tax on certain payments made by a U.S. corporation to its non-U.S. corporate affiliates. That change is the subject of this post.
The excise tax is designed to eliminate the tax benefit of the deduction for a broad category of payments by a U.S. corporation to a non-U.S. affiliate unless the non-U.S. affiliate elects to treat the payment as ECI. It is expected that, depending upon the application of the branch profits tax, it will generally make sense for the non-U.S. affiliate to make the election to treat the payment as ECI (and, even then, in the longer term there will still be a significant incentive to minimize such inter-group cross-border payments.) However, the excise tax would not be effective until 2019 and would apply only to “international financial reporting group” (“IFRG”) with aggregate payments of specified amounts averaging at least $100 million per year.
Excise Tax. New Section 4491 would impose an excise tax on a U.S. corporation equal to 20% (the new U.S. corporate income tax rate) on each “specified amount” paid or incurred by the U.S. corporation to a non-U.S. corporation where both corporations are members of the same IFRG. Two corporations are members of the same IFRG if they are part of a group of entities that prepares a consolidated financial statement.
A “specified amount” is any amount that is allowable to the U.S. corporation as a deduction or is includible in costs of goods sold, inventory or the basis of a depreciable or amortizable asset. However, a specified amount does not include (i) interest, (ii) amounts paid to acquire actively traded commodities and identified hedges of certain commodities, (iii) intercompany services paid for at cost and (iv) a portion of amounts treated as effectively connected with the conduct of a U.S. trade or business.
The U.S. corporation is not permitted a deduction for the excise tax imposed. Moreover, if the ECI election described below is not made, a payment that is subject to the excise tax may be taxable to a United States shareholder of the non-U.S. recipient under the subpart F rules or the rule for high return income.
For purposes of the excise tax, a non-U.S. corporation engaged in a U.S. trade or business is generally treated as if it were a U.S. corporation with respect to specified amounts paid, incurred or received in connection with such U.S. trade or business. The excise tax also applies to similar payments made in the partnership context.
ECI Election. Importantly, the excise tax does not apply to the payment of a specified amount if the non-U.S. recipient has elected to treat such amount as effectively connected income that is attributable to a U.S. permanent establishment. Any such election applies for the current taxable year and all future taxable years unless revoked with the consent of the Secretary.
If such an election is in effect, the non-U.S. affiliate is allowed deductions in computing its ECI but only in respect of the “deemed expenses” with respect to a specified amount. The deemed expenses are defined as the amount of expenses such that the net income ratio of the electing foreign corporation with respect to such amount is equal to the net income ratio of the international financial reporting group with respect to the product line to which the specified amount relates. This net income ratio is determined on the basis of the consolidated financial statements and books and records of the IFRG and is calculated by dividing (i) net income determined without regard to interest income or expense and income taxes by (ii) revenues, in each case for the relevant product line. The provision also disallows any foreign tax credits (or any deduction for such disallowed credit) in respect of any specified amount, and would provide for joint and several liability of all domestic members in an IFRG for any underpayments.
The ECI election would allow the payment to be taxed on a “net” basis rather than a gross basis. However, in contrast to the rules that normally apply in the ECI context, the net basis would not be based on the expenses actually attributable to the ECI and would not take into account interest expense or, unless taken into account in the group’s consolidated financial statements, other expenses that typically reduce net income for tax purposes (such as intangible amortization deductions).
Also, if the non-U.S. affiliate has elected ECI treatment, the ECI will also be subject to the so-called branch profits tax. Because the bill treats any such ECI as attributable to a U.S. permanent establishment, it would seem appropriate to allow for a reduction of the branch profits tax under an available treaty, but the statute is not clear on this point.
Finally, it is important to note that, even though such payments are subject to tax at a 20% rate on a “net” basis, such payments still reduce the paying U.S. corporation’s “adjusted taxable income” for purposes of the proposed Section 163(j) thin capitalization rule, under which a U.S. corporation’s deduction of net interest is generally limited to 30% of its adjusted taxable income (generally, a measure of cash flow) – therefore reducing the payor U.S. corporation’s ability to deduct interest expense, even though the recipient non-U.S. affiliate is also denied the ability to deduct any interest expense in determining its tax on the payment. (Contrast this result with the situation where either the recipient non-U.S. affiliate is a disregarded entity with respect to the payor U.S. corporation or the recipient is a U.S. affiliate of the payor – in each case, the net income attributable to the function performed by the recipient giving rise to the payment is subject to U.S. corporate tax at a 20% rate – but on the basis of its actual net income, including the incremental interest expense allowable under proposed Section 163(j) with respect to such payment.)
Information Reporting. Foreign corporations must report, with respect to each member of the foreign corporation’s IFRG from which it receives any amount that is ECI by reason of having made the ECI election, (i) the name and TIN, (ii) aggregate amounts received, (iii) the product lines to which the aggregate amounts relate and the net income ratio for each such product line and (iv) a description of any changes to the method by which the net income ratio was computed.
Domestic corporations that make payments of specified amounts to electing foreign corporations must retain records sufficient to determine the resulting tax liability and make returns setting forth the name and TIN of the common parent of its IFRG and the information described in (ii) through (iv) above.