The Trump Tax Bill: What it means in Switzerland (Part II)

Part I of this blog series addressed the larger thematic issues for Swiss financial institutions and investors from the new US tax code provisions. Part II will explore the first of several significant topics, coupled with an analysis of the implications for Swiss financial institutions and investors.
 
Competitive Corporate Tax Rates
Prior to the Tax Cuts and Jobs Act, the US imposed one of the developed world’s steeper corporate tax rates at 35% (coupled with a further tax of up to 39.6% on the shareholder for dividends received). The new bill slashes that rate to 21% (and repeals the alternative minimum tax for corporations). The business- and investor-friendliness of this rate reduction is indisputable. In a flash, it will enhance the post-tax return on investment for US corporations, which ought to make the US operations of Swiss companies more profitable and the investment holdings of non-US investors more valuable. As noted in Part I of this series of blogs, numerous non-tax factors may mitigate the intended impact, but the tax wind clearly gusts in the direction of higher corporate post-tax profits and thus presumably a more attractive investment destination (for further illustration of this attractiveness, please see ECI section below).
 
One quirk of the rules for tax accounting, however, will result in an immediate harm to the balance sheets of US corporations (both US-headquartered companies or the subsidiaries of non-US parents) due to the reduction of the corporate tax rate. This harm is superficial, but may lead to some holes on the asset side of the balance sheets for US corporations with significant accumulated losses (called “net operating losses” in tax parlance or NOLs, for short). The US tax code permits US corporations to carry forward NOLs from one year for use against positive earnings in future years (subject to multiple limitations). As such, NOLs are valuable for reducing future tax costs and thus may be treated as an asset in the financial reports of the corporation. For accounting purposes, the amount of future deductible losses is known as a deferred tax asset (DTA) and boosts the asset side of a balance sheet so long as the corporation has a reasonable expectation that it will earn enough income to offset it in future years before it expires.
 
Well, in 2008 a lot of banks lost a lot of money. A LOT. Since then, they have been carrying DTAs of up to USD 20B, inflating their balance sheets correspondingly. However, the amount of a DTA is a product of the total NOL multiplied by the corporate tax rate. For example, if you have an NOL of USD 100, it still can only offset USD 100 of future income. Going forward though, the value to the corporation on taxes saved will be 100 x 0.21 or a DTA of USD 21, whereas previously it would have been 100 x 0.35 or a DTA of USD 35. Fortunately, the financial markets tend to discount such tax elements of a balance sheet as they do not signal the overall health and future prospects of the corporation (arguably, a large DTA signals the opposite). Nonetheless, there may be some secondary effects in response to this tax accounting adjustment.
 
Lower Rates on ECI, an Incoming Withholding Regime and More
Effectively Connected Income or ECI is income earned through a direct investment in an active trade or business (mainly). At its most straightforward, the US branch or other permanent establishment-type operations of non-US corporations generate ECI. Non-US investors can also earn ECI through investments in private equity, venture capital or other investment funds that acquire ownership stakes in start up companies, which tend to operate as LLCs or in other flow through forms. In the absence of a “blocker” corporation, the earnings of the portfolio companies pass through to the investment fund and then on to the non-US fund investors as if such non-US fund investor had earned the active operating income directly. Accordingly, income earned through such investments is taxed at the rate applicable to US corporations, not the standard dividend or capital gains rates that typically avail for non-US investors in US securities.
 
The new tax bill contains several provisions that will affect ECI calculations for non-US investors. It also institutes a new withholding requirement that will impose a further operations burden on QIs and other withholding agents. The core changes are as follows:

• First, as noted above, the tax rate for ECI is tied to the corporate tax rate. Thus, the reduction in the standard corporate tax rate reduced the ECI rate to 21% as well (for corporate recipients of ECI).
  • However, to the extent that a non-US investor receives the payment directly as an individual, the corporate tax rate reduction has no impact. The reduction in the individual tax rates and thresholds will apply, but the rate cut is less dramatic (e.g. top rate dropped from 39.6% to 37%).
• Second, the reduced corporate tax rate may make the use of US blocker corporations by investors (or by funds on behalf of investors) more attractive because of the reduced US rate and the non-reduction in the Branch Profits Tax rate.
• Third (and at odds with the second point), individual investors may opt to eschew blockers entirely to the extent the new deductions for income earned through qualifying flow through entities per §199A is available.
  • While this section is particularly complex and thus primed for substantial modification through the eventual IRS regulations, nothing currently disqualifies non-US Person taxpayers or fund investors from claiming the deduction.
  • So long as the taxpayer is not a corporation (trusts and estates qualify, as well as individuals), such non-corporate taxpayer may deduct 20% from “qualified business income” (QBI) allocated to such investors by a flow through entity (e.g. an investment fund).
  • This deduction is, however, limited by numerous constraints, which may render the deduction markedly less valuable to many fund investors, as follows:
    • Most types of investment income (e.g. capital gains, dividends) are omitted from the scope of QBI (i.e. passive income earned at the portfolio company level is not eligible for the deduction once allocated to the investor taxpayer);
    • Income from specified types of service-oriented businesses are excluded (including, tragically, the provision of tax and legal advisory services); and
    • Wages paid and depreciable assets owned by the company operate as discrete limits on the amount of QBI eligible for the deduction (though subject to an overall taxable income threshold exemption).
  • In light of the complexities of the rules, the effects of the limitations, the 2025 sunset clause (i.e. expiration date), the potential for gamesmanship at the lower levels in the investment structure and the on-going operational hassle of filing US tax returns act as a blunt deterrent to this set up, nonetheless, for non-US investors accruing significant amounts of QBI through indirect investment in active business with salaried employees, this option should be examined.
  • Please note: QBI earned through investments in publicly traded partnerships are eligible for the deduction free of the wage limitation, making it more readily available.
• Fourth, the statute overrules a court decision from summer 2017. Grecian Magnesite challenged the IRS position set forth in Revenue Ruling 91-32 that the sale of a partnership interest in a fund investing in assets that yield ECI must also be treated as ECI. In Grecian Magnesite, the Tax Court contended that in certain circumstances it might not qualify as ECI. Congress overturned that ruling, reaffirming the long-standing IRS view.
  • Congress did not stop there, however.
  • The new provisions introduce a withholding requirement of 10% of the gross purchase price paid to the transferee (i.e. the seller of the partnership interest) under §1446, unless the seller self-certifies as a US Person.
  • Non-compliance by the selling partner will result in withholding obligations foisted on the partnership itself with respect to subsequent distributions to the purchaser.
  • The new withholding requirement looks likely to yield a tangled gnarl of new withholding rules. An assessment of the impact on QIs and other custodial banks must wait, however, for these regulations to be drafted and released.
  • While the new rule withholding requirements on qualifying sales of partnership interests are technically in effect since the start of 2018, the withholding rules are deferred for sales of interests in publicly–traded partnerships (PTPs) until 2019 per IRS Notice 2018-8.

 
Part III of this blog series dissecting the new US tax code provisions will be published in a few days’ time. If you wish to be automatically notified when it’s posted, please send an email to blog@millentaxandlegal.ch and you will be added to our subscriber list.