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

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 set out the scope and consequences of the reduced corporate tax rate and changes relevant to taxation of certain US investments. Part III explores several more relevant topics, including the movement towards a territorial tax system for US corporations and notable miscellaneous provisions before ending with a light-hearted, non-technical look at some of the more idiosyncratic elements of the Trump Tax Bill.
 
Towards a Territorial Tax System
Most countries operate a territorial tax system. That means, that income is taxed where earned, irrespective of where the taxpayer is located. Historically, the US does not. Instead, the US relies on a quasi-territorial system for corporate tax under which a US corporation was subject to taxation on income earned by its subsidiaries abroad. However, the US parent could defer such taxation until the subsidiary distributed such earnings to the parent by means of a dividend. Receipt of such a dividend payment often entitled the US parent corporation to claim a foreign tax credit (FTC) for taxes paid by the subsidiary in its home jurisdiction. Nonetheless, for dividend payments from subsidiaries operating out of tax-friendlier jurisdictions, the FTC was substantially lower than the tax rate imposed in the US. Therefore, many US corporations hoarded cash in overseas subsidiaries, rather than repatriate it. This approach was upended in December.
 
Per the new tax bill, dividends paid from non-US subsidiaries (or at least the portion consisting of non-US earnings) are entitled to a 100% dividends received deduction (DRD). The result of this DRD is non-taxation of such dividends for the US corporate parent (provided it owns 10% or more of the non-US subsidiary). In parallel, the provision granting an FTC for any taxes paid by the non-US subsidiary is repealed (as is any FTC attached to any dividend entitled to the 100% DRD). The overall re-shaping through these two changes looks a lot like a move to a pure territorial tax system.
 
However, there are other international bits of the US tax code – new and pre-existing – that maintain some aspects of the previous universal (i.e. non-territorial) system. The most obvious one is the treatment of the historical aggregate earnings and profits (E&P) of the non-US subsidiaries that were not yet distributed (i.e. the amount that would have been subject to US taxation had the dividends been paid under the previous system). Per the recent changes, this E&P will be deemed to have been repatriated (i.e. paid to the US parent as a dividend), even though it was not yet. This hoarded E&P will be taxed at varying rates, depending essentially on whether it is held in liquid (cash or equivalent) or non-liquid form (15.5% and 8%, respectively). The amount owed pursuant to the deemed repatriation provision may be paid in installments as set forth in the tax code. Once taxed, dividends containing such historical E&P are also entitled to the 100% DRD deduction.
 
Furthermore, certain exceptions will constrain the 100% DRD going forward, such as:

• The non-US source qualification;
• The requirement for a 10% ownership threshold in the non-US company;
• The non-application to passive investment companies;
• The exclusions of hybrid dividend payments (i.e. dividend payments qualifying as debt interest payments under the subsidiary’s local law); and
• The ineligibility of dividend payments on shares held for less than one year.

 
Oddly, branch profits remittances seem not to enjoy similar tax exemptions, remaining subject to the existing quasi-universal system with US headquarters taxed on the difference between the local tax rate and the new US corporate tax rate. Additionally, a new loss limitation basket for FTCs was introduced specifically for foreign branch operations. This differential treatment is bound to influence the business judgment of US corporations when deciding on the form of their overseas operations. All things being equal, branch operations will be less attractive economically due to their US tax treatment. This differential seemingly violates a cardinal norm of international taxation: To avoid tax rules that distort business decisions.
 
Meanwhile, in other parts of the tax code, the non-territorial aspects of the US corporate tax regime continue to prevail. Foremost, the controlled foreign corporation (CFC) rules remain intact, meaning that certain non-US corporations owned in part by US Persons will continue to pay US taxes on specified types of current income earned outside the US. Moreover, new treatments for certain types of income derived from intangible assets further muddy the subpart F waters. Non-US investors ought to take another look at the rules governing CFCs – the new ones and their effect on the existing ones – in order to spot any knock-on consequences to their investments.
 
Miscellaneous Items of Interest
Scattered changes that merit a mention include the following:

• The deemed repatriation tax, phantom income and fund investors
  • Under US federal tax principles, a partnership itself it not subject to tax. Instead, the taxable income of the partnership must be allocated to the partners pursuant to the negotiated terms of the partnership agreement (with some specified limitations on the freedom of allocation in order to thwart abusive practices). Critically, the taxable incidence (i.e. the allocation) need not be connected to a distribution of income to the partner.
  • In order to avoid the dreaded scenario under which partners are taxed on income not actually received, an investment fund may make a limited tax distribution in the amount of the maximum possible tax on the income allocation. However, a fund may not have the wherewithal to cover the new deemed repatriation tax on its affected foreign corporate holdings.
  • Thus, investors may wish to inquire if they might receive an allocation of deemed repatriated income without the cash to pay the tax on it.
• A derivative, defined.
  • Despite clear-cutting entire forests in order to produce the regulations for §871(m), a code provision that taxes payments from non-US derivative instruments that substantially replicate the economic benefits of holding an underlying US equity, the IRS did not define a derivative for that purpose. In fact, prior to last month, nowhere in the US tax code was a derivative defined.
  • However, in an effort to set out a formula for calculating the new transfer pricing provision (called BEAT), the code now enjoys a definition of a derivative. Whether his definition will be imported for purposes of §871(m) or any other code sections is as-yet unknowable.
  • Nevertheless, in the absence of any other guidance, if you are in need of a handy tax definition for a derivative, you might consider IRC §59A(d)(4)(h)(4)), which broadly defines one, as follows:
    • “The term ‘derivative’ means any contract (including any option, forward contract, futures contract, short position, swap, or similar contract) the value of which, or any payment or transfer with respect to which, is (directly or indirectly) determined by reference to one or more of the following:
      • (i) Any share of stock in a corporation.
      • (ii) Any evidence of indebtedness.
      • (iii) Any commodity which is actively traded commodity
      • (iv) Any currency
      • (v) Any rate, price, amount, index, formula, or algorithm.”
• “Carried interest” carries on
  • The “carried interest” exception is a long-panned IRS interpretation of partnership taxation rules. In essence, it entitles the performance fees paid to a fund’s managers (e.g. 20% of the fund’s profits) to claim preferential capital gains rates, thus incentivizing fund managers to convert (tax-free) their management fees (e.g. 2% of total assets under management) into profit participations solely for tax purposes.
  • Both 2016 Presidential candidates declared their resolve to revoke this treatment, which is negatively perceived as a license for fund managers to slash their tax rates. While the new bill extends from one to three years the holding period needed to obtain the preferential capital gains treatments (for non-corporations only), conceptually the beneficial treatment remains otherwise untouched.
• A stay of execution for the death tax
  • Despite long-standing Republican aspirations to eliminate the estate tax, the recent tax bill merely restrained its impact by doubling the threshold value of an estate at which it applies to USD 10M (the baseline number, which is indexed to inflation from 2011 and thus projected to reach USD 11.2M per person for 2018). The higher the threshold is, the greater the number of estates that will be excluded from the tax (all things being equal).
  • The new baseline is scheduled to sunset (i.e. automatically expire) in 2025 unless extended by Congress.
• Sourcing rule for inventory produced
  • The new code simplifies (the aim of any good tax reform) the sourcing rule for income from the sale of inventory produced by the seller (as opposed to inventory bought and then re-sold) per §863(b).
  • Previously, any inventory produced abroad, but sold in the US by a non-US Person was subject to partial treatment as US-source income.
  • Under the new bill, such income will be sourced entirely to the location of production and thus generally not subject to US taxation.
• Intragroup Interest Deductions, Ltd.
  • Due to the previously high rate of US corporate taxation, international groups had an incentive to bulk up their US operations with deductible expenses. One common method was through debt and thus deductible interest costs. Under the new revisions to §163(j), the interest deductions of a US corporation will be limited to 30% of its adjusted taxable income (as defined in the code and subject to its own adjustment in 2022). Any unused interest expenses may be carried forward to subsequent tax years (provided, of course, that the limit is not breached).
  • This provision is already receiving lashings for some of its details, so may be narrowed through IRS regulations.

 
The Peculiarities
In order to close on a lighter note, let’s consider some of the odder elements of the Trump tax bill. Sometimes, strange revisions may address quirks or lacunae in the current rules and are thus bonafide clean ups of debris leftover in the tax system from previous revisions. However, other times, these curios are the products of the personal leverage of individual politicos over the drafting process. Such “pork-barrel” provision are promoted by or promised to one or a small cadre of legislators for the benefit of a narrow and/or local constituency. A few provisions in the new bill stand out as particularly peculiar (and smell a bit bacon-y), such as:

• Lower taxes on mead
  • Admittedly, the set of rule changes are more concerned with beer and wine than with mead, a honey-infused ale more commonly quaffed in medieval courts than contemporary pubs.
  • This rather ancient intoxicant is, however, notably included by name in the broader excise tax reductions on various forms of alcohol and timing of the tax’s application.
  • So, heft thee flagons aloft, ye olde mead drinkers, in a toast: Long live the new tax bill!
• Native American trusts in Alaska
  • Is it a coincidence that a crucial senate vote and one of the more highly specific revisions in the new bill both feature Alaskans? Could be, but it’d be a fairly remarkable one if it were.
• Aircraft management fees
  • This reduction in taxation on, and thus the costs of, air travel should be welcomed by all frequent flyers out there … oh wait... You fly commercial? How awful for you. Never mind then.
  • This provision applies to taxation of airplane flights where a company administers, but does not own the fleet of aircraft. Such circumstances are common in the case of corporate and private jets, but will have no foreseeable impact on normal flights with regular airlines.
• It’s my tax bill, I’ll deduct what I want to
  • Heaps of new provisions that affect the taxation of real estate income and real property holding vehicles, which may or may not benefit a certain unnamed real estate magnate.

 
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