A U.S. Treasury Department press release on 4 May provided a first glimpse at the international tax changes underlying the Obama Administration’s budget proposal to raise $210bn over 10 years from international tax reform. This outline briefly describes the possible resulting legislative changes that may particularly interest U.S. private equity investors.
This summary provides only general information, not advice on which you can rely to avoid U.S. tax penalties
A U.S. Treasury Department press release on 4 May1 (www.treasury.gov/press/releases/tg119.htm) provided a first glimpse at the international tax changes underlying the Obama Administration’s budget proposal to raise $210bn over 10 years from international tax reform. The changes include increased reporting of tax haven income, deferred deductions for expenses related to foreign income, enhanced limitations on foreign tax credits and elimination of strategies that use disregarded entities to avoid subpart F income. This outline briefly describes the possible resulting legislative changes that may particularly interest U.S. private equity investors.
The press release outlines general concepts, not legislative proposals. This outline speculates about the legislative proposals likely to result.2 At present, the Obama Administration’s substantive proposals appear likely to have relatively few negative consequences for typical U.S. private equity investors. But the U.S. does not have a parliamentary system, and Congress ultimately may enact international tax measures different from those proposed by the Administration.
Check-the-box foreign subsidiaries
- The Administration wants to stop U.S. multinational companies from electing to disregard foreign subsidiaries so that they can shift income from high-tax to low-tax jurisdictions without U.S. tax consequences.
- Loans between disregarded entities are disregarded transactions; therefore, finance subsidiaries in low-tax jurisdictions have no interest income for U.S. purposes when they make loans to subsidiaries in high-tax jurisdictions.
- U.S. private equity investors holding (through a fund) less than 10 per cent of a foreign company’s shares generally would not have additional current income (under the subpart F or PFIC rules). However, cash distributions and exit gains of investors who are individuals are more likely to be taxed at the higher rates (unless they are qualified dividend income entitled to the same rate as capital gains) because the recognition of previously disregarded payments could cause portfolio companies to have higher earnings and profits.
- U.S. investors holding at least 10 per cent of the shares of a controlled foreign corporation (directly or indirectly) would likely have additional current income (under subpart F), particularly if the Administration proposals also restrict look-through rules for dividends and interest.3
- The use of check-the-box elections to ameliorate PFIC concerns in groups with significant real estate, intangible assets or financial services businesses could be adversely affected or entirely prevented.
- Multi-tiered holding company structures used to avoiding foreign withholding tax on repatriated profits and to pushing down acquisition debt into operating subsidiaries, which rely on disregarding intermediate entities to avoid generating earnings from intra-group interest payments, would be impacted. U.S. private equity investors holding at least 10 per cent of an affected company would have additional current income, but the effect on others is likely to be limited to possible higher tax rates on dividends and gains of individual investors.
Expenses related to foreign investment
- The Administration wants to defer U.S. deductions for the expenses of earning foreign income (including interest expense) until the taxpayer pays U.S. tax on the income.
- Interest expense related to foreign investment probably would be determined by allocating interest, possibly worldwide interest, based on the relative value of the taxpayer’s U.S. and foreign assets.
- Since acquisition debt is typically pushed down into portfolio companies, the proposal should generally not affect interest expense deductions unless worldwide interest allocation is required.
- Deductions for other expenses related to foreign investments would be deferred until U.S. investors repatriate income or recognize gain.
Foreign tax credits
- The Administration’s foreign tax credit proposal is vague but the Administration probably proposes:
- to pool a corporate group’s worldwide foreign tax credits to prevent taxpayers from repatriating only high-taxed earnings;
- to deny credits when another party has claimed relief for the same tax in another jurisdiction; and
- to deny credits until the U.S. taxpayer takes into account the foreign income on which the tax was imposed.
- The first proposal might foreshadow a major change in U.S. law. The second two proposals appear to advance changes made in temporary and proposed Treasury regulations on foreign tax credit arbitrage and foreign consolidated groups.
- The Administration’s first proposal would change the computation of foreign tax credits for taxes paid by a foreign company. This would affect very few U.S. private equity investors because only a U.S. taxpayer holding at least 10 per cent of a foreign company’s shares can claim credits for tax paid by the company (as distinguished from credits for tax withheld from distributions to the U.S. taxpayer).
- The other two proposals are also unlikely to affect U.S. private equity investors because private equity funds have typically not been significant participants in foreign tax credit arbitrage and foreign consolidated group tax credit planning.