Focus on Finance: The Impact of Tax Reform
The sweeping overhaul of the tax code is a mixed blessing for the finance industry. First and foremost, as a sector that is subject to relatively high effective rates, a 40% reduction in the statutory corporate rate stands to yield major benefits, particularly for those companies with primarily domestic operations. The bullish sentiment is reflected in the wave of banks announcing tax-reform related bonuses, raises and other investments in their workforce since its enactment. While the impact of such beneficial topline provisions to the industry may be readily apparent, others, including international anti-abuse laws targeted at taxpayers artificially reducing their income through payments to affiliates domiciled, or holding valuable assets, in low tax jurisdictions outside the United States, unintentionally may burden banks that are not the primary targets of the new legislation.
The most obvious change that affects the finance industry, and banks generally, is the limitation on the deductibility of interest. Until now, debt financing has been attractive for many businesses due to the general ability to deduct interest payments on debt. In contrast, no deduction is permitted for returns on equity financing. Corporations were curtailed by so-called earnings stripping rules, which limited deductions for loans by, or guaranteed by, certain related lenders if their debt:equity ratio exceeded 1.5:1, and related party debt typically has been subject to scrutiny and possible recharacterization as equity.
Under the Tax Cuts and Jobs Act (TCJA), interest on indebtedness generally may be deducted only up to an amount equal to the sum of business interest income and 30% of adjusted gross income (Interest Deduction Limit). The disallowed interest may be carried forward indefinitely to succeeding taxable years. There is an exception for small taxpayers whose annual gross receipts over a prior three year period do not exceed $25 million, as well as special rules for partners in partnerships. The earnings stripping rules have been repealed, which is aligned with the Interest Deduction Limit (which eliminates the need for a specific disallowance for related taxpayers).
While the full impact of the Interest Deduction Limit is unclear, we expect companies to at least initially reconsider their cash needs and possibly consider alternative methods of financing operations and acquisitions. While borrowing still provides some tax advantage, we do not expect banks to provide any additional flexibility in their lending, meaning that companies still would have to comply with restrictive covenants in credit agreements and risk default and related penalties. Accordingly, we may see at least an initial decline in borrowing activity as the market adjusts to the change.
However, in the recent U.S. oil and gas industry downturn and related restructurings, banks have been more willing to accept senior equity positions in companies restructuring their debt. Typically, these investments are in corporations, but banks have taken interests in partnerships (and limited liability companies treated as partnerships) as part of a debt restructuring. This has been particularly true in the oil and gas industry. While many banks may be prohibited from direct, primary equity investments, we may see more flexibility where borrowers (presumably troubled) seek to restructure their debt and equity. Such borrowers may be able to piggyback on the restructuring opportunity to exchange bank debt for preferred equity in light of the Interest Deduction Limit – this may be particularly relevant for insolvent or troubled companies where the limit could be precariously low, given that the determination is based on adjusted gross income as described above (and the company may have little to no such income). Also, even banks that cannot invest in equity directly often own or are affiliated with securities firms and private equity type investors that could benefit from more equity investment. Investment banks that serve as underwriting agents also may see an uptick in equity placements, both private and public.
Non-bank lenders, such as private equity funds, often invest in equity, and thus it is possible that such investors would gain an advantage over banks in the finance and capital markets industries as and if companies consider alternatives to traditional lending. Of course, the decision to pursue debt or equity financing is complex and takes into account many non-tax considerations, including the typical higher return on equity that would be borne by the company and the negotiation of governance rights. Moreover, private equity funds often borrow and also may be considering alternatives (including structuring alternatives involving the use of so-called blockers) in light of the new Interest Deduction Limitation.
Note the Interest Deduction Limitation only will affect debt financing taking place in the United States, while global banks and borrowers may continue to enter into lending transactions that take advantage of deductions allowed by other countries and not suffer disproportionately from these new U.S. limitations. However, as described more fully below, other international tax law changes in the TCJA unexpectedly may affect global banks with U.S. operations and limit interest deductions taken in connection with so-called hybrid entities and instruments.
Other provisions of the TCJA may prove to be traps for the unwary, particularly for banks with international holdings or activities. Corporate tax reform in the new law has been focused on slashing the rate and making the system territorial for U.S. corporations (rather than taxing corporations on worldwide income). However, there are a number of taxes that will impact U.S. banks with foreign subsidiaries, operations or assets, and non-U.S. banks with U.S. subsidiaries or branches.
The Base Erosion and Anti-Abuse Tax (BEAT) was enacted to prevent U.S. corporations from artificially reducing their income subject to U.S. tax through deductible payments to foreign affiliates. The BEAT, discussed in more detail here,generally requires corporations with average annual gross receipts of $500 million to pay a tax equal to ten percent (for most years before 2025) as modified for this purpose; while 2018 has a phase in at five percent generally, the rate for financial firms is six percent for such year.
As a number of banks noted publicly and in letters to Congress before the TCJA was passed, the BEAT unexpectedly and unfairly traps banks. The Act does not indicate whether the payments to related foreign corporations are taken into account on a net or gross basis. Accordingly, as the letters indicate, a gross basis requirement could amplify income for global banks that frequently move money among units, by overstating the amount of targeted deductible payments going out of the United States. As the banks point out, foreign banks with domestic subsidiaries and branches could have the same income taxed twice, as payments between a U.S. branch or unit and a foreign affiliate will be subject to the tax, even though the U.S. branch or unit already pays tax in the United States. Congress did address a few issues raised by the banks, notably excluding derivatives from the scope of BEAT taxation. However, many banks have noted that the exception is too narrow and that, as passed, BEAT unduly subjects banks to increased tax – even though foreign banks with U.S. operations were not the target of this anti-abuse provision. See here for more information.
Significantly, the BEAT would not increase the tax liability of domestic banks with only U.S. operations, and domestic banks generally will be subject to the new, lower corporate rate. To the extent that banks would face this risk, the industry expects that technical corrections will address this point, and our Policy Resolution Group is working with industry groups to keep the scope of the BEAT as an issue at the top of the list for correction.
Another new international provision in the TCJA designed to impose a minimum tax on companies that hold valuable patents and copyrights offshore – the global intangible low-taxed income (GILTI tax) – significantly could impact banks. Under the new provision, certain U.S. shareholders of a controlled foreign corporation must include such corporation’s global intangible low-taxed income in gross income for the tax year, subject to a new deduction when computing related income. However, the Act does not clearly define “intangible” and thus the term could be interpreted expansively to include assets (e.g., goodwill or going concern value) commonly held by businesses such as banks. To be clear, the law applies only where a company’s non-U.S. tax bill is below a minimum threshold, or where there is “excess foreign profit.” There are deductions against the tax that take the effective rate to 10.5% through 2025. Corporations – including most banks – generally will fare better than partnerships as a result of how the provision was drafted, including being able to take advantage of the 10.5% rate. However, given that this income otherwise would not be taxed until repatriated, it is a surprising potential liability for banks with certain assets offshore. Our Policy Resolution Group also is monitoring responses to the GILTI tax and working with various industry organizations to narrow the scope in technical corrections. Indeed, practitioners already have noted the potentially draconian nature of the tax. See here for more information.
Interest deductibility comes up again in another international provision designed to target financing structures that utilize different tax treatments of other countries. Specifically, the Act denies a deduction, including for interest payments, to a foreign related party paid (i) pursuant to hybrid transactions, where such interest payments are not subject to taxation in the jurisdiction of the foreign related party, and (ii) to hybrid entities, which are entities treated as transparent in the United States but as nontransparent in the recipient’s country, or vice-versa. This change will impact treaty structures that rely on the treatment of certain payments as nontaxable return of capital or nontaxed foreign earnings in the foreign jurisdiction where the related party resides, but as interest payments for U.S. federal income tax purposes. Before the TCJA was passed, there were rumblings throughout the international community that the new provision violates international treaty laws; we do not expect this will develop much further but will continue to monitor.
One provision that was in both the House and Senate bills but did not survive would have repealed Section 956 of the Internal Revenue Code for domestic corporations. This is the so-called “deemed dividend” rule that requires banks to accept limitations on their collateral and security packages with respect to foreign subsidiaries. Section 956 and related regulations are the reason that foreign subsidiaries cannot guarantee debt of a U.S. borrower and that there is a 65% (or 66%) limit on the pledge of voting stock of such subsidiaries. These rules also limit the ability of foreign corporations to be co-borrowers with U.S. entities. Unfortunately, these limits will continue.