Potential Changes in Draft Tax Bill Could Cause Unexpected Anxiety for Traders and Investors in Some Companies

By Stuart E. Leblang Michael J. Kliegman, Geoffrey K. Verhoff, and Amy S. Elliott

No one knows exactly what to expect in the draft tax reform text that could be released as early as November 1. This is not only because it is being closely guarded, ¹  but also because the tax writers are still changing it to make the numbers—and the politics—work. When news came out October 30s that it could reportedly take 5 years to get the top corporate tax rate down to 20 percent, the stock market dropped. ² This market movement is an early warning: Not all of the proposals in the draft will be welcome, and traders should be prepared for proposals that create unexpected uncertainty for certain businesses.

Below is an outline of some possible changes that could have particularly negative consequences. Because the real-world impacts of these changes have not been widely discussed, the market may not have assimilated some of these potential threats. We explain how they could have a material impact on U.S. companies that have re-domiciled abroad and are now foreign-parented (inverters), certain U.S.-parented multinationals, certain U.S. shareholders of foreign companies with accumulated foreign earnings, real estate investment trusts (REITs) and master limited partnerships (MLPs).

• Inbound tax on foreign-parented multinationals: The tax bill will propose massive changes to our system of international taxation. In a territorial system, U.S. multinationals will face higher U.S. taxes on their U.S.-derived income than on their foreign-derived income. It is possible that tax writers may try to level the playing field so that U.S.-parented companies can better compete with foreign-parented companies for U.S.-source profits by raising taxes on foreign-parented firms that sell into America.

One way they might do this is by imposing what has been referred to as an inbound surcharge or a half-BAT (as it may borrow consumption tax principles from the border-adjusted tax (BAT) by disallowing import deductions, but only for foreign firms). This new inbound tax is designed in part to stop inversions, and while it could be a major pay-for (raising hundreds of billions of dollars in new revenue), it could also cause a tectonic shift in supply chain decisions. Firms most impacted could be foreign-parented multinationals (including inverters) that do significant business in the United States.

• Global minimum tax on U.S.-parented multinationals: A move to a territorial tax system requires stringent anti-base erosion measures to prevent the now smaller tax base from further shrinkage. Under current law, a U.S. multinational can reduce its effective tax rate by locating highly mobile intangible income in lower-tax jurisdictions. One anti-base erosion measure that could be included in the draft as part of a move to territorial is a global minimum tax on U.S.-parented multinationals.

While there had been some speculation that a global minimum tax could be imposed at a rate closer to 10 percent, more recent reports indicate it could be as high as 15 percent. ³ The details of such a proposal were explained in our August 16 report, “Contemplated Move to Territorial Tax System Could Have Significant Negative Impact on Some Large U.S. Multinationals, Including Certain Pharma and Tech Firms.”

Although the global minimum tax will likely be billed as a tax on foreign intangible income, it could be drafted in such a way that would harm U.S. multinationals that earn high foreign profits while having few foreign tangible assets (such as many pharmaceutical and technology companies with worldwide operations).

• Deemed repatriation for U.S. owners of foreign companies: While there has been an uptick in the number of foreign firms acquiring domestic targets over the last several years, U.S. corporations still acquire a fair number of foreign businesses in whole or in part. While the deemed repatriation tax rules are not yet public, it is possible that the tax could be imposed on any U.S. shareholder that owns between 10 percent and 100 percent (by vote) of a foreign corporation.

Such an owner of a foreign corporation—holding a stake as small as 10 percent—could suddenly owe a deemed repatriation tax on its share of the foreign corporation’s historic (post-1986) accumulated earnings. That could be the case even if 100 percent of those earnings have long since been used to buy buildings or equipment and even if the owner only just recently acquired its interest. To learn more about this trap for the unwary, see our October 16 report, “Deemed Repatriation Tax Could Hit Altaba, Possibly Making Taxable Sale of Yahoo Japan Cheaper.”

• Special pass-through rate: Taxing at 25 percent certain income of businesses structured as pass-throughs could present issues for two types of entities: MLPs and REITs. It all depends on how much of a pass-through’s income will benefit from the 25 percent rate (as opposed to the presumably higher individual rate paid by owners).

If the 25 percent pass-through rate is only available for a small portion of an MLP’s profits, these entities will become significantly disadvantaged relative to C corporations. As we explained in detail in our May 3 report, “Major Corporate Rate Cut Could Alter MLP Landscape,” the double tax hit of C corporations is somewhat offset by the larger investor base, inclusion on market indices and lesser cash distribution pressures of these entities. Lowering the rate on C corporations to 20 percent while taxing all or most MLP income at closer to 40 percent could trigger many MLP-to-C-corporation conversions.

On the other hand, if the 25 percent pass-through rate is available for a large portion of an MLP’s income—and, in particular, on the returns from an active real estate business, including active rental income—many REITs could decide to convert to MLPs. That is assuming tax writers do not include a special rule reducing the tax rate on REIT dividends. As we described in our May 9 report, “REIT and Real Estate Implications of a Reduced Pass-through Rate,” because REIT investors do not currently get a preferential rate on REIT dividends, tax reform could make real estate MLPs more prevalent.

• Limiting interest deductibility: Tax writers have said they plan to partially limit a business’s ability to deduct the portion of its interest expense that remains after it is netted against its interest income. While we are hearing that companies in certain industries may have secured carve-outs from a possible cap on the amount of net interest expense they can deduct (capping it at what may be 30 percent of the business’s EBITDA, which is comparable to its earnings before tax), other companies, including those taxed as REITs, could be threatened. Unless REITs are allowed to treat their rental and other income as interest income for purposes of the netting rules, they could be forced to pay out more cash than they generate—meaning significant problems for certain REITs. Plus, if tax writers decide not to allow interest payments on existing debt to continue to benefit from full deductibility, companies with high net interest expense-to-EBITDA ratios could find themselves in a tough spot. See our September 29 report, “Changes to the Deductibility of Business Interest Expense—Grandfathering the Treatment of Old Debt Is Not a Given.”
• State and local tax (SALT) deduction for businesses: While chances are that tax writers will preserve the SALT deduction for businesses, revenue considerations may force their hands. If businesses cannot deduct the amount they pay out in state and local taxes— including income, excise, property and sales taxes—businesses in states that impose high income taxes on corporations could be particularly impacted. See our October 26 report, “Could the State and Local Tax (SALT) Deduction for Corporations Become a Bargaining Chip?”

[1] Lorenzo, Aaron and Seung Min Kim, Oct. 28, 2017, “GOP tax bill shrouded in secrecy,” Politico (https://www.politico.com/story/2017/10/28/gop-tax-bill-secrecy-244253).

[2] Mui, Ylan, Oct. 30, 2017, “Markets react to talk of corporate tax cut phase-in,” CNBC Business News (https://www.cnbc.com/2017/10/30/house-reportedly-considering-phasing-in-corporate-tax-rate-reduction.html).

[3] Moses, Molly, Oct. 26, 2017, “Goldman Sachs Predicts 25% Corporate Rate In Tax Proposal,” Law360 (https://www.law360.com/corporate/articles/978640/goldman-sachs-predicts-25-corporate-rate-in-tax-proposal). In the Tax Reform Act of 2014, former House Ways and Means Chairman Dave Camp proposed amending tax code Section 954 at 15 percent a U.S. multinational’s income stemming from the foreign exploitation of intangible property.