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U.S. tax reform: changing dynamics will influence deal-making in Europe and the United States

Radical changes to the U.S. tax regime, with possibly more to come, offer big advantages for European companies doing business in the United States, but watch out for unintended consequences.

In December 2017, U.S. President Donald Trump signed into law a sweeping tax overhaul bill, the Tax Cuts and Jobs Act (“TCJA”). The TCJA will have immediate wide-ranging effects on M&A, intercompany arrangements, financing, and investment for both U.S. and non-U.S. businesses. However, the TCJA is without precedent in many ways, including the speed with which it was passed and the lack of bi-partisan support for it. As a consequence, some aspects of it are unclear and will need to be further developed through regulations. In addition, certain provisions appear to have unintended consequences that will need to be remedied through further legislation. Finally, with mid-term elections approaching in November, changes in the political environment may result in some of the new rules being reversed in the future. Nonetheless, the effects of the TCJA are already being felt.

Below are some of the key provisions that boards and GCs of UKbased businesses with operations in the United States (or that are contemplating conducting operations in the United States) should pay particular attention to.

…the TCJA will have immediate wide-ranging effects on M&A, intercompany arrangements, financing, and investment for both U.S. and non-U.S. businesses.

Key points

What are the key changes you need to know about?

One of the most significant changes under the TCJA is the permanent reduction of the top corporate U.S. federal income tax rate from 35% to 21%, the lowest corporate tax rate in the United States in almost 80 years.

In addition, the TCJA eliminated the corporate alternative minimum tax. These changes should result in immediate benefits to non-U.S. based multinational groups with significant U.S. operations in the form of increased after-tax returns and, depending on the particular operations of a group, these changes to the U.S. corporate tax regime may make the United States a much more attractive option for conducting business going forward.

These changes may also influence the structuring of mergers and acquisitions by making inversion transactions (i.e. transactions to relocate a company to another tax juristiction) less compelling and increasing interest in structuring transactions as asset purchases instead of as stock purchases. U.S. corporations may also be incentivised to dispose of non-core assets in light of the reduction in tax cost on any gain on such dispositions.

New rules introduce a beneficial deduction for individual owners of businesses organised as passthroughs (i.e., partnerships and LLCs) of 20% of business income. This rule doesn’t apply to passthroughs in certain service businesses, such as accounting, consulting, financial services, health and law.

These changes are likely to influence the ways that U.S. businesses are set up and may create structuring challenges for incentivising management in acquisitions of smaller and middle market U.S. businesses, as managers may prefer to hold partnership or LLC interests eligible for this beneficial tax treatment, instead of stock in a corporation.

The TCJA introduced a new cap on interest deductions to the extent that a company’s net business interest expense exceeds 30% of its “adjusted taxable income” (i.e. EBITDA for taxable years beginning before 1 January 2022, and EBIT thereafter). This may reduce the benefits of using leverage to finance acquisitions, as debt becomes more expensive if interest is not deductible.

For the next five years, taxpayers will be able to immediately deduct 100% of the amount paid for certain depreciable property instead of capitalising the purchase price and depreciating the cost over time.

This rule applies not only to new property, but also to used property acquired from third parties. Goodwill and other intangible property are not eligible for full expensing and continue to be amortisable over 15 years. Nonetheless, this change is likely to spur additional capital expenditure by U.S. businesses and further increase the appeal of asset acquisitions.

Due to the significant benefits of the full expensing rule in the context of asset acquisitions, there is likely to be an increased interest in agreeing on purchase price allocations in advance of signing deals in order to avoid disputes after closing.

Prior to the TCJA, U.S. multinationals generally were subject to tax in the United States on all of their worldwide income. However, U.S. tax on operating income generated by foreign subsidiaries (i.e. controlled foreign corporations) generally was deferred until the income was repatriated. In addition, audit rules generally allowed U.S. multinationals to avoid recording a deferred tax liability to the extent that they intended to permanently reinvest foreign earnings outside the United States.

As a consequence, many U.S. multinationals built up significant cash reserves outside the United States and were incentivised to invest those reserves in capital projects and acquisitions outside the United States.

The TCJA eliminates the U.S. system of worldwide taxation by introducing a quasi-territorial tax system. The primary feature of the change to a territorial system is a new participation exemption. Dividends paid by foreign subsidiaries to their U.S. corporate shareholders are now exempt from U.S. tax, provided the U.S. corporation owns at least 10% of the foreign corporation. Gains from the sale of stock may also be eligible for full or partial exemption under this rule (i.e. to the extent they are recharacterised as dividends).

This change makes bringing cash back to the United States much more attractive. As a consequence, U.S. multinationals may be less interested in non-U.S. acquisitions and capital investments, and more inclined to pursue domestic mergers and acquisitions, repay debt, and return cash to shareholders in the form of stock buybacks and dividends. In addition, the elimination of tax on certain stock dispositions may make internal restructurings to move foreign corporations out from under U.S. shareholders more attractive.

In connection with the move to a territorial taxation regime, the TCJA imposed a one-time tax on the deferred foreign earnings of foreign subsidiaries of U.S. corporations. The tax is imposed at a rate of 15.5% for cash and cash-equivalents and 8% on other items. The tax is imposed on the U.S. shareholders of the foreign subsidiaries that own 10% or more of the stock of the foreign subsidiaries on the last day of the subsidiary’s year that began before 2018.

As a consequence, for foreign subsidiaries with a fiscal year ending on 30 November, the U.S. shareholder that owns the stock on 30 November 2018 would be liable for the tax. Accordingly, acquirers will need to carefully consider the impacts of this rule in connection with their acquisition of foreign corporations, including U.S. groups that own foreign subsidiaries, in order to ensure that the cost of the tax is borne by the target’s selling shareholders.

Although the reduction in tax rates and move to territorial taxation will generally reduce tax costs for groups doing business in the United States, the TCJA introduces guardrails designed to prevent U.S. corporations from reducing their U.S. tax base or shifting profits overseas.

The base erosion and anti-abuse tax, commonly referred to as “BEAT”, is intended to protect the U.S. tax base by increasing taxes on corporations making significant deductible payments to non-U.S. related parties. Such deductible payments (also known as “base erosion payments”) include payments of interest and royalties and amounts paid or accrued to acquire depreciable or amortizable assets. However, payments treated as cost of goods sold are not considered as base erosion payments for purposes of BEAT.

The BEAT tax calculation is based on a complex formula that compares a U.S. group’s tax base with and without these base erosion payments. The BEAT tax applies if the difference between the two calculations exceeds a certain threshold. Multinational groups will need to determine whether they will be subject to the BEAT tax.

If the BEAT tax is likely to apply, restructuring to reduce or eliminate the impact of BEAT may be warranted and further consideration should be given to determine whether certain payments could be recategorised in a manner that allows them to be excluded from the BEAT calculation. Among other things, replacing intra-group loans with third-party borrowing (possibly with a parent guarantee) may help to reduce the likelihood of the BEAT tax applying.

Although the TCJA generally moves the U.S. to a territorial system of taxation and eliminates the system of deferring tax on operating income generated by foreign subsidiaries, it also introduces a new tax on certain excess income generated by foreign subsidiaries (referred to as “global intangible low-taxed income”, or “GILTI”).

This tax applies if the operating income of a foreign subsidiary exceeds a 10% return on the tax basis in the tangible business assets owned by the subsidiary. Foreign tax credits may be used to reduce or offset this tax liability. Non-U.S. multinationals that have U.S. entities that own interests in foreign subsidiaries (i.e. sandwich structures), should consider restructuring in order to eliminate these structures in order to avoid the GILTI tax.

In addition, U.S. acquirers are more likely to prefer asset acquisitions (or elections that allow transactions to be treated as asset acquisitions) to step-up the basis of assets for purposes of determining whether the GILTI tax will apply. U.S. sellers will likely prefer stock sales, since income from asset sales will increase income for purposes of calculating GILTI and stock sales may generate tax-free income to the extent gain is eligible for the participation exemption discussed above.

In summary, here are the issues for GCs to note:

These provisions are only a few of the myriad provisions contained in the TCJA, and depending on the operations of a particular multinational group, other provisions may also impact such group’s business.

One

The reduction in U.S. tax rates, combined with the move to a territorial tax system, is likely to stimulate U.S. mergers and acquisitions activity.

  • This is likely to include an increased interest by larger groups in disposing of non-core assets.
  • For acquisitions of U.S. targets, significant benefits may arise from structuring transactions as asset acquisitions.
  • In the non-U.S. context, U.S. sellers are likely to prefer stock sales and U.S. buyers are more likely to prefer asset acquisitions.
  • The changes are likely to increase the importance of the negotiation of tax provisions in acquisitions agreements, along with tax due diligence and tax structuring.

Two

New interest deduction limitations may reduce the attractiveness of debt financing for U.S. operations and, where such financing is still beneficial, the new BEAT tax may make third-party financing of U.S. operations more attractive.

Three

The impact of the BEAT tax on U.S. operations will need to be considered, along with restructuring steps to reduce or eliminate the potential impacts of the tax.

Four

For groups with U.S. corporations that are shareholders of foreign subsidiaries, the impact of GILTI should be considered, along with steps that can be taken to move those foreign corporations out from under their U.S. shareholders.