Global Tax Alert | 12 March 2014

Highlights of Ways and Means Committee Chairman’s tax reform proposal for non-US investors in the United States

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Executive summary

The long-awaited comprehensive tax reform discussion draft (Camp Proposal or Proposal) released by House Ways and Means Committee Chairman Dave Camp (R-MI) on 26 February 2014 would reduce the statutory corporate tax rate from 35% to 25% over five years, reduce or restrict many corporate tax deductions and preferences, and would reform all areas of the Internal Revenue Code, including areas of interest to foreign investors in the US. The Camp Proposal provides statutory language and is supplemented by the Joint Committee on Taxation’s revenue estimates and technical explanations (No. 1 and No. 2) released on the same day. This Alert addresses only the international tax provisions most relevant to non-US persons investing in the United States as well as federal income tax proposals that may affect them.

A summary of key provisions that may impact non-US entities investing in the United States is below:

  • Limits on deductions for foreign affiliate reinsurance premiums;
  • Taxation of passenger cruise ship income of foreign corporations and individuals;
  • Earnings stripping rules tightened;
  • Restriction of treaty benefits for certain deductible payments made to a related person; and
  • Limitation of other federal deductions and preferences that may affect non-US investors.

Detailed discussion

Introduction

Chairman Camp released the Proposal as part of the Ways and Means Committee’s continued effort to effect comprehensive tax reform. The announcement states that the Proposal is a product created with extensive bipartisan and stakeholder input and would simplify the tax code and lower rates. Chairman Camp also released a draft tax reform proposal in 2011(2011 Discussion Draft).1 The 2011 Discussion Draft did not contain any cross-border provisions directly impacting non-US investors in the US. However, the current Camp Proposal has new provisions including several that directly affect non-US investors.

Modifications in the taxation of foreign persons

Limits on deductions for foreign affiliate reinsurance premiums

Under current law, insurance companies generally may deduct premiums paid for reinsurance. If the reinsurance transaction results in a transfer of reserves and reserve assets, tax liability for earnings on those assets is shifted to the reinsurer. However, insurance income of a foreign company that is not engaged in a US trade or business generally is not subject to US income tax.

Under the Camp Proposal, US insurance companies would not be permitted to deduct reinsurance premiums paid to affiliated corporations that are not subject to US tax on the premiums.2 For purposes of this provision, there is a 50% ownership requirement to be an affiliated corporation. The Proposal also excludes from a US insurance company’s income any ceding commission, return premium, reinsurance recovered or other amount received by the insurance company with respect to reinsurance policies for which a premium deduction is denied to the extent the item is properly allocable to the premium. However, if the taxpayer demonstrates to the Internal Revenue Service (IRS) that the recipient of the reinsurance premiums is resident in a foreign jurisdiction that taxes those premiums at a rate as high as or higher than the US corporate rate, the deduction for reinsurance premiums would be allowed.

Similar to a provision in the Foreign Investment in Real Property Tax Act (FIRPTA rules), the Proposal would allow an affiliated non-US reinsurer to elect to be subject to US tax on the reinsurance income. The rationale for the election is to ensure that foreign affiliates are not treated less favorably than US reinsurers. Thus, an affiliated foreign corporation that makes the election would treat the reinsurance income as effectively connected with the conduct of a trade or business (or attributable to a permanent establishment) in the United States. Consequently, the deduction for reinsurance premiums would not be disallowed, and any amounts paid as return premiums, ceding commissions or reinsurance recovered would be included in the US insurance company’s income.

The Camp Proposal is very similar to the proposal made by Senate Finance Committee Chairman Max Baucus, in his International Tax Reform Staff Discussion Draft, which was released on 19 November 2013 (Baucus Proposal).3

This provision is estimated by the JCT staff to increase revenues by $8.7 billion over 10 years.

Taxation of passenger cruise ship income of foreign corporations and individuals

Under current law, a foreign individual or corporation generally is subject to US tax on income that is effectively connected with the conduct of a US trade or business (ECI). However, income derived by a foreign individual or corporation from the international operation of a ship is exempt from US tax on ECI to the extent the foreign person’s country of residence grants an equivalent exemption to US taxpayers.

The Camp Proposal would provide specific rules for determining when passenger cruise ships operating in US waters have ECI. The provision further would subject that income to net basis taxation regardless of reciprocal exemptions.

This provision is estimated by the JCT staff to increase revenues by $0.9 billion over 10 years.

Earnings stripping rules tightened

In general, the earnings stripping rules limit the deduction of certain interest (i) paid by a US taxpayer to non-US, related persons or (ii) paid on debt that is subject to a non-US, related-party guarantee (disqualified interest). Under current law, no current deduction is allowed for disqualified interest in excess of 50% of the adjusted taxable income (ATI). The earnings stripping limitations, however, only apply to taxpayers with a debt-to-equity ratio in excess of 1.5 to 1. Disqualified interest that is disallowed in a tax year (disallowed interest) can be indefinitely carried forward and deducted in future tax years. Any excess limitation (i.e., the amount by which a corporate taxpayer’s 50% ATI limitation exceeds its net interest expense) can be carried forward for a three-year period.

The earnings stripping rules have been a consistent target in tax reform. The Camp Proposal includes a provision that would tighten the earnings stripping rules by reducing the ATI limitation threshold to 40% of ATI (from the current threshold of 50% of ATI); and, eliminating the three-year carry-forward period for excess limitation. It includes a grandfathering provision for excess limitation accrued prior to 1 January 2015.

This provision is estimated by the JCT staff to increase revenues by $2.9 billion over 10 years.

Limitation on treaty benefits for certain deductible payments

Under current law, certain payments of fixed or determinable, annual or periodical (FDAP) income, such as interest, dividends, rents, and royalties, to non-US recipients (payees) are subject to a statutory 30% flat tax. However, such tax rate may be reduced by treaty.

The Camp Proposal would eliminate the lower treaty tax rates for certain deductible FDAP payments made by US payors to foreign payees if the payor and the payee are commonly controlled by a foreign parent, which is not eligible for US treaty benefits. For such payments, the 30% tax could not be reduced by treaty unless such tax would also be reduced under a treaty if the payment were made directly to the foreign parent. For these purposes, control is defined as greater than 50% ownership.

The Technical Explanation to the Proposal makes clear that the amount of the treaty reduction in the parent jurisdiction is irrelevant when determining whether or not a payment is eligible for treaty benefits. Thus, the deductible payment made to the foreign payee would be eligible for treaty reduction at the payee’s treaty tax rate even if that tax rate is lower than the tax rate that would be applied if the payment were made directly to the foreign parent.

This provision is similar to a proposal that has been introduced by Rep. Lloyd Doggett (D-TX) several times. It is a controversial provision because it gives Congress the power to unilaterally override a bilateral income tax treaty.

This provision is estimated by the JCT staff to increase revenues by $6.9 billion over 10 years.

Other modifications affecting non-US investors doing business in the United States

In addition to the cross-border rules, the following federal provisions (among others) may affect non-US entities investing and doing business in the United States:

Corporate tax rate: The Camp Proposal reduces the maximum corporate tax rate from 35% to 25%, phased in ratably over five years.

Last-in/first out, lower-of-cost-or-market inventory costing methods: For tax years beginning after 2014, the last-in/first-out (LIFO) method of accounting and lower-of-cost-or-market (LCM) method would both be repealed under the plan. Repeal is subject to a transition rule that LIFO reserves and any positive adjustment from LCM repeal be included in income over four years, starting in 2019.

Accelerated depreciation: The Modified Accelerated Cost Recovery System (MACRS) rules would be repealed and replaced by rules substantially similar to the Alternative Depreciation System. This would lengthen class lives and require the use of the straight-line method. Taxpayers would be able to adjust their basis in depreciable assets in accordance with the chained consumer price index rate at the end of each year. This provision is prospective and is effective for property placed in service after 2016.

Amortization of acquired intangibles: The amortization period for the cost of acquired intangibles, including purchased goodwill, would be lengthened to 20 years (from the current 15 years).

R&E expenditure: All research and experimentation expenses would be amortized over five years. This would be phased in over several years, during which more than 20% of R&E expenses would continue to be currently deductible. A credit for qualified research expenses would be available on a permanent basis (see below).

Research credit: A modified research credit would be made permanent. The credit would equal 15% of qualified research expenses and basic research payments exceeding the average of those expenses and payments for the three preceding years. Amounts paid for supplies or computer software would no longer qualify as qualified research expenses.

Net operating losses (NOL): The Proposal would limit the deduction of an NOL carryforward or carryback to 90% of a C corporation’s taxable income for the year, and would repeal certain special NOL carryback rules.

Section 199 domestic production activities: The Proposal would phase out the Section 199 deduction over two years, reducing the current 9% deduction to 6% for 2015 and 3% for 2016. At the same time, the Proposal would create a “qualified domestic manufacturing income” exclusion from the 10% surtax for high-income individuals.

Energy: The Proposal repeals nearly all tax incentives for renewable energy along with several of the provisions relating to the tax treatment of fossil fuels.

Implications

The release of the Camp Proposal represents a significant development in the tax reform debate. The details of this comprehensive plan, together with the JCT staff revenue estimates, serve to highlight the difficult choices that would be required in any base-broadening, rate-reducing income tax reform.

The international tax provisions in the Camp Proposal would make dramatic changes in key elements of the US tax regime. Many of the Camp provisions affecting foreign investors in the US have been proposed in other forums. It is not clear that Camp’s plan will be brought up for consideration in the Ways and Means Committee or in Congress this year. Companies should, however, (i) review the international tax provisions and the broader Camp Proposal to evaluate the implications for their business; and, (ii) consider all opportunities available to them to participate in the ongoing debate on international tax reform. Taxpayers should weigh-in on the issues; get their voices heard; and, help to shape the tax reform debate.

Endnotes

1. See ITS Alert, Ways and Means Committee chairman unveils territorial tax proposal, dated 31 October 2011.

2. This provision applies to reinsurance of risks other than life insurance, annuity, or noncancellable accident and health insurance risks.

3. See ITS Alert, International Tax Reform Staff Discussion Draft may impact inbound investors into the United States, dated 4 December 2013.

For additional information with respect to this Alert, please contact the following:

Ernst & Young LLP, International Tax Services – Inbound, New York
  • Steve Jackson
    +1 212 773 8555
    steve.jackson@ey.com
  • Katherine Loda
    +1 212 773 6634
    katherine.loda@ey.com
  • Beate Erwin
    +1 212 773 9578
    beate.erwin@ey.com

EYG no. CM4251