US tax reform: Business and investing
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First published by the Canadian Tax Foundation in 2018 Ontario Tax Conference and Live Webcast (Toronto: Canadian Tax Foundation, 2018).
The following figures are in U.S. dollars unless otherwise stated.
The Tax Cuts and Jobs Act (“TCJA”)
On November 2, 2017, the House of Representatives released the legislative text of H.R. 1, the “Tax Cuts and Jobs Act”. Over the next few weeks, the proposed legislation was marked-up by both the House and Senate. The House version of the legislation passed the House on November 16, 2017 and the Senate version passed the Senate on December 2, 2017. These versions went on to a committee conference where a unified bill would pass.
On December 22, 2017, the TCJA was signed into law by President Trump.
The TCJA, or Public Law 115-97 (“P.L. 115-97”), looks to permanently modify business taxation, while most changes to individual taxation are generally set to expire after December 31, 2025. The Joint Committee on Taxation (“JCT”) estimates that the net tax reduction will be approximately $1.4 trillion over the next ten years.[i]
Among the numerous other provisions of the TCJA, the new law dramatically reduces corporate tax rates, moves to an effective territorial system of taxation for offshore business profits of domestic businesses, introduces a new concept of a reduced tax burden on pass-through business income, and limits business interest expense deductions.
Effect on U.S. Domestic Corporations Impacting All U.S. Taxpayers
Tax Rate Changes
For U.S. C-Corporations with a tax year beginning after December 31, 2017, federal tax rates are dropping to a flat rate of 21%.[ii] Prior to tax reform, C-Corporations were subject to graduated tax rates, with the highest marginal federal corporate income tax rate being 35%.
This is one of the hallmark changes introduced by the TCJA to encourage investment in the U.S., and it has shown some effectiveness. In January, Apple repatriated over $200 billion in cash to invest in the U.S. in light of these new rates.[iii] At a 21% federal corporate income tax rate, the U.S. now also offers a more competitive tax rate compared to Canada,[iv] which may render the cross-border tax strategies currently in place less effective. With the U.S. becoming a comparative tax-advantageous jurisdiction, taxpayers are highly incentivized to shift or retain income in the U.S., which is directly opposite of the pre-TCJA taxpayer mindset.
Immediate expensing of capital assets is back. For qualified assets that have been both purchased and placed in service after September 27, 2017, 100% bonus depreciation can be taken, up from a maximum of 50% prior to the TCJA.[v] Bonus depreciation has also been expanded to include not only brand new, but also used assets provided they were not previously used by the taxpayer or a related party.
In addition, the TCJA has increased the cap on depreciation deductions under Section 179 to $1 million, up from $500,000 previously.[vi]
Net Operating Losses (“NOL”)
Some limitations on the applications of NOLs are being introduced in the 2018 tax year.[vii] Previously, NOLs could be carried back two tax years, and carried forward for 20. NOLs generated in tax years starting in 2018 can no longer be carried back and now have an unlimited carryforward period. NOL deductions will also be limited to 80% of taxable income, meaning taxpayers will not be able to wipe out their entire tax liability by utilizing only NOLs.
Corporate Alternative Minimum Tax (“AMT”)
The corporate AMT has been entirely repealed[viii], which is welcome news to many taxpayers. For entities with AMT credits from prior tax years, these credits will continue to carry forward, and can be applied in certain circumstances against the company’s regular tax liability. Excess AMT credits over regular tax liability may also be refundable from 2018 to 2021.
Domestic Production Activity Deduction (“DPAD”)
The DPAD under IRC §199 has been entirely repealed.[ix] Originally, the DPAD existed to provide tax benefits to businesses that carried on production activities domestically. These deductions were often used by oil and gas companies, but were also eligible to be claimed by businesses that carried on activities such as manufacturing, engineering, and construction within the U.S.
Interest Expense Limitation
Prior to the TCJA, determining whether a corporation was subject to interest deduction limitation was a multi-step process under IRC §163(j). Generally, for interest expense to be subject to limitation, the following criteria would have needed to apply:
- The payer corporation paid interest to a related party;
- The related party payee was not subject to U.S. tax;
- The payer’s debt-to-equity ratio exceeded 1.5 to 1; and
- The net interest expense exceeded 50% of the payer’s adjusted taxable income (“ATI”).
Following the TCJA, IRC §163(j) was amended by having the first three criteria removed.[x] In addition, its application is no longer limited to corporations, but rather applies to all taxpayers that incur business interest. This means that all interest payments made by a U.S. business can be subject to limitation, even if the payments are to an unrelated third party and the business falls within the debt-equity safe harbor. Additionally, the net interest expense is limited to 30% of ATI instead of 50%.
However, relief exists for smaller taxpayers with an average gross receipts of less than $25 million as they are excluded from the interest expense limitation provisions. Additionally, certain real estate and farming businesses are exempt from the new IRC §163(j) provided they elect to use the alternative depreciation system for certain assets.
Amortization of Research and development (“R&D”) Expenses
Under previous rules of IRC §174, corporations with R&D expenditures could choose to deduct them immediately in the current period’s tax return, or amortize them over a period of at least 60 months. Amortization would begin in the month that the business first receives economic benefit from the R&D activities.
Under new rules, immediate expensing benefits begin to sunset and beginning with the 2021 tax year, businesses will no longer have the option to immediately expense R&D expenditures.[xi] The new rules also offer preferential treatment for expenses incurred in the U.S. Starting in 2021, U.S.-based R&D will be eligible for amortization over a five-year period, whereas foreign R&D must be amortized over 15 years.
International tax considerations
Canadian Corporations Operating in the U.S.
For Canadian corporations with U.S. subsidiaries, tax planning strategies have historically tried to shift income up to Canada in order to take advantage of the lower Canadian corporate tax rates. With the drastic decrease in corporate rates introduced in the U.S., repatriating income into Canada may no longer be as tax efficient for these entities.
Additionally, many of the new rules and incentives have been introduced with the purpose of encouraging investment in the U.S. For example, with preferential treatment of R&D expenses incurred in the U.S., Canadian entities may wish to shift their R&D activities into the U.S. in order to take advantage of accelerated deductions. Shifting more operations into to the U.S. may also offer immediate expensing of capital assets in addition to lowered tax rates (through the foreign derived intangible income deduction under IRC §250) and is an alternative that will generate increased focus for international businesses.
Territorial Tax System
One of the more drastic changes from the TCJA is the shift to an effectively “territorial” tax system, which is a first for the U.S. Starting in the 2018 tax year, multinational corporations (Subchapter C corporations) may no longer pay tax on foreign-earned profits. Corporations will receive a dividends received deduction (“DRD”) from specified (i.e. more than 10% owned) foreign corporations.[xii] The DRD is equal to 100% of the foreign dividend received, which effectively wipes out these foreign dividends from taxable income.
It is important to note that while the results of the DRD effectively creates a territorial tax system on actively earned income, it is not a true territorial system. Mechanisms such as the subpart F income provisions still exist, and continue to be applicable to U.S.-controlled foreign corporations that earn movable income such as interest and dividends.
Additionally, the introduction of GILTI, which is described below, is a prominent exception to the DRD and effectively precludes for many US taxpayers from a true territorial tax system.
Section 965 Repatriation Tax
To bridge into the effectively territorial tax system, the TCJA introduces a mandatory, one-time, deemed repatriation tax, effective for tax years beginning before January 1, 2018, on previously untaxed earnings and profits that are held in specified foreign corporations.[xiii] This one-time tax is often referred to as the IRC §965 transition tax.
The §965 transition tax is designed to tax the accumulated earnings in foreign corporations that have not yet been taxed by the U.S. The tax is calculated as a function of the specified foreign corporation’s accumulated earnings and profits (“E&P”). If the accumulated E&P is held as cash or cash-like assets, a flat rate of 15.5% is applied. Non-cash earnings are taxed at a reduced rate of 8%. Rates for U.S. individuals who are U.S. shareholders in a specified foreign corporation are slightly higher.
Understandably, the §965 repatriation tax could present a major cash flow hurdle for many taxpayers. In response, the IRS has mitigated the immediate impact of the transition tax by allowing taxpayers to elect to pay over 8 years on an interest-free basis.
Foreign derived intangible income (“FDII”)
Effective for tax years beginning on or after January 1, 2018, Congress added a section that effectively establishes a new preferential tax rate for domestic entities organized as C corporations on income derived from qualifying foreign activities, which includes income from licensing, leasing, and service activities.
The new IRC §250[xiv] allows a special deduction from income of a U.S. C corporation that earns foreign derived intangible income (“FDII”). For tax years 2018 through 2025, taxpayers may deduct 37.5 percent of their FDII. Starting in 2026, the deduction percentage decreases to 21.875 percent. When combined with the 21 percent tax rate for U.S. C corporations, the effective U.S. tax rate on FDII is 13.125 percent for 2018 through 2025 and 16.406 percent starting in 2026. This section was designed to attract U.S. multinationals to relocate foreign operations back to the U.S. or increase new investment dollars in U.S. operations.
The FDII tax benefit is computed using a complex, multi-step process. At a high level, a corporation will need to determine the foreign portion of its deduction eligible income, which will be its FDII. The corporation’s FDII includes income attributable to the sale of property to any foreign person for foreign use, consumption or other disposition outside the U.S. A sale can also include leasing or licensing activities. For FDII purposes, the foreign income can also include income generated from qualifying services provided to persons outside of the U.S. or with respect to property located outside of the U.S.
A corporation will then need to determine its deemed intangible income. This is generally its gross income adjusted for certain exceptions and allocable deductions reduced by 10 percent of its qualified business asset investment (“QBAI”). Using a quarterly measuring convention, QBAI is the average of a corporation’s adjusted tax basis of its depreciable tangible assets used in its business.
Based on the foreign portion of a corporation’s deduction eligible income, a ratio is computed and applied to the deemed intangible income to calculate FDII.
Depending on the facts of the taxpayer, foreign transactions that can qualify for the reduced tax rate can be with unrelated and related parties.
Consequently, it will be imperative for U.S. multinationals to understand their cross-border transactions to identify tax saving opportunities under IRC §250. For example, property that is sold to a related party may meet the foreign use requirement as long as it can be determined that the foreign related party ultimately sells the property to an unrelated party who uses it outside of the U.S. This can also extend to the licensing of intellectual property.
Global intangible low-taxed income (“GILTI”)
Under pre-TCJA law, earnings of foreign corporations were generally deferred from U.S. taxation until it was repatriated via a dividend or unless an income inclusion event under Subpart F occurred.
The new IRC §951A[xv] of the TCJA, effective for tax years beginning after December 31, 2017, requires that U.S. shareholders of controlled foreign corporations (“CFC”) include certain foreign earnings in U.S. taxable income on a current basis, similar to the Subpart F income inclusion. The section looks to impose effectively a 10% minimum tax on an amount over net deemed tangible income, countering a total shift to a territorial tax system
This annual GILTI inclusion is generally the aggregate CFC tested income of the U.S. shareholder that exceeds its net deemed tangible income return. The net deemed tangible income return is defined as the 10% return on the U.S. shareholder’s pro rata share of the adjusted tax basis of the QBAI of the CFC reduced by certain net interest expense. However, U.S. C corporations receive a corresponding 50 percent deduction against GILTI resulting in an effective 10.5 percent tax rate until 2026. After 2026, the deduction is reduced to 37.5 percent, resulting in an effective 13.125 percent tax rate. U.S. C corporations are also entitled to a reduced foreign tax credit for 80 percent of foreign taxes paid on GILTI.
For the purposes of GILTI, the new law defines a CFC’s tested income generally as its gross income less certain exclusions, which include income effectively connected to the U.S., Subpart F income, amounts excluded from Subpart F income under the high-tax exception, dividends from a related person, and foreign oil and gas extraction income. This amount is further reduced by certain deductions. This tested income is computed according to US tax principles.
GILTI operates as a minimum tax on certain earnings of foreign corporate subsidiaries and is likely applicable across industries. It may also be applicable even if a U.S. entity has little or no intangibles outside of the U.S. and can have a substantial impact on U.S. entities whose foreign subsidiaries are profitable.
Base erosion and anti-abuse tax (“BEAT”)
Another change to the taxation of cross-border transactions is the introduction of the Base erosion and anti-abuse tax (“BEAT”) which may apply to larger U.S. corporations not treated as flow-throughs, U.S. branches of foreign corporations, or non-U.S. corporations engaged in trade of business within the U.S. regulated investment companies, real estate investment trusts, and S-corporations are specifically exempted from BEAT.
With the intention of preventing companies from reducing their U.S. tax liability by shedding earnings in the U.S., the new IRC §59A[xvi] serves as a minimum tax on payments to foreign related parties. BEAT will only apply to corporations that have average annual domestic gross receipts of at least $500 million for the three-tax year period ending with the preceding tax year, and a base erosion percentage of 3 percent or higher. The BEAT imposes a tax equal to the excess of 10 percent (5 percent for 2018) of the taxpayer’s “modified taxable income,” reduced by the taxpayer’s regular tax liability and certain tax credits.
Modified taxable income is generally taxable income without regard to base erosion tax benefit (i.e. no deduction for base erosion payments, which may include any deductible amounts paid or accrued to a foreign related party). However, base erosion payments exclude (1) any payments related to cost of goods sold or (2) amounts paid for services that meet the requirements for eligibility for use of the services cost method under IRC §482 and have no markup component. Additionally, payments that are subject to U.S. withholding are generally excluded from base erosion payments.
The BEAT will have a significant impact on large taxpayers making payments to related foreign parties as Congress attempts to reduce an erosion of the U.S. tax base. This brings about an increased focus on the appropriate characterization of deductible payments that may be classified as cost of goods sold and the impact it has on existing transfer pricing arrangements and intercompany debt structures within multinational entities.
Expansion of the definition of controlled foreign corporations (“CFC”)
Prior to the TCJA, the term “U.S. shareholder” meant, with respect to any foreign corporation, a U.S. person who owns or is considered owning 10 percent or more of the total combined voting power of all classes of stock entitled to vote for such foreign corporation. Section 14214(a) of P.L. 115-97 amended IRC §951(b) by inserting “, or 10 percent or more of a total value of shares of all classes of stock of such foreign corporation.”
By expanding the definition of a U.S. shareholder, it expanded the number of CFCs that could potentially be subject, indirectly, to U.S. taxation. For example, a U.S. person may have acquired non-voting stock in a foreign corporation that may have made up more than 10 percent of the total value of all classes of shares. Under the old rules, that person would not have been deemed a U.S. shareholder of a CFC. However, with the addition to the definition, that person is now considered a U.S. shareholder of a CFC and the person could now be subject to annual income inclusions from the CFC, even if the income is not distributed, under the provisions of Subpart F (IRC §958).
Another provision expanding the reach of the CFC definition is the elimination of IRC §958(b)(4), a provision which had precluded the attribution rules of IRC §318(a)(3) from applying when stock of a foreign person would be treated as owned by a U.S. person. By striking this provision in Section 14213(a) of P.L. 115-97, the new law allows for the downward attribution of stock ownership from a foreign person to a related U.S. person. For example, if a foreign corporation FC-A owns 100 percent of one class of stock of U.S. corporation U.S.-B and 100 percent of one class of stock of another foreign corporation FC-C, under the new law, U.S.-B is considered as owning the stock owned by its sole shareholder FC-A in FC-C. Similar to the effect of the expanded U.S. shareholder definition above, this could have the potential for U.S.-B to have annual income inclusions from FC-C under subpart F.
Overview of Pass-Through Entities
New for 2018 is section 199A, which allows for a deduction of up to 20 percent of an individual taxpayer’s ‘qualified business income.’ This deduction effectively reduces the top income tax rate applicable to ordinary business income from 37 percent to 29.6 percent. The deduction will not apply to self-employment or net investment income taxes. However, the deduction is applicable in computing Alternative Minimum Taxable Income.
Pass-through owners whose taxable income exceeds $157,500 (or $315,000 for a joint return) are subject to limitations on the deduction. These taxpayers may see the deduction reduced or fully eliminated if the business does not pay a specified amount of wage to its employees, does not hold sufficient amounts of tangible, depreciable assets, or conducts business activities considered in whole or part to be a “specified service” business described in the new law.
Given these changes to the U.S. tax landscape, some new nuances are likely to arise with respect to entity choices for business owners. Consider the following example of a typical company that manufactures widgets that generates $100 of taxable income in a given year, and distributes all of its after-tax cash flow:
Old Corporate Income Tax Rules
New Corporate Rules under TCJA
$100 of corporate income
$65 cash remaining on balance sheet to be distributed to owners
$52 after tax cash, or an effective rate of 48%
$100 of corporate income
$79 cash remaining on balance sheet to be distributed to owners
$63.2 after tax cash, or an effective rate of 36.8%
For the first time since 1986, the all-in individual tax rate is higher than the blended corporate tax rate and is a major factor to be considered when it comes to entity choice review.
Now consider the same widget manufacturer operating post-TCJA with a pass-through entity:
$100 of corporate income
$80 income attributable to owners
$70.4 after tax cash, or an effective rate of 29.6%
$100 of corporate income
$79 cash remaining on balance sheet to be distributed to owners
$63.2 after tax cash, or an effective rate of 36.8%
Compared to the C-Corporation, the pass-through structure appears to be more tax effective. However, there are considerations as to whether the owner would take distributions from the company in the first place. If the income was to be retained and reinvested in the company, the effective tax rate under the C-Corporation structure is only 21%. Other factors such as limitations on the pass-through deduction, the type of business, and owner’s own income levels are all items of consideration when making a tax advantaged entity choice.
State and local response to the TCJA
Notwithstanding federal tax reform, states are collectively facing a number of revenue shortfalls, with some states facing deficits for the 2018 fiscal year. In recent years, state tax revenues came in well below forecasted, forcing states to perform mid-year budget adjustments and ultimately contributing to the shortfalls currently occurring in most states. It should be noted that corporate income tax collections are not a significant source overall state tax collections, generally contributing under 5 percent of a state’s tax revenue.
The TCJA is expected to have wide-ranging impacts on state budgets – both positive and negative – and conformity will play a big role. Almost every state’s personal and corporate income taxes are connected to the federal return in some manner. Over a dozen states conform to the Internal Revenue Code on a rolling basis, which means that they conform to the provisions of the Code automatically as they are passed. Nearly two dozen of the states conform to the Code on a static basis, meaning they conform on a specific date. States may also decouple from federal deductions or provide their own modifications.
One potential state reaction to the TCJA could include the decoupling from the full expensing of new and used asset purchases, as the full expensing could significantly decrease the states’ income tax base. Another would be to follow the limitations on interest expense as this could serve as a potential windfall for states, as it would broaden the income tax base.
The following are examples of how a few states have reacted to the TCJA:
- Georgia – the IRC conformity date was updated to February 9, 2018 for tax years beginning on or after January 1, 2017. Georgia adopted the majority of the TCJA provisions, but did decouple from bonus depreciation and the 30% business interest expense limitations.[xvii]
- Oregon – legislation conforms to most of the TCJA provisions for 2017, but decouples with regard to the IRC §199A 20 percent deduction for flow-through entities.[xviii]
- West Virginia – enacted conformity legislation on February 22, 2018, which adopts all changes to the IRC in effect after December 31, 2016 and before January 1, 2018. It generally conforms to both the individual and corporate law changes, but allows individual exemptions as if they had not been eliminated under the IRC for tax years beginning after 2017.[xix]
State corporate income tax conformity is an ongoing process and state legislation stemming from the TCJA continue to be passed on a daily basis. Businesses, domestic and foreign, should therefore remain cognizant of how the states they operate in conform to the new law, not only in terms of their state income tax reporting, but also should be considered in their choice of entity, potential M&A activity and new investments, and intercompany transactions.
South Dakota v. Wayfair Supreme Court decision
For about 50 years, sales tax nexus has been based on a concept of “physical presence” as most recently confirmed in Quill[xx] in 1992. Simply put, businesses selling taxable products or services must be physically present in a state before that state can obligate the business to collect sales tax. Remote sellers, therefore, were not obligated to collect and remit state sales tax if they were not physically present in that state.
However, three major events have caused the states to take a more aggressive approach to remote sellers: (1) Exponential growth of remote commerce (with the widespread use of the internet), (2) weak sales and use tax collections compared with the amount of economic activity, and (3) an invitation from the U.S. Supreme Court to re-litigate the issue.
In 2016, states began to directly challenge the physical presence standard by enacting so-called economic sales and use tax nexus laws. In South Dakota, the state imposed a sales tax collection and remittance obligation on remote sellers without physical presence in South Dakota when gross revenue from sales of tangible personal property or services exceeds $100,000 or sales occur in 200 or more separate transactions.[xxi] This challenge by South Dakota was central to the Wayfair case brought to the U.S. Supreme Court.[xxii]
On June 21, 2018, the U.S. Supreme Court overruled Quill in a 5-4 decision. The Quill physical presence standard was overturned. Though this decision does not find South Dakota’s law constitutional or imposes South Dakota’s law on the 46 state sales tax jurisdictions, the Wayfair decision opens up the possibility for economic sales tax nexus provisions.
This shift in focus from physical to economic presence represents a significant shift for nexus analysis and can have a large impact on any businesses making sales or purchases across state lines. All businesses selling inbound into the U.S. should remain observant of how the states they sell into react to the Wayfair decision. This decision does not only impact U.S. domestic entities, but also foreign entities, and new collection, remittance and reporting requirements can arise for those that have not done so historically.
Investing in the U.S. and Canada
Hybrid structures under the TCJA
The TCJA enacted a new code section, IRC §267A[xxiii] to target the use of hybrid entities and transactions that erode the U.S. federal tax base. This section generally denies a deduction for any “disqualified related party amount” that is paid or accrued pursuant to a “hybrid transaction” or by, or to, a “hybrid entity.”
A “disqualified related party amount” is any interest or royalty paid or accrued to a related party to the extent that: (1) there is no corresponding inclusion to the related party under the tax law of the country of which the related party is resident for tax purposes or subject to tax, or (2) such related party is allowed a deduction with respect to the amount under the tax law of such country. However, a disqualified related party amount excludes any payment included in gross income of a U.S. shareholder under IRC §951(a).
A “hybrid transaction” is any transaction or series of transactions or agreements in which one or more payments are treated as interest or royalties for U.S. tax purposes which are not so treated for purposes of the tax law of the foreign country of which the recipient of the payment is resident or subject to tax. Similarly, a “hybrid entity” refers to any entity which is either treated as fiscally transparent for U.S. tax purposes but not so treated for purposes of the tax law of the other country of which the entity is resident or subject to tax, or vice-versa.
One type of financing structure which is impacted by IRC §267A is the share repurchase agreement structure (“repo”). A repo may be used by a Canadian entity to finance their U.S. operations. For U.S. tax purposes, the repo structure is deemed to be a borrowing arrangement; thus, the payments made by a U.S. corporation to a Canadian entity on its issued preferred shares are treated as normally deductible interest payments. However, for Canadian tax purposes, those same payments are treated as dividends as the Canadian entity is considered to be the owner of the preferred shares and the dividends may be exempt from income tax under Canada’s foreign affiliate exempt surplus guidelines.
Since the transactions in the repo fall under the definition of a hybrid transaction, the interest payments that would have normally been deducted for U.S. tax purposes would be disallowed under IRC §267A. While the dividends still may be exempt from taxation from the perspective of the Canadian entity, the U.S. corporation now realizes no deduction for the payments made on the preferred shares, making the structure ineffective.
Structures to consider
One type of financing structure that may still be effective is the tower structure. At a high level, this structure involves the establishment of a U.S. limited partnership (“U.S. LP”) with two Canadian corporate partners. In order to finance U.S. operations, the U.S. LP would obtain third-party financing and contribute it to a Canadian unlimited liability company (“Canada ULC”) which would in turn contribute those same funds to a U.S. limited liability company (“U.S. LLC”). The U.S. LLC then loans these funds to a U.S. corporation (“U.S. Co.”) that ultimately carries on the operations in the U.S.
With Canada ULC and U.S. LLC being treated as disregarded entities for U.S. tax purposes, the interest paid by U.S. Co. to U.S. LLC flows to U.S. LP, which elects to “checks-the-box” to be treated as a U.S. corporation. While the U.S. LP recognizes the interest payment as income, it should have a corresponding deduction for its interest payment to the third party.
Since from a U.S. perspective the interest being paid by U.S. Co. is to another U.S. company (i.e. U.S. LP), IRC §267A should not disallow the deduction on the interest, further supported by having U.S. LP recognize that interest payment as income. From a Canadian perspective, the dividends paid by Canada ULC to U.S. LP, which are allocated to the Canadian corporate partners, are generally not subject to tax[xxiv] and the dividends paid by U.S. LLC to Canada ULC are generally not subject to tax as they are being paid out of exempt surplus.[xxv]
Effect of U.S. tax reform on Canadian corporations investing in the U.S.
The TCJA is expected to have a significant impact on Canada’s competitiveness, especially the significant decrease in corporate tax rates and other incentive measures. Looking at the bright side, these tax reform provisions may bring stronger economic growth in the U.S., which in turn may boost Canada’s economy, as Canada is able to export more goods and services to the U.S. Even with the recent contentious passing of the United States-Mexico-Canada Agreement (“USMCA”), uncertainty still remains with respect to where capital investment should flow. Also, the tightening immigration policies in the U.S. may have caused an outflow of labor and capital out of the U.S. Given all these variables, U.S. tax reform may not be the only determining factor in considering where the operations of the business should reside.
While the decreased corporate tax rates may provide incentives for Canadian companies to shift their operations to the U.S, other provisions may inadvertently increase the tax cost of doing business in the U.S.
Federal corporate tax rates
Given the lower U.S. corporate tax rates, it may be more favorable to carry on business in the U.S., especially for companies that carry on active business. However, it may not be beneficial for companies earning passive income in the U.S. Historically, Canadian parents with U.S. subsidiaries have faced higher tax rates in the U.S. so that even in the case of foreign accrual property income (“FAPI”) earned, as long as the U.S. subsidiaries had paid sufficient taxes in the U.S., there should be a deduction to offset the FAPI inclusion so that the net income inclusion for the Canadian parent is nil. As the gap between the U.S. and Canadian corporate tax rates narrows, there may now still be Canadian taxes payable on FAPI up to a maximum of tax effected at 4 percent (if the U.S. subsidiaries are subject to state tax, this difference should become relatively immaterial).
There should be less repatriation of funds back to Canada, as companies will keep funds invested in the U.S. According to the Bureau of Economic Analysis, some $305.6 billion returned to the U.S. from overseas accounts in Q1 2018 in response to the TCJA.[xxvi] A few years ago, there was a trend on inversions to Canada (i.e., shifting headquarters from U.S. to Canada because of the lower corporate tax rates in Canada); now the tables have turned.
The bonus depreciation rules that allow U.S. businesses to write off machinery and equipment capital costs may encourage Canadian companies to shift their operations to the U.S., especially for industries that have significant depreciable assets. Canadian companies that intend to acquire businesses in the U.S. may also find an asset acquisition more tax effective than a share acquisition.
The recent trade war between U.S. and Canada imposed additional tariffs on Canadian exports of steel and aluminum to the U.S. and Canada has also proposed trade surtaxes as countermeasures on imports from the U.S. These measures have adversely impacted industries that depend heavily on these metals such as automotive, appliance, and heavy machinery. Therefore, companies would have to weigh the cost vs. benefit in light of the tax incentives provided.
Interest expense deduction limitation
Historically, Canadian companies have often relied on intercompany financing to obtain interest deductions in the U.S. as it was more tax effective (i.e. a $1 interest deduction in the U.S. is worth more than its inclusion in Canada). The hurdle of intercompany financing is now exacerbated by the new limitation on interest expense as discussed earlier in this article. Despite this limitation, cross-border financing may still be beneficial as interest payments between the U.S. and Canada is generally not subject to any withholding tax under the Canada-U.S. tax treaty.
[i] JCX-67-17 “Estimated Budget Effects Of The Conference Agreement For H.R.1, The ‘Tax Cuts And Jobs Act’” by the Joint Committee on Taxation.
[ii] P.L. 115-97 §13001.
[iii] The Associated Press. January 18, 2018. Tax reform prompts Apple to pay $38B tax bill to bring home $248B in foreign profits. https://www.cbc.ca/news/business/apple-tax-cut-1.4492807
[iv] Canadian corporate tax rates are 26.5% for non-CCPCs, 13.5% for CCPCs for entities with Ontario as their tax jurisdiction.
[v] P.L. 115-97 §13201.
[vi] P.L. 115-97 §13101.
[vii] P.L. 115-97 §13302.
[viii] P.L. 115-97 §12001.
[ix] P.L. 115-97 §13305.
[x] P.L. 115-97 §13301.
[xi] P.L. 115-97 §13206.
[xii] P.L. 115-97 §14101.
[xiii] P.L. 115-97 §14103.
[xiv] P.L. 115-97 §14202.
[xv] P.L. 115-97 §14201.
[xvi] P.L. 115-97 §14201.
[xvii] Georgia Code §48-1-2(14).
[xviii] Oregon S.B. 1528.
[xix] West Virginia H.B. 4146.
[xx] Quill Corp. v. North Dakota, 504 U.S. 298 (1992).
[xxi] South Dakota S.B. 106.
[xxii] South Dakota v. Wayfair, Inc., et al., No. 17-494 (June 21, 2018) 585 U.S.
[xxiii] P.L. 115-97 §14222.
[xxiv] Income Tax Act, §112.
[xxv] Income Tax Act, §113.
[xxvi] Bureau of Economic Analysis, U.S. International Transactions, 1st quarter 2018 and annual update, http://www.bea.gov/news/2018/us-international-transactions-1st-quarter-2018-and-annual-update