The 2018 U.S. Tax Reform - Impact on German Investments in the United States
German Practice Alert
July 27, 2018
The U.S. Tax Cuts and Jobs Act of 2017 (the “Tax Reform Act”) includes some sweeping changes to U.S. tax law. Some of these will have a material impact on how German businesses and individuals structure their operations and investments in the United States. Critical changes include a sizeable reduction of corporate income tax rates, new limitations on interest expense for businesses, provisions to prevent tax base erosion, changes in the treatment of the disposition of partnership or LLC interests, and the taxation of previously deferred earnings parked abroad.
Aggressive Reduction of Corporate Income Tax Rates
The United States federal corporate income tax rate of 35% used to constitute a material threshold for German corporate investments in the United States. The Tax Reform Act reduced the highest corporate income tax rate to 21%. This will, to a large extent, not only eliminate the prior large incentive for foreign-owned U.S. corporations to keep their U.S. taxable income low (for instance, through the payment of royalties or interest to foreign affiliates), but may now have the opposite effect of enticing German corporations to shift taxable income back to the United States.
Among other things, this material reduction may well affect how foreign investors structure their investments in U.S. real estate. Previously, in the event of the sale of real estate through a U.S. corporation, gains on such sales were taxed at the federal corporate rate of 35%. Therefore, it was beneficial for individuals and trusts to use limited liability companies, which by default are generally transparent for U.S. tax purposes (like German Personengesellschaften), resulting in a taxation of gains from a sale at the individual federal long-term capital gains tax rate of 20%. An important disadvantage of using such tax transparent entities was that the beneficial owner subjected itself to U.S. tax filing obligations. Now, with the implementation of the 21% federal corporate tax rate, corporate structures have become much more attractive, as they avoid the necessity for the owner to file a U.S. tax return while maintaining a low tax rate on gains from asset sales. Additionally, taxation of dividend payments following the sale of real estate by a corporation generally can be avoided by effecting a liquidation of the corporation upon the sale of the real property.
Interest Expense Limitation
While under prior law there was already a limitation on interest expense that corporations could deduct from their taxable income based in part on debt-equity ratios, this limitation has now been replaced by a flat limitation of interest expense deductions of 30% of the taxpayer’s adjusted taxable income – equal to earnings before interest, taxes, depreciation, and amortization (EBITDA). Commencing in 2022, this limitation will be based on EBIT, thereby decreasing the adjusted taxable income for purposes of the interest expense limitation and, accordingly, further decreasing the allowable interest expense. Note, however, that disallowed interest expense in excess of the 30% limitation is carried forward indefinitely.
Base Erosion and Anti-Abuse Tax
A crucial element of the international tax provisions of the Tax Reform Act is the taxation of certain income shifting actions from the U.S. to foreign jurisdictions.
One element is the new minimum taxation of global intangible low-taxed income (GILTI). The new regime effectively imposes a minimum tax on U.S. shareholders who own at least 10% of controlled foreign corporations (CFCs) to the extent the CFCs have GILTI. This will significantly affect the tax strategies of multinational corporations with valuable intellectual property rights held abroad. GILTI generally imposes a U.S. corporate minimum tax of 10.5%, which may be reduced by foreign tax credits.
Notably, the Tax Reform Act does not define intangible property through a list of specific types of assets, including intellectual property like patents. Rather, intangible property under the new laws encompasses anything not strictly considered a tangible asset. This expanded definition applies when determining the GILTI taxation. The purpose of this rule is to create a disincentive to shift intellectual property to a low-tax jurisdiction.
Additionally, the Tax Reform Act targets base eroding payments. Generally speaking, base eroding payments are payments to a foreign affiliate which are tax deductible or used to acquire property which is subject to additional depreciation or amortization deductions in the U.S. The base erosion and anti-abuse tax (BEAT) imposes a 10% minimum tax (5% in 2018) on corporations (i) with a 3-year average of annual domestic gross receipts of at least $500 million and (ii) who make base eroding payments of 3% or more of certain of their deductible expenses.
Sale of Foreign Partner’s Partnership Interest as ECI
Under the Tax Reform Act, a non-U.S. partner in a partnership (or LLC) recognizes gain or loss as “effectively connected” to a U.S. trade or business when the partner sells its partnership (or LLC) interest. The transferee in such a transaction must withhold 10% of the amount realized, unless the transferor certifies that it is a U.S. resident or U.S. corporation. Such a withholding obligation previously only existed to the extent that the partnership (or LLC) held U.S real estate, but the Tax Reform Act now extends the withholding obligation to sales of interest in any partnerships or LLCs doing business in the United States.
Repatriation Toll Tax
Previously, earnings and profits of a controlled foreign corporation (CFC) were taxed only upon repatriation into the United States. Accordingly, vast amounts of cash of U.S. corporations were trapped overseas to shield them from U.S. taxation. The Tax Reform Act imposes a mandatory one-time tax on repatriation. This tax imposes a 15.5% tax on cash and an 8% tax on illiquid assets not previously taxed in the United States. Importantly, this tax is payable regardless of whether the assets are actually brought back to the United States.
The Tax Reform Act includes numerous and material changes that can affect the tax structure of German investments in the United States, be it through corporate operations or personal direct investments, for instance in real property. While some of these changes are intended to avoid tax base eroding structures that German investors may have tried to implement in the past, the need for at least some of these structures may have evaporated as a result of the dramatic decrease of the U.S. corporate income tax rates.