US tax reform: Luxembourg considerations for private equity structures

President Trump signed tax-reform legislation, commonly known as the Tax Cuts and Jobs Act (TCJA), on 22 December 2017. The TCJA lowers business and individual tax rates, modernises US international tax rules, and provides the most significant overhaul of the US Internal Revenue Code in more than 30 years.

This PwC Insight provides a Luxembourg perspective of select provisions in the TCJA that are most relevant to private equity structures with a Luxembourg presence.

Business

Corporate income tax rate

Under the TCJA, the 35% top corporate rate is reduced permanently to 21% for tax years beginning after 31 December 2017.
Observation: The reduced tax rate for corporations may trigger restructuring of existing private equity fund managers from partnerships into corporations. This could give rise to withholding tax (WHT) exemptions for repatriations from Luxembourg holding platforms. In addition, the expected reduced effective tax rate for these groups may affect the value of their deferred tax assets (DTAs). Luxembourg tax losses should also be valued, because a change in DTA values may affect debt covenants or issuers' regulatory requirements.

Interest expense limitation

Under the new Section 163(j), interest deductions are limited to the sum of the taxpayer's business interest income plus 30% of the taxpayer's 'adjusted taxable income' (ATI) for the tax year. ATI is roughly equivalent to earnings before interest, taxes, depreciation and amortisation (EBITDA) for tax years beginning after 31 December 2017 and before 1 January 2022. For tax years beginning on or after 1 January 2022, ATI will roughly equal EBIT. Disallowed interest may be carried forward indefinitely.

The new Section 163(j) applies to the business interest expense, whether paid to a related or unrelated party, of most large taxpayers, including both corporate and pass-through entities, as well as both entirely domestic entities and entities that are part of a US-parented or foreign-parented group.

Observation: In light of the new interest expense limitation rules and the EU Anti  Tax Avoidance Directive (effective from 1 January 2019), taxpayers should consider alternative financing structures, such as back-to-back financing strategies.

International provisions

Participation exemption for dividends

The TCJA provides for a 100% deduction for the foreign-source portion of dividends received by a domestic corporation from a 10%-owned foreign corporation (other than a passive foreign investment company (PFIC) that is not also a CFC). This provision applies to distributions made after 31 December 2017. The deduction should also be available for indirect ownership by a domestic corporation through a partnership. The TCJA does not allow a deduction for any dividend received that is a hybrid dividend, such as an amount for which the foreign corporation received a deduction (or other tax benefit) from taxes imposed by a foreign country.

Observation: Taxpayers should analyse any Luxembourg holding platforms that include hybrid instruments. They also should consider repatriations, taking into account that the deduction is granted only for dividends and not for capital gains.

Mandatory repatriation tax ('toll charge')

Beginning in 2018, non-US earnings will no longer be subject to US federal income tax when repatriated. However, for non-US earnings that have accumulated up to 31 December 2017, the TCJA imposes a transitional one-time 'toll charge' at an effective rate of 15.5% on cash and cash equivalents and 8% on illiquid assets of (a) all CFCs and (b) all foreign corporations (other than PFICs) in which a US person holds a 10% voting interest.

Observation: Taxpayers should consider the immediate and future impacts on cash flows, especially on WHT implications and payments on hybrid instruments issued by a Luxembourg company.

Base erosion and anti-abuse tax (BEAT)

The TCJA imposes what is essentially a new base erosion minimum tax on corporations (excluding regulated investment companies (RICs), real estate investment trusts (REITs) and S corporations) whose average annual gross receipts for the past three tax years are at least USD 500 million and that make base erosion payments to foreign related parties greater than 3% of total deductions. The provision applies to base erosion payments paid or accrued in tax years beginning after 31 December 2017.

Companies subject to BEAT pay excess tax calculated at a 10% rate on an expanded definition of taxable income over their regular tax liability, reduced by certain credits.

Observation: While BEAT primarily affects US-based portfolio companies, Luxembourg companies with US investments should consider the inbound context, since BEAT will also apply to non-US corporations that are engaged in US conduct of a trade or business and that will derive effectively connected income (ECI).

Global intangible low-taxed income (GILTI)

GILTI is a new anti-avoidance and subpart F rule targeting profit shifting abroad through the use of intangibles. The GILTI provisions (new Section 951A) tax foreign CFC income exceeding a 10% routine return, imposing a minimum tax on 10% US shareholders of CFCs insofar as the CFCs are treated as having GILTI.

GILTI is the excess, if any, of the shareholder's net CFC-tested income over the shareholder's net deemed tangible income return. Tested income is defined as the CFC's gross income excluding ECI, subpart F income, income excluded from subpart F treatment under the high-tax exception, dividends received from a related person, and foreign oil and gas extraction income, less allocable deductions (including taxes). The net deemed tangible income return is an amount equal to 10% of specified depreciable tangible business assets of each CFC (qualified business asset investment, or QBAI).

Observation: US shareholders such as domestic corporations should assess the new provision's impact on their investments in CFCs that generate GILTI. In brief, when a Luxembourg company is a CFC for US tax purposes and its aggregate effective tax rate is higher than 13.125%, deemed taxes paid will offset GILTI in full, and thus should not lead to additional US taxation. However, if GILTI applies to the Luxembourg company, structuring may be required, especially for US and foreign individual investors who own, directly or indirectly, investments in the Luxembourg CFC through a domestic US partnership.

Hybrid mismatch rule

The hybrid mismatch rule disallows a deduction for payment or accrual of interest or royalty to a related party when there is a hybrid transaction (a different qualification of payment between the United States and another country) or hybrid entity (a different qualification of company between the United States and another country), to the extent that the corresponding income is neither included nor deducted in the other country.

Observation: The wording of the hybrid mismatch rule is broad. We expect more guidance under this rule, such as regulations regarding its impact on specific arrangements, including hybrid instruments with Luxembourg entities.

Pass-throughs

Deduction for business income of individuals

The TCJA includes a deduction of up to 20% for pass-through income, subject to a limitation based on 50% of W-2 wages. Income from publicly traded partnerships (PTPs) is not subject to the W-2 wage limitation. Corporate partners do not qualify for the deduction. This new deduction is available for tax years beginning after 31 December 2017. Pass-through income for the purpose of this deduction (e.g. qualified business income) does not include investment-type income such as capital gains, dividends and non-business interest, or reasonable compensation and guaranteed payments.

Observation: The rule has limited benefit, if any, for general partners and management companies, as their income is generally investment income that does not qualify for the deduction. Therefore, existing private equity fund managers should consider restructuring from partnerships into corporations, which should enable WHT exemptions for repatriations from Luxembourg holding platforms.

Impact on investing, management companies and portfolio companies

Carried interest

The TCJA re-characterises certain gains with respect to an 'applicable partnership interest' from long-term capital gains to short-term ones, provided that they relate to property with a holding period not exceeding three years.

In general, an applicable partnership interest is a partnership interest transferred to or held by a taxpayer in connection with the performance of 'substantial services' by the taxpayer in an 'applicable trade or business'. An 'applicable trade or business' involves raising or returning capital or investing in or developing securities, commodities, real estate, or partnership interests.

The TCJA also provides that if a taxpayer holding an applicable partnership interest transfers such interest to a related person, then the taxpayer is required to recognise as a short-term capital gain its share of long-term capital gain “with respect to such interest attributable to” assets not held for more than three years.

Observation: While the provision is vague and raises several questions, it affects allocations from funds with shorter holding periods, so taxpayers should review existing fund strategies.

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Maarten Verjans

Partner, PwC Luxembourg

Tel: +352 49 48 48 3014

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