U.S. Tax Reform - Part 2 of 6
Tax Reform Becomes Reality: What Does It Really Mean For Canadians?
by Julia Klann
On December 22, 2017, President Trump signed into law the biggest change in US tax law in over 30 years. As the world processes the changes to the US tax system, most of which are effective January 1, 2018 (and some with retroactive effect), Canadians with ties to the US tax system are wondering what the implications of tax reform will mean to them.
This series outlines the top twelve changes in US tax law that Canadians, both businesses and individuals with connections to the US, should know. Part 1 discussed that for Canadian businesses eyeing a US expansion, the time to expand may be now. This segment will outline how that expansion should be financed.
• US Expansion Likely Should Not Be Funded With Debt
A popular method of funding expansion of a Canadian business into the US was typically in the form of debt. As the US operations generate profits, the US subsidiary typically would want to repatriate the profits back to Canada. The cost of repatriation of US profits in the form of a dividend distribution is a 5% withholding tax payable to the IRS. This withholding tax is typically a direct tax cost of the taxpayer given that the dividend distribution is usually not subject to tax in Canada as dividends from foreign affiliates engaged in an active business are typically exempt from Canadian taxation. As such, Canadian businesses would typically fund their US expansion via debt, as debt would allow the US subsidiary to repatriate profits back to Canada in the form of interest payments and loan repayments, both exempt from withholding tax.
The new rules tighten the ability of a US corporation to deduct interest expense. Although prior US tax law provided for a limitation in the deduction of interest expense, the rules were more generous than those in the newly enacted law.
In general, the new provisions provide that a US corporation will only have the ability to deduct interest expense to the extent of its interest income and 30% of its “adjusted taxable income”. Adjusted taxable income is taxable income with modifications for NOL deductions, depreciation, amortization and other items that may be prescribed under US Regulations. The goal is to essentially determine the amount of cash earnings a taxpayer has in a particular year. Of those earnings, 70% are to be invested back into the business, and therefore the US economy, while the remaining 30% can be used to pay interest to various creditors. Previous law also had a threshold for the deductibility of interest, but the limitation was 50% of adjusted taxable income.
The other significant change to the interest deductibility rules is the application of the provision to all interest expense. The new rules require that all of a taxpayer’s interest expense is subject to the limitation described above, not just interest payable to a related party or guaranteed by a related party as it had been in the past. Given the 30% limitation, taxpayers may not be able to deduct their full interest expense. As such, the combination of debt vs. equity investment in the US may need to be reconsidered by some Canadian businesses with significant US debt.
• Small Businesses Get Tax Breaks
There are relieving provisions for small businesses in the new legislation. In the past, most, if not all, US corporations would be subject to all of the various rules and restrictions on deductions under the Internal Revenue Code (IRC), regardless of their size. The new law provides for a small business carve out for many provisions, including the limitation on interest expense deductibility described above. In addition, small businesses do not have to comply with the inventory uniform capitalization provisions of IRC §263A, which can be quite cumbersome for corporations, nor do they necessarily have to use an accrual method of accounting or the percentage of completion method for reporting income from long-term contracts.
A small business is defined under tax reform to be a corporation that has less than $25M in gross receipts on average for the preceding three years. As such, many small businesses should have simpler reporting obligations than in the past.
The third segment of this series will discuss expanded filing requirements for US corporations with related parties, and the penalties for failure to file. Stay tuned.