Pub. L. No. 115-97, originally known as the “Tax Cuts and Jobs Act,” was signed into law by President Trump on December 22, 2017 (“Act”). This is probably the most extensive revision to the provisions of the Internal Revenue Code during the lifetime of most readers and its impact will be significant for individuals, corporations and other business entities, both domestic and foreign. We previously distributed a Client Alert on February 8 dealing generally with most changes made by the Act.

Acquisition of interests in US real estate by non-US persons is typically structured so that the acquisition of such interests is made by a US corporation (generally organized in Delaware and referred to herein as “Delcorp”) which is directly owned for various reasons (including US estate tax) by a non-US corporation.  The non-US corporation may in turn be owned ultimately by individuals resident in various other countries.  In the case of larger projects Delcorp frequently joins with others as a partner in a partnership or as a co-member in a limited liability company (each such arrangement referred to herein as a “partnership” with holders of interests therein being referred to as “partners”).

Below are some significant provisions in the Act that will impact US real estate investment by non-US persons. We will consider the impact of such changes on real estate development for sale and real estate held for rental income.

RULES APPLICABLE TO US AFFILIATES

• Corporate Income Tax Rate/AMT.  The corporate income tax rate payable by Delcorp (which had a top marginal rate of 35% before 2018) has been reduced to a flat 21% tax rate. Also, the alternative minimum tax (“AMT”) on corporations has been repealed. These changes are effective for 2018 and later years.  This is a very significant change since the tax imposed by the US federal government (even after the impact of state and local taxation) is extremely favorable.  Also, unlike the rules applicable to individuals, any state and local taxes will be deductible in computing Delcorp’s US taxable income.
  
  
• Limitations on Deduction of Business Interest/Exemption for “Electing Real Property Trade or Business.” A frequent tax planning approach used by non-US shareholders is to fund Delcorp with shareholder debt in addition to equity. This enables the US affiliate to deduct interest expense on such debt thereby reducing its U.S. tax base.  Generally, this interest is payable to a shareholder based in a country which has a treaty with the United States that provides a low or zero withholding tax on interest income from US sources.  
  
  Before the effective date of the Act, the “earnings stripping” rules set forth in old Section 163(j) limited only the deduction for certain related party interest. The Act repealed these earnings stripping rules and replaced them with a new limitation on the deductibility of business interest. Subject to the election below regarding an election for real estae businesses, new Section 163(j) now limits a deduction for business interest expense (whether it is incurred on related or unrelated party debt) to an amount equal to the taxpayer’s business interest income plus 30% of its “adjusted taxable income” (essentially EBITDA until 2022 when EBITDA is replaced by EBIT). Also, the new limitation under the Act applies regardless of whether the business is conducted in corporate or pass-through form. However, in the case of debt incurred by a partnership, the limitation is computed at the partnership (rather than the partner) level. Thus, if Delcorp is a partner in a partnership and the partnership is the borrower on debt secured by the underlying property or mezzanine debt on the project, this limitation would be determined at the partnership level with any interest currently deductible then passing through to each partner (including Delcorp). The amount of interest deductible on shareholder loans made to Delcorp would then be determined at the partner (Delcorp) level. In this case, Delcorp’s “adjusted taxable income” would include only the amount of section 163(j) limitation that is unused at the partnership level (referred to as “excess taxable income”) plus 30% of any “adjusted taxable income from any other business that such partner has from other sources. Because Delcorp, as a partner, is generally a single purpose entity, Delcorp’s adjusted taxable income will usually approximate its excess taxable income from the partnership. Any business interest that isn't deductible because it exceeds the business interest limitation will be carried forward indefinitely. New section 163(j) is similar to the OECD’s Base Erosion and Profit Shifting (“BEPS”) Action 4.
  
  The Act exempts from this limitation taxpayers with average annual gross receipts that do not exceed $25 million for the three taxable year period ending with the prior taxable year.
  
  Of greater significance, however, is the exemption for an electing real property trade or business which is not treated as a “trade or business” for purposes of the business interest limitation and therefore will not be subject to this limitation on deductibility.  An “electing real property trade or business” is generally any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business” that elects such treatment.  This definition is intended to include any such real property trade or business, including such a trade or business conducted by a corporation or real estate investment trust (REIT). Once made, the election is irrevocable.
  
  The advantage to the election is that it avoids both the old and new section 163(j) limitation. Thus, so long as shareholder debt constitutes debt under existing law and subject to transfer pricing rules, interest on such debt should provide a tax benefit. (see, however the BEAT and Hybrid provisions discussed below).
  
  A disadvantage to such an election is that an electing real property trade or business must use the alternative depreciation system (“ADS”) to depreciate any of its non-residential real property, residential rental property and qualified improvement property. ADS requires use of a longer depreciable period. This would not be a concern with real estate development for sale (including condominium development)  since such property is not depreciable but in the case of property held for rental income, the depreciation allowance could be significant.  With regard to residential rental property, if it were depreciated using the Modified Accelerated Cost Recovery System (“MACRS”), depreciation deductions would be spread over 27.5 years.  However, because of another change made by the Act, if ADS were to apply because the Delcorp (or the partnership in which it is a partner) has elected to be an electing real property trade or business, the depreciable period will be 30 years (shortened from the 40-year term that applied prior to the Act).
  
  
• Limitations on Carryback and Carryforward of Net Operating Losses (NOLs). A net operating loss (“NOL”) generally is the amount by which a taxpayer’s current-year business deductions exceed its current-year gross income.  Before the Act, NOLs could be carried back two years and carried forward 20 years to offset taxable income in such years. Under the Act, the carryback of NOLs is generally eliminated, subject to a few exceptions. A corporation’s ability to deduct a carryforward NOL is limited to 80% of its taxable income determined without regard to any NOLs. Any unutilized NOLs can be carried forward indefinitely. These changes are generally effective for NOLs arising in tax years beginning after 2017. Obviously, this provision can be significant for properties held for rental income as compared to properties in the development stage where most expenses will be required to be capitalized rather than expensed.
  
  
• Section 179 and Bonus Depreciation and MACRS/ADS Depreciation. In recent years the annual cost recovery of depreciable property  has generally been the sum of three  separate  deductions. These are (i) the “Section 179 deduction” which has been 100% up to a dollar limitation (previously $500,000), (ii) Bonus Depreciation with respect to the remaining basis which before the Act had been up to 50%, and finally (iii) depreciation of  the remaining basis after first subtracting both the Section 179 deduction and Bonus Depreciation. The Act makes changes to each of these components:
  
  
  • Section 179 deduction (first-year expensing deduction). Under the Act, businesses can now expense up to $1,000,000 of the cost of any “section 179 property” placed in service in a taxable year. However, if the section 179 property placed in service is more than $2.5 million in a taxable year, the amount available for immediate expensing is reduced by such excess. The Act modifies the expensing limitation by indexing both the $1 million and $2.5 million limits for inflation.  Note, however, that because the Act now makes Bonus Depreciation available at a 100% rate through 2022 (after which it is incrementally phased out through 2026) and makes it available for new as well as used property, Section 179 currently confers no benefit that is not otherwise available with Bonus Depreciation.¹
    
    
  • Bonus Depreciation/100% Expensing (Temporary). Under the Act, a 100% first-year deduction for its adjusted basis is allowed for qualified property acquired and placed in service after September 27, 2017, and before Jan. 1, 2023 and is now allowed for both new and used property. The 100% allowance is phased down by 20% per calendar year for property placed in service in taxable years beginning after 2022 with total expiration after 2026.
    
    
  • Shorter recovery periods for certain real property. For property placed in service after 2017, the separate definitions of qualified leasehold improvement, qualified restaurant and qualified retail improvement property are eliminated.  Instead, any improvement to an interior portion of a building on nonresidential real property is referred to as “qualified improvement property” so long as the improvement is placed in service after the date the building was first placed in service. The Act contains a drafting error where qualified improvement property was not statutorily categorized as 10-year or 15-year property, making the property 39-year property for MACRS purposes and thus recovered by depreciation over 39 years. A technical corrections bill is expected that will properly classify qualified improvement property as either 10-year or 15-year property, and not under the general 39 year recovery period.

As noted above, for residential rental property placed in service after 2017, the ADS recovery period has been shortened from 40 years to 30 years.

• Repeal of Partnership Technical Terminations.  As discussed above, it is not uncommon for the Delaware corporation to be a partner in a partnership or member of a limited liability company (which is treated as a partnership for US tax purposes). Effective for years after 2017, the Act repeals the rule that if within any 12-month period, there is a sale or exchange of 50% or more of the total interest in partnership capital and profits, the partnership is terminated.

• Look-Through Rule Applied to Gain on Sale of Partnership Interest. For sales and exchanges on or after Nov. 27, 2017, gain or loss from the sale or exchange of a partnership interest by a non-US person is treated as being effectively connected with a U.S. trade or business to the extent that the transferor would have had effectively connected gain or loss had the partnership sold all of its assets at fair market value as of the date of the sale or exchange. Any gain or loss from the hypothetical asset sale by the partnership must be allocated to interests in the partnership in the same manner as non-separately stated income and loss. This provision overrules the result in the recent Tax Court case of Grecian Magnesite Mining. For sales, exchanges, and dispositions after 2017, the transferee of a partnership interest must withhold 10% of the amount realized on the sale or exchange of a partnership interest unless the transferor certifies that the transferor is not a nonresident alien individual or foreign corporation..
  
  

CROSS BORDER TAX PROVISIONS

• Avoid Base Erosion of US businesses owned by Foreign Persons.  The US Congress was concerned about efforts by foreign investors to reduce the US tax base of their US affiliates by imposing financial obligations on their US affiliates such as Delcorp. These intercompany arrangements include interest on intercompany debt and management services agreements. While deductible by the US affiliate in computing its US tax liability, the interest income received by the foreign affiliate was not subject to US withholding tax because of a treaty, and management fees were not taxable because they were deemed to be income for services performed outside the United States. Apart from US transfer pricing rules and the previous more favorable earnings stripping rules in the case of interest expense, there was no limitation on deductibility for US tax purposes.
  
  Reacting to this, the Act imposes the Base Erosion Anti-Abuse Tax (“BEAT”) on “applicable taxpayers”. BEAT is a minimum tax equal to the excess of 10 percent (5% for 2018) of the modified taxable income of the taxpayer (after adding back certain base erosion tax benefit payments) for the taxable year over an amount equal to the regular tax liability of the taxpayer for the taxable year with certain adjustments. For years beginning after 2025, the 10-percent rate is increased to 12.5%. A base erosion payment generally includes any amount paid or accrued by a US corporation to a related foreign party with respect to which a deduction is allowable. Such payments also include any amount paid or accrued by a domestic corporation to its related party in connection with the acquisition by the domestic corporation from the related party of property of a character subject to the depreciation or amortization. (Base erosion payments do not include payments for the cost of goods sold.)
  
  An “applicable taxpayer” means with respect to any taxable year, a taxpayer: (A) which is a corporation (such as Delcorp) other than a regulated investment company, a real estate investment trust, or an S corporation; (B) the average annual gross receipts of the corporation for the three-taxable-year period ending with the preceding taxable year are at least $500 million, and (C) the base erosion percentage (as defined below) of the corporation for the taxable year is three percent or higher.
  
  With regard to the $500,000,000 requirement, if Delcorp is a member of  a controlled group of corporations, at least to the extent that they have U.S. operations, Delcorp’s gross receipts would need to be aggregated with its affiliates’ US gross receipts to determine whether or not this dollar amount has been attained.  In the case of real estate interests held for rental, the gross receipts include only gross income from rentals. However, in the case of condominium development, gross receipts will include the cost of goods sold as well as the gross income portion from such activities. Some measure of relief is available.² For example, a partnership engaged in condominium development has no receipts in year 1 and year 2. Sales begin in year 3 and continue into year 4, concluding in year 5. In determining whether Delcorp’s share of the partnership’s gross receipts exceeds the $500 million threshold, Delcorp must average receipts for the previous 3 years. This enables Delcorp to include years 1 and  2 with zero sales  in computing the average gross receipts in applying the test for year 4, and year 2 with zero sales  in applying the test for year 5.
  
  The “base erosion percentage” for any tax year is equal to the aggregate amount of base erosion tax benefits of the taxpayer for the tax year divided by the aggregate amount of specified deductions allowable to the taxpayer for the tax year.
  
  “Related party” includes: (i) any 25-percent owner of the taxpayer, (ii) any person who is related to the taxpayer or any 25-percent owner of the taxpayer, within the meaning of sections 267(b) or 707(b)(1), and (iii) any other person related to the taxpayer within the meaning of section 482. For these purposes, certain constructive ownership rules apply.

• Certain Related Party Amounts Paid or Accrued in Hybrid Transactions or with Hybrid Entities. New Section 267A denies a deduction for any disqualified related party amount paid or accrued pursuant to a hybrid transaction or by, or to, a hybrid entity. New Section 267A denies a deduction for any disqualified related party amount 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 such related party is a resident for tax purposes or is subject to tax, or (2) such related party is allowed a deduction with respect to such amount under the tax law of such country.
  
  A hybrid transaction is any transaction, series of transactions, agreement, or instrument one or more payments with respect to which are treated as interest or royalties for US Federal income tax purposes and which are not so treated for purposes of the tax law of the foreign country of which the recipient of such payment is resident for tax purposes or is subject to tax. A hybrid entity is any entity which is either: (1) treated as fiscally transparent for Federal income tax purposes but not so treated for purposes of the tax law of the foreign country of which the entity is resident for tax purposes or is subject to tax, or (2) treated as fiscally transparent for purposes of the tax law of the foreign country of which the entity is resident for tax purposes or is subject to tax but not so treated for Federal income tax purposes. Section 267A further provides that the Secretary of the Treasury has broad authority to issue regulations to carry out the purposes of this provision. This provision is similar to, but does not appear to be as extensive as, BEPS Action 2 which does not limit its application to related party payments. See Example 1.31 in the OECD’s Final Report for Action (2015). 

• Fair market value method of interest expense allocation or apportionment repealed. It is often necessary to determine income from either U.S. or foreign sources for a number of different US tax purposes. Under pre-Act law allocation and apportionment of interest expense was allocated or apportioned on the basis of assets. The Regulations allowed taxpayers to determine the value of their assets either on the basis of the tax book value or the fair market value of their assets. The tax book value was generally the asset's adjusted basis for U.S. tax purposes. Under the fair market value method, a taxpayer had to establish the fair market value of its assets to the satisfaction of IRS. Under the Act, allocations and apportionment of interest expense must be determined using the adjusted bases of the assets rather than the fair market value of the assets. This provision was enacted because under the Act, taxpayers may expense 100% of the cost of qualified property as Bonus Depreciation. The effect of this change will be to sharply reduce the adjusted basis of U.S. assets. Thus, the U.S. assets will often have a fair market value that is greater than their tax book value. The repeal of the fair market value alternative, will, therefore, tend to reduce the amount of interest expense allocated to U.S. source income.
  
  

SUMMARY

Even with the limitations on deductions introduced by the Act, Delcorp’s US federal income taxes should decrease because of the significant drop in the corporate tax rate from 35% to 21%. Moreover, if Delcorp and the partnership in which it is a partner both make the election for the real property trade or business exemption, both the limitations under old and new section 163(j) can be avoided. So long as use of hybrids are avoided and transfer pricing rules are satisfied, a deduction for interest expense should be close to assured.  As for the new BEAT minimum tax, it is unlikely to apply in most cases because of the extremely high threshold of the gross receipts test.

If you should you have any questions or need further clarification of the Act’s provisions, please contact Jim Guadiana at JGuadiana@bartonesq.com or 212-885-8837.

FOOTNOTE
¹ Note, however, that because the Act now makes Bonus Depreciation available at a 100% rate through 2022 (after which it is incrementally phased out through 2026) and makes it available for new as well as used property, Section 179 currently confers no benefit that is not otherwise available with Bonus Depreciation.

² If the entity was not in existence for the entire 3-year period referred to in paragraph (1), such paragraph shall be applied on the basis of the period during which such entity (or trade or business) was in existence.