New U.S. tax rules alter competitive landscape

Toronto lacks a tax advantage that the 19 other contenders on the short list to host Amazon’s second headquarters now enjoy. The recently adopted U.S. Tax Cuts and Jobs Act (TCJA) provides companies based in the United States with an effective tax rate of 13.125 per cent on a portion of earnings derived from selling services and/or intellectual property into foreign markets.

Even while acknowledging the World Trade Organization might characterize this as “overtly protectionist”, Paul Seraganian, managing partner in Osler, Hoskin & Harcourt LLP’s New York office, cites it as one example of how far-reaching the overhaul of the U.S. tax system is likely to be. “The rules just reshape the competitive landscape,” he told seminar attendees in Toronto earlier this month.

“It’s changing things, certainly. The (U.S.) corporate tax rate is going down to 21 per cent so that should definitely improve investment returns,” concurs Bruno Godin, a partner and national leader, U.S. corporate tax, with the accounting and business advisory firm, Grant Thornton LLP. “Historically, on average, factoring in state and local taxes, you were looking at a corporate tax rate of just under 40 per cent from the U.S. perspective versus under 30 per cent from the Canadian perspective. If you were going to invest money for the purpose of earning a gain on it, it was much more beneficial to invest that money here than in the U.S.”

Observers familiar with the evolution of tax policy and the pace of U.S. law-making marvel at the TCJA’s speedy progress from Nov. 2 introduction, through the usually cumbersome process of reaching consensus in the House of Representatives and the Senate, to Dec. 22 presidential affirmation. Previously, some adjustments to tax law — including one that had positive implications for Canadian pension funds investing in U.S. real estate and infrastructure — were approved during President Barack Obama’s tenure, but few major changes have occurred since President Ronald Reagan last tackled reforms.

“I think it is fair to characterize this reset as the biggest transformation in the last 30 years,” Seraganian said. “We’re learning these rules alongside everybody. Because this was rushed through, there is still a lot do.”

The significant reduction in the corporate tax rate — slashed to 21 per cent from the previous 35 per cent — is straightforward to grasp, but it comes with a swath of other new directives pertaining to credits, deductibles and international activities, now in place for the 2018 tax year. Just like follow-up regulations guide the implementation of Canadian legislation, the U.S. Internal Revenue Service is tasked with providing further clarification and interpretation of the TCJA’s intent.

“There will be a series of aftershocks over the next few years as the regulations come out,” Seraganian predicted.

Unsettling the cross-border dynamic
Commercial real estate operations within Canada could experience fallout from the new U.S. tax rules simply due to the interconnectedness of the two economies, while companies with holdings on both sides of the border may be pushed to reassess some of their current financing strategies and structures. Osler’s tax experts speculate the new tax regime could boost the equity value of U.S. based companies, giving them an edge over Canadian and other international players when it comes to securing capital, and that the traditional case for incorporating in Canada could be shifting.

“For many years, the value of a $1 deduction in the U.S. was, all other things being equal, greater than a $1-deduction in Canada. This simple reality has directed the flow of billions of dollars of cross-border arrangements and payments across the Canada-U.S. border,” they advise. “The domestic U.S. tax changes unsettle that simple premise in ways that are not yet fully appreciated.”

Among instruments potentially in flux, Seraganian identifies the leveraged blockers that have enabled Canadian investors in U.S. real estate funds (and other kinds of investment funds) to minimize tax impact and avoid filing U.S. federal income tax. Conventionally, non-U.S. investors acquire debt and equity capital in the blocker, which is structured as a limited liability company that acts as a corporation for U.S. income tax purposes. The blocker, in turn, invests in the real estate fund, but the new rules diminish tactics for lowering the blocker’s effective tax rate.

When the real estate fund distributes proceeds down to the blocker, the portion of the distribution allocated to interest on investors’ debt can be deducted as an interest expense. However, the TCJA now places a more restrictive limit on the interest expense deductible — previously based on 50 per cent of adjusted taxable income, but now lowered to 30 per cent — and stipulates that it be calculated at the fund level, not at the blocker.

This presents what Seraganian calls a “double whammy” hit. “Just by virtue of the new methodology, people will feel a squeeze on their interest deductions,” he said.

Many of the other rules could prompt new kinds of decision-making. For example, Osler’s tax experts suggest a five-year window, to 2023, for 100 per cent expensing of tangible depreciable property (excluding land and buildings) could affect the timing of acquisitions or be an incentive to purchase assets in order to trigger the eligibility.

Partnerships could also become a preferred option, ahead of incorporation, based on the new rule that allows individuals, trusts and estates to deduct 20 per cent of qualified business income received through pass-through arrangements. This includes real estate, but excludes professional services or “any trade or business where the principal asset is reputation and skill of one or more of the employees or owners”.

Together, these rules could raise the profile of some business approaches. “I think we are going to see partnerships take a greater role in the cross-border M&A scene,” Seraganian said.

FIRPTA unchanged
Despite some earlier calls for moderation, few changes have been made to withholding tax that applies under the U.S. Foreign Investment in Real Property Tax Act (FIRPTA). With the exception of one sizable and active group of institutional investors defined in U.S. tax law as “qualified foreign pension funds” — granted an exemption as part of the 2015 Protecting Americans from Tax Hikes Act — Canadian investors are subject to FIRPTA withholding tax on capital gains on: the direct sale of U.S. properties; sales of U.S. property fund shares; and fund and REIT distributions resulting from the disposition of U.S. properties.

As the name suggests, buyers, REITs or real property holding companies are required to withhold and submit a percentage of the value to the IRS. Subject investors can claim back any amounts that exceed their actual tax liability by filing a U.S. tax return — arguably making it more of an administrative than financial disincentive to investment.

“Generally, in a lot of transactions, the withholding tax is mostly a timing issue. In some cases you may be able to apply to have the withholding reduced if you can demonstrate that the actual tax will be lower than the withholding amount,” Godin explains. “That could happen more and more with the reduced tax rate.”

Real estate analysts likewise theorize that Canadian and other foreign investors will have few complaints. “While the FIRPTA rules would not be materially revised, many non-U.S. investors in U.S. real estate would see significant rate reductions under the TCJA. Since the FIRPTA rules effectively subject non-U.S. person to U.S. taxation on sales of real U.S. real property interests, the lower rates for U.S. taxpayers would apply to non-U.S. persons,” a pwc whitepaper examining the TCJA’s impact on real estate affirms.

“A broader exemption would have been a very nice gift,” reflects Brooks Barnett, manager, government relations and policy for REALPAC, which represents Canada’s largest commercial real estate companies and institutional investors. “For Canadian investors outside pension funds, it would have made U.S. property and infrastructure more attractive. But the fact that FIRPTA remains unchanged is actually, I think, a good outcome at a time when we’re facing some uncertainty around NAFTA.”