Impact of Tax Reform on Commercial Finance

Documents: Adjustments to Financial and

Other Covenants

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WEDNESDAY, JUNE 6, 2018

Presenting a live 90-minute webinar with interactive Q&A

Elena Otero, Partner, Holland & Knight, Miami

Matthew D. Mosby, Managing Director, KPMG, Charlotte, N.C.

Sean J. Tevel, Atty, Holland & Knight, Miami

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Copyright © 2018 Holland & Knight LLP. All Rights Reserved

Impact of Tax Reform on Commercial

Finance Documents: Adjustments to

Financial and Other Covenants

© 2018 KPMG LLP, a Delaware limited liability partnership and the

U.S. member firm of the KPMG network of independent member

firms affiliated with KPMG International Cooperative (“KPMG

International”), a Swiss entity. All rights reserved.

6

Faculty

Elena Otero, Partner, Holland & Knight LLP Phone: 305-789-7437 Fax: 305-789-7799 elena.otero@hklaw.com

Elena Otero is an attorney in Holland & Knight's Miami office who primarily practices in the areas of real

estate, finance and banking law, with a focus on all aspects of commercial lending and real estate

transactions. Ms. Otero counsels local, national and international financial institutions and lenders in

commercial lending transactions, including construction and permanent real estate financing, healthcare

real estate finance and asset-based lending. She also represents borrowers, purchasers and sellers in the

acquisition, development, disposition and financing of commercial and residential real estate.

Sean Tevel, Associate, Holland & Knight LLP

Phone: 305-789-7771 Fax: 305-789-7799 sean.tevel@hklaw.com

Sean Tevel is a Miami private wealth services attorney who focuses his practice primarily on tax planning

for high-net-worth individuals, as well as tax planning for multinational corporate and trust structures. Mr.

Tevel advises foreign and domestic clients on U.S. federal income, gift and estate tax matters associated

with their cross-border investments, including their U.S. real estate investments and business ventures.

Matthew Mosby, Managing Director, KPMG LLP

Phone: 704-371-5265 Fax: 404-745-8398 mmosby@kpmg.com

Matt Mosby is a Managing Director in the Financial Institutions and Products group of KPMG’s Washington National Tax

office and specializes in the financial services industry. He has experience providing tax consulting, compliance, and

controversy assistance on a variety of issues facing capital market participants, including debt issuances, securitizations,

derivatives, and hedging programs. His clients include banks, broker-dealers, and financing companies. Matt is a frequent

speaker on tax developments in the banking industry.

Overview

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On December 22, 2017, President Trump signed H.R. 1, originally known as the

Tax Cut and Jobs Act, into law as Public Law 115-97 (the “Act”)

The Act represents the most significant revision of the Internal Revenue Code

since 1986

Lower Corporate Rate – 21%

Immediate Expensing

But Strengthened

Interest Expense

Limitation Rule

Base Erosion

Anti-Avoidance Tax (the

“BEAT”)

New Global Intangible Low Taxed Income (“GILTI”) Tax vs.

Deduction for Foreign Derived Intangible Income (“FDII”)

Net Operating Loss

(“NOL”) Limitation

Modifications

Participation Exemption

and Mandatory

Repatriation TaxGlobal

game-

changing tax

reforms

Tax Reform Provisions Relevant to Commercial Finance

Documents

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» Revised Section 163(j)

» Reduction in Tax Rates

» Code Section 199A Pass Through Deduction

» Limitation on Net Operating Losses

» Section 965 Transition Tax

» No change to Section 956

» Shift to Quasi-Territorial System

» Global Intangible Low Taxed Income (“GILTI”)

9

Certain small taxpayers and

industries are excluded from the rule

altogether:

• Taxpayers with average gross

receipts that do not exceed $25

million

• Electing real property businesses

• Electing farm businesses

• Certain regulated utilities

Excluded

businesses

• Interest that cannot be deducted

is carried forward and can be

deducted when the business has

sufficient adjusted taxable

income

• If the business undergoes an

ownership change, the future

deduction may be limited

• Special rules exist for

partnerships

Treatment of carryforward

Rule disallows a deduction for net business expense in excess of 30%

of “adjusted taxable income” – see following slide

Only applies to business interest

Applies to taxable years beginning after December 31, 2017 – no

grandfathering for pre-existing debt

Interest Expense Disallowance Rule – Section 163(j)

10

Section 163(j) Calculation

Business Interest Income

plus

30% of Adjusted Taxable Income

plus

Floor Plan Financing interest

Business interest

deduction cannot

exceed the following:

Adjusted taxable income

equals:

Taxable income excluding the

following:

• Income, gain, deduction of loss not

properly allocable to a trade or

business

• Business interest or business

interest income

• Net operating loss deductions

• The distributive share of any items of

income, gain, deduction or loss from

a partnership

• The “new” pass-through deduction

under section 199A

• Depreciation

• Amortization

• Depletion

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Example – Impact of Section 163(j)

Corporation X borrows $250X from Lender. In the current year, Corporation X’s

(1) EBITDA equals $60X, (2) business interest expense equals $45X, and (3)

depreciation expense equals $30X. Corporation X recognizes $0 of interest

income.

Assume Corporation X does not qualify under an exception to section 163(j).

Except for “new” section 163(j), assume Corporation X’s interest deductions are

not otherwise limited.

Corporation X is a calendar year taxpayer.

Tax Year Ended Tax Years Tax Years

Dec. 31, 2017 2018 - 2021 After 2021

EBITDA $60X $60X $60X

Depreciation Deduction ($30X) ($30X) ($30X)

Interest Deduction ($45X) ($18X) ($9X)

Taxable Income ($15X) $12X $21X

Tax Liability $0 ($2.5X) ($4.4X)

Tax Benefit Carried Forward - NOL $3.2X

Tax Benefit Carried Forward - Interest $5.7X $7.6X

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Going forward, location of debt may be very important. For example, consider

the following example where debt is used to fund foreign operations.

Example - Who Is Now the Borrower?

U.S. Parent[Tax Rate 35%]

Foreign Sub[Tax Rate 25%]

Pre-H.R 1

Lenders

Post-H.R 1U.S.

Parent[Tax Rate 21%]

Foreign

Sub[Tax Rate 25%]

Lenders

Loan

Proceeds

Proceeds

transferred to

foreign sub

• Interest expense used to offset U.S. tax

liability. e.g., $100 interest deduction offsets

taxable income

• Reduces U.S. tax liability by $35

Loan

Proceeds

• If debt continued to be located at U.S. Parent,

interest only reduces tax liability by $21 and

potentially disallowed under section 163(j)

• Lending directly to foreign sub reduces group’s

overall tax liability by $25 (vs. ≤ $21)

• Will need to consider foreign tax law, tax

impact to lenders, and non-tax considerations

• Potential implications if U.S. guarantees debt?

13

Example – Who Is Now the Borrower (cont’d)

Blocker

RE

JVRE

JV

Blocker

Pre-H.R 1 Post-H.R 1

Borrowing

Borrowing

Under pre-H.R. 1 structure, risk that structure may not be eligible for real

property trade or business election

Minority

Partner

Minority

Partner

Reduction in Corporate Tax Rates and Section 199 Pass Through

Deduction

14

» Corporate Tax Rate Reduced to 21%

» NOL carrybacks disallowed and reduction of available carryforwards to 80% of pre-NOL

deduction taxable income

» Section 199A provides a passthrough deduction to partners, S corporation

shareholders and sole proprietors

» The deduction is generally 20% of qualified business income (“QBI”) from a qualified trade or

business, including qualified REIT Dividends and qualified publicly traded partnership income

» The deduction sunsets for taxable years beginning after December 31, 2025

» 20% deduction subject to limitations

Code Section 965 “Deemed Repatriation” or “Transition Tax”

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» Who is impacted?

» 10% U.S. Shareholders (corporate and individuals) of Specified Foreign Corporations

(“SFCs”) which are defined as:

» (1) Controlled Foreign Corporations (“CFCs”), and

» (2) Foreign corporations with at least one 10% U.S. shareholder that is a domestic

corporation

» What is deferred foreign income?

» Pro rata share of accumulated post-1986 accumulated earnings and profit (“E&P”)

» as of either November 2, 2017 or December 31, 2017 (whichever date is greater)

» E&P must be accrued while foreign corporation was an SFC (note for new US

residents)

» Can be reduced by SFCs with foreign E&P deficit

» Does not include previously taxed income (“PTI”), or effectively connected income

(“ECI”)

» Calculated based upon last tax year beginning before Jan. 1, 2018

» Applies to 2017 for calendar year SFCs, and 2018 for fiscal year SFCs (tax due

in 2019)

Code Section 965 “Deemed Repatriation” or “Transition Tax”

» Effective Tax Rates on foreign “cash” and “non-cash” portions

» Corporations: 15.5% on cash (44% of 35% rate), 8% on non-cash (23% of 35% rate)

» Corporate tax liability can be offset by foreign tax credits (but prorated on taxable portion of

income)

» Individuals: 17.5% on cash, 9.05% on non-cash (for 2017, calendar year SFCs)

» For individuals, tax rate increases to 27.31% on cash, 14.1% on non-cash for 2018 (fiscal yr

SFCs)

» Cash position includes:

» Cash, net accounts receivable,

» FMV of marketable securities, commercial paper, CDs, foreign currency, obligations <1 yr

» As of close of last tax yr beginning before Jan. 1, 2018

» Unless avg of 2 prior tax years ending before Nov. 2, 2017 is greater.

» Payment of Section 965 Tax due April 17, 2018 (for 2017, calendar yr SFCs)

» US Shareholders can elect to pay tax in installments

» 8% for the 1st five years starting in April 2018 (for the 2017 tax year),

» 15%, 20% and 25% respectively for the last three years

» Income subject to deferred tax can be distributed currently without accelerating tax due.

16

Code Section 965 “Deemed Repatriation” or “Transition Tax”

Deferral of Section 965 Tax Liability by S corp shareholders

» Each S corp shareholder can elect to defer the tax indefinitely, or until triggering event.

» SFC stock must be held through S corp on or before 12/31/2017.

» S corp shareholder must report deferral election each year.

» S corp. to file statement in 1st year, with K-1 to shareholder(s)

» S corp and shareholder joint and severally liable for deferred tax.

» Income subject to deferred tax can be distributed currently without accelerating tax due.

» Triggering events include:

» (i) S Corp ceases to be an S Corporation (or is disqualified);

» (ii) S Corporation liquidates, sells all assets or ceases business; or

» Can’t defer immediate tax liability on this triggering event w/o IRS consent.

» (iii) Individual shareholder of S Corp transfers shares but transferee does not assume tax

liability.

» Partial trigger is possible.

17

Code Section 245A Participation Exemption

Applies to Domestic Corporate Shareholders on foreign source portion of

dividends and Code Section 1248 Amounts

» 10% ownership requirement

» Required holding period

» Specific Exclusions:

» Hybrid Dividends

» Dividends paid by PFICs

» Does not apply to Code Section 956 inclusion amounts

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Code Section 951A Global Intangible Low-Taxed Income (“GILTI”)

GILTI is a new category of Subpart F income attributed to US Shareholders of

CFCs.

» Formula backs into a deemed intangible income inclusion amount

» Exempts certain types of income, and compares remaining gross income to artificial 10% deemed

return on depreciated cost bases of specified tangible property used in a trade or business

» Depreciated costs bases is computed using alternative depreciation system under IRC s.

168(g).

» Only takes into account specified tangible property used in the production of tested income.

» Taxed at ordinary income tax rates, with a deduction for domestic C corporations

» After tax GILTI treated as PTI, not subject to second level of tax on distribution

GILTI tested income starts with the gross income of each CFC and then excludes:

» (1) effectively connected income (“ECI”),

» (2) Subpart F income,

» (3) high-taxed income (taxed at rate exceeding 90% of U.S. corporate income tax rate, i.e.,

18.9%),

» (4) dividends from related subsidiaries with >50% vote or value, and

» (5) foreign oil and gas extraction income.

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Deduction available only for domestic C corporation shareholders of CFCs

» TYs 2018-2025: deduction equal to 50% of GILTI (effective tax rate of 10.5%)

» TYs after 2025: deduction equal to 37.5% of GILTI (effective tax rate of 13.125%)

Deemed paid foreign tax credits available to domestic C corporations

» 80% of the foreign taxes paid and attributable to GILTI inclusion. Code s. 960(d)(1).

Potential Planning Opportunities

» Code s. 962 election to treat individual CFC shareholder as a domestic C corporation

» GILTI taxed at corporate rates (with corresponding deduction)

» Allows foreign tax credit to be claimed as if individual shareholder were a domestic C

corporation.

» Tax due on actual payment of (qualified) dividend from “domestic C corporation”

» US shareholder must be CFC shareholder on last day of tax year to be subject to GILTI tax.

20

Code Section 951A Global Intangible Low-Taxed Income (“GILTI”)

Code Section 956 Retained Following Tax Reform

» Pledging of stock of foreign subsidiaries can create a current tax inclusion for parent entity

» Pledge of stock should be limited to 65% of each respective subsidiary’s outstanding voting

stock

21

Pledging of Stock of Foreign Subsidiaries

22

Impact on Provisions of Commercial Finance Documents

Financial Covenant Ratio Potential Impact

Leverage ratio Total Debt/Total Equity

or

Indebtedness (minus cash on

hand)/EBITDA

• Revaluation of DTA and mandatory repatriation reduces

equity in short-term

• Revaluation of DTL increases equity in short-term

• After 2017, reduced rate likely increases equity

(although for multi-nationals, BEAT/GILTI may

significantly reduce benefit)

• Timing differences (e.g., expensing) may not have a

direct impact

• If calculation uses EBITDA, EBITDA generally not

directly impacted by taxes. However, deploying excess

cash (from reduced rate) may improve ratio

• Increase in cash from reduced rate (or repatriation) may

be used to repay indebtedness (reducing numerator)

Fixed Charge

Coverage Ratio

(Earnings+ Fixed Charges) /(Fixed

Charges+ Interest)

or

(EBIT+ Fixed charges before

tax)/(Fixed charges before tax +

Interest)

• Revaluation of DTA and mandatory repatriation reduces

earnings in the current year (revaluation in DTL

increases earnings)

• Going forward, reduced rate may increase earnings

• If calculation uses EBIT, EBIT generally not directly

impacted by taxes. However, consider how increase in

cash flows can be deployed

Other Items to Consider

» Impact on eligible tax distributions for pass-through entities

» Excess cash flow provisions

Conclusions

» Meet with tax professionals and attorneys to discuss the impact of Tax

Reform.

» Review Financial Covenants in your Credit and Loan Agreements.

» Proactively meet with Lenders to discuss any one-time Covenant

Waivers needed or to discuss potential modification of Covenants that

will no longer work from a Borrower perspective.

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Questions?

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