The Tax Cuts and Jobs Act passed the House on November 16, 2017 (House Bill) and the Senate on December 2, 2017 (Senate Bill and together, the Bills). Because the Bills contain significant differences, additional changes are expected in Conference, and there is no accurate way to predict the contents of any final legislation. However, businesses should be aware of the following five tax opportunities and costs.
1. Deemed Repatriation of Foreign Earnings
Under current law, profits accumulated in a foreign subsidiary that is a “controlled foreign corporation” (CFC) are not subject to U.S. tax until they are repatriated, unless the “Subpart F” rules accelerate the tax. Both Bills call for deemed repatriation of accumulated foreign profits of a CFC by 10-percent U.S. shareholders of the CFC, whether or not the cash is actually repatriated. In effect, this provision would allow U.S. businesses to repatriate earnings and profits of CFCs at a preferred rate. The House Bill would tax cash and cash equivalents at 14% and noncash assets at 7%, and the Senate Bill would tax cash and cash equivalents at 14.5% and noncash assets at 7.5%.
Neither Bill places any restrictions or demands on how the shareholders spend the deemed repatriated cash. In 2004, the U.S. had a repatriation tax holiday that allowed businesses to repatriate foreign profits at a 5.25% rate so long as the cash was spent for enumerated purposes. Many corporate shareholders of CFCs used the repatriated cash to buy back their stock, a permitted purpose. The current expectation is that U.S. corporate shareholders will actually repatriate foreign earnings and use the cash for stock buybacks, but some U.S. businesses have pledged to invest the repatriated cash in the United States.
2. Changes to M&A Structuring Incentives
Both Bills would lower the corporate tax rate, shift to a territorial tax system, allow for immediate expensing for certain assets, and modify interest expense deductions—all of which are likely to change the incentives in M&A deals. These are among the many proposed changes may lead to more taxable asset acquisitions and fewer tax-free reorganizations and leveraged acquisitions.
For example, the House Bill would allow a 100% deduction for (i.e., expensing of) investments in “qualified property,” while expanding the current bonus depreciation definition of what is considered qualified property. Under current law, qualified property generally includes original use property with a recovery period of 20 years or less. The House Bill expands qualified property to include certain used property (e.g., property used by a target company). The Senate Bill does not extend to used property, so a buyer could not expense payment for a target’s assets. Expensing used property makes an asset purchase (whether actual or a stock purchase deemed an asset purchase) extremely attractive to a buyer (even more so than previously), as buyer may be permitted an immediate deduction for the cost of eligible acquired assets. Against the benefit of expensing is a new 90% limitation on net operating losses (NOLs). Businesses will be limited to deducting 90% of their NOL carryforwards (with unlimited carryforward) and will be unable to carry back NOLs to prior tax years. The seller’s cost for the asset sale is likely to be reduced by lower corporate tax rates.
3. Limitations & Opportunities for Like-Kind Exchanges
Under current law, taxpayers may defer gain on like-kind exchanges of property, including real and personal property and certain intangible assets such as copyrights and patents. Both Bills generally limit like-kind exchanges to real property, beginning in 2018.
Although the change may have serious implications for businesses that regularly engage in like-kind exchanges for items such as equipment, its effect may be mitigated by the immediate expensing provision discussed above. For example, in a form of synthetic like-kind exchange when the replacement asset is subject to expensing, if a taxpayer were to sell an asset in 2018 and expense the cost of the replacement asset, in effect the taxpayer could reinvest the proceeds of sale tax-free.
4. Withholding on the Sale of a Partnership Interest by a Foreign Partner
Under a 1991 IRS ruling, a foreign partner’s gain from a sale of an interest in a partnership conducting a U.S. trade or business is treated as effectively connected income to the extent that the gain is attributable to partnership assets used in the conduct of the partnership’s U.S. trade or business. The foreign partner is subject to U.S. tax on the gain attributable to its share of those U.S.-related assets. A 2017 Tax Court case, Grecian Magnesite, rejected that conclusion (unless the gain was attributable to U.S. real property interests), and in effect the Senate Bill overturns Grecian Magnesite and reinstates the 1991 rule. Moreover, to ensure collection of tax imposed on the foreign partners, the Senate Bill includes two new withholding rules. A purchaser or other transferee must withhold 10% of the amount it pays to any partner on the sale of a partnership interest unless the seller or transferor furnishes an affidavit stating the transferor is a U.S. taxpayer, and in the absence of withholding by the transferee, the partnership is obligated to withhold from post-transfer distributions to a partner. This provision is retroactive to November 27, 2017, and would require partnerships to more closely monitor sales of interests.
5. Elimination of Fringe Benefits Deductions
Under current law, there are a number of “fringe benefits” for which employers may take a deduction but which are excluded from employees’ income. Both Bills disallow or alter deductions for entertainment, amusement, recreation, club memberships, personal amenities, transportation benefits, meals and other things. Under the House Bill expenses for goods, services and facilities will continue to be deductible, but only to the extent that the expenses are treated as compensation or wages to an employee for the purposes of the employee’s income and withholding.
Employers should consider how this will impact both their own tax bills and that of their employees. Employers may be limited in deducting expenses they traditionally were able to write off or employees may be saddled with significantly higher tax bills, without seeing any change to their compensation. Employers with executive compensation agreements that contain tax gross-up provisions or require other benefits may also need to evaluate how these changes would impact their existing obligations.
These are just a few of the many consequences of the Bills. There will be many more. Businesses should be aware of their positions as the Bills move forward to possible passage.