On November 2, Kevin Brady (R-TX), Chairman of the US House of Representatives' Ways and Means Committee, released the Tax Cuts and Jobs Act, a comprehensive tax reform proposal consisting of legislative language and a detailed explanation. He also announced that the Ways and Means Committee would begin consideration, or "markup," of the proposal on November 6. House Republican leaders' goal is to have the tax reform bill passed by the full House of Representatives and sent to the US Senate prior to the Thanksgiving holiday.
From a big-picture standpoint, the Tax Cuts and Jobs Act is generally consistent with the nine-page "Unified Framework for Fixing our Broken Tax Code" released by President Trump and Republican congressional leaders on September 27. Still, the House bill includes a few departures from the framework and some surprises of its own.
Highlights of the House bill
Like the framework, the House bill would replace the current 10 percent, 15 percent, 25 percent, 28 percent, 33 percent and 35 percent rate brackets with three new rate brackets of 12 percent, 25 percent and 35 percent. The current highest rate bracket, 39.6 percent would be retained, although it would not begin until a taxpayer had taxable income in excess of US$1 million for joint filers and US$500,000 for individual filers.
The House bill makes no change to capital gains or dividend tax rates. It also retains the 3.8 percent tax on net investment income.
As suggested in the framework, indexing of the rate brackets for inflation will be based on the chained consumer price index (CPI), which will generally result in smaller inflation-adjusted increases in the rate brackets and other parts of the tax law that are indexed for inflation, such as the standard deduction.
The House bill would eliminate the top three corporate tax rates, replacing them with a top tax rate of 20 percent.
For certain pass-through entities, the bill would adopt a special rate of 25 percent. Only a portion of the income from a pass-through entity (the amount attributable to the individual's "capital percentage") would be eligible for the 25 percent rate; the remainder would be taxed at the same rate as compensation. Excluded entirely from the 25 percent rate are personal service businesses such as law firms and accounting firms, unless they can demonstrate a significant capital percentage.
The House bill does not eliminate the "carried interest" provision.
Changes affecting individuals include:
- The standard deduction is increased to US$24,000 for joint filers and US$12,000 for individual filers.
- The child tax credit is increased and collapsed into a new family tax credit.
- Personal exemptions are eliminated and folded into the increased standard deduction and family tax credit.
- Most itemized deductions would be repealed, although:
- The mortgage interest deduction is retained but limited
- The deduction for charitable contributions is retained but modified
- The deduction for state and local taxes is retained only for real property taxes (up to US$10,000)
The House bill is silent as to certain itemized deductions, such as the deduction for investment interest expense.
Changes affecting businesses include:
- The bill would provide full expensing of equipment acquired between September 27, 2017, and January 1, 2023. In addition, the limits on section 179 expensing for small businesses would be increased as well.
- For businesses with average gross receipts of more than US$25 million, business interest expense would generally be limited to 30 percent of adjusted taxable income, which is similar to earnings before interest, taxes, depreciation and amortization (EBITDA).
- New limitations would apply to
- Net operating losses
- Like-kind exchanges
- Contributions of capital
- Deductions for Federal Deposit Insurance Corporation (FDIC) premiums
- A variety of existing business deductions, credits and other incentives would be repealed, including:
- The section 199 "manufacturing" deduction
- The deduction for entertainment expenses
- The deduction for employee fringe benefits
- The deduction for lobbying expenses
- Sales of self-generated intangible assets would be subject to higher taxes.
- Several credits would be repealed:
- The "orphan" drug credit
- The employer-provided child care credit
- The rehabilitation credit
- The work opportunity tax credit
- New allocations of the new markets tax credit
- The credit for expenditures to provide access to disabled individuals
- The enhanced oil recovery credit
- The credit for producing oil and gas from marginal wells
- Other credits would be modified:
- The credit for the portion of employer social security taxes paid with respect to employee tips
- The credit for electricity produced from certain renewable resources
- The energy investment tax credit
- The credit for residential energy efficient property
- The credit for production from advanced nuclear power facilities
- Tax exempt bonds would be significantly curtailed:
- New issuances of private activity bonds would no longer be tax-exempt
- Future advance refunding bonds would be taxable
- New issuances of tax credit bonds would be prohibited
- Professional stadiums could not be financed by tax-exempt bonds
Impact on particular sectors
Significant new rules would apply to
- Insurance companies
- Retirement plans
International tax reform
Other than the uncertainty as to what would be in the "base erosion" provisions, the international tax provisions are generally consistent with what was described in the framework. The bill would adopt a "territorial" tax system for US corporations: a 100 percent exemption for dividends from foreign subsidiaries, but the "base erosion" provisions, especially the tax on "foreign high returns," take away much of the benefit of the dividend exemption. The 100 percent dividend exemption is limited to domestic corporations which hold a 10 percent or greater interest in a foreign corporation. It applies only to foreign-source dividends and does not apply to income earned directly by a domestic corporation, for example, through a branch.
The bill makes various changes to the Subpart F "anti-deferral" rules, some of which (for instance, increasing the "de minimis" threshold and making the Controlled Foreign Corporation (CFC) look-through rule permanent) reduce the likelihood of immediate taxation while others (such as modifying the constructive ownership rules and eliminating the requirement that a foreign corporation be a CFC for 30 days before being subject to Subpart F) increase the likelihood of immediate US taxation. The bill also includes some controversial provisions that US multinationals will not like, such as the new tax on "foreign high returns" and sourcing income from sales of inventory based solely on the place of production of the inventory.
As promised in the framework, the House bill includes a deemed repatriation provision for offshore earnings that have not been subject to US tax. The deemed repatriation proposal:
- Applies to domestic corporations and US individuals owning 10 percent or more of a foreign corporation
- Is imposed at a five percent rate on offshore earnings held as illiquid assets and at a 12 percent rate on offshore earnings held as cash or cash equivalents.
The measuring date for offshore earnings subject to the deemed repatriation tax is November 2, 2017, or December 31, 2017, whichever balance is higher. Tax liability can be paid over an eight-year period.
The deemed repatriation provision applies more broadly than the dividend exemption proposal because the deemed repatriation provision applies to all US persons who own a 10 percent interest, not just domestic corporations. Thus, individuals are subject to the deemed repatriation tax as well, even though they are not eligible for the 100 percent dividend exemption provision.
Indeed, non-corporate taxpayers generally receive only the disadvantages of the new international tax rules. Individuals are not eligible for the dividend exemption, but they are subject to the deemed repatriation provision and the income inclusion for "foreign high returns."
Non-US corporations and their US subsidiaries fare even worse. To "level the playing field" between US corporations and non-US corporations, new tax provisions would apply to foreign corporations and their US investments. The House bill would:
- Impose an excise tax on certain payments by domestic corporations to foreign affiliates (subject to an election by the foreign corporation to pay regular US corporate income tax on such payments)
- Limit reductions in withholding tax on payments by a domestic entity to a foreign affiliate if the ultimate parent of those two affiliates would have been subject to a higher withholding tax rate had it received the amount directly (dropped in the proposed Chairman's amendment released November 3).
Both provisions would appear to override US tax treaties.
The estate tax exemption amount is doubled to US$10 million and indexed for inflation. After 2023, the estate tax is repealed while step-up in basis for heirs is retained. The gift tax is retained, although the gift tax rate is lowered to 35 percent and the exemption amount is increased to US$10 million.
Many taxpayers will benefit from the reduction in tax rates. On the other hand, all taxpayers will be, to varying degrees, unhappy with the deductions and exclusions they will be losing. For the next few days or weeks, affected taxpayers will be comparing the proposed changes to their current tax liability, to see how much better or worse off they will be under the House bill compared to current law.
Many taxpayers, industry groups and organizations will be fighting to retain or restore existing tax incentives and rules. In response, proponents of the Tax Cuts and Jobs Act will attempt to dismiss attempts to change the bill as the work of "special interests." But the fact remains that all of the tax incentives and special rules in the Internal Revenue Code were not put there by "special interests." They were put there by benefactors in Congress. The Ways and Means Committee is seeking to reverse a decades-long practice of using the Internal Revenue Code to encourage activities favored by Congress or to provide exceptions to an otherwise applicable tax rule to a sympathetic group. Historically, sympathetic pleas have defeated abstract arguments of tax policy. This month, the Tax Cuts and Jobs Act will be the test as to whether Congress has, unlike the proverbial tiger, changed its stripes.