The Tax Cuts and Jobs Act (the Act) passed with lightning speed by Congress and was signed into law today by President Trump. It will have a significant impact on nearly all individuals and businesses, some starting even before the turn of the year. As we’ve reported previously, both the House and the Senate passed major tax bills with much in common. The imperative to pass a tax bill this year, without bipartisan support and using the “budget reconciliation” process in the Senate (budget reconciliation permitted passage in the Senate with just 51 votes), continues to be reflected in the predominance of Senate provisions remaining in the Act. But there are significant new provisions and changes wrought by the Conference Committee process, from political wrangling, from industry and other taxpayer reactions to the Senate and House bills and from continuing divides within the GOP.
The Act is designed to spur growth and is touted as simpler and fairer. However, the growth projections are controversial, the simplifying measures mostly affect individual taxpayers and the Act has been and will continue to be criticized for creating winners and losers. Rather than compare the Act to the congressional bills we’ve reported on previously, or simply prepare a tabular comparison to current tax law (others have done this already), we instead provide some analysis for the headline changes to the current tax law below.
Generally the Act takes effect January 1, 2018. However, notably the investment incentive rule allowing 100% expensing of qualified property begins with qualified property acquired and placed in service after September 27, 2017. Most of the changes that affect corporations are permanent, but many of the changes that affect individuals, including lowered individual tax rates, are temporary and terminate after 2025. GOP leaders explaining the purpose and benefits of the Act project that the individual rates will be extended beyond 2025, but that will require new legislation by a future Congress.
The big headline item of the Act is a new 21% corporate income tax rate, reflecting a reduction from the current 35%. Unlike reduced individual rates, this lowered corporate rate is permanent and designed to drive domestic capital formation from here and abroad. To backstop this pro-growth provision, the Act shifts to a more “territorial” tax system for corporations and includes provisions designed to prevent tax base erosion. We expect the reduced corporate tax rate, the BEAT tax (described below) and the other provisions discussed below to fundamentally change the way US multinationals approach structural decisions, where assets are located, companies are formed and how they are capitalized. We also expect debate about whether certain of the Act’s provisions violate agreements with the WTO.
Shift to “Territorial” Tax System
In order to move to a territorial system, the Act imposes a deemed repatriation tax on offshore untaxed earnings and profits as of the end of 2017 (with a provision designed to avoid E&P manipulation prior to year’s end). The repatriation tax is imposed at effective rates of 8% on illiquid assets and 15.5% of liquid assets and is recovered ratably over eight years with inclusion of foreign tax credits, deemed-paid foreign tax credits and available NOL carryforward elections. The Act also establishes a participation exemption system (similar to the one in effect in the EU) effectively exempting foreign source dividends received by US corporations from 10% owned foreign corporations. No foreign tax credits (including with respect to any withholding taxes) are allowed with respect to participation exempted dividends. The participation exemption does not apply to dividends out of earnings with respect to which foreign tax credits have been claimed; nor does it apply to dividends out of passive foreign investment companies. We expect the repatriation tax, the complex calculations required to determine that tax (which is technically imposed at the end of 2017) and the balance sheet impacts thereof to be a significant focus of effort for US multinationals through 2018 and beyond.
The Act does move the US in the direction of a territorial system, but references to the Act as one that accomplishes or finishes the move greatly oversimplify its details. In particular, the Act contains several anti-abuse provisions designed to capture income shifting, including the Senate’s base-erosion antiabuse tax (the BEAT tax), as well as provisions that force the recognition of additional items of foreign income in the US at a reduced rate, including on global low-taxed intangible income (the GILTI tax) and on foreign derived intangibles income (FDII).
The BEAT tax applies to corporations with over $500 million in revenue whose deductions to overseas affiliates exceed 4% of overall deductions. The Act adopted this provision but modified the Senate version, essentially giving corporations an additional year before full minimum BEAT tax rates apply in 2019. In simple terms, large US corporations subject to BEAT will tack on to their regular tax liability (much like an AMT) the amount by which 10% of their taxable income, excluding deductible payments to foreign affiliates, exceeds regular tax liability (5% for 2018, 10% for 2019 through 2025 and 12.5% after 2025).
In addition to the BEAT tax, the Act contains earnings stripping provisions limiting business interest deductions. From 2018 through 2021, net interest deductions are limited to 30% of EBITDA and after 2021 are limited to 30% of EBIT. Disallowed interest may be carried forward indefinitely and smaller businesses with average annual gross receipts not exceeding $25 million are exempted from this interest limitation. (This same $25 million average also becomes the limit for the use of the cash method of accounting for many smaller businesses).
The corporate alternative minimum tax is repealed. However, the BEAT, together with the GILTI and FDII provisions discussed above, add back a similar limitation against income stripping. In a further effort to stop US companies from moving business offshore, the Act not only leaves in place the rules against corporate inversions but also eliminates the active trade or business exception for outbound transfers that had allowed some US companies to transfer businesses offshore without incurring US tax.
In addition to reduced corporate income tax rates, the Act is designed to spur US investment through expanded deduction opportunities. For smaller businesses, the Section 179 expense election is expanded for investments in qualifying property of up to $1 million. The ability to utilize Section 179 is also phased out over a higher threshold, between $2.5 million and $3.5 million of such investment. In addition to expanding eligibility for expensing, the Act retains and expands the range of investments qualifying for the deduction. For example, the Act retains the existing $25,000 sport utility vehicle provision and adds depreciable tangible personal property used predominantly to furnish lodging or in connection with furnishing lodging and to include improvements to nonresidential real property such as roofs, heating, ventilation and air-conditioning equipment, fire protection and alarm systems and security systems.
Of more immediate, though somewhat temporary, importance is an increase in first-year bonus depreciation (currently 50% and moved to 100% under the Act) and expansion of “qualifying property” to include used as well as new property, for property acquired and placed in service as early as September 28, 2017 through the end of 2022. Beginning 2023, the deduction is phased down by 20% each year and goes away after 2026. The Act does away with NOL carryback after 2017 so that losses, including those generated from these new expensing opportunities, may only be carried forward to offset taxable income. Notwithstanding new limitations on interest deductions, Section 179 and added first-year bonus depreciation are expected to increase capital expenditures in the US in the near term.
The significantly lowered corporate rates, combined with watered-down provisions for flow-through business income (described below), is expected to force hard decisions for those operating as small business corporations (S corporations). Under the Act, persons converting S corporations to C corporations may take advantage of the new lower corporate rates, while treating distributions during 2018 and 2019 as partially from already taxed income and partially from current earnings and profits (i.e., taxable dividends).
Finally, despite politicized efforts to eliminate the advantageous tax treatment of carried interest, the Act imposes a relatively mild three-year holding period for continued favorable treatment. The longer threeyear holding period applies not only to gains passed through to holders of carried interests but also to sales of carried interests and to the assets generating the underlying gain. We expect carried interests to continue to be a very desirable tool for compensating investment managers.
Although individual rates come down by a small amount under the Act (to expire in 2025) and standard exemptions are roughly doubled, itemized deductions are significantly reduced. Charitable deductions, as well as mortgage interest deductions for new purchases to $750,000 (equity loans are excluded), remain. However, property taxes and either of state income or sales taxes are together limited to a combined $10,000 deduction, and the Act does not permit deduction in 2017 of future years’ state income taxes paid in 2017. The $10,000 limitation is estimated to raise over $43.5 billion in 2018 and $70 billion or more in each of the years thereafter. Whether the lowered rates, higher standard deductions and eliminated itemized deductions benefit a particular taxpayer depends on their circumstances and location, with some experiencing an increase in tax due.
After significant debate about a reduced flow-through business tax rate for individuals, the Act sets up a deduction system that promises a lower effective rate for business income where it applies. However, the Act imposes stringent limitations on the amounts for which a deduction is applicable and lower applicable income thresholds. As a result of the limitations and low thresholds, the flow-through business tax provisions are not expected to result in a wholesale change in business structures, outside of a wide range of relatively low dollar circumstances.
The individual alternative minimum tax is retained but with higher exempt levels of income and phaseouts. Combined with limits on itemized deductions, the AMT should be significantly reduced in its impact on taxpayers. Also, the penalty for individuals who do not buy health insurance, which is viewed as critical to making the Affordable Care Act (Obamacare) work, is reduced to zero in 2019 (effectively repealing the mandate). Finally, the Act doubles the estate tax exclusion to $10 million.
With the Act having been agreed so late in 2017, with enormous changes for US corporations in particular, we expect to be advising our clients well into 2018 concerning both planning opportunities and structuring to address the changed business tax landscape. We foresee a renewed interest in inbound investment and structuring activity. We also expect several important collateral consequences, from changes to key balance sheet metrics, to changes in financing structures and capitalization choices.
Just as taxpayers are digesting the changes, so are state and local governments. We expect states to implement new rules or legislation to blunt the effect of any revenue loss from the federal changes. We of course are monitoring state and local activities, as well as federal, and will continue to report the impact as the details become available.
You can check here for our other updates on both the federal and state proposed revisions.