On November 2, 2017, the House Ways and Means Committee (the “House Committee”) released its plan for comprehensive tax reform: the “Tax Cuts and Jobs Act of 2017” (H.R. 1) (the “House Bill”). Following a week of hearings, the House Committee amended and approved the House Bill by a party-line vote of 24-16 on November 9. On November 16, the House of Representatives passed the House Bill by a vote of 227-205.
The Senate Finance Committee (the “Senate Committee”) released its policy highlights regarding comprehensive tax reform, and the Joint Committee on Taxation released its description of the Senate Committee’s proposal on November 9 (the “Senate Proposal”). On November 14, the Senate Committee released a number of revisions to the Senate Proposal, including the sunset of the changes to the individual tax rates beginning in 2026 and the elimination of the Affordable Care Act’s individual mandate. The Senate Committee approved an amended version of the Senate Proposal by a party-line vote of 14-12 on November 16.
This client alert summarizes the key income, compensation, estate and gift tax provisions and the key differences of the House Bill and the Senate Proposal as of November 17, 2017. As of the date of publication of this client alert, the Senate Committee has not released legislative text regarding the Senate Proposal. We expect that a final tax reform bill developed pursuant to a conference agreement would combine elements from each of the House Bill and the Senate Proposal.
Changes That Affect Individuals
Changes in Individual Tax Rates
The House Bill reduces the number of tax brackets, from seven to four, and increases the threshold for each bracket. For married taxpayers filing jointly, the rates are as follows:
- 12 percent: $0 – $89,999
- 25 percent: $90,000 – $259,999
- 35 percent: $260,000 – $999,999
- 39.6 percent: $1,000,000 and over
Taxpayers with adjusted gross income above $1,000,000 for individuals (and above $1,200,000 for married taxpayers filing jointly) are subject to an additional six percent tax rate (the so-called “bubble tax”) which phases out the benefit of the 12-percent bracket. Accordingly, a married taxpayer filing a joint return with adjusted gross income in excess of $1,200,000 would pay a marginal tax rate of 45.6 percent while the benefit of $24,840 (27.6 percent of $90,000) phases out over a range of $414,000, after which point the top 39.6 percent marginal rate would resume.
The Senate Proposal retains the current seven tax bracket structure, though it imposes slightly lower marginal rates on slightly wider brackets. Under the Senate Proposal, a married taxpayer filing a joint return is subject to the following rates:
- 10 percent: $0 – $19,050
- 12 percent: $19,051 – $77,400
- 22.5 percent: $77,401 – $120,000
- 25 percent: $120,001 – $290,000
- 32.5 percent: $290,001 – $390,000
- 35 percent: $390,001 – $1,000,000
- 38.5 percent: over $1,000,000
Accordingly, under the Senate Proposal, the top marginal tax rate is 38.5 percent (slightly less than the current top marginal tax rate of 39.6 percent), and there is no phase-out of the 12 percent bracket as there is in the House Bill. However, these reduced rates expire in 2026.
Larger Standard Deduction and Family/Child Tax Credits
Overall, the House Bill encourages taxpayers to take the simpler standard deduction, rather than itemizing their deductions. It does this by increasing the standard deduction and eliminating, or severely restricting, important itemized deductions. Some of the most significant itemized deductions curtailed or repealed by the House Bill include the deduction for state and local income taxes and the deduction for home mortgage interest.
Under the House Bill, the standard deduction nearly doubles (increasing from $12,700 to $24,400 for married taxpayers filing jointly) and is accompanied by an enhanced child tax credit as well as a new family tax credit. The child tax credit increases from $1,000 to $1,600 for each qualifying child, and is refundable up to $1,000 per child. The House Bill adds a $300 credit for the taxpayer (each spouse in the case of a joint return) and each dependent that is not a qualifying child. The credit is subject to a phase-out for single taxpayers with adjusted gross income above $115,000 (and $230,000 for married taxpayers filing jointly). The House Bill eliminates the deduction for personal exemptions.
The Senate Proposal repeals the personal exemption but roughly doubles the standard deduction ($24,000 for married taxpayers filing jointly, $18,000 for head-of-household filers, and $12,000 for all other taxpayers), increases the child tax credit to $2,000, and creates a $500 nonrefundable credit for other qualified dependents (compared to $1,600 and $300, respectively, in the House Bill). The bill also modifies the threshold amount where the credit begins to phase-out to $500,000 for married taxpayers filing a joint return. This modification is effective beginning in 2018 and expires in 2026.
State and Local Taxes
The House Bill completely repeals the deduction for state and local income and sales taxes. The deduction for state and local property taxes is retained, but it is limited to $10,000 per year. For state and local income taxes paid on business income, see the summary below in the section titled, “Business Income of Individuals (i.e., Special Rate for Pass-Through Income) – Business Income and the Effect on the State and Local Tax Deduction.”
Under the Senate Proposal, which further restricts the deduction, individuals cannot deduct state or local taxes except for property taxes which are paid or accrued in a trade or business (or for the production of income). No similar exception exists for state and local income taxes.
Under the House Bill, the deduction for home mortgage interest is significantly reduced. While indebtedness on a taxpayer’s principal residence incurred on or before November 2, 2017 is grandfathered (which includes subsequent refinancings, as long as certain conditions are met), interest is deductible on no more than $500,000 of new indebtedness, and the deduction is further limited to indebtedness on one qualified residence.
Senate Proposal maintains the home mortgage interest deduction with the current restrictions but repeals the deduction for interest on home equity loans.
Other Important Provisions
The House Bill also repeals or limits a number of other deductions and exemptions. For example, the House Bill denies deductions for expenses attributable to the trade or business of being an employee and repeals the deduction for student loan interest. It also places new limits on the $500,000 exclusion of gain from the sale of a principal residence by extending the duration for which the residence must be the principal residence for at least five of the prior eight years (compared to the current rule of at least two of the prior five years), limits the exclusion to one sale or exchange every five years, and phases out of the exclusion for individual taxpayers with taxable income exceeding $250,000 for the two years preceding the sale (or $500,000 for married taxpayers filing jointly). The House Bill also repeals the deduction for medical expenses.
The House Bill repeals both the overall limitation on itemized deductions (often referred to as the Pease limitation) and the individual Alternative Minimum Tax (AMT). Since both the Pease limitation and the AMT limit the taxpayer’s ability to utilize itemized deductions, these repeals would have less of an impact in light of the elimination and reduction of important itemized deductions under other provisions of the House Bill.
Finally, certain provisions remain unaffected by the House Bill, including the reduced rates for long-term capital gains and qualified dividend income, as well as the 3.8 percent Medicare tax net investment income.
The Senate Proposal repeals all miscellaneous itemized deductions subject to the two percent floor and the individual AMT. However, these repeals expire in 2026.
In addition, beginning in 2019, the Senate Proposal repeals the Affordable Care Act’s individual mandate. However, unlike many other provisions affecting individuals, this repeal does not expire in 2026.
Finally, the Senate Proposal also requires taxpayers selling securities to determine the cost of the disposed securities on a first-in, first-out (“FIFO”) basis, rather than continuing the current practice of allowing taxpayers to specifically identify which of their shares were sold. The proposal similarly restricts a broker’s basis reporting method to the FIFO method. However, the proposal provides exceptions to the FIFO requirement (i) for securities held by a RIC and (ii) to the extent one of the average-cost-basis methods, described in Treasury regulations, would otherwise be allowed.
Estate, Gift and Generation-Skipping Tax
Under the House Bill, beginning in 2018, the basic exclusion amount for estate, gift and generation skipping transfer taxes is doubled to $10 million, indexed for inflation (in 2018, this translates to a basic exclusion amount of $11.2 million for an individual and $22.4 million for a married couple).
The House Bill repeals the estate tax for decedents dying after 2024, but maintains the provision permitting a basis step-up for income tax purposes on property received from a decedent to the fair market value of such property on the date of the decedent’s death. The House Bill phases out the tax on distributions made after 2034 from qualified domestic trusts (QDOTs) created by decedents dying before December 31, 2024 and eliminates the estate tax on such QDOTs on the death of the surviving non-citizen spouse after 2024.
The House Bill also repeals the generation-skipping transfer tax on generation-skipping transfers after 2024.
The House Bill maintains the gift tax on lifetime transfers, but the maximum rate on gifts after 2024 is lowered from 40 percent to 35 percent. The House Bill does not affect the annual exclusion for gifts, which is $15,000 per donee in 2018 and indexed for inflation in future years.
Under the House Bill, the estates of non-resident non-citizen decedents dying prior to December 31, 2024 continues to have a $60,000 estate tax exemption on US situs assets, and the estate tax is repealed for non-resident non-citizen decedents dying after 2024. Non-resident non-citizens continue to be subject to gift tax on lifetime transfers of US situs real and tangible property, with the maximum rate on transfers after 2024 decreasing to 35 percent.
The Senate Proposal contains provisions identical to those in the House Bill with respect to the basic exclusion amount. However, the Senate Proposal does not provide for the future repeal of the estate and generation-skipping transfer taxes as the House Bill does after 2024. In addition, the Senate Proposal maintains the current gift tax rates and does not provide for a reduced maximum tax rate of 35 percent on gifts made in 2025 and beyond. However, the Senate Proposal modifications expire in 2026.
Corporate Tax Provisions
Reduction in Corporate Tax Rate
The House Bill replaces the graduated tax rates for corporations (current maximum rate of 35 percent) with a flat 20 percent corporate tax rate. Personal service corporations are subject to a flat 25 percent corporate tax rate, which is the same tax rate under the House Bill for business income of pass-through entities (subject to certain exceptions). The new 20 and 25 percent rates apply for tax years beginning after 2017 (that is, the rate reduction is immediate with no phase-in, as had previously been considered). In addition, the House Bill eliminates the corporate AMT.
The substantial decrease in corporate tax rates is expected to cause the largest reduction in tax revenues that would result from the House Bill over the next 10 years, with the Joint Committee on Taxation estimating an aggregate reduction of about $1.4 trillion. Given the significant reduction in tax revenues, it is not certain that any enacted tax reform would include a 20 percent corporate tax rate (and, instead, could be a higher rate such as 25 percent). The House Bill imposes a section 481(a) adjustment on distributions from an eligible termination of an S corporation that converts to a C corporation following the enactment of the House Bill over a six-taxable year period.
The House Bill is expected to be beneficial to many US corporations. Notwithstanding the existing 35 percent maximum rate, many US corporations have a lower effective tax rate due to, among other items, deductions for depreciation/amortization and interest paid. The particular benefit to a US corporation of the proposed corporate tax rate decrease would depend on its operations as well as other effects the House Bill could have on its effective tax rate, such as the proposed limitations on interest deductions.
The Senate Proposal adopts a flat 20 percent corporate tax rate for all corporations, but is not effective until 2019 (rather than effective in 2018 under the House Bill). The Senate Proposal eliminates the corporate AMT in 2018.
Reduction in Dividends Received Deduction Percentage
Under current law, a corporation is entitled to a 100 percent dividends received deduction (“DRD”) for dividends received from a corporation in its affiliated group, an 80 percent DRD to the extent the corporate recipient owns 20 percent or more of the stock of the dividend-paying corporation (by vote and value), and a 70 percent DRD for dividends received by a corporate recipient that owns less than 20 percent of the stock of the dividend-paying corporation.
The House Bill lowers the 80 percent DRD to 65 percent and the 70 percent DRD to 50 percent. The House Bill does not modify the 100 percent DRD for dividends received from members within the same affiliated group. Under the House Bill, the effective tax rate on dividends received by a corporation with the reduced proposed 20 percent corporate tax rate is roughly the same as under current law with the 35 percent corporate tax rate (seven percent effective corporate tax rate with a 65 percent DRD and 10 percent effective corporate tax rate with a 50 percent DRD). The House Bill does not explain why dividends received by a corporation would not enjoy the benefit of a reduction in the corporate tax rate.
The Senate Proposal adopts the same changes to the DRD as the House Bill, but is effective in 2019 to parallel the effective date of the proposed reduction in the corporate tax rate.
Modification of Net Operating Loss Deduction
The House Bill permits taxpayers to carryforward net operating losses (“NOLs”) indefinitely, but limits the use of NOLs to 90 percent of the taxpayer’s taxable income for the year. The House Bill generally does not allow carrybacks of NOLs. Any NOLs that are carried forward are increased by an interest factor in order for the NOLs to preserve their value. This House Bill is effective for losses arising in taxable years beginning after 2017.
For NOLs of corporations, the Senate Proposal generally is the same as the House Bill, except that there is no discussion of increasing NOL carryforwards by an interest factor. Beginning in 2023 (if certain government revenue targets are not met), the Senate Proposal limits the use of NOLs to 80 percent of the taxpayer’s taxable income for the year.
Other Business Provisions
The House Bill allows taxpayers to immediately expense 100 percent of the cost of “qualified property” that is placed in service after September 27, 2017 and before January 1, 2023 (with an additional year for certain property with longer production periods). Under the House Bill, new qualified property, as well as used qualified property acquired by a taxpayer, is eligible for immediate expensing.
Qualified property is defined as tangible property with a recovery period of 20 years or less under the modified accelerated cost recovery system (i.e., MACRS), certain off-the-shelf computer software, water utility property or qualified improvement property. Certain trees, vines and fruit-bearing plants also are eligible for additional depreciation when planted or grafted.
Under the House Bill, property of real property trades or businesses and regulated public utilities are not eligible for immediate expensing; however, such trades and businesses are not subject to the House Bill’s limitations on interest deductions discussed below. Real property trades or businesses include real property development, construction and rental and management businesses. As a more general matter, discussions of tax reform this year have focused on allowing immediate expensing along with limitations on interest deductions. Although immediate expensing can have a benefit of lowering cash taxes upfront, depreciation generally is a timing issue while limitations on interest deductions generally are permanent.
Because the House Bill generally eliminates the carryback of NOLs for tax years beginning after 2017, corporations are not permitted to carryback any NOLs for the 2017 taxable year that are attributable to immediate expensing.
The Senate Proposal includes a similar immediate 100 percent expensing rule for qualified property that is placed in service for the same 5-year period as the House Bill, but the Senate Proposal does not exclude immediate expensing for real property trades or businesses. Significantly, the Senate Proposal limits the expensing rule to original use property (rather than the House Bill which also applies to used acquired property).
Limitations on Interest Deductions
The House Bill limits interest deductions for businesses, whether in corporate or pass-through form, to 30 percent of adjusted taxable income. Adjusted taxable income is computed without regard to business interest income or expense, NOLs and depreciation, amortization and depletion (i.e., similar to EBITDA). Any interest deductions that are disallowed may be carried forward for five taxable years on a first-in, first-out basis. The House Bill applies to taxable years beginning after 2017. Accordingly, there is no grandfathering for existing debt instruments.
In the case of affiliated corporations that file a US federal consolidated tax return, the limitation on interest deductions applies at the consolidated tax return filing level. In the case of partnerships, the limitation on interest deductions is determined at the partnership level. In addition, to prevent double counting of income at the partner level, the unused portion of the 30 percent limitation with respect to a partner is available to the partner to ensure that net income of the partnership is not double-counted at the partner level. Similar rules apply to S corporations.
The House Bill does not apply to real property trades or businesses or regulated utility companies (which, as mentioned above, are not eligible for immediate expensing of their assets). In addition, the House Bill does not apply to the trade or business of being an employee. The House Bill also contains an exception for businesses with average gross receipts of $25 million or less per year over a three-year period.
To the extent a corporation with disallowed interest deductions is acquired, the carryover of such disallowed interest deductions is treated as a net operating loss for purposes of the section 382 ownership change rules and thus may be subject to limitation (and, further, could expire unused given the limited five-year carryforward period).
Finally, given the limitations discussed above, the House Bill eliminates the “earnings stripping” rules (which currently apply only to deductions for interest paid by US corporations to, or guaranteed by, related foreign parties and only if certain other factors are present).
The House Bill is similar to interest deduction limitations employed by European countries and other jurisdictions.
For multinational groups, the House Bill imposes an additional restriction on interest deductions if the group’s global net interest expense exceeds 110 percent of the US corporation’s share of the group’s global EBITDA. See “International Tax Provisions—Limitation on Interest Expense Deductions by US Shareholders” below for a discussion of this rule.
The Senate Proposal includes a limitation on interest deductions similar to that contained in the House Bill, with the following differences:
- The Senate Proposal provides for an unlimited carried forward period for disallowed interest deductions.
- Real property trades or businesses can elect out of the Senate Proposal; however, upon such an election, real property trades or businesses are required to use a less favorable depreciation method.
- The Senate Proposal computes adjusted taxable income without regard to unrelated items of income and expense, business interest income or expense, NOLs or the 17.4 percent pass-through deduction for partnerships discussed below (but the Senate Proposal does not explicitly carve-out depreciation, amortization, and depletion from the computation).
- The Senate Proposal excludes businesses with average gross receipts of $15 million or less (compared to $25 million or less in the House Bill) per year over a three-year period from the limitation on interest deductions.
Treatment of Contributions to Capital by Non-Shareholders
Under current law, the contribution of money or property to a corporation by a non-shareholder is generally not treated as taxable income to the corporation under section 118. The House Bill treats a contribution of money or other property to a corporation as gross income to such corporation to the extent that the amount of money and fair market value of property contributed to the corporation exceeds the fair market value of any stock that is issued in exchange for such money or property. The House Bill also requires non-corporate entities to recognize income upon contributions of money or other property made by non-members or non-partners, as applicable. While the intent of this provision is not clear from the face of the House Bill, the Committee summary of the provision states that its intent is to “remove the Federal tax subsidy for State and local governments to offer incentives and concessions to businesses that locate operations within their jurisdictions (usually in lieu of locating operations in a different State or locality).” In describing the scope of this bill, the Joint Committee on Taxation report distinguishes a contribution of land to a business (treated as taxable income by the House Bill) from other valuable benefits provided by municipalities such as a tax abatement granted by a municipality to a business (not treated as taxable income by the House Bill). The House Bill is effective for contributions made, and transactions entered into, after the date of the enactment of the House Bill.
The Senate Proposal does not contain a similar provision.
Business Income of Individuals (i.e., Special Rate for Pass-Through Income)
Maximum Rate on Business Income of Individuals
Under the House Bill, “qualified business income” derived by an individual from a pass-through entity (i.e., a partnership, a limited liability company treated as a partnership for tax purposes or an S corporation) or by a sole proprietor is subject to a maximum federal income tax rate of 25 percent. Other income and loss of an individual (whether or not derived from a pass-through entity) generally will continue to be subject to tax in the same manner as under present law (as modified by the House Bill).
For any individual, qualified business income is equal to:
- any net business income from a passive business activity of such individual; plus
- the capital percentage (as defined below) of any other net business income derived by such individual; reduced by
- any net business losses derived by the individual from a passive business activity of such individual; 30 percent of other net business losses derived by such individual (other than losses arising from a “specified service activity” (as defined below)); and any carryover business loss determined for the preceding taxable year.
As described above, the starting point for the calculation of qualified business income is “net business income.” Net business income is determined separately for each business activity. It includes the individual’s share of the income and gain derived by the pass-through entity from the business activity, and also includes any amounts received by the individual as wages, director’s fees, guaranteed payments, and amounts received from a partnership other than in the individual’s capacity as a partner, in each case, that are properly attributable to the business activity. For these purposes, a “business activity” is any activity which involves the conduct of any trade or business. Income and loss that is not derived from or attributable to a business activity (including investment income) is not taken into account in determining net business income. Furthermore, net business income does not include:
- capital gain or loss,
- dividends and dividend equivalent payments,
- interest income other than that which is properly allocable to a trade or business,
- the excess of gain over loss from commodities transactions, other than those entered into in the normal course of a trade or business or with respect to inventory property, property used in the trade or business, or supplies regularly used or consumed in the trade or business,
- the excess of foreign currency gains over foreign currency losses from section 988 transactions, other than transactions directly related to the business needs of a business activity,
- net income from notional principal contracts, other than clearly identified hedging transactions, and
- any amount received from an annuity that is not used in the trade or business of the business activity.
Passive Business Activities: As stated above, 100 percent of net business income derived from a passive business activity is qualified business income taxed at no higher than a 25-percent rate. For this purpose, “passive business activity” generally has the same meaning as a passive activity under section 469 (passive loss rules). However, a passive business activity does not include an activity in connection with the production of income with respect to which expenses are allowable as a deduction under section 212 rather than section 162.
The determination of whether a taxpayer is active or passive with respect to a particular business activity relies on the material participation rules of the section 469 regulations. These rules, including the rules regarding taxpayer substantiation, establish the various ways taxpayers can establish that the adverse consequences of the passive loss rules do not apply to deductions and losses from certain business activities because they materially participate in those activities. The House Bill now creates the opposite incentive for taxpayers to avoid material participation in order to receive a lower rate of tax on business income.
Under the material participation rules, a limited partner has not materially participated in a business activity of the partnership during a particular tax year, unless:
- the limited partner participated in the activity for more than 500 hours during the tax year;
- the limited partner materially participated in the activity (other than by meeting this five-out-of-ten years test) for any five of the ten immediately preceding tax years; or
- the activity is a “personal service activity” in which the limited partner materially participated for any three preceding tax years.
Under the House Bill, two partners in the same partnership may see their partnership income taxed at dramatically different rates depending on their level of participation in the entity.
Capital Percentage—Non “Specified Service” Businesses: Any net business income not derived from a passive business activity (i.e., active business income) generally is divided into the portion treated as if it were attributable to the individual’s capital investment, which is qualified business income, and the remainder, which is treated as if it were attributable to the individual’s personal services to the business (i.e., as compensation). The portion treated as if it were attributable to the individual’s capital investment is called the “capital percentage.” The capital percentage generally is determined in one of two ways.
- Default Rule: If no election is made by the individual, a default capital percentage of 30 percent applies unless the individual is engaged in a specified service activity. In such case, 70 percent of the individual’s net business income from the trade or business treated as compensation subject to ordinary individual income tax rates and the remaining 30 percent of such income is qualified business income subject to the 25 percent maximum rate.
- Elective Alternative: Individuals may elect to determine their capital percentage with respect to a business activity by using a formula based on the individual’s share of the tax basis (determined without taking into account basis adjustments for bonus depreciation under section 168(k) or expensing under section 179) of the capital assets used in the business (the “asset balance”). The election binds only the individual that makes it and is binding for a five-year period. Under the formula, the capital percentage of an individual for an activity is the ratio of (i) a hypothetical annual return (the short-term AFR rate plus seven percent) on the individual’s share of the asset balance, less the individual’s interest deductions with respect to such activity for such tax year, to (ii) the individual’s net business income derived from that activity for that taxable year. The qualified business income determined by application of the capital percentage is then reduced, if necessary, so as not to recharacterize as qualified business income any wages, director’s fees, guaranteed payments, and amounts received from a partnership other than in the individual’s capacity as a partner.
Capital Percentage—“Specified Service” Businesses: A different set of rules determines the capital percentage in the case of an individual for whom a specified service activity is an active business activity. A “specified service activity” means any trade or business activity involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees, or investing, trading, or dealing in securities, partnership interests, or commodities.
In the case of an active business activity that is a specified service activity, the default capital percentage is zero and no amount of net business loss from the specified service activity offsets qualified business income. A taxpayer may, however, elect the application of an increased percentage with respect to a specified service activity if the capital percentage resulting from the elective formula above would be at least 10 percent.
The Senate Proposal also reduces the income tax imposed on qualified business income, but takes a fundamentally different approach. Specifically, the Senate Proposal creates a new deduction equal to 17.4 percent of the domestic qualified business income of each individual, regardless of the individual’s tax bracket.
Qualified business income for a taxable year is defined as the net amount of domestic qualified items of income, gain, deduction, and loss with respect to the taxpayer’s “qualified businesses,” which generally means any trades or businesses other than specified service activities. The Senate Proposal allows individuals that derive business income from specified service activities to treat such activities as qualified businesses if their taxable income is less than $500,000 (for married couples) or $250,000 (for individuals); the benefit of the deduction for service providers is phased out over a $100,000 range (for married individuals filing jointly; $50,000 for other individuals). As a result of the size of the deduction, the top tax rate on qualified business income under the Senate Proposal is 31.8 percent as compared to 25 percent in the House Bill.
The Senate Proposal limits the deduction for an individual’s qualified business income derived from a partnership, S corporation or sole proprietorship to 50 percent of the individual’s “W-2 wages” paid. Such wages include wages subject to wage withholding, elective deferrals, and deferred compensation paid by the taxpayer during the calendar year. The W-2 wage limit does not apply for taxpayers with taxable income not exceeding $500,000 (for married individuals filing jointly) or $250,000 (for other individuals).
Qualified business income includes dividends from REITs (other than capital gain dividends) and dividends from certain cooperatives. However, qualified business income does not include certain investment-related income, gains, deductions, or losses. If a taxpayer has negative qualified business income for a particular year, the amount of such loss can be used to offset qualified business income in the following taxable year.
The Senate Proposal does not use the “capital percentage” approach outlined in the House Bill. Rather, the Senate Proposal excludes from qualified business income (1) any amount paid by an S corporation that is treated as reasonable compensation of the taxpayer, (2) any amount allocated or distributed by a partnership for services to a partner who is acting other than in his or her capacity as a partner and (3) any amount that is a guaranteed payment for services actually rendered to or on behalf of a partnership.
The Senate Proposal includes a new limitation on the deductibility of losses for taxpayers other than corporations, including losses from qualified businesses. Under the Senate Proposal, “excess business losses” of an individual, estate, or trust are not currently deductible. Excess business losses of a taxpayer for a taxable year are defined as the excess of (1) all of the taxpayer’s deductions attributable to trades or businesses of the taxpayer, over (2) the sum of (A) the total gross income or gain attributable to trades or businesses of the taxpayer and (B) a threshold amount ($500,000 for married individuals filing jointly and $250,000 for other individuals). In the case of a partnership or S corporation, the excess business loss rules apply at the partner or shareholder level. Excess business losses are carried forward as part of the taxpayer’s NOL carryforward. Thus, business losses of a non-corporate taxpayer for a taxable year can offset no more than $500,000 (for married individuals filing jointly), or $250,000 (for other individuals), of non-business income of the taxpayer for that year. Excess business losses appear to include losses that are not from passive business activities under section 469.
The Senate Proposals are effective for taxable years beginning after December 31, 2017.
Business Income and the Effect on the State and Local Tax Deduction
Under the House Bill, state and local income taxes paid on business income (other than compensation received as an employee) are fully deductible regardless of whether such taxes are imposed on income from a passive business activity and regardless of the capital percentage applicable to such income. As drafted, these provisions maintain a portion of the state and local tax deduction for individuals who receive business income in comparison to individuals who receive only salary and similar compensation income for which the state and local tax deduction has been removed in the House Bill. However, Chairman Brady sent a letter to Representative Blumenauer on November 10 stating that state and local income taxes paid by owners of pass-through would not be deductible by the owners, but the text of the bill still allows a different reading.
The House Bill is effective for tax years beginning after 2017.
The Senate Proposal does not allow individuals to deduct state and local income taxes. Therefore, whether state and local taxes are paid or accrued by individuals in carrying on a trade or business activity is not relevant under the Senate Proposal.
Other Provisions Relating to Pass-Through Entities
Cooperative Patronage Dividends and REIT Ordinary Dividends
The House Bill provides that a 25 percent rate of tax applies to patronage dividends from cooperatives and to REIT dividends (other than capital gain dividends, which are already subject to tax at a rate lower than 25 percent).
The House Bill is effective for tax years beginning after 2017.
The Senate Proposal treats patronage dividends from cooperatives and REIT ordinary dividends as qualified business income that qualifies for the 17.4 percent deduction.
Repeal of Technical Termination of Partnerships
The technical termination rule, under which a partnership terminates if, within any 12-month period, there is a sale or exchange of 50 percent or more of the interests in partnership capital and profits, is repealed under the House Bill. Under present law, when a partnership that holds depreciable property undergoes a technical termination, the remaining basis in such property is recovered over an elongated cost recovery period as if it were placed in service by a new taxpayer on the date of the termination. Repeal renders moot partnership agreement provisions that prohibit any transfer of interests that would trigger a technical termination. The House Bill is effective for tax years beginning after 2017.
The Senate Proposal does not make any changes to present law with respect to technical terminations.
Recharacterization of Certain Gains in the Case of Certain Carried Interests
The House Bill generally provides that capital gain allocated by a partnership to an individual partner as long-term capital gain with respect to carried interest is recharacterized as short-term capital gain to the extent the gain is from the disposition of property in which the partnership’s holding period was not more than three years in such property. Moreover, the capital gain or capital loss realized by an individual partner from the disposition of a profits interest is short-term gain unless the partner’s holding period in the partnership interest itself was more than three years, provided that these three-year holding period requirements apply only to “applicable partnership interests.” Such interests are defined as profits interests received in connection with the performance of substantial services in an “applicable” investment-related trade or business. An applicable trade or business generally consists of the raising or returning of capital and either the investing in or developing of “specified assets.” Specified assets include commodities, real estate held for rental or investment, cash, and options, among others. This generally includes hedge fund, private equity, and real estate businesses.
The House Bill is effective for tax years beginning after 2017.
The Senate Proposal includes a proposal on carried interest that appears to match the House Bill. As the Senate Committee has not provided legislative text of the Senate Proposal, the details regarding their carried interest proposal are not yet clear.
Senate Proposal on Taxing Foreign Partner’s Gain on the Sale of a Partnership Interest in a Partnership Engaged in a US Trade or Business
The Senate Proposal (but not the House Bill) effectively codifies IRS Revenue Ruling 91-32, by providing that a foreign transferor’s gain or loss from the transfer of a partnership interest is effectively connected with a US trade or business to the extent that the transferor would have recognized effectively connected gain or loss had the partnership sold all of its assets at fair market value on the date of the transfer, provided that the asset-level gain or loss from the hypothetical sale must be allocated among the partners in the same manner as nonseparately stated income and loss of the partnership (even if the allocation of such gain or loss that is provided for by the partnership’s operating agreement would be respected as having substantial economic effect). Therefore, the Senate Proposal is intended to override the US Tax Court’s decision in the Grecian Magnesite case from July of this year which held that the gain from the complete redemption of a partnership interest in a partnership holding US trade or business assets was not subject to tax because the gain was not US source income.
The Senate Proposal also requires the transferee of a partnership interest to withhold 10 percent of the amount realized by the transferor if the transferor is a non-resident alien individual or a foreign corporation. The Senate Proposal does not say whether a transferee would be required to withhold if the partnership provides a statement that the partnership is not engaged in a US trade or business. If the transferee fails to withhold the correct amount, the partnership is required to deduct and withhold from distributions to the transferee partner an amount equal to the amount the transferee failed to withhold.
International Tax Provisions
As summarized below, the House Bill and the Senate Proposal make dramatic and far-reaching changes to the US international tax rules by:
- permitting tax-free repatriations of future foreign profits of foreign corporations to their 10 percent US shareholders that are domestic corporations,
- imposing immediate tax at a reduced rate on all US shareholders on accumulated earnings of those foreign corporations in a one-time deemed repatriation of those earnings,
- modifying certain aspects of the “subpart F” anti-deferral rules, and
- enacting several new provisions intended to prevent erosion of the US tax base.
Participation Exemption System/Foreign-Source Dividends Received Deduction
The House Bill ends the tax on repatriations to US corporations from foreign corporations in which they hold 10 percent interests by establishing a “participation exemption system” and repealing the section 956 “deemed dividend” rules. Under the participation exemption system, a US corporation that owns 10 percent or more of a foreign corporation will receive a 100 percent dividends received deduction on dividends paid by the foreign corporation out of its foreign-source earnings. No foreign tax credit or deduction is allowed to US shareholders on dividends for which they receive a deduction. Any US corporation receiving the deduction must reduce its basis in the foreign corporation’s stock by the amount of such dividend for purposes of determining its loss (but not gain), if any, on a subsequent disposition of such stock. In addition, the House Bill extends the extraordinary dividend provision of section 1059 to dividends to which the dividends received deduction applies. As a result, if dividends eligible for the dividends received deduction are treated as extraordinary dividends, the US parent is required to reduce its basis in the stock of the foreign corporation for all purposes.
The dividends received deduction is subject to a holding period requirement pursuant to which the US corporation is eligible for the deduction only if it has held the stock of the foreign corporation for more than 180 days during the 361-day period beginning 180 days before the ex-dividend date (excluding periods during which the US corporation has diminished its risk of loss in the stock).
The House Bill repeals the current section 956 “deemed dividend” rules, which generally treat an investment in US property by a controlled foreign corporation (“CFC”) as a taxable repatriation to its US shareholders, except in the case of non-corporate US shareholders of the CFC.
The Senate Proposal establishes a participation exemption system that is similar to that contained in the House Bill, but with the following modifications:
- The Senate Proposal requires the US shareholder to hold the stock of the foreign corporation for more than 365 days during the 731-day period beginning 365 days before the ex-dividend date in order to be eligible for the dividends received deduction.
- The Senate Proposal denies a deduction with respect to dividends for which the payor foreign corporation receives a deduction for foreign income tax purposes, which instead are treated as subpart F income.
- The Senate Proposal clarifies that gain from the sale of stock in a foreign corporation which has been held for one year or more, and which is treated as a dividend under section 1248, is eligible for the dividends received deduction.
- Similarly, under the Senate Proposal, if a CFC sells stock in another CFC and its gain on the sale is treated as a dividend under section 964(e)(1), the dividend (which is treated as subpart F income to its US shareholders) is eligible for the dividends received deduction. However, if the sale of stock results in a loss rather than gain, the selling CFC’s earnings are not reduced by the loss.
- The Senate Proposal clarifies that repeal of section 956 covers both corporate US shareholders that own stock in the CFC directly and corporate US shareholders that own stock in the CFC indirectly through a domestic partnership.
Foreign Branch Income
Under the House Bill, income derived by US persons from foreign branches is ineligible for the participation exemption and is not otherwise exempted from US taxation. In addition, the House Bill imposes a tax on certain transfers of a foreign branch to a foreign subsidiary. Under the new provision, the US corporation transferring the branch is required to include in income the amount of any post-2017 losses previously incurred by the branch to the extent such losses exceed the amount of gain recognized by the US corporation on the outbound transfer. This provision thus expands the current “branch loss rule” of section 367(a)(3)(C) to allow the amount of recaptured branch losses to exceed the amount of built-in gain in the branch assets transferred to the foreign corporation. The recaptured income is treated as US source income.
The Senate Proposal is consistent with the House Bill, except that it limits the amount of previously deducted loss includible in income in the US corporation’s taxable year to the amount of the US corporation’s dividends received deduction, if any, with respect to all of the foreign corporations in which it is a US shareholder under the new participation exemption system (described above). Any loss in excess of the dividends received deduction is carried forward and includible in income in the succeeding taxable year.
The Senate Proposal also creates a new foreign tax credit basket for foreign taxes attributable to branches.
One-Time Deemed Repatriation Tax
The House Bill imposes a one-time deemed repatriation tax on accumulated, untaxed earnings of foreign corporations. The earnings held as “cash or cash equivalents” (referred to as the “cash position”) are taxed at a rate of 14 percent, and all other earnings are taxed at a rate of seven percent. For repatriated earnings held as cash or cash equivalents, 60 percent of the foreign tax credit is disallowed. For other repatriated earnings, 80 percent of the foreign tax credit is disallowed. Unused foreign tax credits may be carried forward 20 years (rather than the current 10 year carryforward limit). A US shareholder may elect to pay its net tax liability on the one-time deemed repatriation in eight equal installments (i.e., 12.5 percent per year).
Who is Covered: The one-time deemed repatriation is taken into account by all US shareholders (i.e., US persons who own 10 percent or more of the voting power of the foreign corporation’s stock), without regard to whether the foreign corporation is a CFC (however, earnings of PFICs that are not CFCs are excluded). An exception permits S corporations that are US shareholders of a foreign corporation to defer the deemed repatriation tax until the S corporation liquidates, or ceases doing business, or the stock of the S corporation is transferred.
Measuring Earnings: The accumulated, untaxed earnings of a foreign corporation are measured as of November 2, 2017 (the date the House Bill was released) or December 31, 2017, whichever is higher. Importantly, a US shareholder’s share of the deficit earnings of one foreign corporation may reduce, pro rata, the US shareholder’s share of the untaxed earnings of other foreign corporations. Similarly, a US shareholder that is a member of an affiliated group may offset its share of a foreign corporation’s accumulated, untaxed earnings with deficit earnings of a foreign corporation allocated to another member of the affiliated group.
Cash and Cash Equivalents: Under the House Bill, “cash and cash equivalents” include:
- net accounts receivable,
- personal property traded on a financial market,
- commercial paper, certificates of deposit, and state, federal, and foreign government securities,
- foreign currency,
- short-term obligations (i.e., obligations with a term of less than one year), and
- other assets that the IRS may identify.
The House Bill provides exceptions to prevent double-counting of cash equivalents such as debt owed by a foreign corporation to its sister company. Furthermore, cash and cash equivalents that cannot be distributed to a US shareholder because of currency or other foreign law restrictions are not treated as cash or cash equivalents. An anti-abuse rule allows the IRS to disregard any transaction undertaken with a principal purpose of reducing the aggregate foreign cash position. The amount of a foreign corporation’s earnings that are treated as heldin cash or cash equivalents (and thus subject to the higher one-time rate of 14 percent) is measured by the average earnings of the foreign corporation that are so held on:
- the last day of the foreign corporation’s taxable year that ended before November 2, 2017 and
- the last day of the foreign corporation’s preceding taxable year.
The Senate Proposal generally follows the House Bill with the following modifications:
- The tax is imposed at a lower rate of 10 percent for earnings held as cash and cash equivalents and five percent for other earnings.
- The amount of earnings held as cash and cash equivalents is the greater of (i) the amount determined on the last day of the foreign corporation’s taxable year for which the one-time inclusion occurs, or (ii) the average of the cash position on the last day of each of the two preceding taxable years.
- The Senate Proposal disallows 71.4 percent of the foreign tax credits on the inclusion attributable to cash and cash equivalents and 85.7 percent of the foreign tax credits on the remaining inclusion.
- If the US shareholder elects to pay the tax in installments, the installment payments are equal to eight percent of the net tax liability for each of the first five years, 15 percent in the sixth year, 20 percent in the seventh year, and the remaining 25 percent in the eighth year.
- Any US shareholder that becomes an expatriated entity (e.g., through an inversion) during the 10-year period following the enactment of the proposal is liable for tax on the full deemed repatriated amount at a 35 percent rate (regardless of how the earnings were held) and no foreign tax credits are permitted to offset the additional tax.
- US shareholders may elect not to use existing NOLs to offset the one-time deemed repatriation amount.
The Senate Proposal also states that rules will be provided to coordinate the interaction of existing NOLs, overall domestic losses, and foreign tax credit carry-forward rules with the one-time deemed repatriation, although such rules have not been released yet.
Modification of Subpart F
The House Bill retains the subpart F regime, with certain modifications.
The House Bill first modifies the rules regarding which corporations are treated as CFCs. Specifically, under the House Bill, a US entity with a foreign shareholder may be treated as owning stock in a foreign corporation that is owned by its foreign shareholder. Accordingly, foreign sister companies of US corporations with a common foreign parent corporation generally would be treated as CFCs.
Other modifications to the existing subpart F rules include repealing the subpart F income category of foreign base company oil related income, and indexing for inflation the de minimis exception for subpart F income (a threshold currently fixed at $1 million per year). It also eliminates the requirement that a foreign corporation be a CFC for an uninterrupted 30-day period in order for US shareholders to be required to include in income their pro rata share of the CFC’s subpart F income.
Finally, the House Bill makes permanent one important feature of the subpart F rules, the section 954(c)(6) “look-thru rule,” under which dividends, interest, rents and royalties received by one CFC from a related CFC are characterized as foreign personal holding company income (or not) based on the source of the income of the payor CFC.
The Senate Proposal generally follows the House Bill. The Senate also expands the definition of a US shareholder to include US persons who own 10 percent or more of the total value of a foreign corporation (rather than basing the determination solely on voting power). This expanded definition of a US shareholder, as well as the proposal to treat a US entity as owning stock owned by its foreign shareholder for purposes of determining CFC status, is effective for the last taxable year of a foreign corporation beginning before January 1, 2018 under the Senate Proposal.
Prevention of Base Erosion
As summarized below, the House Bill contains three primary methods of limiting base erosion: a current tax on US shareholders of foreign corporations with “foreign high returns,” a limitation on US corporations’ interest deductions, and a 20 percent excise tax on payments by US corporations to foreign related parties. The Senate Proposal replaces the House Bill’s tax on foreign high returns with a different set of provisions for imposing US tax on low-taxed foreign intangibles income. Like the House Bill, the Senate Proposal includes a limitation on US corporations’ interest deductions. However, in lieu of the House Bill’s excise tax, the Senate Proposal imposes a minimum tax on a tax base increased to offset base erosion. The Senate also imposes additional restrictions on transfers of intangible property, payments to or from hybrid entities, and dividends paid from inverted companies.
Current Tax on Foreign High Returns
The House Bill calls for a current tax on US shareholders of foreign corporations with “foreign high returns.” The House Bill taxes US shareholders on up to 50 percent of the current foreign-source (and otherwise non-subpart F income) earnings of the foreign corporations in which they own 10 percent interests. The earnings subject to the tax exclude a so-called “routine return” on certain investments, and corporate US shareholders may be eligible for a foreign tax credit of up to 80 percent of the amount of foreign taxes deemed paid. The House Bill also modifies the existing foreign tax credit rules by creating a new basket of foreign tax credits paid or accrued with respect to foreign high returns. Such foreign tax credits could only be used to offset tax on foreign high returns inclusions, and not tax on other types of income, and could not be carried back or forward.
Under the House Bill, US shareholders of CFCs must include in income 50 percent of the CFC’s “foreign high return amount.” The “foreign high return amount” is equal to the US shareholder’s share of:
- The CFC’s gross income (subject to certain exclusions, such as income effectively connected with a US trade or business and subpart F income); reduced by
- The excess of (i) a “routine return,” equal to the federal short-term rate plus seven percent, multiplied by the foreign corporation’s aggregate adjusted bases in depreciable tangible property used in its trade or business, over (ii) the foreign corporation’s net interest expense.
US shareholders of foreign corporations with relatively high interest expenses, or corporations with little basis in depreciable property, such as service corporations and corporations with high value intangibles, may find that most of the foreign corporation’s income is treated as a “foreign high return amount.”
Even a relatively high “foreign high return amount” may result in little or no tax to a corporate US shareholder. For example, assume that a corporate US shareholder wholly owns a foreign corporation, and all of the foreign corporation’s $100 of income is treated as foreign high return amount. If the foreign corporation pays local income taxes of $15 (15 percent tax rate on $100 of income), the US shareholder would be eligible for a foreign tax credit of $12 (80 percent of $15 foreign taxes). After taxes, the foreign corporation would have $85 ($100 of income less $15 of taxes) treated as foreign high returns. However, the section 78 gross-up would require the US shareholder to increase its foreign high return amount by the entire $15. The US shareholder would include 50 percent of the foreign high return amount or $50 (i.e., 50 percent of $85 of income plus $15 section 78 gross-up attributable to the foreign tax on such income) in taxable income. Assuming a 20 percent corporate rate, the US shareholder’s total tax on the $50 would be $10. Thus, the US shareholder would have no current income tax liability on the foreign corporation’s earnings (because the foreign tax credit of $12 exceeds its tax liability of $10).
The tax on foreign high returns is intended to reduce the incentive to relocate CFCs to low-tax jurisdictions, since any tax savings achieved by the CFC may be partially offset by an increase in taxes to the US shareholders.
The Senate Proposal for a current tax on “global intangible low-taxed income” (“GILTI”) is similar to the House Bill for a current tax on “foreign high returns,” with a few minor modifications. Whereas the House Bill taxes US shareholders on 50 percent of the income inclusion (resulting in an effective 10 percent rate for corporations, which are taxed on 50 percent of the income at a 20 percent income tax rate), the Senate Proposal treats the full GILTI amount as an income inclusion but provides a 37.5 percent deduction to domestic corporations with respect to foreign-derived intangible income. Furthermore, an amendment to the Senate Proposal may increase the deduction to 50 percent for taxable years beginning prior to December 31, 2025 (as described below under Deduction for Foreign-Derived Intangible Income). Further, whereas the House Bill excludes from the current income inclusion an amount equal to the CFC’s basis in tangible depreciable property times seven percent plus the federal short-term rate, less net interest expense, the Senate simply excludes an amount equal to 10 percent of the CFC’s basis in tangible depreciable property. Like the House Bill, under the Senate Proposal corporate US shareholders may be eligible for a foreign tax credit of up to 80 percent of the amount foreign taxes deemed paid, and the Senate Proposal creates a separate foreign tax credit basket for GILTI, which taxes could not be carried back or carried forward.
Deduction for Foreign-Derived Intangible Income
The House Bill does not contain this provision.
The Senate Proposal allows US corporations a deduction equal to 37.5 percent of the lesser of their (i) “foreign-derived intangible income” plus their GILTI (as described above) that is included in their gross income or (ii) their taxable income (determined without regard to this proposal). The proposal seems designed to reduce the US tax on GILTI of domestic corporations to the extent that such intangible income is derived from foreign sales and services.
The “foreign-derived intangible income” is the corporation’s “deemed intangible income” multiplied by a ratio equal to the corporation’s income from selling goods or services abroad over its net income (excluding income from CFCs and foreign branches, GILTI and domestic oil and gas income). The corporation’s deemed intangible income is its net income (excluding income from CFCs and foreign branches, GILTI and domestic oil and gas income) reduced by a deemed 10 percent return on an amount equal to its basis in tangible depreciable property (determined using straight-line depreciation).
An amendment to the Senate Proposal indicates that the 37.5 percent deduction on GILTI would initially be a 50 percent deduction, but would be decreased to 37.5 percent for taxable years beginning after December 31, 2025. The 37.5 percent deduction on “foreign-derived intangible income” would initially remain at 37.5 percent but would be reduced to 21.875 percent for taxable years beginning after December 31, 2025. However, these amendments would be repealed if the Secretary of the Treasury determines that aggregate on-budget Federal revenue from all sources for the 10-year period beginning October 1, 2017 and ending September 30, 2026 exceeds $27.487 trillion by at least $900 million.
Transfers of Intangible Property from a CFC to US Shareholders
The House Bill does not contain this provision.
The Senate Proposal creates a three-year window in which CFCs can distribute intangible property to US shareholders in a tax-efficient manner.
Under the proposal, if intangible property is distributed from a CFC to its US shareholder as a dividend, the fair market value of the intangible property is treated as not exceeding its basis in the hands of the CFC, thereby precluding any gain to the CFC under section 311(b) and reducing (in some cases, significantly) the taxable dividend amount to the US shareholder. If the intangible property is distributed from a CFC to its US shareholder in a non-dividend distribution, the US shareholder’s basis in the CFC is increased to the extent necessary such that no portion of the distribution is included in the US shareholder’s gross income.
Limitation on Interest Expense Deductions by US Shareholders
Under the House Bill, interest expense deductions are limited for US corporations that prepare consolidated financial statements with foreign corporations (an “International Financial Reporting Group”), but only if the International Financial Reporting Group generates annual gross receipts of $100 million. In such cases, the US corporation’s net interest expense deductions are limited to the percentage of the group’s total net interest expense deductions that is equal to 110 percent of the US corporation’s share of the group’s global earnings before interest, taxes, depreciation and amortization (“EBITDA”). Any disallowed interest expense deductions could be carried forward up to five years. For purposes of calculating the interest expense limitation, the House Bill treats all members of a group that file a consolidated return as a single member. As a result, excess limitation by one member can be used to increase the limitation of another member. This limitation is in addition to the new interest deduction limitation described above in “Other Business Provisions—Limitations on Interest Deductions.”
The Senate Proposal generally follows the House Bill, with the following modifications:
- it compares the US corporation’s equity value to the equity value of the worldwide group (unlike the House Bill, which compares the US corporation’s US EBITDA to its worldwide EBITDA),
- corporations are treated as members of the worldwide group if they are at least 50 percent owned by other members (unlike the House Bill, which determines the members of the group on the basis of whether the corporations file consolidated financial statements), and
- all US members of a worldwide group are treated as a single member (regardless of whether they file as a consolidated group).
The Senate also proposes to modify the existing interest expense allocation regime in section 864(e) by allocating worldwide interest expense among members of an affiliated group based on the members’ adjusted tax bases in their assets, rather than the fair market value of such assets.
Excise Tax on Certain Payments from Domestic Corporations to Related Foreign Corporations
The House Bill imposes a 20 percent excise tax on payments other than interest from US corporations to related foreign corporations. Like the limitation on interest expense deductions, the excise tax applies to US corporations that are members of an International Financial Reporting Group, if such group generates average annual gross payments potentially subject to the excise tax of $100 million or more over a three-year period.
Under the House Bill, payments from a US corporation to a related foreign corporation that are deductible, included in the cost of goods sold, or included in the basis of depreciable or amortizable assets are subject to a 20 percent excise tax. The tax is imposed on the US corporation. However, the US corporation generally is exempt from the tax to the extent the foreign corporation receiving a payment elects to treat the payment as income effectively connected with the conduct of a US trade or business (and therefore taxable in the US). In such case, the foreign corporation is allowed foreign tax credits for 80 percent of the foreign taxes paid with respect to the payment it receives.
The excise tax provision has already been modified in the House several times, significantly decreasing its revenue projections. These amendments affect a foreign corporation electing to treat these payments as effectively connected income. The most recent amendment permitted a credit equal to 80 percent of the foreign taxes actually paid or accrued by the foreign corporation.
The Senate Proposal does not include an excise tax on payments to related foreign corporations. Instead, the Senate Proposal imposes a minimum tax on a corporation’s “modified taxable income.” The provision appears to be aimed at domestic corporations that significantly reduce their US tax base by making large deductible payments, such as royalties, to foreign related parties. The tax imposed is equal to the excess of:
- 10 percent of the corporation’s “modified taxable income;” reduced by
- the tax otherwise imposed on the corporation (after reduction for credits, but adding back the section 41(a) research credit).
A corporation’s modified taxable income is the corporation’s taxable income, increased by certain “base erosion payments.” These “base erosion payments” include deductible payments that the corporation makes to a foreign related party, but do not include payments that are subject tax under sections 871 or 881 and on which the full amount of tax has been withheld under sections 1441 and 1442. They also do not include payments for services if amount of the payments is based on the services cost method under section 482 and represents the total cost of the services without any markup.
The minimum tax is imposed on US corporations and on the income of foreign corporations that is effectively connected with the conduct of a US trade or business. Related parties are treated as a single person for purposes of determining the minimum tax. In order for the minimum tax to apply, the corporation must:
- not be a regulated investment company, real estate investment trust or S corporation,
- have average annual gross receipts of at least $500 million for the three preceding taxable years and
- be making base erosion payments that represent four percent or more of all of all of its deductions (excluding NOLs and the proposed dividends received deduction)
A modification to the Senate Proposal provides that the 10 percent minimum tax rate is increased to 12.5 percent for taxable years beginning after December 31, 2025. However, this modification would be repealed if the Secretary of the Treasury determines that aggregate on-budget Federal revenue from all sources for the 10-year period beginning October 1, 2017 and ending September 30, 2026 exceeds $27.487 trillion by at least $900 million.
Additional Senate Proposals on Base Erosion
In addition to the provisions described above, the Senate Proposal proposes several additional anti-base erosion provisions not contained in the House Bill.
Transfers of Intangibles
The Senate Proposal modifies the definition of intangible property under section 936(h)(3)(B) (which is relevant for purposes of sections 367(d) and 482) to include workforce in place, goodwill (both foreign and domestic) and going concern value.
The Senate Proposal also proposes to clarify the authority of the IRS to specify what method must be used to value intangible property, including to specify methods that value multiple, related intangibles in the aggregate. These determinations could impact outbound restructurings and transfer pricing methods.
Hybrid Transactions and Payments to and From Hybrid Entities
The Senate Proposal also disqualifies deductions for interest and royalty payments made to a related party in a hybrid transaction or by or to a hybrid entity, if a deduction would otherwise be available in the US, but no income inclusion would be taken into account in a foreign country (or by a US shareholder as subpart F income). The provision also gives the IRS expansive power to promulgate regulations restricting similar transactions, including transactions involving conduit arrangements, foreign branches and certain structured transactions, as well as payments only included in income at a preferential tax rate or excluded under a participation exemption.
Dividends From Inverted Corporations
The Senate also proposed to exclude dividends received from inverted corporations from qualified dividend income treatment, making them ineligible for preferential dividend rates in the case of non-corporate taxpayers.
Miscellaneous Income Tax Provisions
Clarification of Unrelated Business Income Tax Treatment of Entities Treated as Exempt From Taxation Under Section 501(a)
The House Bill clarifies that all organizations that are exempt under section 501(a) (exemption from tax on corporations, certain trusts, etc.), including public pension plans that are also described in Code section 115(1) (relating to the exclusion from gross income of certain income derived from the exercise of an essential governmental function), otherwise referred to as “super” tax-exempts, are subject to the unrelated business income tax (“UBIT”) rules. The committee explanations of this provision state that, as a result of this clarification, an organization’s status under section 115 does not cause it to be exempt from tax on its unrelated business taxable income. Nevertheless, unrelated business taxable income does not include any item that is excluded from gross income. We believe this part of the House Bill would need to be amended in order to impose UBIT on items that are excluded from gross income under section 115(1).
The House Bill is effective for tax years beginning after 2017.
The Senate Proposal does not address whether or how UBIT applies to “super” tax-exempt entities described in section 115(1). The Senate Proposal does seek to increase the taxes paid by certain organizations exempt under the current version of section 501(a) by:
- Providing that a deduction from one unrelated trade or business of an exempt organization for a taxable year may not be used to offset income from a different unrelated trade or business for any taxable year; and
- Repealing the exempt status of all professional sports leagues (including MLB, the NBA, the NHL and the NFL).
Excise Tax Based on Investment Income of Private Colleges and Universities
Under the House Bill, certain private colleges and universities that are, under current law, not subject to an excise tax of up to two percent on their net investment income, are subject to a 1.4 percent excise tax such income. However, the House Bill only applies to “applicable educational institutions,” which are certain private colleges and universities that have at least 500 full-time students and own investment assets worth more than $250,000 per full-time student. State colleges and universities that are currently not subject to the tax on net investment income continue not to be subject to such tax under the House Bill.
The House Bill is effective for tax years beginning after 2017.
The Senate Proposal generally follows the House Bill.
Like-Kind Exchanges of Real Property
Current section 1031 provides taxpayers with nonrecognition treatment on the exchange of real estate, tangible personal property, and certain types of intangible property (other than goodwill) held for productive use in a trade or business or for investment for property of like kind that is also held for productive use in a trade or business or for investment. The House Bill limits nonrecognition treatment to like-kind exchanges of real property. This House Bill is effective for taxable years beginning after 2017, with grandfathered treatment for any deferred exchange where any property was disposed of or received by the taxpayer prior to the end of 2017.
The Senate Proposal is the same as the House Bill.
Modification of $1 Million Compensation Deduction Limitation
The Code currently prohibits public companies from deducting compensation in excess of $1 million paid to certain proxy officers, referred to as “covered employees.” “Covered employees” consist of the chief executive officer and the three highest paid executive officers, but the term does not include the chief financial officer. Current law also provides that payments that qualify as “performance-based compensation” will not be counted against the $1 million limitation. It is the rare public company that does not maximize deductibility by structuring at least a portion of its incentive compensation as “performance-based compensation.”
The House Bill repeals the exception to the $1 million limitation for “performance-based compensation.” In addition, the House Bill includes the chief financial officer as a “covered employee” and provides that once an individual is a “covered employee,” the individual remains a covered employee for his or her employer, even if he or she no longer otherwise meets the statutory definition.
Finally, the House Bill provides that tax exempt organizations are subject to a 20 percent excise tax on compensation paid to any of their five highest paid employees that exceeds $1 million and on severance in excess of 3 times the executive’s average compensation over the previous three years.
The Senate Proposal contains similar provisions but provides that the excise tax on tax exempt organizations applies to severance payments that exceed three times the executive’s average compensation over the previous five years. In addition, the Senate Proposal does not apply to any remuneration under a written binding contract which was in effect on November 2, 2017, and which was not modified after that date in any material respect and to which the right of the covered employee was no longer subject to a substantial risk of forfeiture on or before December 31, 2017.
Creation of Qualified Equity Stock
In an effort to provide relief to employees of “eligible corporations,” the House Bill provides that, if an employee makes an election, he or she may defer the tax owed on “qualified stock” that has become transferable or is not subject to a substantial risk of forfeiture. Generally, subject to anti-abuse provisions, the taxes are deferred until the earlier of the first date such qualified stock becomes transferable and the date any of the corporation’s stock becomes readily tradeable on an established securities market.
Under the House Bill, “qualified stock” generally means stock received in connection with the exercise of an option or in settlement of a restricted stock unit (or RSU). “Qualified stock” excludes any stock that the employee may sell to the corporation or settle through the acceptance of cash from the corporation. “Eligible corporations” are corporations that (A) do not have stock readily tradeable on an established securities market and (B) have a written plan covering 80 percent of all of its “qualified” US employees. “Qualified employees” are full-time employees who elect to be subject to the rule, excluding one percent owners, the CEO, CFO and four most highly paid officers (as determined in accordance with the proxy disclosure rules).
The Senate Proposal is the same as the House Bill.
Energy Tax Credits
Elimination of Inflation Adjustments for Production Tax Credits (PTCs)
Under current law, the PTC is available for the production of electricity from certain qualified energy facilities (including wind, biomass, geothermal, solar and hydroelectric facilities) during the 10-year period beginning on the date the facility was placed in service. With the exception of wind facilities (for which the PTC is available for facilities beginning construction before 2020), qualified energy facilities that began construction after 2016 are not eligible for the PTC. The PTC is a per-kilowatt-hour credit that currently adjusts for inflation; the base amount of the credit is 1.5 cents per KWH, but inflation adjustments have increased that credit to 2.3 cents per KWH for 2016.
The House Bill eliminates the inflation adjustment (reducing the PTC to the base amount of 1.5 cents per KWH) for facilities for which construction begins after the date of enactment. The House Bill also clarifies that construction cannot be treated as beginning before a date unless there is a “continuous program of construction” that begins before such date and concludes on the placed in service date.
The Senate Proposal does not include this provision, and thus retains the inflation adjustment for PTCs.
Modifications of Phase-Outs for Energy-Related Investment Tax Credits (ITCs)
Under current law, the ITC is available for a percentage of the basis of eligible energy property, including solar, geothermal and wind energy property, but the credits phase out for new construction over different horizons.
The House Bill alters the expiration and phase-out schedules qualified energy properties. Please see our client publication titled “House Republican Tax Reform Bill Retains and Modifies Energy Credits” for details on the expiration and phase-out schedules of qualified energy properties.
The Senate Proposal does not include these changes.
Special thanks to Devon Yamauchi for her contributions to this client publication.