On November 2, 2017, Republican members of the U.S. House of Representatives Committee on Ways and Means released a draft bill entitled the Tax Cuts and Jobs Act (the “Act”). If enacted in its current form, the Act would make sweeping changes to U.S. tax rules affecting businesses and individuals. The U.S. Senate Committee on Finance is expected to release a competing tax reform bill sometime next week. Below is a summary of some of the Act's changes that would have the greatest effects on businesses, investment funds, and their owners and investors, as well as compensation arrangements for executives and management. These provisions are subject to change as the House and Senate bills advance through the legislative process.
Reduction of Corporate Tax Rate to 20%
The Act generally would reduce the corporate tax rate from 35% to 20% beginning in 2018. The corporate alternative minimum tax would be repealed.
Maximum 25% Tax Rate for Business Income of Individuals
The Act would generally reduce to 25% the maximum tax rate applicable to certain ordinary income earned by individuals (including through partnerships and S corporations). Income qualifying for the 25% rate generally would include:
- 100% of income from passive business activities (e.g., activities of a business in which the individual does not materially participate); and
- 30% of income from active business activities, except that:
- Owners of capital-intensive businesses may elect to demonstrate that more than 30% of their share of the active income of the business is attributable to a return on invested capital (rather than a return on labor).
- Active business income earned from certain personal services business (e.g., health, law, consulting, financial services, brokerage services, and similar businesses, including many investment partnerships) would generally be ineligible for the reduced 25% tax rate.
Other Provisions Applicable to Individuals
The Act would preserve the top tax rates for individuals and there are a number of provisions relevant to itemization of deductions, including limits on state and local tax deductions.
Despite previous statements by the Administration, the Act would preserve the favorable treatment of “carried interest.”
Territorial Corporate Tax System
Under the Act, the earnings of foreign subsidiaries of U.S. corporations generally would no longer be subject to U.S. tax upon repatriation to the United States (subject to a new anti-base erosion tax on certain foreign subsidiary earnings that exceed a specified return on the subsidiary’s depreciable tangible property). Similarly, foreign subsidiary earnings would no longer be included in the income of a U.S. parent corporation as a result of an investment in U.S. property by the foreign subsidiary (such as a pledge of the stock of the foreign subsidiary as collateral for a borrowing of the U.S. parent). Accumulated foreign earnings (determined as of November 2, 2017 or, if higher, December 31, 2017) would be deemed repatriated and taxed at 12% (to the extent represented by cash or cash equivalents) or 5% (to the extent represented by fixed assets). The U.S. shareholder may elect to include these amounts in income ratably over 8 years.
The Act generally would permit taxpayers to immediately expense 100% of the cost of certain qualified tangible property acquired and placed into service after September 27, 2017 and before January 1, 2023. Expensing also would be available for acquisitions of used property not acquired from a related party.
- Real estate is not eligible for immediate expensing.
Limitations on Interest Deductibility
Net business interest expense (business interest expense in excess of business interest income) of any U.S. business (other than certain small businesses) generally would be available to offset only 30% of the business’s adjusted taxable income (defined similarly to EBITDA). Excess business interest expense may be carried forward for up to 5 years. The current interest “earnings stripping” rules would be repealed.
- This proposed limitation on the deductibility of interest may have a significant effect on leveraged acquisitions, leveraged recapitalizations, and similar transactions. How this provision interacts with the immediate expensing rule remains to be determined.
- Banks and other lending businesses that earn interest income in excess of interest expense are not expected to be affected by this proposal.
- Real estate businesses would not be subject to this limitation.
Limitations on the Use of Net Operating Loss Deductions
Under the Act, a corporation’s net operating losses (“NOLs”) arising in taxable years beginning after 2017 generally would not be eligible for carry back, but could be carried forward without limitation (and carried forward amounts would increase by an interest factor). In addition, the deduction for carryforwards and carrybacks would be limited to 90% of the taxpayer’s taxable income determined without regard to the NOL deduction. This limitation would apply to tax years beginning after 2017.
Limitations Affecting International Groups
U.S. companies that are members of international groups would be subject to a variety of limitations, including deductible payments to foreign affiliates that are not reported as ECI and a limitation on the net interest expense available to a U.S. corporation that is a member of an international group in certain circumstances, based on the EBITDA contributed by the U.S. corporation to the group.
Like-Kind Exchanges Limited to Real Property
The Act would limit the rule allowing deferral of gain on like-kind exchanges to exchanges of U.S. real property. Thus, for example, taxpayers would no longer be able to defer gain on exchanges of intangible property. This provision generally would be effective for transfers after 2017, but a transition rule would allow transactions partially completed to receive tax deferred treatment.
State Sovereign Investors
The Act provides that all entities exempt from tax under section 501(a), including certain state government-sponsored entities, like pension plans, would be subject to tax on any UBTI, notwithstanding qualification under another exemption in the Code (e.g., the provision applicable to governmentsponsored entities). The Act does not address the Constitutional theory for the exemption from federal tax for state sovereign entities.
Executive Compensation Provisions
- Overhaul of Deferred Compensation Regime. The Act would repeal the current deferred compensation tax regime (section 409A) and replace it with the revenue raising section 409B. Under section 409B, all deferred compensation would be includable in income when no longer subject to a service-based risk of forfeiture. As a result:
- The Act would essentially eliminate the elective deferral of base salary or bonus payments and the establishment of supplemental executive retirement plans (SERPs) and other nonqualified retirement programs.
- Deferred compensation, including stock options, restricted stock units (RSUs) and stock appreciation rights (SARs), would be included in income as soon as any service-based vesting condition is satisfied, even if a performance-based vesting condition remains in effect.
- The Act would apply to deferred compensation that remains unvested as of the end of 2017. For example, if an option was granted on January 1, 2015 with a four year annual vesting schedule, the portions that vest in January 2018 and 2019 would be subject to the new accelerated income inclusion regime.
- Deferred compensation that is vested as of December 31, 2017 would be includible in income on the earlier of payment or 2025.
Expansion of Section 162(m). The Act would also greatly expand the reach of the $1 million compensation deduction limitation under section 162(m) for public companies by eliminating section 162(m)’s commission and performance-based compensation exceptions. The Act would also expand section 162(m)’s coverage to include companies that do not have publicly traded stock but do have public debt. Finally, the Act would expand coverage to individuals who at any time were the company’s CEO, CFO, or one of the three most highly compensated employees, regardless of whether they remain at such level or position. If enacted, these changes to section 162(m) would take effect for tax years beginning after December 31, 2017.