The U.S. Senate passed its version of the GOP tax reform bill, the Tax Cuts and Jobs Act (the “Senate Bill”), on Saturday, December 2, 2017. Shortly before approving the Senate Bill, the U.S. Senate adopted a Manager’s Amendment which significantly modified the prior version of the Senate Bill. Passage of the Senate Bill considerably increases the likelihood that some form of tax reform legislation will be enacted before the end of the year, although several key differences between the Senate Bill and the U.S. House version of the Tax Cuts and Jobs Act (the “House Bill”) must first be reconciled. For prior coverage of the House Bill, click here. Several of the important provisions of the Senate Bill and House Bill are summarized below.
Corporate Tax Rate and AMT, Deductibility of Interest, NOLs, and Expensing
The Senate Bill, like the House Bill, reduces the corporate income tax rate from 35% to 20%. However, under the Senate Bill this reduction in the corporate tax rate is effective beginning in 2019, in contrast to the House Bill, where this change is effective beginning in 2018. The Senate Bill retains the alternative minimum tax (“AMT”) for corporations in its current form, whereas the House Bill repeals the corporate AMT. Both bills reduce the corporate deduction for dividends received from less-than-80%-owned subsidiaries to reflect the lower corporate income tax rate.
Both the House Bill and the Senate Bill significantly limit the deductibility of interest expense by a business, regardless of the form of the business. Interest deductions would be capped at the amount of the business’s interest income earned plus 30% of its annual adjusted taxable income. Whereas under the House Bill adjusted taxable income is generally a proxy for earnings before interest, taxes, depreciation and amortization (“EBITDA”), adjusted taxable income under the Senate Bill is generally a proxy for earnings before interest and taxes (“EBIT”), further limiting the interest deduction for many businesses. For businesses organized as partnerships, this limitation on the deductibility of interest expense would be determined at the partnership level. Interest deductions disallowed due to this limitation would be carried forward indefinitely under the Senate Bill (or, under the House Bill, for up to 5 years) but would remain subject to the overall calculation of the limitation on deductibility.
Under both the Senate Bill and the House Bill, a U.S. corporation or corporate group that is part of a multinational corporate group may be subject to an additional, more complex interest deduction limitation based on the leverage of the U.S. corporation or corporate group compared to the leverage of the multinational corporate group, and the lower of the two limits would apply. The additional limit applicable to multinational groups is formulated differently under the Senate Bill and the House Bill.
Under both the Senate Bill and the House Bill, corporations lose the ability to carry back net operating losses (“NOLs”) but would be allowed to carry forward NOLs indefinitely. The House Bill increases the value of any unused NOLs by an interest factor to preserve their value, but no similar adjustment exists in the Senate Bill. Both the Senate Bill and the House Bill limit the ability of an NOL to reduce taxable income to 90% of taxable income. However, under the Senate Bill, this limit would be reduced to 80% of taxable income beginning in 2023.
Both the Senate Bill and the House Bill allow immediate expensing of 100% of the cost of qualified property (which under the House Bill includes certain used property) placed in service before 2023 (or in the case of certain property having a longer production period, 2024). Under the Senate Bill this 100% expensing is phased out 20% per year beginning with property placed in service in 2024 (or in the case of longer-lived property, 2025), whereas the House Bill does not contain a similar phase-out mechanism. Both the Senate Bill and the House Bill repeal the deduction for domestic production activities, currently in Code Section 199.
Taxation of Individuals
Lower Tax Rate on Pass-Through Income
Both the Senate Bill and the House Bill provide individuals with preferential treatment of income from businesses conducted in pass-through form. The Senate Bill allows individual owners of pass-through businesses to deduct the lesser of their taxable income or 23% of domestic qualified business income, limited in certain cases to 50% of the W-2 wages of the business. In addition, a taxpayer’s income from a business primarily engaged in professional services (a “specified service business”) would only be eligible for preferential treatment under the Senate Bill if the taxpayer’s income is below a certain threshold.
In contrast, the House Bill generally taxes an individual’s share of pass-through business income at a maximum rate of 25%. Generally, the preferential 25% rate in the House Bill applies to all business income derived from a business in which the individual owner does not materially participate and to only 30% of business income from a business in which the individual owner materially participates, but not to income from a specified service business. Under both bills income received by the taxpayer for services and certain types of investment income would not be eligible for preferential treatment. In addition, under each bill the preferential treatment described above also applies to certain qualifying dividends received from real estate investment trusts (“REITs”), while the Senate Bill also extends this preferential treatment to income from master limited partnerships (“MLPs”).
Potential Limitation on Carried Interest
Both the Senate Bill and the House Bill generally impose a new 3-year holding period requirement for service providers to receive long-term capital gain from carried interests granted with respect to real estate or investment businesses, although this provision would not change the ability under current law for a carried interest to be received tax-free.
Consolidation of Individual Tax Rates and Elimination of Deductions
The Senate Bill retains seven individual income tax brackets on ordinary income, with the highest marginal rate set at 38.5%, whereas the House Bill consolidates the current seven tax brackets into four tax brackets and maintains the current highest marginal rate of 39.6%. Both bills roughly double the standard deduction and repeal the overall limitation on itemized deductions, while also repealing the deduction for personal exemptions as well as numerous other deductions, including the deduction for state and local taxes (although both the Senate Bill and the House Bill allow a deduction of up to US$10,000 for state and local property taxes).
Both the Senate Bill and the House Bill modify the deductibility of home mortgage interest, with the Senate Bill repealing the deduction for home equity indebtedness (but leaving intact the deduction for acquisition indebtedness) and the House Bill lowering the limit on the deductibility of home mortgage interest, currently allowable on home mortgage debt of up to US$1 million, to US$500,000, although existing mortgages would not be subject to this lower limitation. The House Bill repeals the AMT for individuals, whereas the Senate Bill keeps the individual AMT with an increased exemption. Both the Senate Bill and the House Bill double the estate and gift tax exemption, to US$10 million, while the House Bill repeals the estate tax for years after 2024.
The provisions in the Senate Bill relating to the taxation of individuals generally would expire after 2025 (including the preferential tax treatment of certain pass-through business income; the simplification and reform of rates, deductions, exemptions and exclusions; the higher gift and estate tax exemption threshold; and the increased exemption for the individual AMT).
In addition the Senate Bill, but not the House Bill, effectively repeals the individual mandate under the Affordable Care Act by eliminating the shared responsibility payment for individuals failing to maintain minimum essential coverage.
Changes to International Tax Rules
The Senate Bill largely follows the House Bill in moving the United States closer to a territorial system, with both bills excluding 100% of the foreign-source portion of the dividends received by U.S. corporations from 10%-or-more owned foreign corporations, subject to holding period requirements. Under both bills the foreign tax credit would be disallowed for any foreign taxes paid or accrued with respect to any excluded foreign dividend. In addition, both the Senate Bill and the House Bill deem all previously untaxed foreign earnings repatriated and subject such repatriated earnings to immediate taxation, although the rates at which such previously untaxed earnings would be subject to tax differ slightly in the two bills: the Senate Bill calls for a tax rate of 14.5% for earnings held in cash or cash equivalents and 7.5% for the remainder, while the House Bill imposes rates of 14% and 7%, respectively. Both bills would repeal rules under Code Section 956 which currently treat U.S. shareholders of a controlled foreign corporation (“CFC”) with untaxed foreign earnings as receiving a dividend when the CFC invests in U.S. property.
The Senate Bill also contains several base erosion provisions, at least one of which is significantly different from any provision in the House Bill. Specifically, the Senate Bill requires certain domestic corporations to pay a base erosion minimum tax amount (“BEMTA”) equal to the amount by which 10% of the corporation’s modified taxable income (i.e., its taxable income determined without regard to certain related-party payments) exceeds the corporation’s regular income tax liability reduced by certain credits. While no similar provision appears in the House Bill, the BEMTA provision may be an alternative to the 20% excise tax in the House Bill on specified payments from domestic corporations to related foreign corporations. In addition, the Senate Bill, similar to the House Bill, contains a provision which taxes currently income of a CFC that exceeds a certain rate of return on the tax basis of the CFC’s assets.
Other Significant Provisions
The Senate Bill does not contain a provision similar to that in the House Bill which would clarify that state and local pension plans (so-called “super” tax-exempt investors) are subject to the unrelated business taxable income (“UBTI”) rules. Currently such investors often take the position that they are exempt from the UBTI rules under Code Section 115.
The Senate Bill generally requires gain or loss on the sale of specified securities to be calculated using the first-in first-out (“FIFO”) method, unlike current rules under which a taxpayer generally may identify which specific securities are sold, although regulated investment companies (“RICs”) would be exempted from this requirement. The House Bill does not adopt this change.
Summary of Select Provisions in the Senate Bill and House Bill