On February 1, 2010, the Obama administration (the "Administration") introduced its budget proposals for the 2011 fiscal year (the "Budget"), and the Treasury Department released its "General Explanations of the Administration's Fiscal Year 2011 Revenue Proposals" (the "Green Book"). The Budget includes numerous tax proposals that, if enacted, would impact both individual and corporate taxpayers. This Tax Alert highlights certain of the tax proposals included in the Budget, as described in the Green Book.
Tax Incentives for Business
Additional Tax Credits for Qualifying Advanced Energy Manufacturing Projects – Section 48C of the Internal Revenue Code of 1986, as amended (the "Code"), provides a 30 percent tax credit for taxpayers that manufacture property to be used in producing specified types of renewable energy. Credits are to be allocated pursuant to a competitive application process based on criteria set forth in the statute. The law provides for $2.3 billion of credit availability. All available credits were allocated in January 2010. The Budget includes a proposal that would increase available credits by $5 billion. The application process would be generally similar to the process under current law. This proposal would be effective on the date of enactment.
Extension of Increased Limitations for Section 179 Expense Deductions for Small Business – The American Recovery and Reinvestment Act of 2009 (the "Recovery Act") extended for one year the maximum amount of certain depreciable tangible personal property that a taxpayer may expense for taxable years beginning in 2009. That limit was $250,000 of the cost of property placed in service during 2009, reduced by the cost of such property in excess of $800,000. Under current law, these limits are reduced for tax years beginning in 2010 to $125,000 and $500,000, respectively. The Budget includes a proposal to extend the rules in effect for 2009 to property placed in service in a taxable year beginning in 2010. In addition, off-the-shelf software would be eligible property even though it is intangible property ("IP").
Extension of Additional 50 Percent First-Year Bonus Depreciation – The Recovery Act extended for one year the additional 50 percent first-year bonus depreciation deduction for certain qualified property placed in service in 2009 (2010 for property with a MACRS recovery period longer than 10 years, and transportation property). The Budget includes a proposal to extend the additional first-year bonus depreciation deduction for property acquired and placed in service during 2010 (or placed in service during 2011 for property eligible for the one-year extension of the placed-in-service date).
Elimination of Capital Gains Tax on Qualified Small Business Stock – Under current law, taxpayers other than corporations may generally exclude 50 percent of the gain from the sale of certain small business stock acquired at original issue and held for at least five years. The exclusion is increased to 75 percent for certain small business stock acquired after February 17, 2009 and before January 1, 2011. The taxable portion of the gain is taxed at a maximum rate of 28 percent, and 7 percent of the excluded gain is a tax preference item subject to alternative minimum tax ("AMT"). The Budget includes a proposal to exclude 100 percent of the gain and eliminate the AMT preference. This proposal would be effective for qualified small business stock acquired after February 17, 2009.
Making the Research and Experimentation Tax Credit Permanent – The research and experimentation ("R&E") tax credit consists of three components: (i) the "qualified research credit," which is 20 percent of "qualified research expenses" above a base amount; (ii) the "basic research credit," which is 20 percent of "basic research payments" above a base amount; and (iii) an "energy research consortium credit," which is 20 percent of all eligible payments to an energy research consortium for energy research. The R&E tax credit was originally enacted in 1981 as a temporary measure to encourage taxpayers to increase their R&E activities conducted within the United States ("U.S."), and has been extended numerous times prior to its expiration on December 31, 2009. The Budget includes a proposal that would make the R&E tax credit permanent, effective January 1, 2010.
Increased Tax Burden on High-Income Individuals
The Budget includes proposals that would increase the tax rates applicable to certain high-income individuals with respect to ordinary income and capital gains. Specifically, the Budget includes the following proposals:
- Increasing the top marginal income tax rates applicable to individuals from 33 percent and 35 percent to 36 percent and 39.6 percent, respectively. These rates generally would apply to single individual taxpayers having income in excess of $200,000 and married couples filing joint returns having income in excess of $250,000 (in each case, subject to adjustment for inflation). These increased marginal income tax rates would apply beginning in 2011.
- Increasing the maximum tax rate on capital gains and qualified dividends from 15 percent to 20 percent for individual taxpayers having income in excess of $200,000 and married couples filing joint returns having income in excess of $250,000. These increased tax rates would apply beginning in 2011.
- Allowing the repeal of the limitation on certain itemized deductions to expire after 2010. As a result, beginning in 2011, itemized deductions would be reduced by 3 percent of the amount by which adjusted gross income exceeds certain statutory floors (for 2011, $200,000 for individual taxpayers and $250,000 for married couples filing joint returns, but indexed annually for inflation), but not more than 80 percent of otherwise allowable itemized deductions.
- Allowing the repeal of the personal exemption phase-out to expire after 2010. As a result, beginning in 2011, the personal exemption amount would be reduced by 2 percent for each $2,500 by which adjusted gross income exceeds certain statutory floors (for 2011, $200,000 for individual taxpayers and $250,000 for married couples filing joint returns, but indexed annually for inflation).
Financial Products and Financial Institutions
Financial Crisis Responsibility Fee – The Budget includes a controversial "financial crisis responsibility fee." If enacted, this fee generally would be imposed on financial institutions having at least $50 billion in consolidated assets. The rate of the fee applied to certain covered liabilities would be approximately 15 basis points. Financial institutions would report the fee on their income tax returns, and estimated payments of the fee would be made on the same schedule as estimated income tax payments. This fee would be effective as of July 1, 2010.
Interest Accrual on Certain Forward Sales – Under current law, a corporation does not recognize gain or loss on the issuance of its own stock (whether sold currently or pursuant to a forward sale), but does recognize interest income upon the current sale of any stock (including its own) in exchange for a deferred payment. To equalize the tax treatment of these two transactions, the Budget includes a proposal that would require a corporation that enters into a forward contract to issue its stock to treat a portion of the sales proceeds as a payment of interest. This proposal would be effective for forward contracts entered into after December 31, 2011.
Repeal of Section 1256 Treatment for Certain Dealer Activities – In general, certain dealers in commodities, commodities derivatives, securities and equity options treat 60 percent of their income or loss from "section 1256 contracts" as long-term capital gain or loss, and 40 percent of their income or loss from such contracts as short-term capital gain or loss. The Budget includes a proposal that would require such dealers to treat their income and loss from section 1256 contracts as ordinary, not capital. This proposal would be effective for taxable years beginning after the date of enactment.
U.S. International Tax Reform
The Budget includes numerous proposals that, if enacted, would modify the U.S. international tax system, a number of which are summarized below. It is also worth noting that the Budget does not include the previously proposed modification of the check-the-box regime that would have required foreign single-member entities (other than first-tier subsidiaries) organized outside of their direct owner's jurisdiction to be treated as corporations for tax purposes.
Deferral of Deduction of Interest Expense Related to Deferred Foreign-Source Income – Under current law, a U.S. person who incurs interest expense properly allocable and apportioned to foreign-source income may generally may deduct those expenses even if the expenses exceed the taxpayer's foreign-source income or if the taxpayer earns no foreign-source income. The Budget includes a proposal that would defer the deduction of such interest expense until and to the extent that previously deferred foreign-source income is subject to U.S. income tax during a subsequent tax year.
Determining the Foreign Tax Credit on a Pooling Basis – Under section 902 of the Code, a domestic corporation that owns 10 percent or more of the voting stock of a foreign corporation is deemed to have paid the foreign taxes paid by certain foreign subsidiaries from which it receives a dividend (the "Deemed Paid Foreign Tax Credit"). The Budget includes a proposal that would require a domestic corporation to determine its Deemed Paid Foreign Tax Credit on a consolidated basis, based on the aggregate foreign taxes and earnings and profits of all of the foreign subsidiaries with respect to which the U.S. taxpayer can claim a Deemed Paid Foreign Tax Credit (including lower-tier subsidiaries described in section 902(b) of the Code). The Deemed Paid Foreign Tax Credit for a taxable year would be determined based on the amount of the consolidated earnings and profits of the foreign subsidiaries repatriated to the U.S. taxpayer in that taxable year. This proposal would be effective for taxable years beginning after December 31, 2010.
Prevent Splitting of Foreign Income and Related Foreign Taxes – Current law permits separation of creditable foreign taxes from the associated foreign income in certain cases, such as those involving hybrid arrangements where the foreign taxes are incurred by the U.S. taxpayer, but the related income earned by a foreign subsidiary is not included in income. The Budget includes a proposal that would adopt a matching rule to prevent the separation of creditable foreign taxes from the associated foreign income.
Limiting Shifting of Income Through Intangible Property Transfers and Taxing Currently Excess Returns Associated with Transfers of Intangibles Offshore – When a U.S. taxpayer transfers IP to a related foreign party, sections 482 and 367(d) of the Code generally require the U.S. transferor to receive income commensurate with income attributable to the IP. Under current law, such allocation of income is not clearly required upon the transfer by a U.S. taxpayer of foreign goodwill and going concern value. The Budget includes a proposal that would expand the definition of IP for section 367(d) and 482 purposes to include workforce in place, goodwill and going concern value. This proposal would also clarify that where multiple intangible properties are transferred, the Internal Revenue Service ("IRS") may value the IP on an aggregate basis where such aggregation achieves a more reliable result. In addition, this proposal would clarify that the IRS may value IP taking into consideration the prices or profits that the controlled taxpayer could have realized by choosing a realistic alternative to the controlled transaction undertaken.
The Budget includes a related proposal that would apply if a U.S. person transfers IP from the U.S. to a related controlled foreign corporation that is subject to a low foreign effective tax rate in circumstances that evidence excessive income shifting. In such case, an amount equal to the excessive return would be treated as subpart F income in a separate foreign tax credit limitation basket and, as such, be currently subject to tax.
Extension of Section 954(c)(6) – Under section 954(c)(6) of the Code, U.S. shareholders with dividends, interest, rent, and royalties received or accrued from a controlled foreign corporation that is a related person, are not treated as having foreign personal holding company income to the extent attributable, or properly allocable, to income of the related person that is not Subpart F income or income treated as effectively connected with the conduct of a U.S. trade or business. Section 954(c)(6) expired on December 31, 2009. The Budget includes a proposal that would extend section 954(c)(6) through December 31, 2011.
Modify Sourcing Rule for Substitute Dividend Payments on Notional Principal Contracts – Under current law, a non-U.S. investor holding stock in a U.S. corporation generally is subject to a withholding tax of 30 percent (or lower applicable treaty rate) on the gross amount of dividends received with respect to such stock. However, a substitute dividend payment made to a non-U.S. investor with respect to a notional principal contract referencing a U.S. corporation generally is treated as foreign-source income, and therefore, is not subject to U.S. withholding tax. The Budget includes a proposal that generally would treat income earned by a non-U.S. investor with respect to a notional principal contract as U.S.-source income (and therefore, subject to U.S. withholding tax) to the extent such income is attributable (or calculated by reference) to dividends paid by a U.S. corporation. This proposal would be effective for payments made after December 31, 2010.
Reporting and Withholding Rules for Foreign Accounts and Foreign Entities
To reduce tax evasion by U.S. persons hiding unreported income in foreign jurisdictions, the Budget contains a number of proposals intended to strengthen the information reporting and withholding regimes applicable to income earned and/or held in foreign jurisdictions. Such proposals include the following:
- Requiring withholding agents to withhold tax at a rate of 30 percent on payments to a "foreign financial institution" ("FFI") of certain U.S.-source income, unless the FFI has entered into an agreement with the IRS generally requiring the FFI to identify accounts held by U.S. persons, and report the name, address, and taxpayer identification number ("TIN") of the U.S. account holder, the account balance or value of the account, and the receipts, withdrawals and payments from the account. This proposal would be effective beginning after December 31, 2012.
- Requiring any withholding agent making a payment to a foreign entity (other than an FFI) of certain U.S.-source income to withhold a tax of 30 percent, unless the foreign entity certifies that no U.S. person owns, directly or indirectly, an interest of greater than 10 percent, or the foreign entity provides the name, address, and TIN of each such substantial U.S. owner. This proposal would be effective for payments made after December 31, 2012.
- Requiring any U.S. individual holding an interest in a foreign financial account, foreign entity, or financial instrument or contract issued by a foreign person, to file an information return (to be included as part of the taxpayer's tax return) if the aggregate value of all such assets exceeds $50,000. A failure to report the required information would result in a penalty of at least $10,000. These requirements would be in addition to the individual's obligation to report foreign accounts on Form TD F 90-22.1 (FBAR). This proposal would be effective for taxable years beginning after the date of enactment.
Related proposals included in the Green Book would: (i) impose penalties for understatements of tax attributable to undisclosed foreign financial assets; (ii) extend the statute of limitations to six years for omissions of gross income in excess of $5,000 attributable to foreign financial assets; and (iii) require reporting with respect to certain transfers of assets to and from foreign financial accounts.
Additional Revenue Raisers
Taxation of Carried (Profits) Interests as Ordinary Income – Under current law, items of partnership income or loss retain their character and flow through to the partners, who must include such items on their tax returns. Thus, if and to the extent a partnership recognizes long-term capital gain, the partners (including partners who were granted partnership interests in exchange for services, i.e., "profits interests" or "carried interests") will take into account their shares of such gain as long-term capital gain (which, in the case of an individual, is subject to tax at reduced rates). Furthermore, capital gain (as well as certain other types of income) attributable to a profits interest of an individual that is a general partner of a partnership generally is not subject to self-employment tax.
The Budget includes a proposal that would, in general terms, treat a partner's share of income with respect to a "services partnership interest" ("SPI") as ordinary income, regardless of the character of the income at the partnership level, and would subject such income to self-employment taxes. In addition, gain on the sale of an SPI generally would be taxed as ordinary income, not as capital gain. Such characterization generally would not apply to the extent the income or gain was attributable to invested capital. This proposal also extends such ordinary income treatment to persons who perform services for an entity and hold a "disqualified interest" in such entity (generally, convertible or contingent debt, an option, or any derivative instrument with respect to the entity). This proposal would be effective for taxable years beginning after December 31, 2010.
This proposal is substantially similar to previous legislative proposals that would have modified the tax treatment of carried interests held by partners providing asset management advisory services for certain classes of assets, such as investment securities, real estate and commodities (see, e.g., the carried interest reform legislation introduced by Congressman Sander Levin (D-Mich.) on April 2, 2009, discussed in our Tax Alert entitled "Proposed Carried Interest Legislation," located at reedsmithupdate.com/ve/ZZm006984rBRvYVZ.). However, as described in the Green Book, this proposal may apply to a broader range of service partners, not just those providing asset management advisory services.
Repeal of LIFO Method of Accounting for Inventories – Under current law, only taxpayers with inventory who use the last-in, first-out ("LIFO") method of accounting for inventory for financial accounting purposes are eligible to elect LIFO for tax purposes. All other taxpayers must account for inventory using the first-in, first-out ("FIFO") method. The LIFO method can provide a tax benefit for a taxpayer with rising inventory costs, since the cost of goods sold under this method is based on more recent, higher inventory values, resulting in lower taxable income. The Budget includes a proposal that would no longer permit the use of the LIFO method. Taxpayers that currently use the LIFO method would be required to write-up their beginning LIFO inventory to its FIFO value in the first taxable year beginning after December 31, 2011. The amount of the write-up would be taken into income ratably over 10 years, beginning with the first taxable year beginning after December 31, 2011.
Repeal of Gain Limitation Rule for Certain Boot Received in Reorganizations – Under current law, a shareholder receiving both stock and other property ("Boot") as part of a reorganization recognizes gain equal to the lesser of the gain realized on the exchange or the amount of Boot received (the "Boot-Within-Gain Limitation"). Such gain generally is treated as a dividend (to the extent of the shareholder's share of the target corporation's earnings and profits) if the exchange has the effect of a dividend distribution. The Budget includes a proposal that would repeal the Boot-Within-Gain Limitation rule in the case of any reorganization if the exchange has the effect of a dividend distribution. This proposal would apply to taxable years beginning after December 31, 2010.
Codification of the Economic Substance Doctrine – The judicially created economic substance doctrine generally denies tax benefits from a transaction that does not meaningfully change a taxpayer's economic position (other than tax consequences), even if the transaction technically satisfies the applicable requirements of the Code. Courts have not uniformly applied the doctrine. Similar to numerous other proposals in recent years, the Budget includes a proposal that would codify the economic substance doctrine and clarify that a transaction satisfies the doctrine only if: (i) it changes in a meaningful way (apart from federal tax effects) the taxpayer's economic position ("objective" economic substance); and (ii) the taxpayer has a substantial purpose (other than a federal tax purpose) for entering into the transaction ("subjective" economic substance). The proposal would also clarify that a transaction will not be treated as having economic substance solely by reason of a profit potential unless the present value of the reasonably expected pre-tax profit is substantial in relation to the present value of the net federal tax benefits arising from the transaction An understatement penalty of 30 percent (20 percent if the relevant facts are disclosed in the taxpayer's tax return) would be applicable to understatements of tax attributable to transactions lacking economic substance. This proposal would apply to transactions entered into after the date of enactment.
Denial of Deduction for Punitive Damages – The Budget includes a proposal that would disallow a deduction for punitive damages paid or incurred by a taxpayer, whether upon a judgment or in settlement of a claim. Where the liability for punitive damages is covered by insurance, any amounts paid by the insurer would be included in gross income of the insured person. This proposal would apply to damages paid or incurred after December 31, 2011.
Proposals Related to Compliance and Enforcement
Employee/Independent Contractor Classification – The Budget includes a proposal designed to combat the misclassification of employees as independent contractors. Funds are appropriated to both the Department of Labor and the Treasury Department to enhance the ability of both agencies to penalize employers who misclassify employees as independent contractors. This proposal would, among other things, revise the Revenue Act of 1978's "safe harbor" provision to make it more difficult for employers to classify workers as independent contractors for employment tax purposes, encourage the IRS to provide industry and job specific guidance, and significantly increase employer penalties in the event of misclassification. In addition, workers who are classified as independent contractors would be able to force service recipients to withhold tax if they received more than $600 per year. This proposal generally would be effective upon enactment, but certain transition rules may apply.
Extension of Statute of Limitations Where State Adjustment Affects Federal Tax Liability – Although the statute of limitations for the IRS to assess additional tax, interest, penalties, and additions to tax generally is three years after the date a return is filed, some state and local tax codes provide for a longer period for the collection of state and local taxes. The longer state or local statute of limitations can work to the taxpayer's advantage – a taxpayer may seek to extend the state statute of limitations or postpone agreement to a state adjustment until after the federal statute of limitations has expired in order to preclude a federal tax assessment. The Budget includes a proposal that would create a new exception to the three-year statute of limitations that would allow the assessment of an additional federal tax liability resulting from adjustments to a state or local tax liability. This proposal would be effective for tax returns filed after December 31, 2010.