On December 20, 2017, the U.S. House of Representatives and the U.S. Senate passed a tax reform act (formerly known as the Tax Cuts and Jobs Act or the "Act"). President Trump is expected to sign the Act into law soon. The Act includes several major changes to many areas of the Internal Revenue Code (the Code) impacting taxpayers who are engaged in the technology sector. Because most of the changes are effective January 1, 2018, prompt review of your structure and operations is warranted to understand how the new legislation will impact you and whether restructuring in early 2018 might improve your tax situation.
- Changes to Tax Rates
- - Individual Income Tax Rates Lowered - New Effective C Corporation Tax Rate - New Effective Partners Tax Rate - Table of Effective Tax Rates Before and After the Act - Observations
- Changes to Expenses and Deductions
- - Interest Expense Deductions Generally Limited - Bonus Depreciation - NOL Usage Partially Limited and No NOL Carryback - Amortization of Research & Experimental Expenses - Repeal of Section 199 Deduction
- International Provisions
- - Shift to Territorial Tax System - Deemed Repatriation of Foreign Earnings - The Base Erosion Anti-Abuse Tax (BEAT) - Transfers to Foreign Corporations
- Outbound Transfers of Intangible Property
- Repeal of Active Trade or Business Exception Under Section 367(a)
- Loss Recapture on Transfer of a Foreign Branch to a Foreign Corporation
- Certain Related Party Amounts Paid or Accrued in Hybrid Transactions or with Respect to Hybrid Entities
- Expansion of Stock Attribution Rules for Determining CFC Status
- Expansion of Definition of U.S. Shareholder
- Elimination of 30-Day Requirement for Subpart F Inclusions
Changes to Tax Rates
Individual Income Tax Rates Lowered:
The tax reform bill lowers the maximum marginal income tax rate applicable to individuals from 39.6% to 37% (plus unearned income Medicare tax, where applicable) beginning in 2018. The maximum marginal tax rate applicable to long-term capital gains of individuals remains at 20% (plus unearned income Medicare tax, where applicable) under the tax reform bill. These tax rates sunset for taxable years ending after December 31, 2023.
New Effective C Corporation Tax Rate:
The Act permanently reduces the corporate tax rate to a flat 21% beginning in 2018. When combined with the maximum 20% tax rate on qualified dividends paid by a C corporation to an individual shareholder, the effective tax rate on income of a C corporation distributed to its shareholders will be 36.8% (or 39.8% after the 3.8% Medicare tax on dividends).
The Act fully repeals the corporate alternative minimum tax (the AMT) effective January 1, 2018. The AMT imposed a minimum tax of 20% on certain corporations and restricted the use of the research and development tax credit (R&D Tax Credit) and other business tax credits to offset such tax. Repeal of the AMT ensures that the R&D Tax Credit will continue to be fully monetizable by most investors under the lower corporate tax rate (unless the taxpayer is subject to the BEAT provisions, as discussed below).
The version of the bill advanced by the Senate prior to conference retained the AMT, raising alarm from the technology sector. Because of the lower corporate tax rate, the number of corporations subject to the AMT would have sharply increased, and the value of the R&D Tax Credit for such corporations would have been severely curtailed. The Act therefore avoids this undesirable result by repealing the AMT.
New Effective Partner Tax Rate:
The Act reduces the maximum individual tax rate to 37%, beginning in 2018 (subject to sunset at the end of 2025). In addition, the Act provides in certain cases a deduction to individual partners generally equal to 20% of the partnership's U.S. business income (the Section 199A Deduction). However, for an individual partner with income over $315,000 (or $157,500 if the partner does not file joint returns), the Section 199A Deduction is subject to a limit based either on W-2 wages paid or W-2 wages paid plus a capital element. In such a case, the Section 199A Deduction is limited to an amount equal to the greater of (a) 50% of the W-2 wages paid with respect to a "qualified trade or business" and (b) the sum of 25% of the W-2 wages with respect to the "qualified trade or business" plus 2.5% of the unadjusted basis (determined immediately after an acquisition) of all "qualified property" held by the "qualified trade or business" at the close of the relevant tax year.
Table of Effective Tax Rates Before and After the Act:
As the table below shows assuming an individual partner is in the highest tax bracket, the effective tax rate spread between a C corporation and a partnership has been decreased slightly if the full Section 199A Deduction is available or even flips in the extreme case if no Section 199A Deduction is available.
Prior to the Act, the 48% (or 50.47% after the 3.8% Medicare tax on dividends) effective double tax rate, combined with the premium that could be received for tax basis step-up on exit, often resulted in investors and founders preferring to have startup technology companies classified as pass-through entities for U.S. federal income tax purposes (e.g., partnerships or disregarded entities). While the Act also reduces the highest individual tax rate to as low as 29.6% for pass-through business income for taxpayers entitled to the full amount of the Section 199A Deduction, the relative advantage that partnerships had over C corporations has been reduced and can even be eliminated in cases where the Section 199A Deduction is materially limited. As a result, startup technology companies with individual founders and investors will need to consider the impact of the reduced rates and the anticipated Section 199A Deductions to determine the optimal structure for their businesses.
Changes to Expenses and Deductions
Interest Expense Deductions Generally Limited:
Subject to certain exceptions discussed below, the Act generally limits the annual deduction for business interest expense to an amount equal to 30 percent of the "adjusted taxable income" (as defined in the following paragraph), plus the business interest income, plus the floor plan financing interest (if any), of the taxpayer for the taxable year. The amount of any business interest not allowed as a deduction for any taxable year may be carried forward indefinitely and utilized in future years, subject to this and other applicable interest deductibility limitations and to certain restrictions applicable to partnerships.
"Adjusted taxable income" generally means the taxable income of the taxpayer computed by without regard to any item of income, gain, deduction, or loss which is not properly allocable to a trade or business and by adding back (1) any business interest expense or business interest income, (2) the amount of any net operating loss deduction and, for taxable years beginning before January 1, 2022, and (3) any deduction allowable for depreciation, amortization, or depletion.
There are several exceptions to this new limitation on interest deductibility, including the that the limitation does not apply to taxpayers whose annual gross receipts do not exceed $25 million under the test set forth in IRC Section 448(c).
Special rules apply in the case of partnerships. The limitation on the deduction is determined at the partnership level, and any deduction available after applying such limitation is included in the partners' nonseparately stated taxable income or loss from the partnership. Any business interest that is not allowed as a deduction to the partnership for the taxable year is not carried forward by the partnership but, instead, is allocated to each partner as "excess business interest" in the same manner as nonseparately stated taxable income or loss of the partnership. The partner may deduct its share of the partnership's excess business interest in any future year, but only against excess taxable income attributed to the partner by such partnership. The "excess taxable income" with respect to any partnership is the amount which bears the same ratio to the partnership's adjusted taxable income as (a) the excess of (i) 30% of the adjusted taxable income of the partnership, over (ii) the amount (if any) by which (x) the business interest expense, minus the floor plan financing interest, exceeds (y) the business interest income of the partnership bears to (b) 30% of the adjusted taxable income of the partnership. A partner's share of excess taxable income is determined in the same manner as nonseparately stated income and loss.
Under the Act, the bonus depreciation percentage is generally increased to 100% (from its current level of 50%) for property placed in service after September 27, 2017 and before 2023. After 2022, the bonus depreciation percentage is phased-down to 80% for property placed in service in 2023, 60% for property placed in service in 2024, 40% for property placed in service in 2025, and 20% for property placed in service in 2026. Importantly, the Act expands the availability of bonus depreciation to non-original use property, as long as it is the taxpayer's first use. Accordingly, a portfolio company that acquires assets may be able to deduct a significant portion of the purchase price, as compared to the acquisition of the equity interest of a target business.
NOL Usage Partially Limited and No NOL Carrybacks:
The Act generally limits the amount of net operating loss (NOL) that may be utilized in any taxable year to 80% of the taxpayer's taxable income (determined without regard to the NOL deduction). Carryovers to other years are adjusted to take account of this limitation, and may be carried forward indefinitely. The bill also generally repeals provisions allowing for the carryback of NOLs. The foregoing provisions apply to losses arising in taxable years beginning after December 31, 2017.
Amortization of Research & Experimental Expenses:
Under prior law, a taxpayer could elect to take a current deduction for certain research and experimental expenses paid or incurred in connection with a trade or business. The Act mandates that taxpayers must capitalize and amortize such expenses over five years or, in the case of expenses attributable to foreign research, 15 years. This mandatory capitalization is effective for amounts paid or incurred in taxable years beginning after December 31, 2021.
Repeal of Section 199 Deduction:
The Act fully repeals Section 199, which provided a deduction for income attributable to domestic production activities. The repeal is effective for taxable years beginning after December 31, 2017.
Shift to Territorial Tax System:
Another one of the more notable changes in the Act is the shift in the corporate tax system from a worldwide tax to a territorial tax system. Under this new territorial system, a U.S. corporation generally will not be subject to U.S. federal income tax on dividends received from foreign corporations or gains recognized from the disposition of foreign corporation stock to the extent that such dividends or gains are attributable to foreign earnings and profits and the U.S. corporation owns 10% or more of the foreign corporation. This is a significant change from the worldwide tax system currently in place, which would subject a U.S. corporation to U.S. federal income tax at 35% on such dividends or gains and then allow the U.S. corporation a foreign tax credit for foreign taxes incurred on such foreign earnings and profits. This worldwide system ultimately resulted in foreign earnings and profits being subjected to a minimum worldwide tax rate of 35%. The new territorial system will generally cause most foreign earnings and profits to not be subject to any additional U.S. corporate tax.
Under the worldwide tax system, portfolio companies that operated in pass-through entities generally preferred to hold foreign operations through foreign entities that were also pass-through vehicles for U.S. federal income tax purposes. Such a structure allowed individual investors to be able to claim foreign tax credits to offset the U.S. federal income tax liability attributable to the foreign operations, which helped prevent double taxation of the foreign earnings and profits. This shift to a territorial tax system, together with the inapplicability of the Section 199A Deduction previously discussed to non-U.S. business income, could lead to a preference by funds to have their portfolio companies with foreign operations hold such operations through foreign corporations wholly-owned by a U.S. corporation, even if the portfolio company operates in pass-through form with respect to its U.S. business and operations. This structure may allow the foreign earnings and profits to be taxed at an effective U.S. tax rate that is lower than the highest individual rate of 37%.
Deemed Repatriation of Deferred Foreign Earnings:
As part of the shift to the territorial system, the Act imposes a mandatory tax on accumulated earnings and profits of specified foreign corporations by requiring require a 10% U.S. shareholder of a controlled foreign corporation (a CFC) or other foreign corporation with a 10% domestic corporate shareholder (other than a PFIC) to include in income, for the last taxable year of such foreign corporation beginning before January 1, 2018, such shareholder's pro rata share of the foreign corporation's post-1986 deferred foreign income that was not previously subject to U.S. tax (but excluding earnings and profits that were accumulated prior to the foreign corporation becoming a CFC or having a 10% U.S. shareholder).
This deemed repatriation is effected by increasing the Subpart F income of the foreign corporation by the greater of such foreign corporation's post-1986 deferred foreign income as of (i) November 2, 2017, or (ii) December 31, 2017. The deemed repatriation amount is generally unreduced by distributions made during the taxable year. The 10% U.S. shareholder's income inclusion is reduced (but not below zero) by an allocable portion of the shareholder's share of any foreign earnings and profits deficit of each foreign corporation with respect to which it is a 10% U.S. shareholder.
Under the Act, the deemed repatriation generally will be taxed at a 15.5% rate to the extent the underlying foreign earnings are attributable to the U.S. shareholder's cash position and an 8% rate for all other amounts. A U.S. shareholder's cash position is the greater of (i) the pro rata share of the cash position of all foreign corporations in which it is a 10% U.S. shareholder as of the last day of the last taxable year beginning before January 1, 2018, and (ii) the average of such cash position determined on the last day of each of the two taxable years ending immediately before November 9, 2017. This computation includes the cash position of certain non-corporate entities with 10% U.S. owners. An entity's "cash position" is its cash, net accounts receivable, and the fair market value of similarly liquid assets.
The Act provides that a U.S. shareholder that is required to include an amount in income under Section 965 is allowed a credit for approximately 44.3% of the foreign income taxes paid that are attributable to the cash position portion of the inclusion and approximately 22.9% of the foreign income taxes paid that are attributable to the remainder of the inclusion.
In the case of any corporation that inverts (i.e., becomes an expatriated entity within the meaning of Section 7874(a)(2)) at any point within the 10-year period following the enactment of the Act, a U.S. shareholder of such expatriated entity is subject to U.S. tax at a 35% rate (with no reduction for foreign tax credits) on the entire amount of the deemed repatriation with respect to such corporation.
This provision is effective for the last taxable year of a foreign corporation that begins before January 1, 2018, and with respect to U.S. shareholders, for the taxable years in which or with which such taxable years of the foreign corporations end.
The Base Erosion Anti-Abuse Tax:
The BEAT is a new minimum tax intended to prevent "earnings stripping" by multinational corporations. The BEAT minimum tax amount is computed each year and is generally the excess of (a) a percentage (generally 10%) of the taxpayer's "modified taxable income" (generally, income computed without regard to certain "base erosion" payments made to foreign subsidiaries), over (b) the taxpayer's regular tax liability reduced by its tax credits, except for certain business tax credits. In effect, the Act allows the taxpayer to offset any tax owed under the BEAT by 80% of certain business tax credits. The Act does not provide a carry-forward mechanism to allow unused tax credits to offset the BEAT in future taxable years.
Whether and to what extent a corporation will be subject to the BEAT will not be certain until the end of each taxable year because the determination turns on a complex set of factors unique to each taxpayer.
Transfers to Foreign Corporations:
Outbound Transfers of Intangible Property: The Act expands the definition of "intangible property", which in turn expands the scope of intangible property subject to the rules Section 367(d) governing the outbound transfer of such intangible property and the transfer pricing rules of Section 482. This expansion overturns several Tax Court cases that held that intangibles such as workforce in place and goodwill were beyond the scope of the statutory definition of intangible property. The Act also requires Treasury to issue regulations that value of intangible properties for outbound transfers under Section 367(d) or transfer pricing purposes under Section 482 based on an aggregate basis or on the basis of realistic alternatives to such transfers if Treasury determines that such a basis is the most reliable means of valuation.
Repeal of Active Trade or Business Exception Under Section 367(a): The Act provides that, if a U.S. person transfers to a foreign corporation property that is used in the active conduct of a foreign trade or business, then such foreign corporation shall not be treated as a corporation for purposes of determining the extent to which gain is recognized on such transfer. The Act thus repeals the active trade or business exception under current law. This provision applies to transfers after December 31, 2017.
Loss Recapture on Transfer of a Foreign Branch to a Foreign Corporation: Under the Act, if a domestic corporation transfers substantially all of the assets of a foreign branch to a specified 10%-owned foreign corporation with respect to which it is a 10% U.S. shareholder after the transfer, then the domestic corporation must recapture in income any net branch losses incurred after December 31, 2017, and before the transfer. This provision applies to transfers after December 31, 2017.
Certain Related Party Amounts Paid or Accrued in Hybrid Transactions or with Respect to Hybrid Entities: The Act adds new Section 267A, which disallows a deduction for interest or royalties paid or accrued to a related party pursuant to a "hybrid transaction" or by or to a "hybrid entity" if such amount is not included in the income of such party under the local tax laws of the country of which such related party is a resident or if such party is entitled to a deduction with respect to such payments under the local tax laws of such country.
For purposes of this rule, a "hybrid transaction" is any transaction, series of transactions, or instrument one or more payments with respect to which are treated as interest or royalties for U.S. tax purposes but not so treated under the local tax laws of the country of which the recipient is a resident. A "hybrid entity" is an entity that is treated as fiscally transparent under U.S. tax law but not so treated under the local tax laws of the country of which the recipient is a resident, or vice versa.
Passive and Mobile Income:
The Act adds to the Code new Section 951A, which requires a 10% U.S. shareholder of a CFC to include in income, as a deemed dividend, the global intangible low-taxed income (GILTI) of the CFC. A 10% U.S. shareholder that is a domestic corporation is allowed a deduction (under new Section 250) equal to 50% of GILTI (reduced to 37.5% for tax years beginning after December 31, 2025). Thus, a domestic corporation is subject to U.S. tax on GILTI at an effective rate of 10.5% (that is, 50% of the U.S. corporate tax rate of 21%).
For purposes of this rule, "GILTI" is defined as the excess of the U.S. shareholder's net CFC tested income over a net deemed tangible income return. "Net CFC tested income" generally means a CFC's gross income, other than income that is subject to U.S. tax as effectively connected income, Subpart F income (including income that would be Subpart F income but for the application of certain exceptions), and foreign oil and gas extraction income, less allocable deductions. The "net deemed tangible income return" generally is an amount equal to (i) 10% of the aggregate of the U.S. shareholder's pro rata share of a CFC's qualified business asset investment (generally, a quarterly average of the CFC's tax basis in depreciable property used in its trade or business) over (ii) the amount of interest expense taken into account to determine such U.S. shareholder's net CFC tested income.
Under the Act, a domestic corporation is entitled to a credit for 80% of its pro rata share of the foreign income taxes attributable to the income of the CFC that is taken into account in computing its net CFC tested income. The foreign tax credit limitation rules apply separately to such taxes, and any taxes that are deemed paid under these rules may not be carried back or forward to other tax years.
This provision is effective for taxable years of foreign corporations beginning after December 31, 2017, and to taxable years of United States shareholders in which or with which such taxable years of foreign corporations end.
Effective 13.125% Tax Rate on Foreign-Derived Intangible Income of a Domestic Corporation:
The Act adds to the Code new Section 250, which allows a domestic corporation to claim a deduction (for tax years from 2018 through 2025) for an amount equal to 37.5% of its foreign-derived intangible income (reduced to 21.875% for tax years beginning after December 31, 2025). Thus, a domestic corporation is subject to U.S. tax on foreign-derived intangible income at a rate of 13.125%.
At a high level, a domestic corporation's "foreign-derived intangible income" is calculated by applying a complex series of formulas and definitions that ultimately look to determine the extent to which the domestic corporation's income in excess of a 10% return on its U.S. depreciable assets (increased to 15.625% for tax years beginning after December 31, 2025) is attributable to (i) the sale of property to foreign persons for use outside the United States or (ii) the performance of services for foreign persons, or with respect to property located, outside the United States. Income of the domestic corporation is not taken into account for this purpose to the extent it is Subpart F income, GILTI, financial services income, a dividend received from a CFC in which the domestic corporation is a U.S. shareholder, domestic oil and gas extraction income, and foreign branch income. Special rules apply to transactions involving intermediaries and related parties.
Provisions Affecting Determination of CFC Status:
Expansion of Stock Attribution Rules for Determining CFC Status: The Act repeals Section 954(b)(4), which provides that stock in a foreign corporation is not attributed "downward" from a foreign person to a related U.S. person for purposes of determining whether such U.S. person is a U.S. shareholder of such foreign corporation (and, thus, whether such foreign corporation is a CFC). This provision apparently is intended to render ineffective "de-control transactions" in which a foreign parent acquires a greater than 50% interest in a CFC of its U.S. subsidiary and, thus, causes the CFC to be a non-CFC.
This provision is effective for the last taxable year of foreign corporations beginning before January 1, 2018, and each subsequent year of such foreign corporations and for the taxable years of U.S. shareholders in which or with which such taxable years of foreign corporations end.
Expansion of Definition of U.S. Shareholder: Under current law, a U.S. shareholder is defined as any U.S. person that owns 10% of the voting stock in a foreign corporation. The Act expands this definition to include any U.S. person that owns 10% of the vote or value of the stock in a foreign corporation. This change accordingly expands the circumstances in which a foreign corporation will be treated as a CFC (including in situations where a U.S. person owns "low vote" stock that represents at least 10% of the value of the foreign corporation).
This provision is effective for taxable years of foreign corporations beginning after December 31, 2017, and for taxable years of U.S. shareholders in which or with which such taxable years of foreign corporations end.
Elimination of 30-Day Requirement for Subpart F Inclusions: Under current law, a U.S. shareholder of a foreign corporation is required to include amounts in income under Subpart F for a particular tax year only if such foreign corporation has been a CFC for at least 30 consecutive days for such year. The Act eliminates this 30-day requirement. This provision is effective for taxable years of foreign corporations beginning after December 31, 2017, and for taxable years of U.S. shareholders in which or with which such taxable years of foreign corporations end.
This provision, along with the expanded stock attribution rules and the expanded definition of a U.S. shareholder, expands the scope of foreign corporations that will be CFCs and subject to the applicable income tax rules.