On May 11, 2009, the Treasury Department issued the 131-page General Explanations of the Administration's Fiscal Year 2010 Revenue Proposals, which outlines the tax proposals the Obama Administration intends to provide to Congress in order to achieve its fiscal year 2010 budget plans.
While the release offers some insight into the tax legislation the Administration hopes to enact, it does not provide significant details on the proposed legislation. Future releases and the actual House Bills will provide additional detail. We will continue to monitor new developments in the weeks and months to follow. If you have any questions or would like additional information about the proposals contained in the release (not all of which are discussed in this Tax Alert), please contact one of the authors or the Reed Smith attorney with whom you regularly work.
Tax Changes For Businesses
- Repeal of the Last-In, First-Out Accounting Method for Inventories. Taxpayers with inventories are currently permitted to value their inventory and cost of goods sold using a number of different methods including both first-in, first-out and last-in, first-out. The release includes a proposal that would disallow the use of the LIFO accounting method for Federal income tax purposes. Taxpayers using LIFO would be required to write-up their LIFO inventory to its FIFO value beginning in January 2012, with any resulting gross income being taken into account ratably over the next 7 years.
- Repeal Expensing of Intangible Drilling Costs. Costs associated with expenses that benefit future periods may not be deducted in the period the costs are incurred, but must instead be capitalized and recovered over time. Current law contains an exception from this general rule for intangible drilling and development costs associated with oil and gas businesses. Taxpayers are permitted to either expense these intangible costs in the year the costs are paid or incurred or amortize them over a 60-month period. A proposal in the release would eliminate the ability of taxpayers to expense these intangible drilling and development costs, would prohibit amortization over a 60-month period, and instead would require such costs to be capitalized as depreciable or depletable property, as the case may be, and recovered under the general depreciation/depletion rules. This proposal would be effective for costs paid or incurred after December 31, 2010.
- Reinstate Certain Superfund Excise and Income Taxes. For taxable years beginning before January 1, 1996, three Superfund excise taxes were applicable to taxpayers dealing in certain petroleum and hazardous products. Additionally, a corporate environmental income tax was applicable to modified corporate income in excess of $2 million. While both of these taxes expired in 1996, there is a proposal in the release which would reinstate these taxes for taxable years beginning after December 31, 2010.
- Eliminate Capital Gains Taxation on Investments in Small Business Stock. Taxpayers other than corporations are currently permitted to exclude 50% of the gain from the sale of qualified small business stock held for at least 5 years. Even so, 7% of this excluded gain is a tax preference item that is subject to the alternative minimum tax. A proposal in the release would provide for no Federal income tax on the sale of qualified small business stock by increasing the percentage exclusion to 100% for stock issued after February 17, 2009 and eliminating this gain as a preference item subject to the alternative minimum tax.
- Deny Deduction for Punitive Damages. While taxpayers are not currently permitted to deduct payments made to satisfy fines or similar penalties paid to governmental agencies, a deduction is permitted for damages paid or incurred in carrying on a trade or business irrespective of whether such damages are punitive or compensatory. The release contains a proposal which would disallow a deduction for punitive damages paid or incurred by a taxpayer. If the liability for the punitive damages is covered by insurance, the proposal would require the insured party to include the amount of such damages paid by the insurer in its gross income. This proposal would apply to damages paid or incurred after December 31, 2010.
- Expand Net Operating Loss Carryback. When a corporation's business deductions exceed its gross income in any given year, a net operating loss arises. Generally, taxpayers are permitted to carry net operating losses back 2 years and forward 20 years. While no specifics are given, the release indicates that it is the Administration's intent to provide a lengthened net operating loss carryback period. Future legislation will be required in order to determine exactly what the Administration has in mind.
- Make the Research and Experimentation Tax Credit Permanent. The research and experimentation tax credit provides a credit equal to 20% of qualified research expenses in the United States above a base amount. While the research and experimentation credit is currently scheduled to expire on December 31, 2009, the release contains a proposal aimed at making the credit permanent.
International Tax Changes
Reform the Foreign Tax Credit.
- Taxpayers are currently permitted to claim a credit against their U.S. income tax liability for certain taxes paid or accrued during the year to foreign countries. Corporations are deemed to have paid the foreign taxes which are paid by foreign subsidiaries from which they receive a dividend. Under a proposal in the release, all foreign taxes paid by a U.S. taxpayer's consolidated group, including its controlled foreign corporations, would be aggregated to determine an average effective foreign tax rate, with this rate being used for foreign tax credit purposes. This will prevent cross-crediting strategies currently used by some U.S. taxpayers.
- A separate proposal in the release would adopt a matching rule to prevent the separation of creditable foreign taxes from associated foreign income. Under current rules, such separation could be accomplished in certain circumstances by using hybrid and reverse hybrid entities to separate the foreign income from the creditable foreign taxes. This proposal would be effective for taxable years beginning after December 31, 2010.
- Defer Deduction of Expenses Related to Deferred Income. Currently, a U.S. corporation is permitted to deduct expenses associated with foreign investment without regard to whether the profits from these foreign ventures have been repatriated. There is a proposal in the release which would defer a deduction for most expenses properly allocated and apportioned to foreign-source income to the extent that the foreign-source income is not currently subject to U.S. tax. Thus, if a U.S. taxpayer borrows money to purchase a foreign company, no deduction will be permitted unless and until the foreign entity's profits are repatriated, and then only to the extent of the funds subject to U.S. tax. This proposal would be effective for taxable years beginning after December 31, 2010.
- Reform Business Entity Classification Rules for Foreign Entities. Eligible business entities are currently permitted to elect their classification for Federal tax purposes. The release contains a proposal which would permit a foreign eligible entity to elect to be treated as a disregarded entity only if the single owner of the foreign entity is created or organized in the foreign country in which the foreign eligible entity is created or organized. This proposal would be effective for taxable years beginning after December 31, 2010.
- Repeal of the 80/20 Company Rule. Dividends and interest paid by domestic corporations are, under current law, generally U.S.-source income subject to withholding if paid to a foreign person. If, however, at least 80% of a corporation's gross income during a three-year look-back period is foreign-source and attributable to the active conduct of a trade or business, the general rule does not apply. There is a proposal contained in the release which would repeal this exception to the general rule and treat all such dividends and interest as U.S.-source income subject to withholding. This proposal would be effective for taxable years beginning after December 31, 2010.
Other Tax Changes
- Tax Carried Interest as Ordinary Income. Partnerships are not subject to Federal income tax and instead the income and loss of the partnership retains its character and flows through to the partners. Under current law, partners receiving a partnership interest in the profits of the partnership in exchange for services are taxed on their distributive share of the partnership's income in the same manner as partners holding a capital interest in the partnership. Further, most income attributable to a profits interest is currently not subject to self-employment tax. The release contains a proposal which would tax a partner's share of income on a "services partnership interest" as ordinary income, regardless of the income's character at the partnership level. Additionally, such a partner would be required to pay self-employment tax on all income and would be taxed at ordinary income rates on the sale of his "services partnership interest." While the intent behind this change is to target managers of traditional investment funds that receive a share of the fund's profits in exchange for managerial services, the language of the release makes it clear that this proposal, if enacted, could impact an even broader range of taxpayers. This proposal would be effective for taxable years beginning after December 31, 2010.
- Codify the Economic-Substance Doctrine. The economic-substance doctrine is the judicially created notion that while taxpayers are permitted to decrease the amount of what otherwise would be their taxes by any means which the law permits, when their transaction has no purpose other than tax avoidance and lies outside the plain intent of the statute, it will not be respected. Courts have not uniformly applied the doctrine with some requiring both subjective and objective substance, others requiring one or the other, and still others employing a facts and circumstances test. A proposal in the release would codify the doctrine in the Internal Revenue Code, with a transaction being respected only if it changes in a meaningful way (apart from Federal tax effects) the taxpayer's economic position and the taxpayer has a substantial purpose (other than Federal tax purpose) for entering into the transaction. An understatement penalty of 30% (20% if the relevant facts are disclosed in the taxpayer's return) would be applicable to understatements of tax attributable to transactions lacking economic substance.