On December 19, 2017, the Senate passed the “Tax Cuts and Jobs Act of 2017” (H.R. 1) (the “Bill”). The House of Representatives passed the Bill on December 20, 2017. This follows the release by the conference committee of the final legislative text on December 15, 2017. The Bill replaces the prior versions of H.R. 1 passed by the House of Representatives (the “House Bill”) on November 16, 2017 and the Senate (the “Senate Bill”) on December 2, 2017. President Trump is expected to sign the Bill into law and may do so on January 3, 2018. The Bill represents the most significant changes to the US tax code since 1986.
This client alert summarizes the key income, compensation, estate and gift tax provisions of the Bill.
Changes That Affect Individuals
Changes in Individual Tax Rates
The Bill retains the current seven tax bracket structure, although it imposes slightly lower marginal rates on slightly wider brackets. Under the Bill, married taxpayers filing a joint return are subject to the following rates:
- 10 percent: $0 – $19,050
- 12 percent: $19,051 – $77,400
- 22 percent: $77,401 – $165,000
- 24 percent: $165,001 – $315,000
- 32 percent: $315,001 – $400,000
- 35 percent: $400,001 – $600,000
- 37 percent: over $600,000
Accordingly, the top marginal tax rate is 37 percent (less than the current top marginal tax rate of 39.6 percent), and the top marginal rate applies to income over $600,000 in the case of married taxpayers filing a joint return (as compared to the current threshold amount of $470,700). These reduced rates, as well as most of the other provisions impacting individuals, sunset at the end of 2025.
Larger Standard Deduction and Family/Child Tax Credits
Overall, the Bill encourages taxpayers to take the simpler standard deduction, rather than itemizing their deductions. It does this by increasing the standard deduction and eliminating, or severely restricting, itemized deductions. Some of the most significant itemized deductions curtailed by the Bill include the deduction for state and local taxes and the deduction for home mortgage interest.
The Bill eliminates the personal exemption but roughly doubles the standard deduction ($24,000 for married taxpayers filing a joint return, $18,000 for head-of-household filers, and $12,000 for all other taxpayers) and is accompanied by an enhanced child tax credit as well as a new family tax credit. The child tax credit increases from $1,000 to $2,000 for each qualifying child, and is refundable up to $1,400 per child. The Bill adds a $500 credit for each dependent that is not a qualifying child. The child and dependent credits are subject to a phase-out for married taxpayers filing a joint return with adjusted gross income above $400,000 (and $200,000 for all other taxpayers).
State and Local Taxes
The Bill significantly curtails the state and local tax deduction for individuals. If incurred in carrying on a trade or business (or for the production of income), an individual may deduct state, local and foreign property taxes, as well as state and local sales taxes. Otherwise, individuals are limited to a maximum itemized deduction of $10,000 for the aggregate of (i) state and local income taxes (or sales taxes, in the alternative), and (ii) state and local property taxes not paid or accrued in the carrying on of a trade or business or for the production of income.
The deduction for home mortgage interest may be significantly reduced. Although qualified residence indebtedness incurred on or before December 15, 2017 is grandfathered (including subsequent refinancings, as long as certain conditions are met), interest is deductible on no more than $750,000 of new indebtedness. Similarly, the Bill eliminates a taxpayer’s ability to deduct interest on home equity indebtedness after December 31, 2017 (with no grandfathering for existing home equity indebtedness).
Other Important Provisions
Most of the individual tax changes are temporary and only apply to the 2018 through 2025 taxable years.
In addition, beginning in 2019, the Bill permanently repeals the Affordable Care Act’s individual mandate.
The Bill eliminates all miscellaneous itemized deductions subject to the two percent floor.
Under the Bill, the individual alternative minimum tax (“AMT”) is retained with several adjustments. For taxable years 2018 through 2025, the AMT exemption amount is increased to $109,400 for married taxpayers filing a joint return and $73,000 for all other individual taxpayers. The phase-out thresholds are increased to $1,000,000 for married taxpayers filing a joint return and $500,000 for all other individual taxpayers.
The Bill does not include the requirement contained in the Senate Bill that taxpayers who sell securities determine the cost of the disposed securities on a first-in, first-out (“FIFO”) basis. Thus, the current practice generally allowing taxpayers to specifically identify which of their shares are sold has been retained. Finally, certain provisions remain unaffected by the Bill, including the reduced rates for long-term capital gains and qualified dividend income, as well as the 3.8 percent Medicare tax on net investment income.
Estate, Gift and Generation-Skipping Tax
Under the Bill, beginning in 2018 and continuing through December 31, 2025, the basic exclusion amount for estate, gift and generation-skipping transfer taxes is doubled to $10 million, indexed for inflation (in 2018, this translates to a basic exclusion amount of $11.2 million for an individual and $22.4 million for a married couple). Beginning on January 1, 2026, the basic exclusion amount for estate, gift and generation-skipping transfer taxes reverts to the current amount (i.e., $5,000,000, indexed for inflation). The Bill adds a provision authorizing the Secretary to issue regulations as may be necessary or appropriate to account for any difference between the basic exclusion amount at the time of a decedent’s death and the basic exclusion amount at the time gifts were made by the decedent for the purposes of calculating the decedent’s estate taxes. Thus, assuming no further changes in the law, the estate tax of an individual dying after 2025 who had fully utilized the higher exclusion may pay additional estate tax in order to retract the benefit of the then expired higher exclusion.
The Bill maintains the provision permitting a basis step-up for income tax purposes on property received from a decedent to the fair market value of such property on the date of the decedent’s death.
Under the Bill, the maximum rate on gifts remains at 40 percent. The Bill keeps the annual exclusion for gifts in 2018 at $15,000, indexed for inflation in future years.
Under the Bill, the estates of nonresident noncitizen decedents continue to have a $60,000 estate tax exemption on US situs assets. Nonresident noncitizens continue to be subject to gift tax on lifetime transfers of US situs real and tangible property, with the maximum rate on such transfers remaining at 40 percent.
Corporate Tax Provisions
Reduction in Corporate Tax Rate
The Bill replaces the graduated tax rates for corporations (current maximum rate of 35 percent) with a 21 percent corporate tax rate. The new 21 percent rate applies for taxable years beginning after December 31, 2017 (that is, the rate reduction is immediate with no phase-in, as had previously been considered). In addition, the Bill eliminates the corporate AMT.
The Bill is expected to be beneficial for most US corporations. Notwithstanding the existing 35 percent maximum rate, many US corporations have a lower effective tax rate due to, among other items, deductions for depreciation/amortization and interest paid. The benefit to a particular US corporation of the corporate tax rate reduction will depend on its operations as well as other effects the Bill may have on its effective tax rate, such as the limitation on interest deductions.
Reduction in Dividends Received Deduction Percentage
Under current law, a corporation is entitled to a 100 percent dividends received deduction (“DRD”) for dividends received from a corporation in its affiliated group, an 80 percent DRD to the extent the corporate recipient owns 20 percent or more of the stock of the dividend-paying corporation (by vote and value), and a 70 percent DRD for dividends received by a corporate recipient that owns less than 20 percent of the stock of the dividend-paying corporation.
The Bill lowers the 80 percent DRD to 65 percent and the 70 percent DRD to 50 percent. The Bill does not modify the 100 percent DRD for dividends received from members within the same affiliated group. Under the Bill, the effective tax rate on dividends received by a corporation with the reduced 21 percent corporate tax rate is roughly the same as under current law with the 35 percent corporate tax rate (7.35 percent effective corporate tax rate with a 65 percent DRD and 10.5 percent effective corporate tax rate with a 50 percent DRD).
Modification of Net Operating Loss Deduction
The Bill permits taxpayers to carryforward net operating losses (“NOLs”) indefinitely, but limits the use of NOLs to 80 percent of the taxpayer’s taxable income for the year. The Bill generally does not allow carrybacks of NOLs. NOLs that are carried forward are not increased by an interest factor in order for the NOLs to preserve their value (as had been included in the House Bill). The 80 percent limitation, indefinite carryforward rule and no carryback rule of the Bill are effective for net operating losses arising in taxable years beginning after 2017. Existing net operating losses (including for 2017) can continue to be carried back two years or carried forward for up to 20 years and can offset 100 percent of taxable income.
Other Business Provisions
The Bill allows taxpayers to immediately expense 100 percent of the cost of “qualified property” that is placed in service after September 27, 2017 and before January 1, 2023 (with an additional year for certain property with longer production periods). Under the Bill, new qualified property, as well as used qualified property acquired by a taxpayer, is eligible for immediate expensing. The bonus depreciation percentages will begin to wind down gradually after December 31, 2022 from 100 percent to zero beginning January 1, 2027.
Qualified property is defined as tangible property with a recovery period of 20 years or less under the modified accelerated cost recovery system (i.e., MACRS), certain off-the-shelf computer software, water utility property, qualified improvement property, qualified film or television production, or qualified live theatrical production. Certain trees, vines and fruit-bearing plants also are eligible for additional depreciation when planted or grafted.
Under the Bill, regulated public utilities are not eligible for immediate expensing; however, such trades and businesses are not subject to the Bill’s limitations on interest deductions discussed below. Unlike the House Bill, the Bill does not exclude immediate expensing for real property trades or businesses. As a more general matter, discussions of tax reform this year have focused on allowing immediate expensing along with limitations on interest deductions. Although immediate expensing can have a benefit of lowering cash taxes upfront, depreciation generally is a timing issue while limitations on interest deductions generally are permanent.
Because the Bill generally eliminates the carryback of NOLs for taxable years beginning after December 31, 2017, corporations are not permitted to carryback any NOLs to the 2017 taxable year that are attributable to immediate expensing in 2018.
Limitations on Interest Deductions
The Bill limits interest deductions for businesses, whether in corporate or pass-through form, to 30 percent of adjusted taxable income. For taxable years beginning before January 1, 2022, adjusted taxable income is computed without regard to depreciation, amortization and depletion (i.e., similar to EBITDA). Beginning on January 1, 2022, adjusted taxable income will take into account depreciation, amortization and depletion (i.e., similar to EBIT). The Bill provides for an unlimited carryforward period for disallowed interest deductions. The Bill applies to taxable years beginning after December 31, 2017. Accordingly, there is no grandfathering for existing debt instruments.
It is unclear whether this provision (i) requires each member of a consolidated group to apply the 30 percent limitation on an entity-by-entity basis or (ii) treats all members of a consolidated group as a single taxpayer. The current “earnings stripping” rule that is being replaced by this provision has statutory language that treats all members of a consolidated group as a single taxpayer. This new limitation on interest deductions does not contain any statutory language regarding the treatment of members of a consolidated group. The House Bill contained a similar version of this provision and the accompanying committee report provides that a consolidated group will be treated as a single taxpayer. In addition, the Conference Agreement that accompanies the Bill contains the same description of the House Bill, and provides that the Senate Bill follows the House Bill (with modifications) and the Bill generally follows the Senate Bill (with modifications).
In the case of partnerships, the limitation on interest deductions is determined at the partnership level. In addition, the unused portion of the 30 percent limitation with respect to a partner is available to the partner. The Bill contains provisions to prevent double counting of income at the partner level. Similar rules apply to S corporations.
The Bill does not apply the interest expense deduction limitation to regulated utility companies (which, as mentioned above, are not eligible for immediate expensing of their assets). In addition, the Bill does not apply to the trade or business of being an employee. Real property trades or businesses can elect out of the interest expense deduction limitation; however, upon such an election, real property trades or businesses are required to use a slightly less favorable depreciation recovery period. The Bill also contains an exception from the interest expense deduction limitation for businesses with average gross receipts of $25 million or less per year over a three-year period. The interest expense deduction limitation does not apply to investment interest.
To the extent a corporation with disallowed interest deductions is acquired, the carryover of such disallowed interest deductions is treated as a net operating loss and its use may be limited under section 382.
Finally, given the limitations discussed above, the Bill eliminates the “earnings stripping” rules (which currently apply only to deductions for interest paid by US corporations to, or guaranteed by, related foreign parties and only if certain other factors are present).
The House and Senate Bills also limited the interest expense deduction of US corporations that are members of worldwide groups based on the US corporation’s relative share of EBITDA or a comparison of the US corporation and worldwide group’s debt/equity ratios. The Bill does not include either of these provisions.
Treatment of Certain Contributions to Capital by Non-Shareholders
Under current law, the contribution of money or property to the capital of a corporation generally is not treated as taxable income to the corporation under section 118. The Bill treats the following types of contributions as income to the corporation: (i) any contribution in aid of construction or any other contribution as a customer or potential customer and (ii) any contribution by any governmental entity or civic group (other than a contribution made by a shareholder as such). The Bill is more limited in scope than the House Bill and does not require corporations to issue stock in connection with capital contributions from shareholders and also does not repeal section 108(e)(6). The Bill is effective for contributions made, and transactions entered into, after the date of the enactment of the Bill (with an exception for any contribution by a governmental entity made pursuant to a master development plan approved prior to the date of enactment of the Bill).
Business Income of Individuals (i.e., Special Rate for Pass-Through Income)
Reduced Rate of Tax on Qualified Business Income of Individuals
The Bill reduces the income tax imposed on qualified business income (“QBI”) derived by an individual, estate or trust from a partnership, S corporation or sole proprietorship by creating a new deduction of up to 20 percent of the QBI of each individual, regardless of the individual’s tax bracket. Thus, the top marginal tax rate on QBI that qualifies for the 20 percent deduction under the Bill is 29.6 percent.
QBI for a taxable year is defined as the net amount of domestic qualified items of income, gain, deduction and loss with respect to the taxpayer’s qualified trades and businesses, which generally means any trades or businesses other than specified service businesses. “Specified service businesses” are professions in the fields of health, law, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, or which involves the performance of services that consist of investing and investment in management trading, or dealing in securities, partnership interests, or commodities (excluding engineering and architecture). The Bill allows individuals that derive business income from specified service businesses to treat such income as QBI if their taxable income is less than $315,000 (for married taxpayers filing a joint return) or $157,500 (for individuals). The benefit of the deduction for income from specified service businesses is phased out over a $100,000 range (for married individuals filing jointly; $50,000 for other individuals).
The Bill limits the deduction for an individual’s QBI to the greater of (a) 50 percent of the individual’s “W-2 wages” paid with respect to the qualified trade or business, or (b) the sum of 25 percent of the W-2 wages plus 2.5 percent of the unadjusted basis of all “qualified property” immediately after its acquisition. Qualified property includes property of a character subject to depreciation and used in production of QBI. Such wages include wages subject to wage withholding, elective deferrals, and deferred compensation paid by the taxpayer during the calendar year. The W-2 wage limit does not apply for taxpayers with taxable income not exceeding $315,000 (for married taxpayers filing a joint return) or $175,500 (for other individuals) with the same phase out as for income from specified service businesses.
QBI does not include certain investment-related income, gains, deductions, or losses. If a taxpayer has negative QBI for a particular year, the amount of such loss can be used to offset QBI in the following taxable year.
The Bill excludes from QBI (1) any amount paid by an S corporation that is treated as reasonable compensation of the taxpayer and (2) any amount that is a guaranteed payment for services actually rendered to or on behalf of a partnership. Qualified REIT dividends, qualified cooperative dividends and qualified publicly traded partnership income separately give rise to a 20 percent deduction that is not subject to the W-2 wages, etc. limitation described above. These provisions are effective for taxable years beginning after December 31, 2017.
Business Income and the Effect on the State and Local Tax Deduction
The Bill includes a new limitation on the deductibility of losses from trades and businesses for taxpayers other than corporations. Under the Bill, “excess business losses” of an individual, estate, or trust are not currently deductible. Excess business losses for a taxable year are defined as the excess of (1) all of the taxpayer’s deductions attributable to trades or businesses of the taxpayer, over (2) the sum of (A) the total gross income or gain of the taxpayer attributable to trades or businesses and (B) a threshold amount ($500,000 for married taxpayers filing a joint return and $250,000 for other individuals). In the case of a partnership or S corporation, the excess business loss rules apply at the partner or shareholder level. Excess business losses are carried forward as part of the taxpayer’s NOL carryforward. Thus, business losses of a non-corporate taxpayer for a taxable year can offset no more than $500,000 (for married taxpayers filing a joint return), or $250,000 (for other individuals), of non-business income of the taxpayer for that year. Excess business losses include losses that are not from passive business activities under section 469. This limitation is effective for taxable years beginning after December 31, 2017.
Other Provisions Relating to Pass-Through Entities
Cooperative Patronage Dividends and REIT Ordinary Dividends
The Bill will treat cooperative patronage dividends like QBI that is eligible for a full 20 percent deduction, to the extent of the taxpayer’s taxable income reduced by net capital gain for the year. REIT dividends (except those that are capital gain dividends) are likewise eligible for a full 20 percent deduction. These changes are effective for taxable years beginning after December 31, 2017.
Repeal of Technical Termination of Partnerships
The technical termination rule, under which a partnership terminates if, within any 12-month period, there is a sale or exchange of 50 percent or more of the interests in partnership capital and profits, is repealed under the Bill. Under present law, when a partnership that holds depreciable property undergoes a technical termination, the remaining basis in such property is recovered over an elongated cost recovery period as if it were placed in service by a new taxpayer on the date of the termination. Repeal renders moot partnership agreement provisions that prohibit any transfer of interests that would trigger a technical termination. The repeal of the technical termination rule is effective for partnership taxable years beginning after December 31, 2017.
Recharacterization of Certain Gains in the Case of Carried Interests
The Bill provides that capital gain allocated by a partnership to an individual partner as carried interest is characterized as short-term capital gain to the extent the gain is from the disposition of property in which the partnership’s holding period was not more than three years in such property. The three-year holding period requirement also applies to gain from the disposition of carried interest partnership interests. The recharacterization rule applies only to “applicable partnership interests,” which are those that are acquired or held by an individual, a trust or an estate in connection with a trade or business that consists of the raising or returning of capital and either investment in or development of “specified assets.” Specified assets include commodities, real estate held for rental or investment, cash, and options, among others. This provision is effective for gain recognized in taxable years beginning after December 31, 2017.
Senate Proposal on Taxing a Foreign Partner’s Gain on the Sale of a Partnership Interest in a Partnership Engaged in a US Trade or Business
The Bill effectively codifies IRS Revenue Ruling 91-32, by providing that a foreign transferor’s gain or loss from the transfer of a partnership interest is effectively connected with a US trade or business to the extent that the transferor would have recognized effectively connected gain or loss had the partnership sold all of its assets at fair market value on the date of the transfer. Therefore, the Bill is intended to override the US Tax Court’s decision in the Grecian Magnesite case from July of this year which held that gain from the complete redemption of a partnership interest in a partnership holding US trade or business assets was not subject to tax because the gain was not US source income. The IRS has appealed the Grecian Magnesite decision in the US Court of Appeals for the District of Columbia. In determining the gain or loss the transferor would have recognized in a taxable asset sale by the partnership, the hypothetical asset-level gain or loss must be allocated among the partners in the same manner as nonseparately stated income and loss of the partnership (even if the allocation of gain or loss that would be provided for by the partnership’s operating agreement would be respected as having substantial economic effect).
The Bill also requires the transferee of an interest in a partnership that is engaged in a US trade or business to withhold 10 percent of the amount realized by the transferor if the transferor is a non-resident alien individual or a foreign corporation. The Bill does not say whether a transferee would be required to withhold if the partnership provides a statement that the partnership is not engaged in a US trade or business, but Treasury has the authority to issue regulations providing for exceptions from the withholding requirements. If the transferee fails to withhold the correct amount, the partnership is required to deduct and withhold from distributions to the transferee partner an amount equal to the amount the transferee failed to withhold. While withholding is required with respect to publicly traded partnership interests (i.e., MLP units), the portion of the Bill treating as effectively connected income gain or loss on the disposition of a partnership interest is effective for dispositions after November 27, 2017. The portion requiring withholding on sales or exchanges is effective after December 31, 2017.
International Tax Provisions
As summarized below, the Bill makes dramatic and far-reaching changes to the US international tax rules by:
- imposing an immediate tax at a reduced rate on all US shareholders on accumulated earnings of foreign corporations that are controlled foreign corporations (“CFCs”) or have 10 percent US shareholders in a one-time deemed repatriation of those earnings,
- permitting tax-free repatriations of future foreign profits of foreign corporations to their 10 percent US shareholders that are domestic corporations,
- imposing a current tax, similar to subpart F, on a US shareholder’s “global intangible low-taxed income” of a controlled foreign corporation,
- modifying certain aspects of the “subpart F” anti-deferral rules, and
- enacting several new provisions intended to prevent erosion of the US tax base.
One-Time Deemed Repatriation Tax
The Bill imposes a one-time deemed repatriation tax on accumulated, untaxed earnings of foreign corporations. The earnings held as “cash or cash equivalents” (referred to as the “cash position”) are taxed at a rate of 15.5 percent, and all other earnings are taxed at a rate of 8 percent. The tax rates on the one-time deemed repatriation are achieved by providing the US shareholder a deduction in the amount necessary to achieve 15.5 percent and 8 percent net rates. The earnings are included in the income of a US shareholder on the last day of the last taxable year of the foreign corporation that began before January 1, 2018. A US shareholder may elect to pay its net tax liability on the one-time deemed repatriation in eight installments equal to 8 percent of the net tax liability for each of the first five years, 15 percent in the sixth year, 20 percent in the seventh year, and the remaining 25 percent in the eighth year.
Foreign tax credits are available to corporate US shareholders. For repatriated earnings held as cash or cash equivalents, 55.7 percent of the foreign tax credit is disallowed. For other repatriated earnings, 77.1 percent of the foreign tax credit is disallowed. The section 78 gross-up is modified to require the US shareholder to include in income a portion of the deemed paid foreign taxes on such accumulated, untaxed earnings equal to the net portion of such earnings included in income after taking into account the deduction.
The one-time deemed repatriation is taken into account by all US shareholders (i.e., US persons who own 10 percent or more of the voting power of the foreign corporation’s stock) of foreign corporations if the foreign corporation is a CFC or with respect to which a domestic corporation is a US shareholder (but excluding all PFICs that are not CFCs). An exception permits S corporations that are US shareholders of a foreign corporation to defer the deemed repatriation tax until the S corporation liquidates, or ceases doing business, or the stock of the S corporation is transferred.
The accumulated, untaxed earnings of a foreign corporation are measured as of November 2, 2017 or December 31, 2017, whichever is higher. Importantly, a US shareholder’s share of the deficit earnings of one foreign corporation may reduce, pro rata, the US shareholder’s share of the untaxed earnings of other foreign corporations. Similarly, a US shareholder that is a member of an affiliated group may offset its share of a foreign corporation’s accumulated, untaxed earnings with deficit earnings of a foreign corporation allocated to another member of the affiliated group.
Under the Bill, “cash and cash equivalents” include:
- net accounts receivable,
- personal property traded on a financial market,
- commercial paper, certificates of deposit, and state, federal, and foreign government securities,
- foreign currency,
- short-term obligations (i.e., obligations with a term of less than one year), and
- other assets that the IRS may identify.
The Bill provides exceptions to prevent double-counting of cash equivalents such as debt owed by a foreign corporation to its sister company. Furthermore, cash and cash equivalents that cannot be distributed to a US shareholder because of currency or other foreign law restrictions are not treated as cash or cash equivalents. An anti-abuse rule allows the IRS to disregard any transaction undertaken with a principal purpose of reducing the aggregate foreign cash position. The amount of a foreign corporation’s earnings that are treated as held in cash or cash equivalents (and thus subject to the higher one-time rate of 15.5 percent) is equal to the greater of:
- The cash position determined on the last day of the foreign corporation’s taxable year for which the one-time inclusion occurs, or
- The average cash positions of the foreign corporation determined on (i) the last day of the foreign corporation’s taxable year that ended before November 2, 2017 and (ii) the last day of the foreign corporation’s preceding taxable year.
Any US shareholder that becomes an expatriated entity (e.g., through an inversion) during the 10-year period following the enactment of the Bill is liable for tax on the full deemed repatriated amount at a 35 percent rate (regardless of how the earnings were held) and no foreign tax credits are permitted to offset the additional tax.
US shareholders may elect not to use existing NOLs to offset the one-time deemed repatriation.
Participation Exemption System/Foreign-Source Dividends Received Deduction
The Bill ends the tax on repatriations to US corporations from foreign corporations in which they hold 10 percent interests by establishing a “participation exemption system.” Under the participation exemption system, a US corporation that owns 10 percent or more of a foreign corporation will receive a 100 percent DRD on dividends paid by the foreign corporation out of its foreign-source earnings. No foreign tax credit or deduction is allowed to US shareholders on dividends for which they receive a deduction. Note that the DRD does not apply to 10 percent shareholders that are not corporations despite the fact that such shareholders are subject to the immediate tax on existing retained earnings of the foreign corporation.
Any US corporation receiving the deduction must reduce its basis in the foreign corporation’s stock by the amount of such dividend for purposes of determining its loss (but not gain), if any, on a subsequent disposition of such stock. In addition, the Bill extends the extraordinary dividend provision of section 1059 to dividends to which the DRD applies. As a result, if dividends eligible for the DRD are treated as extraordinary dividends, the US parent is required to reduce its basis in the stock of the foreign corporation for all purposes.
Gain from the sale of stock in a foreign corporation which has been held for one year or more, and which is treated as a dividend under section 1248, is also eligible for the DRD. Similarly, if a CFC sells stock in another CFC and its gain on the sale is treated as a dividend under section 964(e)(1), the dividend (which is treated as subpart F income to its US shareholders) is eligible for the DRD. However, if the sale of stock results in a loss rather than gain, the selling CFC’s earnings are not reduced by the loss.
The DRD is subject to a holding period requirement pursuant to which the US corporation is eligible for the deduction only if it has held the stock of the foreign corporation for more than 365 days during the 731-day period beginning 365 days before the ex-dividend date (excluding periods during which the US corporation has diminished its risk of loss in the stock).
The Bill denies a deduction (as well as a foreign tax credit) for certain hybrid dividends, for which the payor foreign corporation receives a deduction for foreign income tax purposes. Hybrid dividends received by one CFC from another CFC are treated as subpart F income to a US shareholder.
Unlike prior versions, the Bill does not repeal the application of the current section 956 “deemed dividend” rules to domestic corporations. Section 956 will continue to treat an investment in US property by a CFC as a taxable repatriation to its US shareholders, including domestic corporations, notwithstanding that an actual distribution may have qualified for the DRD.
Current Tax on Global Intangible Low-Taxed Income
The Bill calls for a current tax on US shareholders of CFCs with “global intangible low-taxed income” (“GILTI”). The full amount of the US shareholder’s share of the GILTI is treated as an income inclusion, but US corporations are provided a 50 percent deduction (reduced to 37.5 percent in 2026, as described below). The earnings subject to the tax exclude a 10 percent return on certain investments, reduced by net interest expense.
Corporate US shareholders may be eligible for a foreign tax credit of up to 80 percent of the amount of foreign taxes deemed paid, but include 100 percent of the foreign taxes deemed paid in income under the section 78 gross-up. The Bill also modifies the existing foreign tax credit rules by creating a new basket of foreign tax credits paid or accrued with respect to GILTI. Such foreign tax credits can only be used to offset tax on GILTI inclusions, and not tax on other types of income, and cannot be carried back or forward.
The GILTI inclusion is equal to the US shareholder’s share of:
- The CFC’s gross income (subject to certain exclusions, such as income effectively connected with a US trade or business and subpart F income); reduced by
- The excess of (i) 10 percent of the CFC’s aggregate adjusted bases in depreciable tangible property used in its trade or business, over (ii) the CFC’s net interest expense.
The CFC’s aggregate adjusted bases in depreciable, tangible property is measured using the average amount determined at the close of each quarter. Basis must be calculated using the alternative depreciation system under section 168(g) and allocating the depreciation deduction ratably to each day during the period to which the depreciation relates. A look-through rule allows the CFCs to include the adjusted basis of such property held through a partnership.
US shareholders of CFCs with relatively high interest expenses, or corporations with little basis in depreciable property, such as service corporations and corporations with high value intangibles, may find that most of the foreign corporation’s income is treated as GILTI.
For example, assume that a corporate US shareholder wholly owns a CFC, and all of the CFC’s $100 of income is treated as GILTI. If the CFC pays local income taxes of $15 (15 percent tax rate on $100 of income), the US shareholder would be eligible for a foreign tax credit of $12 (80 percent of $15 foreign taxes). After taxes, the CFC would have $85 ($100 of income less $15 of taxes) treated as GILTI. However, the section 78 gross-up would require the US shareholder to increase its GILTI by the entire $15. The US shareholder would have $100 of GILTI income inclusion and a 50 percent deduction (as discussed below) of $50. Thus, its net income would be $50. Assuming a 21 percent corporate rate, the US shareholder’s total tax on the $50 would be $10.50. After taking into account the foreign tax credit, the US shareholder would have no current income tax liability on the foreign corporation’s earnings (because the foreign tax credit of $12 exceeds its tax liability of $10.50). Generally, foreign tax rates under 13.125 percent will result in a GILTI inclusion to a US corporate shareholder.
The tax on GILTI is intended to reduce the incentive to relocate CFCs to low-tax jurisdictions, since any tax savings achieved by the CFC may be partially offset by an increase in taxes to the US shareholders.
Deduction for Foreign-Derived Intangible Income
The Bill generally allows US corporations a deduction equal to 37.5 percent its “foreign-derived intangible income” and 50 percent of its GILTI (including the section 78 gross-up on GILTI). For taxable years beginning after December 31, 2025, the deduction for foreign-derived intangible income is reduced to 21.875 percent and the deduction for GILTI is reduced to 37.5 percent. However, if the sum of the US corporation’s foreign-derived intangible income and GILTI is greater than its taxable income (determined without regard to this proposal), then, solely for purposes of calculating the amount of the deduction, the amounts of foreign-derived intangible income and GILTI are reduced proportionately such that their sum does not exceed the amount of taxable income. The deduction is only available to corporations that are not RICs, REITs, or S corporations.
The “foreign-derived intangible income” is the corporation’s “deemed intangible income” multiplied by a ratio equal to the corporation’s income from selling, leasing, licensing, exchanging or disposing of property or services abroad over its net income (excluding certain income from CFCs and foreign branches, GILTI, financial services income and domestic oil and gas income). The corporation’s deemed intangible income is its net income (excluding certain income from CFCs and foreign branches, GILTI, financial services income and domestic oil and gas income) reduced by a deemed 10 percent return on an amount equal to its basis in tangible depreciable property (determined using straight-line depreciation).
Modification of Subpart F Regime
The Bill retains the subpart F regime, with certain modifications.
The Bill first modifies the rules regarding which corporations are treated as CFCs. Specifically, a US entity with a foreign shareholder may be treated as owning stock in a foreign corporation that is owned by its foreign shareholder. Accordingly, foreign sister companies of US corporations with a common foreign parent corporation generally are treated as CFCs. This change is effective beginning in the last taxable year of foreign corporations beginning before January 1, 2018 and thus applies for purposes of the deemed repatriation described above. The Bill also expands the definition of a US shareholder to include US persons who own 10 percent or more of the total value of a foreign corporation (rather than basing the determination solely on voting power).
Other modifications to the existing subpart F rules include eliminating the requirement that a foreign corporation be a CFC for an uninterrupted 30-day period in order for US shareholders to be required to include in income their pro rata share of the CFC’s subpart F income, and repealing the subpart F income category of foreign base company oil related income.
Foreign Branch Income
Under the Bill, income derived by US persons from foreign branches is ineligible for the participation exemption and is not otherwise exempted from US taxation. In addition, the Bill imposes a tax on certain transfers of a foreign branch to a foreign subsidiary. Under the new provision, the US corporation transferring the branch is required to include in income the amount of any post-2017 losses previously incurred by the branch to the extent such losses exceed the sum of (i) the amount of income of such branch incurred in a taxable year after the year in which such losses were incurred, and (ii) the amount of gain recognized by the US corporation on the outbound transfer. This provision thus expands the current “branch loss rule” of section 367(a)(3)(C) to allow the amount of recaptured branch losses to exceed the amount of built-in gain in the branch assets transferred to the foreign corporation. However, the amount of gain that reduces the branch loss recaptured under this provision is reduced by the amount of losses which were incurred before January 1, 2018, and which, but for this Bill, would have been recaptured under section 367(a)(3)(C). The recaptured income is treated as US source income.
The Bill also repeals the active business exception of section 367(a)(3). As a result, outbound transfers of property generally are treated as taxable transactions regardless of whether the property is used in an active trade or business.
Finally, the bill creates a new foreign tax credit basket for foreign taxes attributable to branches.
Base Erosion and Anti-Abuse Tax (BEAT) on US Corporations
The Bill imposes a minimum tax on a domestic corporation’s “modified taxable income.” The provision appears to be aimed at domestic corporations that significantly reduce their US tax base by making large deductible payments, such as royalties or interest, to foreign related parties. The tax imposed is equal to the excess of:
- 10 percent of the corporation’s “modified taxable income,” reduced by
- the tax otherwise imposed on the corporation, after reduction for credits, but adding back (i) 100 percent of the section 41(a) research credit and (ii) 80 percent of the lesser of (a) the low-income housing credit, the renewable electricity production credit, and certain investment credits allocable to the energy credit, or (b) the minimum tax amount imposed by this provision (determined without regard to the addition of 80 percent of such credits).
The 10 percent rate is reduced to 5 percent for the single taxable year beginning in 2018 and increased to 12.5 percent for taxable years beginning in 2026. The add-back for certain credits is also eliminated for taxable years beginning in 2026. Each rate is increased by 1 percent for taxpayers that are members of an affiliated group that includes a bank or a securities dealer.
A corporation’s modified taxable income is the corporation’s taxable income, increased by certain “base erosion payments.” These “base erosion payments” include deductible payments or payments for depreciable property that the corporation makes to a foreign related party, but do not include payments that are subject to tax under sections 871 or 881 and on which the full amount of tax has been withheld under sections 1441 and 1442. There does not appear to be a similar exclusion for payments that are effectively connected income to the foreign recipient. Base erosion payments also do not include payments treated as costs of goods sold (unless paid to an inverted corporation) or payments for services if amount of the payments is based on the services cost method under section 482 and represents the total cost of the services without any markup. They also do not include payments for certain derivatives that the taxpayer marks-to-market.
The minimum tax is imposed on US corporations and on the income of foreign corporations that is effectively connected with the conduct of a US trade or business. Related parties are treated as a single person for purposes of determining certain aspects of the application of the minimum tax. In order for the minimum tax to apply, the corporation must:
- not be a regulated investment company, real estate investment trust or S corporation,
- have average annual gross receipts of at least $500 million for the three preceding taxable years, and
- be making base erosion payments that represent three percent or more of all of all of its deductions, excluding NOL deductions, the new foreign DRD, and the foreign-derived intangible income and GILTI deductions (or, for members of an affiliated group that includes a bank or securities dealer, this applicable threshold is decreased to two percent).
Additional Base Erosion Measures
In addition to the provisions described above, the Bill provides several additional anti-base erosion provisions.
Transfers of Intangibles
The Bill modifies the definition of intangible property under section 936(h)(3)(B) (which is relevant for purposes of sections 367(d) and 482) to include workforce in place, goodwill (both foreign and domestic), going concern value, and all other items of value not attributable to tangible property or services of an individual.
The Bill also proposes to clarify the authority of the IRS to specify what method must be used to value intangible property, including methods that value multiple, related intangibles in the aggregate. These determinations could impact outbound restructurings and transfer pricing methods.
Hybrid Transactions and Payments to and From Hybrid Entities
The Bill disqualifies deductions for interest and royalty payments made to a related party in a hybrid transaction or by or to a hybrid entity, if a deduction would otherwise be available in the US, but no income inclusion would be taken into account in a foreign country (or by a US shareholder as subpart F income). The provision also gives the IRS expansive power to promulgate regulations restricting similar transactions, including transactions involving conduit arrangements, foreign or domestic branches, and certain structured transactions, as well as payments only included in income at a preferential tax rate or excluded under a participation exemption.
Dividends from Inverted Corporations
The Bill excludes from qualified dividend income treatment dividends that are received from corporations that invert after the date the Bill is passed. As a result, such dividends are ineligible for preferential dividend rates in the case of non-corporate taxpayers.
Repeal of Fair Market Value Method of Interest Expense Apportionment
The Bill modifies the existing interest expense allocation regime in section 864(e) by allocating worldwide interest expense among members of an affiliated group based on the members’ adjusted tax bases in their assets, rather than the fair market value of such assets.
Miscellaneous Income Tax Provisions
Excise Tax Based on Investment Income of Private Colleges and Universities
Under the Bill, certain private colleges and universities are subject to a 1.4 percent excise tax on their net investment income. The Bill applies to “applicable educational institutions,” which are certain private colleges and universities that have at least 500 full-time tuition paying students (more than 50 percent of whom are located in the US) and own investment assets worth more than $500,000 per full-time student. For determining assets-per-student and net investment income, income includes amounts with respect to related institutions (those that control, or are controlled by, the institution or by one or more persons that control the intuition, or supported or supporting organizations). State colleges and universities are not subject to the excise tax. The Bill is effective for taxable years beginning after December 31, 2017.
Like-Kind Exchanges of Real Property
Current section 1031 provides taxpayers with nonrecognition treatment on the exchange of real estate, tangible personal property, and certain types of intangible property (other than goodwill) held for productive use in a trade or business or for investment for property of like kind that is also held for productive use in a trade or business or for investment. The Bill limits nonrecognition treatment to like-kind exchanges of real property. This Bill is effective for taxable years beginning after December 31, 2017, with grandfathered treatment for any deferred exchange where any property was disposed of or received by the taxpayer prior to December 31, 2017.
Modification of $1 Million Compensation Deduction Limitation
The Code currently prohibits public companies from deducting compensation in excess of $1 million paid to certain proxy officers, referred to as “covered employees.” “Covered employees” consist of the chief executive officer and the three highest paid executive officers, but the term does not include the chief financial officer. Current law also provides that payments that qualify as “performance-based compensation” will not be counted against the $1 million limitation. Most public companies seek to maximize deductibility by structuring at least a portion of their incentive compensation as “performance-based compensation.”
The Bill repeals the exception to the $1 million limitation for “performance-based compensation” for taxable years beginning after December 31, 2017. In addition, the Bill includes the chief financial officer as a “covered employee,” specifies (consistent with SEC rules) that “covered employees” include any person who served as chief executive officer or chief financial officer during any part of the taxable year, and provides that any individual who is a “covered employee” for any taxable year beginning after December 31, 2016 will remain a covered employee for all future years.
These changes to the $1 million compensation deduction limitation do not apply to any remuneration under a written binding contract which was in effect on November 2, 2017, and which was not modified after that date in any material respect. There is no requirement that the amount have been vested as of November 2, 2017. As a result of this grandfathering provision, to the extent that employees had a contractual right as of November 2, 2017 to receive performance awards upon vesting (such as through a performance share unit agreement), compensation realized upon vesting (or later exercise or settlement) will continue to qualify for the exception for performance-based compensation as long as the conditions to the exception are satisfied, including that a committee of two or more outside directors certify the relevant performance goals at the end of the performance period.
Finally, the Bill provides that tax exempt organizations are subject to a 21 percent excise tax on compensation paid to any of their five highest paid employees that exceeds $1 million and on severance in excess of three times the executive’s average compensation over the previous three years. Once an employee’s compensation is subject to this rule, such employee’s compensation remains subject to the rule for all future years, even if the employee is no longer one of the five highest compensated employees of the organization.
Creation of Qualified Equity Stock
In an effort to provide relief to employees of “eligible corporations,” the Bill provides that, if an employee makes an election, he or she may defer the tax owed on “qualified stock” that has been transferred to the employee, even if it is no longer subject to a substantial risk of forfeiture. Generally, subject to anti-abuse provisions, the taxes are deferred until the earlier of the first date such qualified stock becomes transferable and the date any of the corporation’s stock becomes readily tradeable on an established securities market. In no event, however, can the taxes be deferred to later than five years after the first date that the rights of the employee in such stock are transferable or are not subject to a substantial risk of forfeiture.
Under the Bill, “qualified stock” generally means stock received in connection with the exercise of an option or in settlement of a restricted stock unit (or RSU). “Qualified stock” excludes any stock that the employee may sell to the corporation or settle through the acceptance of cash from the corporation. “Eligible corporations” are corporations that (A) do not have stock readily tradeable on an established securities market and (B) have a written plan under which eighty percent of its “qualified” US employees are all granted either stock options or RSUs. “Qualified employees” are full-time employees who elect to be subject to the rule, excluding any individual who is or was a one percent owner at any time during the ten preceding calendar years, all current and former CEOs and CFOs and any individual who is or was one of the four most highly paid officers (as determined in accordance with the proxy disclosure rules) for any of the ten preceding calendar years. The qualified stock rules will apply to any stock attributable to options exercised, or RSUs settled, after December 31, 2017.
Energy Tax Credits
A number of provisions in the House Bill and the Senate Bill would have had a significant negative impact on the utility of both investment tax credits (“ITCs”) and energy production tax credits (“PTCs”) to spur renewable energy investment. The House Bill would have removed an inflation adjustment for PTCs that would have significantly reduced their value, and it modified the phase-out schedule for ITCs, the most significant change being the elimination of the permanent ITC for solar energy investment. The Senate Bill, while not including these provisions from the House Bill, contained two provisions that could have had a chilling effect on investments in renewable energy products. For one, the Senate Bill retained the corporate AMT, which would have affected many more corporate taxpayers given the lower overall corporate tax rates. Since the ITC cannot offset the corporate AMT, and the use of PTCs against the corporate AMT were subject to limitations, the retention of the corporate AMT may have reduced the utility of these credits. Second, and more significantly, the Senate Bill’s version of the base erosion and anti-abuse tax (“BEAT”), discussed above, acts as a minimum tax, which clawed back a portion of the benefit of ITCs and PTCs. Since a number of financial institutions are investors in renewable energy products, this restriction threatened future investment in renewable energy products.
As an overall matter, the Bill preserves the current renewable energy tax credit regime. The Bill does not include the changes proposed in the House Bill, and as discussed above, repeals the corporate AMT. The Bill also revises the BEAT calculation to preserve most of the benefit of ITCs and PTCs. The Bill measures a taxpayer’s tax liability (after reduction for credits), and then adds back 80 percent of the lesser of (i) a taxpayer’s available renewable energy ITCs and PTCs or (ii) the taxpayer’s BEAT liability without regard to this provision. If this stepped-up measure of tax liability is less than 10 percent of modified taxable income, the BEAT increases the taxpayer’s tax by the difference. By adding back the ITCs and PTCs to the tax liability for purposes of calculating the BEAT, the Bill preserves the some of the benefit of these credits by effectively preventing them from being clawed back by the BEAT minimum tax. The add-back for renewable energy ITCs and PTCs sunsets in 2026. Accordingly, while the Bill’s version of the BEAT will still have a negative impact on the utility of ITCs and PTCs, that impact will not be nearly as substantial as it can be for other credits, such as the foreign tax credit.
Special thanks to Devon Yamauchi for her contributions to this client publication.