A Further Discussion of the Business Provisions in the House Republicans’ Tax Bill
As previously discussed in our Alert dated November 3, 2017, the House Republicans released their comprehensive tax reform bill on November 2. At the present time, the House Ways and Means Committee is marking up this bill, for anticipated votes by the Committee this week and then by the full House prior to Thanksgiving.
The following is a more in-depth discussion of the bill’s business provisions.
Tax Rate Structure for Corporations. The corporate tax rate would be reduced to a flat 20%. Currently, corporate tax rates are graduated and start at 15%, with a maximum rate of 35%. Between $335,000 and $10 million of income, corporations effectively pay a flat 34% because the lower brackets are phased out. The 35% bracket currently applies at $10 million of taxable income.
Alternative Minimum Tax. The corporate alternative minimum tax (“AMT”) would be eliminated. Taxpayers that have AMT credit carryforwards will be able to use them against their regular tax liability and would also be able to claim a refundable credit equal to 50% of the remaining AMT credit carryforward in years beginning in 2019, 2020 and 2021 and the remainder in 2022.
Expensing of Capital Investments. Businesses would be allowed to immediately write off (expense) the cost of new investments in depreciable assets made after September 27, 2017 and before January 1, 2023. Property that is “first-used” by the taxpayer would qualify, so the property would no longer have to be new. Property used by a regulated public utility company or in a real property trade or business would not qualify, but see interest expense later.
Interest Expense. The deduction for net interest expense incurred by any business, regardless of form, would be subject to a disallowance of a deduction in excess of 30% of the business’s “adjusted taxable income.” Adjusted taxable income is the equivalent of EBIDTA and is computed without regard to business interest income and expense, net operating losses, depreciation, amortization and depletion. The amount of disallowed interest would be carried forward for five years. Exempt from these rules would be businesses with average gross receipts of $25 million or less, regulated public utility companies and real property trade or businesses. The rules would apply at the entity level for pass-through entities and special rules would apply to the pass-through entities’ unused interest limitation for the year. Internal Revenue Code (Code) Sec. 163(j), which limits certain interest deductions, would be repealed.
Net Operating Loss Rules. The net operating loss (“NOL”) deduction would be limited to 90% of taxable income (determined without regard to the NOL deduction). The 90% limitation is currently the limitation on AMT NOL usage and it will create a 2% of taxable income minimum tax on all corporations. Carrybacks of NOLs would no longer be allowed except for one-year carrybacks for small businesses and farms with casualty or disaster losses. The provision would apply to losses arising in years beginning after 2017. For year beginning in 2017, the current NOL carryback rules would apply but NOLs created from the increased expensing discussed above would not be available for carryback. NOLs arising in tax years beginning after 2017 that are carried forward would be increased by an interest factor.
Like-Kind Exchanges of Real Property. The like-kind exchange rules would only be available for real property. The rule would be effective for transfers after 2017 but a transition rule would apply to personal property transfers started but not completed by December 31, 2017.
Repeal of Other Business Expenses. The following business deductions would be repealed:
- The IRC Sec. 199 domestic production activity deduction (“DPAD”).
- The deduction for local lobbying expenses.
- The deduction for entertainment expenses other than business meals.
- The deduction for FDIC premiums would only be allowed for institutions with consolidated assets under $10 billion.
Income Exclusion for Contributions to Capital. The exemption from income for contributions to the capital of a corporation would be repealed. For instance, amounts paid to a company to entice it to locate in a jurisdiction would now be taxable. Similar rules would apply to other business entities.
Gain Rollover to Special Small Business Investment Companies (“SSBIC”). The rollover of capital gain on publically traded securities into an SSBIC would no longer be allowed.
Self-Created Intangibles. The gain or loss from the disposition of a self-created patent, invention, model or design (whether or not patented), or secret formula or process would be ordinary in character. This would be consistent with the treatment of copyrights under current law. In addition, the election to treat musical compositions and copyrights in musical works as a capital asset would be repealed.
Sale of Exchange of a Patent. The special rule treating the transfer of a patent prior to its commercial exploitation as long-term capital gain would be repealed.
“Technical Termination” of Partnerships. The technical termination rule would be repealed. Accordingly, a partnership would be treated as continuing even if more than 50% of the total capital and profits interests of the partnership are sold or exchanged, and new elections would not be required or permitted.
Accounting Simplification for Small Businesses. For certain businesses with less than $25 million in average annual gross receipts, the following accounting simplifications would apply:
- Cash Method of Accounting. C corporations and partnerships with C corporation partners would be able to use the cash method of accounting. Currently, the gross receipts limitation is $5 million. The new threshold would be indexed for inflation.
- Accounting for Inventories. Businesses would be able to use the cash method of accounting even though it had inventory. The business would have to treat the inventory as a non-incidental material or supply.
- Capitalization and Inclusion of Certain Expenses in Inventory Costs. Businesses would be fully exempt from the UNICAP rules for real and personal property, acquired or manufactured.
- Long-Term Contract Accounting. Businesses that meet the threshold would be able to use a non-percentage of completion method including the completed contract method.
Business Credits. The research and development (“R&D”) and low-income housing credits would remain. The following credits would be repealed: orphan drug credit, employer-provided child care credit, rehabilitation credit, work opportunity work credit, new markets tax credit and disabled access credit. The deduction for unused credits would be repealed.
Employer Credit for Social Security Taxes Paid with Respect to Tips. This credit would be modified to reflect the current minimum wage so that it is available with regard to tips reported only above the current minimum wage. Additional reporting requirements would also be required.
- Production Tax Credit. The inflation adjustment would be repealed, effective for electricity and refined coal produced at a facility the construction of which begins after November 2, 2017. Accordingly, the credit amount would revert to 1.5 cents per kilowatt-hour for the remaining portion of the ten-year period.
- Investment Tax Credit (ITC). The expiration dates and phase-out schedules for different properties would be synchronized. The 30% ITC for solar energy, fiber-optic solar energy, qualified fuel cell, and qualified small wind energy property would be available for property when the construction begins before 2020 and is then phased out for property when the construction begins before 2022. No ITC would be available for property when the construction begins after 2021. Additionally, the 10% ITC for qualified microturbine, combined heat and power system and thermal energy property would be available for property when the construction begins before 2022. Finally, the permanent 10% ITC available for solar energy and geothermal energy property would be eliminated for property when the construction begins after 2027.
- Residential Energy Efficient Property. The credit for residential energy efficient property would be extended for all qualified property placed in service prior to 2022, subject to a reduced rate of 26% for property placed in service during 2020 and 22% for property placed in service during 2021. The provision would be effective for property placed in service after 2016.
- The enhanced oil recovery credit and the credit for producing oil and gas from marginal wells would be repealed.
- Modification of the Limitation of Excessive Executive Compensation. The exception to the $1 million deduction limitation for performance-based compensation would be repealed. The definition of covered employee would also be amended to include the CEO, CFO and the three other highest paid employees. Additionally, once an employee qualifies as a covered employee, his/her compensation would be subject to the $1 million limitation as long as the executive (or beneficiary) receives compensation from the company.
- Nonqualified Deferred Compensation. An employee would be taxed on compensation as soon as there is no substantial risk of forfeiture (i.e., the compensation is not subject to future performance of substantial services). A condition would not be treated as constituting a substantial risk of forfeiture solely because it consists of a covenant not to compete or because the condition relates (nominally or otherwise) to a purpose of the compensation other than the future performance of services – regardless of whether such condition is intended to advance a purpose of the compensation or is solely intended to defer taxation of the compensation. The provision would be effective for amounts attributable to services performed after 2017. For existing non-qualified deferred compensation plans, the current-law rules would continue to apply until the last tax year beginning before 2026. At that time, the arrangements would become subject to the provision.
- Excise Tax on Excess Tax-Exempt Organization Executive Compensation. The bill proposes a 20% excise tax on compensation in excess of $1 million paid to a tax-exempt organization’s five highest-paid executives. The provision would apply to all remuneration paid to such executives, including cash and the cash value of all remuneration (including benefits) paid in a medium other than cash, and excluding payments to a tax-qualified retirement plan and amounts otherwise excludable from the executive’s gross income. The excise tax also would apply to “excess parachute payments” by the organization to such individuals. An excess parachute payment generally would include a payment contingent on the executive’s separation from employment with an aggregate present value of three times the executive’s base compensation or more. The provision would be effective for tax years beginning after 2017.
Establishment of Participation Exemption System for Taxation of Foreign Income
Deduction for Foreign-Source Portion of Dividends Received by Domestic Corporations for Specified 10%- Owned Foreign Corporations. By way of background, U.S. corporations with foreign subsidiaries are currently taxed in the U.S. on their foreign subsidiaries’ earnings generally when such earnings are distributed back to the U.S. There is also a foreign tax credit regime in place to help alleviate double taxation. The proposed legislation is proposing significant changes to the current U.S. tax paradigms for income earned outside the U.S. For example, the proposal would create a dividend-exemption system commonly referred to as a participation exemption. Under this system, 100% of the foreign-source portion of dividends paid by a foreign corporation to a U.S. corporate shareholder that owns 10% or more of the foreign corporation would be exempt from U.S. taxation. In tandem, no foreign tax credit or deduction would be allowed for any foreign taxes paid or accrued with respect to any exempt dividend under this system. The proposed participation exemption system would be established and in effect for tax years after 2017.
Application of Participation Exemption to Investments in United States Property. In addition, current tax law under IRC Sec. 956 generally results in a taxable deemed dividend in the U.S. (without actual cash repatriation) in situations where foreign subsidiaries invest undistributed earnings and profits (“E&P”) in U.S. property. The proposed bill generally repeals the provisions provided under IRC Sec. 956.
Limitation on Losses with Respect to Specified 10%-Owned Foreign Corporations. The proposed legislation intends to impact gain that is recognized by a U.S. parent when it sells or exchanges stock of a foreign subsidiary. As the law currently stands, the result of such a transaction is treated as a dividend distribution by the foreign subsidiary to the extent of E&P. Any gain in excess of such normally constitutes capital gain for the U.S. parent. Under the proposal, a U.S. parent would be required to reduce its basis in the foreign subsidiary’s stock by the amount of any exempt dividends paid to the U.S. parent – only for calculating a loss (not gain) on any sale or exchange of the foreign stock by its U.S. parent. If passed, this rule would be effective for distributions subsequent to 2017.
Treatment of Deferred Foreign Income upon Transition to Participation Exemption System of Taxation. Further, the Bill proposes U.S. shareholders owning at least 10% of a foreign subsidiary would be taxed on its proportionate share of its subsidiary’s last tax year beginning before 2018 on all E&P post-1986 that has not been subject to U.S. tax (there are proposed rules for determining E&P for this purpose). E&P in this context is comprised of cash or cash equivalents that would be taxed at a reduced rate of 12%, while any remaining (illiquid) E&P would be taxed at a rate of 5%. There are provisions in the bill to elect to pay this particular tax liability over eight years (in equal installments of 12.5% of the liability paid per annum). There are also proposed foreign tax credit rules accompanying these proposed changes.
Modifications Related to Foreign Tax Credit System
Repeal of IRC Sec. 902 Indirect Foreign Tax Credits; Determination of IRC Sec. 960 Credit on Current Year Basis. The bill would modify current rules pertaining to the foreign tax credit whereby no foreign tax credit or deduction would be allowed for any taxes (including withholding taxes) paid or accrued with respect to any dividend which fell under the purview of the proposed participation exemption mentioned above. A foreign tax credit would be allowed for any subpart F income includible in the income of a U.S. shareholder on a current year basis. This provision would be effective for tax years of foreign corporations beginning after 2017 and for tax years of U.S. shareholders in which or with which such tax years of foreign subsidiaries end.
Repeal of Sources of Income from Sales of Inventory Determined Solely on Basis of Production Activities. Changes are proposed for inventory sourcing for foreign tax credit purposes. Per current rules, a maximum of 50% of the income derived from the sale of inventory property that is produced in the U.S. and sold outside of the U.S. (or vice versa) may be treated as foreign-source income. Under the bill, the income would be allocated an apportioned between domestic and foreign sources solely based on the production activities with respect to the inventory.
Modifications of Subpart F Provisions
Repeal of Inclusion Based on Withdrawal of Previously Excluded Subpart F Income from Qualified Investment. Foreign shipping operations would also potentially be impacted in the context of subpart F. The law in this area has fluctuated historically. Foreign shipping income earned between 1976 and 1986 was not subject to subpart F inclusion. Since then, such income is subject to subpart F inclusion in a subsequent year to the extent there is a net decrease in qualified shipping investments during that subsequent year. This rule would be eliminated under the proposed legislation and would be effective for tax years of foreign corporations beginning after 2017 and for tax years of U.S. shareholders in which or with which such tax years of foreign subsidiaries end.
Repeal of Treatment of Foreign Base Company Oil Related Income as Subpart F Income. The current oil and gas rules would also be impacted. Currently, certain foreign oil-related income (“foreign base company oil related income”) of a foreign subsidiary of a U.S. parent is subject to current U.S. tax under subpart F regardless of whether the foreign subsidiary distributes such income to the U.S. parent. Under the proposal, the imposition of current U.S. tax on foreign base company oil related income would be repealed. The provision would be effective for tax years of foreign corporations beginning after 2017 and for tax years of U.S. shareholders in which or with which such tax years of foreign subsidiaries end.
Inflation Adjustment of De Minimis Exception for Foreign-Based Company Income. The existing de minimis subpart F inclusion rule states that if the gross amount of such income is less than the lesser of 5% of the foreign subsidiary’s gross income, or $1 million, then the U.S. parent is not subject to current U.S. tax on any of the income. Historically, the $1 million threshold was not adjusted for inflation, however, under the proposal, the $1 million threshold would be adjusted for inflation. The provision would be effective for tax years of foreign corporations beginning after 2017 and for tax years of U.S. shareholders in which or with which such tax years of foreign subsidiaries end.
Look-Through Rule for Related Controlled Foreign Corporation (“CFC”) Made Permanent. The proposal provides that the existing look-through rules for related CFCs would be made permanent under IRC Sec. 954(c)(6). Generally, a U.S. parent of a foreign subsidiary is subject to current U.S. tax on certain passive income (e.g., dividends, interest, royalties, rents) earned by the foreign subsidiary, regardless of whether the foreign subsidiary distributes such income to the U.S. parent. However, for certain taxable years, special look-through rules provide that passive income received by one foreign subsidiary from a related foreign subsidiary generally is not includible in the taxable income of the U.S. parent, provided such income was not subject to current U.S. tax or effectively connected with a U.S. trade or business. Under the proposal, the look-through rule would be made permanent in coordination with prescribed transition rules.
Modification of Stock Attribution Rules for Determining Status as a Controlled Foreign Corporation. There are proposed adjustments modifying the stock attribution rules for determining CFC status. Generally, a U.S. parent of a controlled foreign corporation is subject to current U.S. tax on its pro rata share of the CFC’s subpart F income. A subsidiary is deemed a CFC if it is more than 50%-owned by one or more U.S. persons (with each owning at least 10% of the subsidiary). Under current rules, a U.S. person is constructively the owner of shares owned by related persons, affiliates and shareholders, but a U.S. corporation generally cannot be treated as constructively owning stock held by its foreign shareholder(s). Per the proposal, a U.S. corporation would be treated as constructively owning stock of its foreign shareholder.
Elimination of Requirement that Corporation Must Be Controlled for 30 Days Before Subpart F Inclusions Apply. The proposed bill would eliminate the current rule whereby a U.S. parent of a CFC is subject to the subpart F regime if it owns stock of a foreign subsidiary for an uninterrupted period of 30 days or more during the year.
Prevention of Base Erosion
Current Year Inclusion by United States Shareholders with Foreign High Returns. The bill provides for modifications focused on limiting base erosion by requiring a current year inclusion for “foreign high returns.” The provision calls for current U.S. tax on 50% of the U.S. parent’s foreign high returns, defined as aggregate income of foreign subsidiaries that exceeds a routine return of 7% plus the federal short-term “applicable federal rate” (“AFR”) on the subsidiaries’ aggregate bases in depreciable tangible property, adjusted downward for interest expense. Notably, foreign high returns exclude “effectively connected income” (“ECI”), subpart F income, insurance and financing income that satisfied the “active financing exemption” under subpart F and income from the disposition of commodities produced or extracted by the taxpayer or certain related-party payments. The U.S. parent would be taxed on foreign high returns each year, regardless of whether or not earnings were repatriated. Foreign tax credits allowed for foreign taxes paid with respect to foreign high returns would be limited to 80% of the foreign taxes paid, would not be allowed against U.S. tax imposed on other foreign-source income and would not be allowed to be carried back or forward.
Limitation on Deduction of Interest by Domestic Corporations Which Are Members of an International Financial Reporting Group. The bill proposes additional limitations on the ability of U.S. corporations to deduct interest expense. U.S. corporations can erode the U.S. tax base by deducting arms-length interest paid on related-party debt without paying U.S. tax on the corresponding interest income until it is distributed back to the U.S. A provision under the bill would limit interest deductions of U.S. corporations that are members of an international group with receipts of more than $100 million to the extent the U.S. corporation’s share of global net interest expense exceeds 110% of its share of the group’s global EBITDA. Any disallowed interest expense would be carried forward for up to five tax years, with the carryforward utilized on a first in, first out basis. For purposes of this provision, an international financial reporting group is a group of entities that includes at least one foreign corporation engaged in a trade or business in the U.S. or at least one domestic corporation and one foreign corporation, prepares consolidated financial statements, and has annual global receipts over $100 million.
Excise Tax on Certain Payments from Domestic Corporations to Related Foreign Corporations; Election To Treat Such Payments as Effectively Connected Income. The proposal contemplates excise taxes on certain payments from domestic corporations to related foreign corporations, unless the foreign corporation elects to treat such payments as effectively connected income. The provision would apply only to international financial reporting groups with payments from U.S. corporations to their foreign affiliates totaling at least $100 million annually. Currently, foreign corporations are generally subject to U.S. tax only on U.S.-source “FDAP” and ECI income. Multinational companies, and particularly foreign-parented multinationals, can erode the U.S. tax base by shifting outside the U.S. their foreign affiliates’ profits associated with functions, assets and risks located outside of the U.S. (consistent with current transfer pricing rules), avoiding U.S. tax on the foreign affiliates’ foreign profits. Under the proposal, payments (other than interest) made by a U.S. corporation to a related foreign corporation that are deductible, includible in costs of goods sold, or includible in the basis of a depreciable or amortizable asset, would be subject to a 20% excise tax – unless the related foreign corporation elected to treat the payments as ECI. As a result, the foreign corporation’s net profits (or gross receipts if no election is made) with respect to those payments would be subject to full U.S. tax, effectively eliminating any potential U.S. tax benefit otherwise achieved. Exceptions would apply for intercompany services which a U.S. company elects to pay for at cost (i.e., no markup) and certain commodities transactions. To determine the net taxable income that is to be deemed ECI, the foreign corporation’s deductions attributable to these payments would be determined by reference to the profit margins reported on the group’s consolidated financial statements for the relevant product line. No credit would be allowed for foreign taxes paid with respect to the profits subject to U.S. tax. Further, in the event no election is made, no deduction would be allowed for the U.S. corporation’s excise tax liability.
Provisions Related to Possessions of the U.S.
Extension of Deduction Allowable with Respect to Income Attributable to Domestic Production Activities in Puerto Rico. The proposal provides that eligibility of domestic gross receipts from Puerto Rico for the domestic production deduction would apply retroactively to tax years beginning after December 31, 2016 and before January 1, 2018.
Extension of Temporary Increase in Limit on Cover-Over of Rum Excise Taxes to Puerto Rico and the Virgin Islands. The proposal provides that the $13.25 per proof gallon excise tax cover-over amount paid to the treasuries of Puerto Rico and the U.S. Virgin Islands would apply retroactively to include imports after December 31, 2016, and be extended to rum imported into the United States before January 1, 2023.
Extension of American Samoa Economic Development Credit. The proposal provides that the credit for taxpayers currently operating in American Samoa would retroactively apply to tax years beginning after December 31, 2016 and be extended to tax years beginning before January 1, 2023.
Other International Provisions
Restriction on Insurance Business Exception to Passive Foreign Investment Company Rules. Current rules regarding captive foreign insurance companies are also subject to change. The bill proposes to amend the passive foreign investment company (“PFIC”) rules as applied to insurance companies. Under current law, U.S. shareholders of PFICs are taxed currently on a PFIC’s earnings, but there is an exception for PFIC income that is derived in the active conduct of an insurance business if the PFIC is predominantly engaged in an insurance business and would be taxed as an insurance company were it a U.S. corporation. The bill would alter the PFIC exception in that it would apply only if the foreign corporation would be taxed as an insurance company were it a U.S. corporation and if loss and loss adjustment, unearned premiums, and certain reserves constitute more than 25% of the foreign corporation’s total assets (or 10% if the corporation is predominantly engaged in an insurance business and the reason for the percentage falling below 25 is solely due to temporary circumstances).
As noted above, during the week of November 6, the House Ways and Means Committee is marking up the House Republicans’ tax reform bill as originally drafted. This mark-up will result in changes to the provisions as described above. EisnerAmper will apprise you of the significant changes once the Ways and Means Committee has completed its work.