Prepared by Robert M. Gordon, Managing Director and Lauren Ansley, Senior Manager
On November 2, 2017, House Ways & Means Committee Chair Kevin Brady (R-TX) introduced the legislative language of H.R. 1, the “Tax Cuts and Jobs Act” (the “Bill”). This much-anticipated bill outlines the House Republicans’ plan for tax reform, including broad changes to the current tax code for both international and domestic businesses and individuals. The Bill attempts to implement the principles set forth in the “Unified Framework for Fixing Our Broken Tax Code” (the “Framework”) which was released in late September 2017. See the True Alert discussing this Framework here.
Unless otherwise indicated in this Alert, the proposed changes in the Bill would take effect for tax years beginning after December 31, 2017.
TAXATION OF BUSINESSES
As proposed in the Framework, the Bill provides for a reduced, flat corporate tax rate of 20 percent. This reduced rate is designed to further drive American businesses to invest in United States operations, and to make America more competitive in the increasingly global business landscape. Income of personal service corporations will be subject to tax at a 25 percent rate.
A portion of the net income of pass-through entities (partnerships, S corporations, etc.) would be treated as “qualified business income” subject to a maximum 25-percent rate. In general, the income from passive activities (determined under current rules regarding material participation in Code section 469) will be treated entirely as qualified business income eligible for the 25 percent rate. On the other hand, income derived from active (i.e., non-passive) business activity would be split between wages and ownership income using one of two options: (i) classifying 70 percent of income as wage income and 30 percent as business income, or (ii) using a formula to determine a capital percentage of more than 30 percent based on rate of return multiplied by the capital investments of the business. The second option (which would be advantageous for capital-intensive businesses) would be binding for five years. Certain personal services businesses (including law and accounting firms, health care companies, engineering and architecture firms, and financial services companies) generally cannot benefit from the 25 percent rate for pass-throughs.
The Bill allows companies that acquire and place into service qualified property after September 27, 2017 and before January 1, 2023 to fully expense the cost of such property in the year it is placed in service. In contrast to the current rules, the proposed bill would not require that the purchaser be the first to use such property, allowing purchases of previously-owned qualified property to be eligible for the additional depreciation. The Bill also enhances deductions for small businesses under Code section 179 by increasing the expensing limitation from $500,000 annually to $5 million. The increase in the annual Code section 179 limitation would only apply to property purchased and placed in service after September 27, 2017 and before January 1, 2023.
Limitation on Business Interest Deductions
The Bill would replace the current limitations on interest expense deductions for certain loans from foreign affiliates (Code section 163(j)) by expanding limitations to all indebtedness. The Bill contains two main limitations on interest deductions:
Other Small Business Initiatives
In addition to the increased Code section 179 expensing described above, the Bill proposes a number of other initiatives aimed at small businesses. In general, small businesses (both corporations and partnerships) with annual gross receipts of less than $25 million would be eligible for the following accounting treatments for tax purposes:
Alternative Minimum Tax
The Bill proposes to repeal both the corporate and individual AMT systems, while providing a mechanism to using existing AMT credits going forward. Generally, the credit for previously paid AMT taxes is limited to the balance of the federal income tax liability; but for tax years beginning in 2019, 2020, 2021, or 2022, the limitation on such credit would be increased by the amount of the “AMT refundable credit” for each year. This refundable amount would equal 50 percent of the excess credits available (above the current year’s tax liability) for tax years 2019 through 2021. In 2022, the entirety of the remaining AMT credits that exceed the regular tax liability would be considered refundable.
Other Notable Changes
The Bill provides for a number of other revisions to the current business tax system, including, but not limited to, the following items:
In addition, there are a number of changes for the energy and insurance industries, tax-exempt bonds, and compensation.
One of the most sweeping aspects of the Bill centers around the treatment of foreign income and foreign persons in the U.S. Currently, U.S. residents are taxed on their worldwide income, although foreign income earned by a controlled foreign corporation is generally deferred until such income is distributed to the U.S. shareholder. In addition, foreign tax credits both directly and indirectly paid by the U.S. shareholder are generally available to offset the U.S. federal income taxes associated with foreign-source income. The Bill changes a number of these tenets, moving the United States to a modified territorial taxation system.
The Bill provides for a deduction for dividends received from a foreign corporation by its U.S. corporate shareholder that owns more than 10 percent of the foreign corporation. Foreign tax credits associated with the income being distributed in the dividend (both directly and indirectly paid taxes) would not be allowed to offset U.S. federal income taxes. In addition, the current law related to deemed distributions of earnings from a foreign subsidiary that are related to investment in United States property (i.e., Code section 956 deemed dividends) would be repealed. Unlike a typical participation exemption system, however, gain from the sale of a foreign corporation will still be subject to U.S. tax.
The Bill provides that U.S. shareholders owning more than 10 percent of foreign subsidiaries would include in their income the pro-rata portion of the post-1986 earnings and profits (“E&P”) of the foreign subsidiary to the extent such earnings have not been previously subject to tax in the U.S. The E&P would be calculated by netting the owner’s pro-rata share of surpluses and deficits of all foreign subsidiaries that meet the ownership requirements. The net E&P of the foreign subsidiaries would be classified into two groups: (i) E&P associated with cash or cash equivalents or (ii) E&P that is invested in the foreign subsidiary’s business. The E&P in the first group would be taxed at a rate of 12 percent, while the E&P in the second category would be subject to tax of only 5 percent. The liability associated with tax would be payable ratably over a period of up to 8 years.
Foreign Tax Credits
As mentioned above, foreign tax credits (including those for withholding taxes) associated with income that is exempt from taxation under the participation exemption would not be allowed to offset U.S. federal income tax. But foreign tax credits would still generally be available to offset Subpart F income. These credits would be calculated on a current year basis, without regard to pools of earnings in the foreign subsidiary.
The Bill makes a number of changes to subpart F income and its taxation in the United States. These changes include, but are not limited to, the following:
Recognizing that a shift to a modified territorial system could lead to increased base erosion, the Bill subjects the U.S. parent of one or more foreign subsidiaries to a minimum tax on 50 percent of the foreign subsidiaries’ “high returns.” Foreign high returns would be present if the aggregate net income of all foreign subsidiaries exceeds a routine return (7 percent plus the Federal short term rate) on the foreign subsidiaries’ aggregate tax bases in depreciable tangible property (adjusted for interest expense). This income would not include income effectively connected with a U.S. trade or business, subpart F income, or other items that would already be subject to U.S. federal income taxation. A foreign tax credit would be allowed to offset this minimum tax, but the credit would be (i) limited to 80 percent of the foreign taxes paid, (ii) not allowable to offset U.S. federal income taxes associated with other foreign sourced income, and (iii) not available as a carryforward or carryback to other tax years.
The Bill also includes an excise tax on certain payments made by U.S. corporations to related foreign corporations if those payments total more than $100 million annually. These payment types (other than interest expense) are items that would be deductible, includible in costs of goods sold, or included in the basis of a depreciable or amortizable asset. These payments would be subject to a 20 percent excise tax unless the foreign subsidiary elects to treat them as effectively connected income associated with the conduct of a U.S. trade or business. This provision would apply only to international financial reporting groups (defined previously).
The Bill would reduce the current seven tax bracket structure to four:
Deductions and Exemptions
The Bill nearly doubles the standard deduction for all taxpayers: Single filers would receive a standard deduction of $12,000 while married filers that file a joint tax return would receive a standard deduction of $24,000. These standard deductions would be adjusted based on inflation. On the other hand, the Bill repeals all personal exemptions.
In addition to these changes to the standard deduction and personal exemptions, there are a number of significant changes or repeals related to deductions available to individual filers. The following deductions or limitations would be repealed under the Bill:
The Bill also provides for changes to a number of the most popular itemized deductions:
Mortgage interest deduction: Interest on indebtedness incurred to acquire a principal residence after November 2, 2017, would be deductible only for mortgages not exceeding $500,000 (reduced from $1 million under current law). The Bill repeals the deduction for mortgage interest expense on a second home.
Charitable contributions deduction:Currently, charitable contributions may be deducted up to 50 percent of the contributor’s AGI. Under the Bill, this limitation would be increased to 60 percent.
Property tax deduction:The Bill allows individuals to deduct up to $10,000 for real property taxes.
The Bill also includes provisions for updating the treatment of tax credits for individuals. A number of the more popular credits would be adjusted as follows:
Child Tax Credit: This credit would be increased from $1,000 to $1,600, and a temporary $300 credit would also be allowed for non-child dependents for tax years ending before January 1, 2023.
Adoption Tax Credit: This tax credit would be repealed.
Education Tax Credits: The tax credits allowed for qualified education expenses would be simplified.
Estate and Generation-Skipping Transfer Taxes
The Bill as written repeals both the estate and generation-skipping transfer taxes beginning after 2023. In the interim, the exclusion amount for such taxes would be doubled from the current $5 million to $10 million. The Bill retains the stepped-up basis in estate property even after the taxes are repealed. Gifts would continue to be taxed at a top rate of 35 percent, with an exclusion amount of $10 million and an annual exclusion of $14,000, as indexed for inflation.
WHAT HAPPENS NEXT?
Both the Administration and Republican legislative leaders are aiming to complete a tax bill before the end of 2017. This is an extremely aggressive schedule, given that legislators from both parties have expressed significant concerns about various provisions of the House Bill (and the Senate has yet to reveal its bill—although that is expected within the next couple of weeks). In addition, Congress will be conducting business for only a limited number of days for the rest of the year. On the other hand, because Congress has passes a budget reconciliation bill, the Senate needs only a simple majority (as opposed to a 60 vote supermajority) to pass legislation.
WHAT SHOULD YOU DO?
The reforms proposed in the Bill are very significant and will impact every U.S. taxpayer. In addition, the Bill contains other specific proposals that we have not discussed in detail. You should therefore study the proposed changes and closely follow the progress of the legislation through the House and Senate. Needless to say, companies should start planning now for the changes that affect them.
HOW TRUE PARTNERS CAN HELP
True Partners Consulting’s corporate and international tax teams offer a combination of highly experienced tax advisors and an approach that puts our clients at a competitive advantage. We are prepared to work closely with clients to identify opportunities and to develop successful strategies to avoid the inevitable pitfalls that come with a once-in-a-generation tax reform package.
John V. Aksak
Northeast Managing Director
John P. Bennecke
Robert M. Gordon
Managing Director &
Assistant General Counsel
Ross J. Valenza