Senate Committee on Finance Reveals Tax Reform Bill
On November 9, 2017, the Senate Committee on Finance revealed its version of the tax reform plan (the “Senate Bill”) in response to the previously-released House tax reform bill (the “House Bill”). While the Senate Bill also includes tax rate reductions for most individuals and businesses, it diverges from the House Bill on a number of issues, which will require negotiations between the two houses of Congress in the coming weeks. The markup for this Senate Bill is expected to begin on Monday, November 13, 2017. See the True Alert discussing the House Bill here.
Unless otherwise indicated in this Alert, the proposed changes in the Senate Bill would take effect for tax years beginning after December 31, 2017.
TAXATION OF BUSINESSES
As proposed in the House Bill, the Senate Bill provides for a reduced, flat corporate tax rate of 20 percent for taxable years beginning after December 31, 2018. However, the Senate Bill notably omits the increased tax rate for personal service corporations, which would thus be eligible for the lower 20 percent rate.
Dividends Received Deduction
The Senate Bill proposes a reduction in the dividends received deduction (“DRD”). This proposal is a departure from the suggested changes in the House Bill. Dividends received from the following transactions would be altered as described below:
- Dividends received from taxable domestic corporations: The DRD percentage would be reduced from 70 percent to 50 percent; and
- Dividends received from an 20-percent-owned corporation: The DRD percentage would be reduced from 80 percent to 65 percent.
This proposal would take effect for tax years beginning after December 31, 2018.
Instead of providing for a reduced income tax rate on income earned by an individual through the use of a pass-through entity as in the House Bill, the Senate Bill provides for a deduction of a 17.4 percent of “qualified business income.” This deduction would not be available for service providers involving health, law, engineering, accounting, actuarial science, performing arts, consulting, athletics, financial, brokerage, or other service industries. In addition, the deduction would be limited to 50 percent of the W-2 wages earned by the taxpayer.
Qualified business income earned from pass-through entities in the business of providing services would be similarly deductible, although this deduction would be phased out for some taxpayers. The phase out of this deduction would come into effect for individuals with taxable income over $75,000, and married couples with taxable income over $150,000.
Certain types of income earned from pass-through entities would not be considered qualified business income for the purposes of calculating the deduction mentioned above. These excluded items include, but are not limited to, investment-related income, gain, deductions, or loss.
In addition, the Senate Bill proposes certain new requirements in order to determine the source of the gain or loss and the taxation of a purchaser upon the sale of a partnership interest. The source of the gain or loss from the sale or exchange of partnership interest would be determined by looking through to a deemed sale of partnership assets. In addition, the transferee of a partnership interest would be required to withhold 10 percent of the amount realized on the sale or exchange of such interest if they cannot certify that the transferor is not a nonresident alien individual or a foreign corporation.
Alternative Minimum Tax
The Senate Bill includes a repeal of the alternative minimum tax (“AMT”) system for both individual and corporate taxpayers. This repeal, as in the House Bill, would allow use of credits for previously-paid AMT liabilities, and a portion of the credits that exceed the regular tax liability in tax years 2018 through 2021 would be considered refundable.
Small Business Proposals
The Senate Bill sets forth a number of proposals for small businesses. These items include changes also proposed by the House Bill, and they include, but are not limited to:
- Increased Code section 179 limitation to $1 million and amended definition of “qualified property”;
- Increased threshold for the gross receipts test to use the cash method of accounting;
- Exemption from inventory accounting for certain small businesses;
- Exemption from uniform capitalization (“UNICAP”) rules for certain small businesses; and
- Increased threshold for the gross receipts test for the requirement to use the percentage-of-completion method.
If a change in accounting method occurs as a result of the adoption of the proposed items above, a Code section 481 adjustment would apply in the year of the change.
One of the most notable proposals in the House Bill is also included in the Senate Bill: bonus depreciation would be modified temporarily to allow for 100 percent depreciation of qualified property placed in service after September 27, 2017, and before January 1, 2023.
The Senate Bill includes additional provisions related to depreciation of farm property, depreciable lives for nonresidential real and residential rental property, and depreciation rules for leasehold improvements. The addition of these incentives illustrates the Senate’s focus on continuing investment in American businesses.
Other Notable Changes
The Senate Bill, similar to the House Bill, provides for a number of other revisions to the current business tax system, including, but not limited to, the following items:
- Excess business losses incurred by a taxpayer other than a corporation would be carried forward as part of the net operating loss carryovers.
- Net operating loss carryovers would be allowed to offset only 90 percent of taxable income, and the carryback period would be repealed.
- Interest expense deduction would be limited to 30 percent of earnings before interest and taxes for both corporations and partnerships with average gross receipts over $15 million in the previous three tax years.
- The application of like-kind exchange treatment is limited to transactions involving only real property that is not primarily held for sale.
- The deduction for the following items would be repealed:
- Code section 199 domestic production activities;
- Any activity related to entertainment, amusement, or recreation;
- Membership dues for clubs organized for business, pleasure, recreation or other social purposes; and
- Expenses associated with providing food or beverages to employees in a facility that reaches the threshold of a fringe benefit would be limited to a 50 percent deduction.
The Senate Bill also provides a number of changes to accounting methods (including those for revenue recognition for federal income tax purposes), to certain laws related to the taxation of banks and certain financial instruments, deferred compensation recognition rules, and insurance company taxation.
The international tax reform proposal in the Senate Bill closely resembles the plan set forth in the House Bill. The plan consists of a participation exemption structure, with 100 percent of the foreign-sourced dividends being deducted from a U.S. corporation’s federal taxable income if it owns more than 10 percent of the distributing foreign corporation. Foreign tax credits would not be allowed under the Senate Bill to the extent they are paid or accrued with respect to a dividend that qualifies for the participation exemption.
On the other hand, the Senate Bill includes a number of provisions that were not part of the House Bill. First, the Senate Bill specifically excludes from the participation exemption dividends that are considered “hybrid”: a distribution for which the foreign corporation received a deduction for foreign income tax purposes.
In addition, the Senate Bill requires the U.S. shareholder to meet certain holding period requirements in order to utilize the participation exemption on dividends from foreign corporations. In order to utilize the exemption, the U.S. shareholder must own more than 10 percent of the foreign corporation for more than 365 days of a 731-day period beginning 365 days before the ex-dividend date with respect to the excluded dividend.
Tax on Deemed Repatriation
Unlike the House Bill, the Senate Bill does not apply a flat tax rate to the amount of undistributed, untaxed accumulated earnings of controlled foreign corporations. Instead, it achieves a lower effective tax rate on these accumulated foreign earnings by providing a deduction for a portion of pre-effective-date earnings. A deduction would be allowed for so much of the aggregate earnings and profits as necessary to result in a tax rate of 10 percent for liquid assets and 5 percent for illiquid assets.
A foreign tax credit would also be allowed to offset the U.S. federal income taxes associated with the previously-deferred foreign earnings. However, this credit would be reduced by a portion corresponding to the amount of deduction allowed (as discussed above).
The tax liability associated with the deemed repatriation tax would be payable in installments if the U.S. shareholder so elects. The installments could be paid over eight years, with the proportion of tax increasing from 8 percent in the first five years to 15 percent, 20 percent, and 25 percent in the following three years.
Intangible Low-Taxed Income
The international tax reform portion of the Senate Bill also includes a provision for the taxation of “global intangible low-taxed income” (“GILTI”) by U.S. shareholders. This is intended to provide for current U.S. taxation of a controlled foreign corporation’s earnings on intangibles if the return earned on such intangibles was in excess of returns earned on tangible assets. A limited foreign tax credit would be allowable to offset a portion of the taxes attributable to the GILTI inclusion.
Foreign Tax Credits
Similar to the House Bill, the Senate Bill makes changes to the foreign tax credit system in light of the transition to a territorial taxation system. Besides certain situations described in detail in the Senate Bill (i.e., deemed repatriation tax, GILTI inclusion, Subpart F income inclusion, etc.), deemed paid credits currently allowed under Code section 902 would no longer be allowed. In addition, the Senate Bill requires foreign branch income to be allocated to its own tax credit limitation basket.
Base Erosion and Profit Shifting
The Senate Bill includes additional measures to further prevent the erosion of the tax base in the United States. As in the House Bill, these measures have been deemed necessary in order to prevent multinational businesses from taking advantage of this new taxation regime in ways that are not intended.
The proposals in the Senate Bill related to base erosion include the following provisions:
- Additional limitation on the deduction of interest expense for U.S. shareholders when the global affiliated group has “excess domestic indebtedness”;
- Updated definition of intangible property for purposes of Code sections 367(d) and 482;
- Confirmation of authority of the Commissioner to determine the valuation method used to value intangibles transferred;
- Termination of special rules for domestic international sales corporations (DISCs); and
- Denial of deductions for interest expense or royalty expense transactions that are either (1) determined to be a “hybrid transaction” or (2) entered into with a hybrid entity.
In addition to these provisions, the Senate Bill also includes a “base erosion minimum tax” on certain corporate taxpayers with gross receipts that average at least $500 million for the three-year measurement period and that also meet a defined base-erosion test. Taxpayers that meet these requirements would pay a minimum tax equal to the excess of 10 percent of modified taxable income over the regular tax liability less certain tax credits. The taxpayer’s modified taxable income would be calculated without deductions allowed for certain payments to related parties.
On the other hand, the Senate Bill does not include the House Bill’s excise tax on payments to related foreign corporations.
Other International Provisions
The Senate Bill includes a number of other proposals related to taxation of foreign earnings. These proposals include, but are not limited to:
- Allowance of a deduction for foreign-derived intangible income;
- Rules related to distributions of intangible property from controlled foreign corporations to domestic shareholders;
- Adjustment to the de minimis exception to foreign base company income;
- Repeal of Code section 955 related to investment of previously excluded Subpart F income;
- Repeal of fair market value method of interest expense apportionment;
- Amendment of attribution rules to include attribution of ownership from a foreign entity to a U.S. related party; and
- The look-through rules under Code section 954(c)(6) made permanent.
The Senate Bill would retain the current seven tax bracket structure, but the rates and the related income ranges would be updated to the following structure beginning in tax year 2018:
|Tax Rates||Married Filing Jointly||Single/Other|
|10%||$0 – $19,050||$0 – $9,525|
|12%||$19,051 – 77,400||$9,526 – 38,700|
|22.5%||$77,401 – 120,000||$38,701 – 60,000|
|25%||$120,001 – 290,000||$60,001 – 170,000|
|32.5%||$290,001 – 390,000||$170,001 – 200,000|
|35%||$390,001 – 1,000,000||$200,001 – 500,000|
|38.5%||Over $1,000,000||Over $500,000|
In comparison to the House Bill, the individual tax rates proposed by the Senate Bill closely resemble those that are currently in force for the 2017 tax year, though the highest tax rate is reduced slightly. However, in an apparent effort to reduce the taxes of lower to middle class Americans, the income ranges for the four lowest tax rates have been widened. For instance, an individual with taxable income of $100,000 in both 2017 and 2018 would pay approximately $21,000 and $19,250 in federal income taxes, respectively. This difference of roughly $1,750 is a result of the changes to the income ranges and federal income tax rates proposed.
Deductions and Exemptions
As in the House Bill, the Senate Bill nearly doubles the standard deduction for all taxpayers: Single filers would receive a standard deduction of $12,000, while married filers filing jointly would receive a standard deduction of $24,000. These standard deductions would be adjusted based on inflation. Both bills repeal all personal exemptions.
The Senate Bill provides for similar repeals of deductions and limitations to the House Bill, with the following notable exceptions:
- State and local property and sales taxes are deductible only in connection with a trade or business;
- The deduction for home mortgage interest associated with acquisition indebtedness remains intact, and only the deduction for home equity indebtedness is repealed;
- Medical expenses would continue to be deductible as under current law;
- All miscellaneous deductions previously subject to the 2 percent of adjusted gross income (“AGI”) floor would be repealed; and
- The deduction for qualified moving expenses for members of the Armed Forces would be retained.
The Senate Bill does not provide for all of the adjustments to the tax credits available to individuals that were addressed in the House Bill. However, there is a notable change to the current child tax credit included in the Senate Bill that differs slightly from the House Bill. Under the Senate Bill, the child tax credit would be increased from $1,000 to $1,650, and the age limit for claiming the credit on a child would be increased by one year to include children under the age of 18. In addition, a nonrefundable credit of $500 would be allowed for qualifying dependents. Lastly, the phase-out thresholds for claiming these credits would be increased.
Estate and Generation-Skipping Transfer Taxes
The Senate Bill does not repeal the estate tax and generation-skipping transfer tax, which was a landmark feature of the House Bill. Instead, the Senate Bill doubles the exemption amount for both the estate and gift taxes from $5 million to $10 million, as indexed for inflation.
WHAT HAPPENS NEXT?
Both the House Bill and the Senate Bill must be passed by their respective chambers. Before that happens, it is anticipated that each will undergo significant revisions in order to gain the required number of votes. Once each legislative body approves the bill, the two groups will reconcile the differences between their respective bills in order to present one unified piece of legislation for final Congressional approval, followed by the President’s signature.
WHAT SHOULD YOU DO?
The reforms proposed in both the Senate Bill and the House Bill are very significant and will impact every U.S. taxpayer. In addition, each 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 and individuals 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.