The House-Approved Build Back Better Act: Business & International Tax Issues
On November 19th, the House approved the Build Back Better Act (BBBA), H.R. 5376, by a vote of 220-213 on party lines. The $1.7 trillion bill includes a package of targeted individual tax relief, clean energy incentives, and increased spending on healthcare, education, childcare, and other programs. The legislation is currently being considered in the Senate, where changes are expected to be made to many of the bill’s provisions.
In a True Insight published earlier this month, we summarized the status and timeline for the BBBA and provisions in the bill affecting individuals. This True Insight provides details of the House-approved version of the BBBA with respect to corporate and other business taxes, including international tax issues. In a future True Insight, we will provide details on the clean energy tax incentives included in the BBBA.
Due to opposition from Senator Sinema (D-AZ), an increase in the corporate tax rate from 21% to 26.5% was dropped from the Ways & Means Committee-approved bill. In its place, however, the BBBA creates a new corporate minimum tax based on book income and an excise tax on stock repurchases. Many of the changes to the international tax rules included in the Committee-approved bill were carried over to the revised BBBA with some modifications.
Corporate & Business Tax Provisions
Imposition of an Alternative Minimum Corporate Tax Based on Book Income
The BBBA would impose a 15% alternative minimum tax (AMT) on the adjusted financial statement (book) income of domestic corporations (other than S corporations, regulated investment companies, and real estate investment trusts) that report over $1 billion in profits to shareholders, which would apply to tax years beginning after December 31, 2022. The JCT has estimated that this provision will raise $318 billion over the 10-year budget period.
The proposal would preserve the value of general business credits, such as the research tax credit, and foreign tax credits (FTCs). It would also allow applicable corporations to indefinitely carry forward their financial statement losses and an AMT credit to be claimed against regular tax liabilities in future years, similar to the former AMT tax credit that was repealed by TCJA.
The proposed AMT applies to C corporations with average annual adjusted financial statement income that exceeds $1 billion for any three consecutive tax years of the corporation occurring during the period ending with the tax year immediately preceding such tax year. Also, in the case of a corporation that is a subsidiary of a non-US parent, the corporation itself (combined with certain subsidiaries, including controlled foreign corporations (CFCs)) must have an average annual financial statement income of at least $100 million.
Based on the effective date beginning in 2023, taxpayers will need to look at their “adjusted financial statement income” (AFSI) during the 3-year period from 2020 through 2022 to determine if they are subject to the AMT. The BBBA includes a general definition of AFSI, but Treasury is also given the authority to include other adjustments.
The carryforward of a financial statement NOL is permitted under rules that generally follow Section 172. Other provisions contain special rules governing the treatment of dividends from corporations outside of the consolidated group, aggregation rules and the inclusion of income from pass-through entities and foreign businesses, changes to the consolidated group, the application of FTCs, etc. Treasury is given the authority to issue guidance on a number of issues that will be key to the operation of this AMT, but with an effective date of 2023, it is assumed that this guidance will be issued before the provision takes effect.
TPC Observation: There has been broad criticism from the accounting industry of this proposal on the basis that using a financial reporting system to measure taxable income could distort information that shareholders rely on and counteract tax policies in the current tax code that were designed to provide tax incentives, such as bonus depreciation. Accounting experts have recommended that the new policy keep the measure of taxable income within the tax code, such as reviving the old AMT rather than basing the tax on a measure of financial income which presents numerous administrative complexities.
Some Congressional tax-writers have responded by stating that the new corporate minimum tax is designed to be a backstop to ensure taxes are paid by the largest corporations that currently are not paying taxes while reporting record profits to their shareholders. However, this response fails to address concerns about the new AMT’s usage of general accounting principles and deviation from tax principles.
Imposition of an Excise Tax on Stock Buybacks
The BBBA would impose a 1% tax on the fair market value of stock buybacks for publicly-traded corporations listed on established securities markets. The bill would exempt certain repurchases in connection with tax-free reorganizations, repurchases treated as dividends, and repurchases for retirement or similar plans. It provides exemptions for shares donated to employee retirement and stock ownership plans as well as buybacks worth less than an aggregate of $1 million for the year. It would apply to stock buybacks made after 2021.
TPC Observation: This proposal was not included in the Ways & Means Committee-approved bill, but it is similar to a proposal released by SFC Chair Wyden. The initial proposal was to levy a 2% excise tax, but the rate was lowered in order to gain broader support in the Senate Democratic caucus for the new tax. The proposal would raise $124 billion over the 10-year budget period.
The provision includes a definition of “repurchase” and several exemptions from the new excise tax. Treasury is given authority to issue guidance necessary to administer the proposal and prevent avoidance. There are special rules applicable to foreign-parented domestic corporations and “specified affiliates” of any publicly traded US corporation, which may also be subject to the excise tax.
TPC Observation: Taxpayers planning stock buybacks in 2022 should consider how the additional cost of this excise tax might impact their plans as well as whether they qualify for any of the exceptions listed in the House bill.
Limitations on Tax-Free Spinoff Monetization
Under current law and subject to certain limitations, a subsidiary can issue debt securities to its parent corporation, which the parent corporation can then distribute tax-free to creditors in redemption of its own outstanding debt in connection with a spinoff of the subsidiary. The BBBA generally would require the parent corporation to recognize gain to the extent that the amount of subsidiary debt that it transfers to its creditors exceeds the aggregate basis in any assets it transfers to the subsidiary less (1) any liabilities the subsidiary assumes from the parent, and (2) any payments the subsidiary makes to the parent. The change is applicable after the date of enactment, although the bill includes a special transition rule.
Deferral of Worthless Stock Deductions on Subsidiary Liquidations
The BBBA would defer a corporate parent’s worthless stock loss on the liquidation of an insolvent subsidiary until the parent disposes of substantially all of the subsidiary’s property to unrelated persons. The provision applies to liquidations occurring on or after the date this provision is enacted.
TPC Observation: This provision is broader than the one that was included in the Ways & Means Committee-approved bill which was targeted to eliminate stock loss recognition in so-called Granite Trust transactions, in which a corporation chooses to liquidate a subsidiary in a taxable liquidation under Section 331, instead of a tax-free liquidation under Section 332, by transferring a portion of the subsidiary’s stock before the liquidation. The BBBA provision would hit not only the Granite Trust transactions, but also certain worthless stock deductions under Section 165(g) involving liquidations.
Application of Section 163(j) to Partnerships and S Corporations
Under current law, Section 163(j) generally allows a deduction for business interest expense only to the extent that it exceeds business interest income plus 30% of EBITDA (earnings before interest, taxes, depreciation or amortization) for tax years beginning before January 1, 2022, and 30% of EBIT for tax years beginning after 2021. The limitation is computed twice: first at the partnership level, which results in the partnership allocating items such as disallowed interest and excess taxable income to each partner, and then again at the partner level.
The BBBA amends Section 163(j) to eliminate the computation at the partnership level, such that the limitation would only be computed at the partner level. The bill also amends Section 163(j) to apply at the shareholder level of an S corporation. Special transition rules are included for partners in a partnership. The new provision would apply to tax years beginning in 2023.
TPC Observation: Many will welcome this proposal, which would adopt an “aggregate approach” to Section 163(j) by applying the limitation exclusively at the partner level, because the existing framework for applying Section 163(j) at the partnership level is widely viewed as complex and administratively burdensome. However, if certain states do not respond quickly and pass laws to immediately adopt this change to the federal rules, then partnerships in those jurisdictions would still be required to perform computations under the existing law in order to comply with reporting requirements in those states.
It is also worth noting that this proposal is incompatible with Senator Wyden’s discussion draft that was released earlier this year, which calls for a stricter “entity approach” than the current rules.
Expensing of Research and Experimental Costs under Section 174
Under current law, Section 174 allows for an immediate deduction of research and experimental costs. This rule is set to expire after 2021, thereby requiring taxpayers to capitalize and amortize these expenses over a 5-year period beginning in 2022. The BBBA would extend rules for immediate deductions under Section 174 until 2025, so that the requirement to capitalize and amortize those costs would not take effect until 2026.
TPC Observation: Unlike nearly every other provision in the BBBA, this modification has bipartisan support in the House and Senate.
The House Ways & Means Committee-approved bill included several international tax provisions with broad changes to tax rates and operational rules of core US international tax areas such as the GILTI regime, the BEAT rules, and the FTC rules. This summary highlights some of the key changes, but taxpayers whose operations are affected by the international tax rules of the Code should review all of the proposed modifications carefully.
Modifications to GILTI and the GILTI Deduction
Under current law, US corporations are taxed annually at a 10.5% effective tax rate (increasing to 13.125% in 2026) on a deemed dividend—known as “global intangible low-taxed income” (GILTI)—that is computed based on the excess of certain income (tested income) earned by their controlled foreign corporations (CFCs) over a deemed return on qualified business asset investments (QBAI). Under Section 250, corporate taxpayers are generally allowed to take a deduction for 50% of their deemed dividend related to GILTI, which produces the 10.5% effective rate (21% corporate tax rate x 50%). Furthermore, US shareholders can claim FTCs related to GILTI, but those FTCs are subject to a 20% haircut.
The BBBA would require US shareholders to compute GILTI and the related FTCs on a country-by-country basis, and would reduce the deemed tangible return on QBAI from 10% to 5%. It would also allow tested losses to be carried forward and would eliminate the exception from tested income for foreign oil and gas extraction income (FOGEI).
Additionally, the BBBA would reduce the deduction for GILTI from 50% to 28.5%, which is intended to result in an effective tax rate of approximately 15% on GILTI income inclusions. It would also reduce the haircut on FTCs related to GILTI income from 20% to 5% and allow taxpayers to carry forward excess FTCs in the GILTI basket for 5 years. This proposal would be effective for tax years of foreign corporations beginning after December 31, 2022, and to the US shareholder’s tax year that includes such tax year.
TPC Observation: These changes would bring the GILTI regime closer in line with the global OECD negotiations under Pillar 2. However, some experts have suggested that the revisions in the House bill still represent fundamental design differences from Pillar 2 that may make US corporations less competitive than foreign businesses, and thus they recommend waiting until other countries act on Pillar 2 before modifying the GILTI regime. This may be part of the reason that House bill’s changes to GILTI would become effective one year later than most other provisions.
Modifications to the FDII Deduction
Under current law, US corporations are allowed a 37.5% deduction (under Section 250) for certain income derived from exports and other sales to foreign customers, which is called “foreign derived intangible income” (FDII). The BBBA would reduce the deduction to 24.8%, which would result in an effective tax rate of 15.8% on FDII. It would also exclude certain categories of income from qualifying for the deduction and eliminate both the taxable income limitation and the NOL ordering rule that applies to the deductions under Section 250 related to both FDII and GILTI. These changes are effective for tax years beginning after December 31, 2022.
TPC Observation: The OECD has expressed concerns about FDII being a preferential tax regime and stated that the US agreed to eliminate the deduction during negotiations. Similar to the changes related to GILTI, this may be part of the reason for delaying the effective date by an additional year compared to other provisions in the BBBA.
Modifications to the Base Erosion and Anti-Abuse Tax
Under current law, an additional tax known as the “base erosion and anti-abuse tax” (BEAT) applies to large corporations with average gross receipts exceeding $500 million that make certain deductible payments to their foreign affiliates (base erosion payments) in excess of 3% of the corporation’s total deductions (2% for groups that include banks and securities dealers). The BEAT is a minimum tax; taxpayers subject to BEAT pay the greater of the BEAT liability or their regular tax liability reduced by certain credits. The BEAT liability generally equals the excess of 10% (increasing to 12.5% in 2026) multiplied by the company’s modified taxable income (MTI), which is the company’s taxable income after adding back deductions for base erosion payments.
The BBBA increases the BEAT to 12.5% beginning in 2023, 15% beginning in 2024, and 18% beginning in 2025. It also eliminates the de minimis exception beginning after 2024. In addition, the bill amends the computation of “modified taxable income” and the definition of base erosion payments, and it would compare the BEAT liability to the company’s regular pre-credit tax liability instead of the tax amount reduced by certain credits.
The BBBA provides an exception for payments subject to US tax and for payments to foreign parties if the taxpayer establishes that such amount was subject to an effective tax rate (ETR) of foreign tax not less than the applicable BEAT rate. It also provides that a taxpayer (and its successor) remains subject to BEAT for the next 10 years after it first becomes subject to BEAT (regardless of any decrease in gross receipts). These changes are effective for tax years beginning after December 31, 2021.
TPC Observation: Some of these proposed changes would increase the adverse effect on taxpayers who are subject to the BEAT, but other changes may result in the BEAT not applying to some US-headquartered companies and in cases where it is determined that they are being taxed appropriately at an effective foreign tax rate of at least 15%. In particular, the taxpayer-friendly change to compare the BEAT liability to the regular tax liability before credits will decrease or eliminate the incremental amount of tax paid by multinationals with material credits, particularly those with significant FTCs.
The exception for payments to foreign affiliates with an ETR equal to or exceeding the BEAT rate, which would be 15% by 2024, would bring the BEAT regime closer to conforming with Pillar Two. The outcome of the OECD global talks on Pillar Two will play a role in shaping the changes proposed in the BBBA and the impact on certain taxpayers.
Limitation on Interest Expense of International Financial Reporting Groups
As discussed above, Section 163(j) currently limits a taxpayer’s ability to deduct business interest expense to the extent that it exceeds their business interest income plus 30% of EBITDA, which will change to EBIT beginning after 2021. The BBBA would create a new Section 163(n) that would limit interest deductions of certain domestic and foreign corporations that are members of an international financial reporting group. Under this new regime, the corporation’s interest deduction would be limited by the greater of the amount disallowed under 163(j) or 163(n).
The Section 163(n) limit generally equals the domestic corporation’s interest income plus 110% of the domestic corporation’s share of the group’s net book interest expense, which is determined based on a financial statement EBITDA ratio. This change is effective for tax years beginning after 2022, and it would apply to US corporations whose average excess interest expense (determined on a 3-year rolling basis) exceeds $12 million. Any interest expense that is disallowed under either Section 163(j) or the new Section 163(n) would be carried forward.
TPC Observation: As written, the BBBA’s new Section 163(n) would be computed on an entity-by-entity basis. This would encourage US consolidated groups to push down debt to their subsidiaries in proportion to their profitability in order to minimize the amount of disallowed interest deductions.
When Section 163(j) was originally drafted, it too applied on an entity-by-entity basis until Treasury released guidance allowing for the limitation to be computed at the consolidated group level. Presumably, Treasury would issue similar guidance for the new Section 163(n).
Modifications to the Foreign Tax Credit Rules
The BBBA proposes a number of changes to the foreign tax credit rules. The following discussion highlights some of the key provisions in the bill, but affected taxpayers should review all the provisions in more detail and consider their interaction with other provisions such as the GILTI regime.
Under current law, Section 904 requires taxpayers to separately compute their FTC limitation for the following “baskets” of foreign-sourced income: 1) GILTI; 2) foreign branch income; 3) passive category income; and 4) general category income. Excluding FTCs in the GILTI basket, unutilized FTCs may be carried back one year or forward 10 years.
The BBBA would amend Section 904 to eliminate the foreign branch income basket and the one-year FTC carryback, but would extend the 10-year carryforward period to the GILTI basket. It also would require determinations of the FTC limitation on a country-by-country basis. The new Section 904(e) generally assigns each item of income and loss to a taxable unit of the taxpayer that is a tax resident of a foreign country (or in the case of a branch, has a taxable presence in such country) and aggregates all taxable units that are subject to tax in the same country.
The BBBA also proposes changes to reduce the amount of the US group’s expenses that are allocated against GILTI inclusions as well as the treatment of overall and separate category losses, including the creation of a special ordering rule for applying losses from other categories against the GILTI category of income. These changes would be effective for tax years beginning after 2022.
TPC Observation: Note that the per-country application of GILTI would increase the compliance burden on multinationals and would prevent their ability to use FTCs generated by affiliates in high-tax jurisdictions from offsetting the US tax liability related to affiliates in low-tax jurisdictions. However, the BBBA contains many taxpayer-friendly changes as well, particularly with regards to GILTI FTCs such as the new carryforward and allocation rules as well as the creation of a separate limitation loss account for GILTI category income. The cumulative effect of these changes to the GILTI FTC, including the reduction to the haircut on the creditable amount of GILTI foreign taxes, would reduce the instances where multinationals would pay a residual amount of US tax on GILTI inclusions where foreign tax is paid at an ETR of 15.8%—the expected ETR on FDII income (see above for the discussion about the FDII ETR) and thus would bring a degree of parity between income that taxpayers earn under those regimes.
Repeal of CFC Downward Attribution
A CFC is any foreign corporation more than 50% of whose voting power or value is directly, indirectly, or constructively owned by 10% US shareholders. Under current law rules after TCJA, constructive ownership was expanded to include downward attribution so that a subsidiary is deemed to own all of the stock owned by any 50% shareholder. This expansion created adverse tax consequences in certain cases, including increased compliance burdens due to the increased number of CFCs as well as situations where taxpayers could be subject to tax on “phantom income” (although this was mitigated by relief from Rev. Proc. 2019-40).
Thus, the BBBA repeals downward attribution and more narrowly targets transactions that were targeted by the TCJA (e.g., decontrol strategies connected to corporate inversions) by creating a new Section 951B.
Limitation of the Participation Exemption to Dividends from CFCs
Under current law, Section 245A exempts US corporations from tax on dividends paid by certain 10%-owned foreign corporations, even when the foreign corporations are not CFCs, so that their earnings are not subject to current US taxation under the subpart F and GILTI regimes. The BBBA would limit the exemption to dividends paid by CFCs and would allow US corporations to elect to treat certain foreign corporations as CFCs. This change would apply retroactively to tax years beginning after the date of enactment.
TPC Observation: The BBBA also includes a new election regime that allows taxpayers to treat certain foreign corporations as CFCs. If that election cannot be made, it presents the possibility that foreign earnings of 10%-owned subsidiaries could be subject to double taxation.
Treatment of Certain Dividends from CFCs to US Shareholders as Extraordinary Dividends
Under current law, Section 1059 includes rules related to extraordinary dividends received by a US shareholder from a CFC related to basis reduction and inclusion in gross income, but it does not apply if the US shareholder has held the stock of the distributing CFC for more than two years at the time of the dividend announcement date.
The BBBA would create a new Section 1059(g) that would treat any “disqualified CFC dividend” as an extraordinary dividend without regard to the period the taxpayer held the CFC’s stock. A disqualified CFC dividend is defined as any dividend paid by a CFC if such dividend is attributable to the CFC’s earnings and profits (E&P) that were earned while such foreign corporation was not a CFC, including E&P attributable to disqualified CFC dividends that the CFC received from another CFC. This provision applies to dividends paid after date of enactment.
TPC Observation: This proposal would likely result in most dividends received from a CFC being treated as a return of capital (or capital gain when in excess of basis) if the dividend is related to E&P earned before the foreign corporation became a CFC.
Modification of the Portfolio Interest Exemption
Under current law, the “portfolio interest exemption” eliminates withholding tax on US-source interest paid to certain foreign persons. The exemption does not apply to 10% shareholders (based on voting power) of the borrower, who instead are subject to withholding on interest at a 30% rate unless an income tax treaty provides otherwise. The BBBA amends the definition to include a holder of at least 10% of the value of the debtor corporation’s stock, which means that large foreign shareholders of a US corporation cannot avoid withholding tax by holding “low vote” stock. The change applies to debt issued after date of enactment.
With the possibility that this legislation will be enacted by the end of 2021, businesses are well advised to monitor reports on the negotiations between Congress and Treasury related to these proposals.
If you have questions about any of the information in this True Insight, please contact a member of your TPC engagement team.