True Alert: Final Tax Bill Released
On December 15, 2017, congressional Republicans released the conference committee report containing the final text and explanation of their Tax Bill (“the Bill”), “The Tax Cuts and Jobs Act” (“H.R. 1”). The Bill contains numerous provisions that we discussed in earlier True Alerts describing the House Bill and the Senate Bill, as well as a few that were not in earlier versions. Congress is expected to vote on the Bill before its holiday recess at the end of this week. The Bill is expected to pass the House easily and Senate Republican leaders believe that they have the necessary 51 votes to pass it in that chamber as well. The President has indicated that he will sign the Bill quickly. The Bill is generally effective for tax years beginning on or after January 1, 2018, which will give taxpayers little time to plan for the changes and will create major complications for public companies that must incorporate these changes into their year-end reporting.
Taxation of Businesses
Corporate Tax Rate
The Bill provides that corporations will be taxed at a flat rate of 21 percent for taxable years beginning January 1, 2018. This is an increase from a 20 percent rate contained in both the House and Senate versions of the legislation. The rate increase from the House and Senate Bills was due to the need to keep the revenue loss below the $1.5 trillion required by the budget resolution.
Business Interest Limitation
The Bill imposes a new limitation on the deductibility of business interest expense, which generally will be limited to 30 percent of the taxpayers “adjusted taxable income.” Adjusted taxable income is the taxable income of the taxpayer, excluding: business interest income and expense; nonbusiness income, gain, deduction or loss; NOLs; any deduction for passthrough income under new section 199A: and—for taxable years beginning before January 1, 2022—any depreciation, depletion, or amortization. Any disallowed business interest deduction may be carried forward indefinitely. The limitation on interest expense does not apply to taxpayers whose average annual gross receipts for the three preceding taxable years do not exceed $25 million.
Net Operating Losses
The deduction for NOLs arising in taxable years beginning after December 31, 2017, will be limited to 80 percent of taxable income. Unused NOL’s may be carried forward indefinitely but may not be carried back. Note that pre-2018 NOLs are not subject to this limitation.
Corporate Alternative Minimum Tax
The corporate alternative minimum tax will be repealed. Taxpayers may continue to use the prior years’ minimum tax credits to offset regular tax liabilities. Furthermore, for tax years beginning after 2017 and before 2021, the prior year minimum tax credit will be refundable against the regular tax liability in an amount equal to 50% of the excess of the credit over the amount allowable for that year. The refundable amount increases to 100% for tax years after January 1, 2021 and before December 31, 2022.
Taxpayers may elect to deduct bonus depreciation equal to 100 percent of the basis of qualified property acquired and placed in service after September 27, 2017 and before January 1, 2023. The provision also removes the original use requirement, which means that bonus depreciation may be claimed on purchases of used property acquired in an arm’s-length transaction (for example, the acquisition or deemed acquisition of assets of a business).
Domestic Production Activities Deduction
The domestic production activities deduction (“DPAD”) of section 199 of the Code is repealed.
Deduction for Qualified Business Income of Passthrough Entities
The Bill generally adopts the Senate’s version of a 20 percent deduction for “qualified business income” received by an individual from a partnership, S corporation, sole proprietorship, REIT, trust, or estate. A limitation on this deduction is phased in for taxable income above $157,500 ($315,000 in the case of a taxpayer that is married filing jointly) based on W-2 wages paid and for certain specified service trades or businesses (such as health, law, accounting, actuarial science, performing arts, consulting, athletics, or financial or brokerage services). Foreign income is not eligible for the deduction.
Qualified business income is determined separately for each qualified trade or business of the taxpayer. The taxpayer’s deduction is equal to the lesser of the combined qualified business income amount for the taxable year or an amount equal for 20 percent of the taxpayer’s taxable income (reduced by any net capital gain). The provision applies at the individual level: each owner takes into account their own allocable share of each qualified item of income, gain, deduction, and loss, and their allocable share of W-2 wages paid by the entity.
Dividends Received Deduction
The Bill reduces the dividends received deduction (“DRD”) to reflect the lower corporate tax rates. Dividends received from 20-percent or more owned taxable domestic corporations are eligible for a 65 percent DRD (down from 80 percent under current law) and dividends from taxable domestic corporations less than 20-percent owned would be reduced from 70 percent to 50 percent.
No deduction is allowed for an activity generally considered to be entertainment, amusement, or recreation, membership dues to any club organized for business, pleasure, recreation or other social purpose, or a facility used in connection with any of those purposes.
Self-created patents, inventions, models and designs that are created by the taxpayer (or acquired with a substituted or transferred basis) will no longer be treated as capital assets eligible for capital gains treatment. Therefore, any gain or loss upon the sale of these assets will be treated as ordinary income.
Limitation on Compensation Paid to Covered Employees
The current $1 million annual limitation on deductions for compensation paid to covered employees of publically traded corporations will no longer contain an exception for commission or performance based compensation, and the definition for covered employees will now include the CEO, CFO and the 3 highest paid employees. This new rule is effective for contracts executed on or after November 3, 2017.
Small Business Proposals
The Bill contains several provisions designed to benefit small businesses, including:
- Code section 179 expensing limitation is increased to $1 million with an increased phase-out threshold amount of $2.5 million.
- The number of taxpayers that may use the cash method of accounting is increased by allowing taxpayers with annual average gross receipts not exceeding $25 million for the three prior taxable years to use the cash method. The $25 million amount is indexed for inflation.
- Taxpayers who meet the $25 million gross receipts test are not required to use inventory accounting and need not comply with the UNICAP rules of section 263A.
Other Notable Business Changes
Other changes include:
- The rule providing for the technical termination of a partnership upon the sale or exchange of 50 percent or more of the partnership interests within a 12-month period is repealed.
- The Bill reverses the recent Tax Court decision in Grecian Magnesite Mining v. Commissioner, 149 T.C. No 3 (July 13, 2017), and requires that a foreign taxpayer’s gain or loss from the sale or exchange of a partnership interest is effectively connected with a U.S. trade or business to the extent that the transferor would have had effectively connected gain or loss had the partnership sold all of its assets at fair market value.
- Like-kind exchanges are limited to exchanges of real property only.
- An accrual method taxpayer must recognize income no later than the taxable year in which such income is taken into account as revenue in an applicable financial statement (with an exception for taxpayers without such financial statements). In addition, the deferral method of accounting contained in Rev. Proc. 2004-34 (allowing accrual method taxpayers to elect to defer income associated with certain advance payments) is codified. These changes constitute a change in the taxpayer’s method of accounting.
- For purposes of section 118, a “contribution to capital” does not include any contribution in aid of construction or any other contribution as a customer or potential customer, and any contribution by any governmental entity or civic group (other than a contribution made by a shareholder as such).
- No deduction is allowed for any qualified transportation fringe or any expense incurred for providing transportation to an employee except as necessary to ensuring an employee’s safety;
- The 50 percent limitation on deduction of employee food and beverage expense is expanded to include expenses for providing food and beverages to employees through an eating facility that meets de minimis fringe benefit requirements and is for the convenience of the employer; such amounts incurred after December 31, 2021, will not be deductible at all.
- The Bill addresses the treatment of “carried interests” by requiring a three-year holding period for certain “applicable partnership interests” to produce long-term capital gain. An applicable partnership interest is any interest in a partnership that is transferred to or held by the taxpayer in connection with performance of services in any applicable trade or business.
- Specified research and experimental expenditures incurred in taxable years beginning after December 31, 2025, will be capitalized and amortized ratably over a five-year period, beginning with the midpoint of the taxable year in which the expenditures were paid or incurred. This will be treated as a change in the taxpayer’s method of accounting.
International Tax Law Changes
New section 245A of the Code allows U.S. corporate shareholders to claim a 100 percent deduction for the foreign-source portion of dividends received from specified 10-percent owned foreign corporations. The foreign-source portion of a dividend is the amount that bears the same ratio to the dividend as the undistributed foreign earnings bears to the total undistributed earnings of the foreign corporation. This deduction is available only to C corporations that are not RICs or REITs and requires a one-year holding period. Moreover, the deduction is not available for any dividend received by a U.S. shareholder from a CFC if the dividend is a hybrid dividend—that is, a dividend for which a deduction (or other tax benefit) is allowed in the foreign country. Such a hybrid dividend will be treated as subpart F income.
No foreign tax credit or deduction is allowed for any taxes paid or accrued on the income related to the dividends that qualify for this deduction.
Tax on Deemed Repatriation
The Bill imposes a tax on of the unrepatriated foreign earnings of any foreign corporation with at least one 10-percent U.S. shareholder. The tax is imposed at the end of the last taxable year beginning before January 1, 2018, on each U.S. shareholder’s pro rata share of the foreign corporation’s earnings; the earnings are treated as subpart F income, but the tax liability may be paid over eight years (with the amount of tax due back-loaded).
The earnings subject to the tax are all post-1986 earnings and profits of the foreign corporation that have not been previously taxed and are neither attributable to income that is effectively connected with a U.S. trade or business nor subpart F income (determined without regard to this provision). The pool of earnings and profits is not reduced by any distributions during the year in which the provision applies, but it is reduced by any deficits in earnings and profits. The amount of earnings and profits is measured as of November 2, 2017 or December 31, 2017, whichever is greater.
In calculating the repatriation tax, taxpayers are allowed a deduction in the amount necessary to result in a 15.5-percent tax rate on the portion of post-1986 earnings held in the form of cash or cash equivalents, and an 8-percent tax rate on all other earnings.
Transfers of or to CFCs
The Bill contains several provisions addressing transfers of CFC stock or transfers to a CFC:
- Solely for purposes of determining a loss on the sale of stock of a 10-percnt owned foreign corporation, a domestic corporation’s adjusted basis in the stock is reduced by an amount equal to the portion of any dividend received that was not taxed as a result of a dividends received deduction under section 245A; this reduction will not occur to the extent that basis in the 10-percent owned foreign corporation’s stock has already been reduced under section 1059.
- If a CFC sells the stock of a lower-tier CFC and an amount is treated as a dividend under section 964(e)(1), then (i) the foreign-source portion of the dividend is treated as subpart F income of the selling CFC; (ii) a U.S. shareholder of the selling CFC includes in its income an amount equal to the shareholder’s pro rata share of the amount treated as subpart F income; and (iii) the deduction under section 245A is allowable with respect to the deemed subpart F income in the manner as if the subpart F income were a dividend received by the shareholder from the selling CFC.
- If a domestic corporation transfers substantially all of the assets of a foreign branch to a specified 10-percent owned foreign corporation with respect to which it is a U.S. shareholder after the transfer, the domestic corporation must generally include in gross income an amount equal to the transferred loss amount. The transferred loss amount is the excess of (i) post-2017 losses of the branch for which a deduction was allowed to the domestic corporation, over (ii) the sum of certain taxable income earned by the foreign branch and gain recognized by reason of an overall foreign loss recapture arising out of disposition of assets in the underlying transfer. Amounts included in gross income because of this provision are treated as U.S.-source income. Proper adjustments must also be made to the basis of the stock in the foreign corporation.
- The active-trade-or-business exception of section 367 is repealed, resulting in a tax on U.S. shareholders who transfer an ongoing business to a foreign corporation.
Current Inclusion in Income of GILTI
The Bill adds a new section 951A to the Code providing that a U.S. shareholder of a CFC must include in gross income its global intangible low-taxed income (“GILTI”) in a manner generally similar to inclusions of subpart F income. GILTI represents the income from intangibles (primarily intellectual property) that Congress believes can easily be transferred offshore but should still be subject to U.S. tax.
Specifically, GILTI means the excess of a shareholder’s net CFC tested income over the shareholder’s net deemed tangible income return. The net CFC tested income means the excess of a shareholder’s pro rata share of the tested income of each CFC in which it is a shareholder over the aggregate of its pro rata share of the tested loss of each CFC in which it is a shareholder. Tested income of a CFC is the excess of the gross income of the shareholder (excluding the corporation’s effectively connected income, subpart F income, gross income excluded from foreign base company income, and dividends received from a related person). The tested loss of a CFC is the excess of deductions (including taxes) properly allocable to the corporation’s gross income—determined without regard to the tested income exceptions—over the amount of gross income.
The net deemed tangible income return is an amount equal to 10 percent of the aggregate of the shareholder’s pro rata share of the qualified business asset investment (“QBAI”) of each CFC with respect to which it is a U.S. shareholder over the amount of interest expense taken into account in determining net CFC tested income. QBAI is the aggregate of the adjusted tax basis in depreciable tangible personal property used in the CFC’s trade or business.
Foreign-Derived Intangible Income and Global Intangible Low-Taxed Income
The Bill also adds a new section 250 to the Code, providing domestic C corporations with reduced rates of U.S. tax on their foreign-derived intangible income (“FDII”) and their GILTI. The effective tax rate on FDII is 13.125 percent and for GILTI is 10.5 percent.
FDII represents income of U.S. corporations from intangibles and is calculated as the product of a corporation’s deemed intangible income and the percentage of its deduction eligible income that is foreign derived. The deduction is meant to provide a lower tax rate for export income related to intangibles, thereby providing an incentive for U.S. corporations to keep their intangibles in the United States (similar to patent boxes in certain foreign jurisdictions).
The Bill adds new section 59A and 59B to the Code that creates a new base erosion and anti-abuse tax (“BEAT”). This tax is equal to the excess of 10 percent of the modified taxable income of the taxpayer over an amount equal to the regular tax liability of the taxpayer reduced by the excess of tax credits over the sum of a portion of the taxpayer’s business tax credits under section 38. “Base erosion payments” are any amounts paid or accrued by a taxpayer to a related foreign person and for which a deduction is allowable, including interest (to the extent not otherwise disallowed) but excluding cost of goods sold (except with respect to inverted corporations).
The tax applies to any taxpayer that is a corporation (other than a RIC, REIT, or S corporation) with average annual gross receipts greater than $500 million and has a base erosion percentage of three percent or higher. The base erosion percentage is the percentage determined by dividing the aggregate amount of base erosion tax benefits of the taxpayer by the aggregate amount of the deductions allowable to the taxpayer without taking into account deductions for NOL carryovers, participation exemption, or FDII or GILTI.
Foreign Tax Credits
The indirect foreign tax credit in section 902 is repealed and a separate foreign tax credit limitation basket is created for foreign branch income.
Subpart F Income
Several changes were made to subpart F:
- The current taxation of previously excluded qualified investments under section 955 is repealed.
- The 30-day rule in section 951 is repealed.
- The look-through rule for related foreign corporations under section 954(c)(6) is made permanent.
- Stock attribution rules for determining CFC status are modified to allow for downward attribution from a foreign person to a related U.S. person.
- The definition of a U.S. shareholder is modified to include any U.S. person who owns 10 percent or more of the total value of shares of all classes of stock of a foreign corporation.
Other International Changes
Other international changes include:
- Addressing methods for valuing intangible property.
- The source of income from the sale of inventory is determined solely on the basis of the location of the production activities.
- Denying a deduction for any interest or royalty paid or accrued to a related party to the extent that (i) there is no corresponding income inclusion to the related party under the tax law of the country of the related party, or (ii) such related party is allowed a deduction with respect to such amount under the tax law of such country.
- Repealing the fair market value method of apportioning interest expense for purposes of calculating the foreign tax credit limitation.
Other Tax Changes
- The Bill reduces the top rate for married taxpayers filing jointly from 39.6 percent to 37.0 percent for taxable income over $500,000.
- The standard deduction is increased to $24,000 for a joint return, but personal exemptions are repealed.
- The phase-out of exemption amounts for the alternative minimum tax is raised to $1 million for taxpayers filing jointly ($500,000 for single taxpayers).
- Miscellaneous itemized deductions subject to the 2 percent floor are suspended for tax years beginning after December 31, 2017, and before January 1, 2026.
- The home mortgage interest deduction for acquisition indebtedness would be limited to $750,000 but reverts back to $1 million after 2025. Deduction for home equity indebtedness is suspended for tax years beginning after December 31, 2017 and before January 1, 2026.
- The deduction for state and local taxes not connected with the conduct of a trade or business is limited to $10,000 (for a joint return) for tax years beginning after December 31, 2017 and before January 1, 2026. For amounts paid in a tax year beginning before January 1, 2018, the payment is treated as if paid on the last day of the tax year for which such tax is imposed.
- The 50 percent AGI limitation on cash contributions to charities is increased to 60 percent for tax years beginning after 2017 and before 2026.
- Personal casualty loss deduction will apply only to losses incurred as a result of a federally-declared disaster.
- The above-the-line deduction for alimony is eliminated and the recipient of the alimony is not required to include the payments into income, effective for divorce decrees and certain modifications entered into after 2018.
- The deduction for moving expenses is suspended for tax years beginning after December 31, 2017 and before January 1, 2016, except for members of the Armed Forces who move pursuant to a military order and incident to a permanent change of station.
- Elementary and secondary school expenses of up to $10,000 are qualified expenses for qualified tuition programs.
- The Affordable Care Act individual mandate penalty amount is reduced to zero.
Estates, Gifts, and Trusts
- The estate and gift tax unified credit exclusion amount and the GST exemption amount are increased to $10 million (with inflation adjustments) effective for decedents dying and gifts made after 2017 and before 2026.
What You Should Do
If the Bill (as expected) is enacted in 2017, public companies will need to recalculate their year-end income tax provision to take into account the new law. In addition, the Bill is generally effective for taxable years beginning after January 1, 2018, so there is very little time for end of the year tax planning. Nevertheless, both businesses and individuals should quickly assess whether it is possible to accelerate deductible costs into 2017 and defer income into 2018. For example, businesses should try to incur capital expenses in 2017 to benefit from the 100 percent bonus depreciation in a year with a 35 percent tax rate. Similarly, some states (such as Illinois) assess property taxes a year in arrears, so individuals in those states should consider pre-paying their property taxes to avoid the $10,000 limitation effective January 1, 2018.
How Can True Partners 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.