Washington Tax Insight September 2018
Politics and Congressional Activity
Congressional activity has slowed in the month of August with both the House and Senate taking a recess, although the Senate recess was shortened to one week. Key legislative issues, including the FY 2019 appropriations bills, must be dealt with in September, but the upcoming mid-term elections will be the primary focus in Washington this fall with the possibility that Republicans could lose the majority in one or both chambers.
The House returns to work after Labor Day and is scheduled to work for 11 legislative days in September and two weeks in October before adjourning to return home for the mid-term elections. The key priority will be to pass a spending bill that prevents a government shutdown on October 1st. The Senate has passed an $857 billion spending bill, but there are key differences between the House and Senate bills that must be resolved, while the President has threatened a government shutdown if the bill does not include funding for a border wall. Two other bills have a November 30th expiration, specifically the Federal Aviation Administration reauthorization bill and an extension of the National Flood Insurance Program.
With the possibility that Democrats may gain control of the House, there has been speculation about what action might then be taken to reverse some of the changes in the Tax Cuts and Jobs Act (TCJA). Priority topics are likely to include increasing the corporate tax rate and changing the treatment of capital gains and carried interest. There is more uncertainty about what action might be taken on the new cap on state and local tax deductions and the section 199A pass-through deduction.
Senate Finance Committee: The Senate Finance Committee has now approved the nominations of Charles Rettig to be IRS Commissioner, Michael Desmond as Chief Counsel for the IRS, and Justin Muzinick as Deputy Secretary of the Treasury. Policy disputes between Democrats and Republicans in the Senate, however, are currently holding up confirmation by the full Senate of all three men with objections lodged by SFC Ranking Member Ron Wyden (D-OR) and Senator Bob Menendez (D-NJ).
South Dakota v. Wayfair – Online Sales Taxation
With the House in recess, Congress has taken no further action in response to the Supreme Court decision in Wayfair. Individual states continue to respond to the decision with reports that 24 out of the 45 states with a sales tax are in various stages of requiring out-of-state retailers to collect taxes. Some states have started to enforce rules they already had in place (including Massachusetts), others have issued administrative guidance (including Alabama, Hawaii, Iowa, North Dakota, and Rhode Island), while others have announced that they will take action (including Utah, South Carolina, and Wisconsin). Other states working on responses include Maryland, Texas, and Louisiana. The state of New Hampshire, which does not have a sale tax, has reacted differently by focusing its efforts on protecting New Hampshire businesses from having to collect sales tax in other states (although an initial piece of legislation failed to gain approval in both the NH House and Senate), so work continues on a bill that will more effectively protect New Hampshire businesses. An unofficial draft of legislation circulating in California would require out-of-state retailers with $500,000 of annual sales into the state to collect and remit sales and use tax and includes a provision that the legislation would not apply retroactively.
The 8th Circuit vacated the Tax Court’s decision in Medtronic, Inc. v. Commissioner, No. 17-1866. The IRS had asserted in the Tax Court that the comparable profits method should be used to determine an arm’s-length royalty under Medtronic’s intercompany license agreement between the US parent and its Puerto Rican subsidiary, but the Tax Court agreed generally with Medtronic that the comparable uncontrolled transaction (CUT) method was the best method for determining an arm’s length royalty. The IRS appealed, looking for a reevaluation of the best transfer pricing method and a recalculation of the arm’s length royalty rate. In a unanimous decision, an 8th Circuit panel vacated the order of the Tax Court holding that the Court “did not address in sufficient detail whether the circumstances of the [agreement used as a CUT] were comparable to the licensing agreement between Medtronic and Medtronic Puerto Rico.” One of the judges wrote a concurrence emphasizing that consideration of all of the factors that affect comparability is mandatory under Treasury regulations under Code section 482.
Treasury and the IRS
- Section 965 Transition Tax: On August 1st, Treasury released proposed regulations related to the section 965 transition tax, which imposes a one-time deemed repatriation tax on the accumulated earnings of US multinationals’ foreign subsidiaries. The 249-page regulation package provides guidance for taxpayers on including the tax on their 2017 returns. Section 965 would tax overseas cash holdings at 15.5% and non-cash earnings at 8%, by deeming those funds repatriated to the US in 2017, with no future tax cost. Determining how to distinguish between cash and non-cash earnings has proven to be a difficult task for taxpayers and the IRS. The law included measurement dates of November 2, 2017, when the tax reform bill was first introduced in the House, and December 31, 2017. The proposed regulations affect US shareholders, as defined in Code section 951(b), with direct or indirect ownership in certain foreign corporations, as under Code section 965(e). The lower effective tax rates applicable to Code section 965 income inclusions are reached using a participation deduction set forth in Code section 965(c). A reduced foreign tax credit also applies with respect to the inclusion under Code section 965(g).
Taxpayers may generally elect to pay the transition tax in installments over an 8-year period under Code section 965(h). The guidance contains detailed information on the calculation and reporting of a US shareholder’s Code section 965(a) inclusion amount, as well as information for making the elections. The new rules generally track earlier guidance and the statutory language rather than “interpreting” the law in a way that might have a significant impact on companies either to their benefit or detriment. They provide more detail on issues addressed in prior Code section 965 notices, but they also addressed some issues for the first time, including foreign tax credits and basis adjustments. They do not address specific individual cases despite requests from taxpayers, stating that to do so would have been difficult to enforce and Congressional intent was clear.
- Passthrough Deduction rules: Treasury and the IRS issued a notice of proposed rulemaking including proposed regulations concerning the deduction for qualified business income under Code section 199A. The proposed rules are intended to provide taxpayers with computational, definitional, and anti-avoidance guidance regarding the application of Code section 199A. Code section 199A provides for a deduction of up to 20% of qualified business income (QBI) from a domestic business operated as a sole proprietorship, partnership, or S corporation and applies to taxable years beginning after 2017 and before 2026. The deduction is not available for wage income or for business income earned through a C corporation.
The proposed rules provide guidance on the following key topics: (1) definition of trade or business; (2) aggregation rules; (3) the definitions of a specified service trade or business (SSTB) and the trade or business of performing services as an employee; (4) rules for calculating QBI , qualified REIT dividends, and qualified publicly traded partnership (PTP) income; (5) operational rules; (6) the wage and basis limitation; and (7) rules for passthrough entities.
Treasury and the IRS also issued Notice 2018-64, which provides a proposed revenue procedure providing methods for calculating W-2 wages (1) for purposes of Code section 199A(b)(2), which, for certain taxpayers, provides a limitation based on W-2 wages to the amount of the deduction for QBI under Code section 199A(a); and (2) for purposes of Code section 199A(b)(7), which, for certain specified agricultural and horticultural cooperative patrons, provides a reduction to the Code section 199A(a) deduction based on W-2 wages.
- Treasury and the IRS released proposed regulations that provide guidance regarding the additional first year depreciation deduction under Code section 168(k), which allows a 100-percent additional first year depreciation deduction for qualified property acquired and placed in service after September 27, 2017 and before January 1, 2023 (with some exceptions). The proposed rules explain the requirements for depreciable property to qualify for the additional first year depreciation deduction. They also instruct on how to determine the additional first year depreciation deduction and the amount of depreciation otherwise allowable for this property.
- State and Local Tax Deduction: The IRS issued proposed regulations intended to block moves by some states to offset the loss of state and local tax deductions resulting from changes enacted in the TCJA. The new guidance sets forth rules for charitable contribution deductions when a taxpayer gets a corresponding state or local tax credit. The proposed rules “generally provide that if a taxpayer makes a payment or transfers property to or for the use of an entity listed in section 170(c), and the taxpayer receives or expects to receive a state or local tax credit in return for such payment, the tax credit constitutes a return benefit, or quid pro quo, to the taxpayer and reduces the charitable contribution deduction.” Exceptions are provided for dollar-for-dollar state tax deductions and for tax credits up to 15 percent of the payment amount, or of the fair market value of property transferred. The rules are proposed to take effect on August 27, 2018, and a public hearing is scheduled for November 5, 2018. Ways & Means Committee Chair Brady (R-TX) issued a statement endorsing the IRS guidance noting that the rules “rightly close the door on improper tax evasion schemes conjured up by state and local politicians … At the same time, Treasury is clearly seeking to preserve important state tax credit programs that were in place before tax reform that are genuinely designed to serve local charities, many of them educational.”
The States of Connecticut, Maryland, New Jersey, and New York have filed suit in federal court claiming that Republicans purposely targeted “blue states” by capping the state and local tax deduction. Republicans have indicated that a permanent extension of the state and local tax deduction cap is likely to be included in a Tax Cuts 2.0 package being worked on for the fall, but this could prove to be problematic as several Republicans from the states affected are opposed to the cap.
- Global Intangible Low-Taxed Income (GILTI): Treasury has submitted the first in what is expected to be a series of proposed regulations on global tax anti-avoidance rules to the Office of Management and Budget (OMB) for review. There is no announced date for completion of the review, but it is expected that these regulations will be released in the coming weeks. Treasury earlier this year set the release date for October.
The GILTI rules are considered to be a key element of the TCJA international framework by targeting income from intangible assets, such as intellectual property, held by US companies in low-tax foreign jurisdictions. The initial package of regulations are expected to address computational issues, with subsequent rules expected to address other important issues such as how foreign tax credit (FTC) limitations will apply to GILTI income, expense allocation, consolidated filers, and the accumulated earnings tax under section 531.
- The IRS issued Notice 2018-67, which provides interim guidance and transition rules for calculating Unrelated Business Taxable Income (UBTI) under Code section 512(a)(6) for exempt organizations with more than one unrelated trade or business. The guidance also covers the treatment of GILTI under Code section 951A for UBTI under Code section 511. The IRS explains that GILTI income will be treated as a dividend and therefore is generally excluded from UBTI under Code section 512(b)(1). Comments are due by December 3, 2018.
- The IRS issued Notice 2018-68, which clarifies the TCJA changes to executive compensation under Code section 162(m), which generally limits the allowable deduction for a taxable year for remuneration paid by any publicly held corporation with respect to a covered employee. The IRS explains that stakeholders have sought early guidance on the changes, and in particular “on the amended rules for identifying covered employees and the operation of the grandfather rule, including when a contract will be considered materially modified so that it is no longer grandfathered.” The notice addresses these issues with comments due by November 9, 2018.
- Revenue Procedure 2018-40 provides the procedures by which a small business taxpayer may obtain automatic consent to change its methods of accounting to reflect certain statutory changes made by the TCJA and requests comments with suggestions for future guidance under Code sections 263A, 447, 448, 460, and 471 to implement these changes. The new law generally expanded the number of small business taxpayers eligible to use the cash method of accounting to include taxpayers with average annual gross earnings of $25 million or less and exempted certain small business taxpayers from the requirements to capitalize costs under Code section 263A, to account for certain long-term contracts using the percentage completion method under Code section 460, and to account for inventories under Code section 471.
- Other areas that could see guidance during the next few months include entertainment expenses, hybrid dividends and payments under Code section 267A, rules regarding the business interest limitation under Code section 163(j), and the carried interest “loophole”.
Other Issues and Guidance
- The IRS issued final regulations on automatic and non-automatic filing extensions for certain information returns. The goal of the changes is to accelerate the filing of the Form W-2 series (except Form W-2G) and forms that report nonemployee compensation (currently Form 1099-MISC with information in box 7) so they are available earlier in the filing season for use in the IRS’s identity theft and refund fraud detection processes.
- Treasury and the IRS has withdrawn and reproposed certain portions of proposed regulations implementing the centralized partnership audit regime to reflect changes made by the Technical Corrections Act of 2018. In light of these technical corrections, to the extent regulations have not already been finalized, the proposed regulations issued in June, November and December of 2017 and February of 2018 are withdrawn and reproposed to reflect the technical corrections. Also, the IRS and Treasury issued final regulations under Code section 6223 regarding the designation and duties of the partnership representative under the centralized partnership audit regime. These final regulations affect partnerships for taxable years beginning after December 31, 2017.
- The IRS issued final regulations on the substantiation and reporting requirements for cash and noncash charitable contributions for: contributions greater than $500; the new definitions of qualified appraisal and qualified appraiser for noncash contributions; and recordkeeping requirements for all cash contributions.
Republican tax writers in Congress are urging the President to nominate a new ambassador to the OECD in order to protect changes in the TCJA which the EU could perceive as a threat and to fight against EU efforts to impose a new digital tax that will primarily hit US tech companies. Treasury historically has assumed a role in protecting US tax policy at the OECD, but they have a full agenda with guidance for the TCJA. Some tax experts in Europe believe that the OECD is working to delay the EU digital tax effort, because the OECD is planning to publish a framework for taxing the digital economy in 2020, signaling a possible turf war on this issue.
Pascal Saint-Amans, the director of the Center for Tax Policy and Administration at the OECD, recently praised the US in a public interview for implementing parts of the OECD BEPS package citing specifically the Base Erosion Anti-Abuse Tax (BEAT), which limits deductions on payments by a US corporate entity to related parties abroad, thereby ensuring that it doesn’t reduce its US taxable income to less than 10 percent. He believes that the US will be more open in the future to updating transfer pricing rules at the OECD in light of the underlying philosophy of this tax.
Tax Reform Update
Tax Cuts 2.0
Ways & Means Committee Chair Brady (R-TX) has said that the House is expected to vote on a Tax Cuts 2.0 package in September when the House returns to work from the August recess, but he also said that the Senate will determine its own schedule on a new tax bill. A spokesman for SFC Chair Hatch (R-UT) has said that he supports making the individual tax cuts from the 2017 law permanent and he will continue to work with his colleagues to find a “viable path and timing to achieve this goal.”
Senator Thune (R-SD) recently suggested that a vote on a Tax Cuts 2.0 package would not occur until the end of the year after the mid-term elections. Because the reconciliation process by which only a simple majority vote is needed will not be available this year, it will be necessary for tax legislation to get 60 votes to pass, which means some Democratic support will be needed.
Ways & Means Committee Chair Brady (R-TX) continues to say that technical corrections legislation will move separately from a Tax Cuts 2.0 package and mostly likely after the mid-term elections in order to give Treasury and the IRS more time to work on TCJA guidance. One issue for technical corrections legislation will be finding a “vehicle” for it to be attached to that will likely be considered in a lame duck session. The SFC has now agreed on a tax title to the FAA reauthorization bill that is identical to what was passed in the House, which eliminates that option.
SFC Chair Hatch (R-OR) and all Republican members of the committee sent a letter to Treasury Secretary Mnuchin and Acting IRS Commissioner Kautter outlining three policy areas which they believe are in need of technical corrections under the TCJA. The letter asks Treasury and the IRS to issue guidance that is consistent with the Congressional intent of the new tax law regarding qualified improvement property expensing, the net operating loss (NOL) deduction, and the sexual misconduct settlement deduction. With respect to the depreciation of real property, the letter states that “eliminating the separate definitions of qualified leasehold improvement, qualified restaurant, and qualified retail improvement property and providing a new single definition of qualified improvement property, the language … failed to designate qualified improvement property as 15-year property under the modified accelerated cost recovery system (“MACRS)”. For NOLs, the letter states that the law includes language stating that the modifications made to NOL carryforwards and carrybacks apply to NOLs arising in taxable years ending after December 31, 2017, while Congressional intent was to provide that the NOL carryforward and carryback modifications are effective for NOLs arising in taxable years beginning after December 31, 2017. For the deduction for settlements, the letter states that the provision arguably prevents the recipient of any payment from deducting legal fees incurred in pursuing sexual harassment cases, because they are “related” to a settlement or payment that is subject to a nondisclosure agreement, and that Congressional intent was that attorneys’ fees would not be subject to the rule. The letter states that the committee continues to review the law for other possible areas that may need regulatory or legislative refinement, and that the intent is to introduce technical corrections legislation to address these items.