The Senate Tax Bill: An Analysis

On November 9, 2017, the “Tax Cuts and Jobs Bill” (the “Bill”) was introduced in the Senate Finance Committee. A version was approved by the committee on November 16 (the “Senate Bill), and has been sent to the full Senate for consideration. The House of Representatives passed a similar version of the Bill on November 16, 2017 (the “House Bill”). The version passed by the House is identical to the version described in our client alert of November 16, 2017, but differs in many respects from the Senate Bill.

The Bill is proposed to be generally effective starting in calendar year 2018 (or fiscal years that begin after December 31, 2017). Under the Senate Bill, most of the tax provisions will expire on December 31, 2025. Unless the effective date is otherwise mentioned, the discussion below applies to 2018 through 2025 taxable years.

Below is a discussion of the provisions of the Senate Bill. The Senate Bill varies significantly from the House Bill and major differences between the two are noted. (References below to the “Bill” are to both the Senate and House Bills (in most cases, due to the fact that the provisions are substantially identical).

Individual Taxation

 

2018 – Current Law

The House Bill

The Senate Bill

Ordinary Income Rate

Seven rate brackets ranging from 10-39.6%

Four rate brackets ranging from 12-39.6%

Seven rate brackets ranging from 10-38.5%

Long-term Capital Gains and Dividend Rate

Three rate brackets ranging from zero to 20%

No change

No change

Rate on Business Income

None

25% maximum rate;

reduction in 12% rate for low and middle-income taxpayers

Deduction of 17.4% to reduce rate

Alternative Minimum Tax (AMT)

Rate of 26-28%

Repealed

Repealed

Net Investment Income Tax

Rate of 3.8%

No change

No change

Personal Exemption

$4,150 per dependent, but a phase-out for high-income individuals

Repealed, but replaced with a credit

Repealed, but replaced with a credit

Basic Standard Deduction

$6,500 – single

$13,000 – joint

$12,200 – single (no children)

$18,300 – single with children

$24,400 – joint

$12,000 – single

$24,000 – joint

Child Tax Credit

$1,000 per child, but a phase-out for middle-income taxpayers

$1,600 per child, but a phase-out for high-income taxpayers

$2,000 per child, but a phase-out for high-income taxpayers

Dependent Credit

None

$300 per dependent, but a phase out for high-income taxpayers (eliminated after 2022)

$500 per US citizen dependent, but a phase out for high-income taxpayers (eliminated after 2022)

Family Flexibility Credit

None

$300 per taxpayer, but a phase out for high-income taxpayers (eliminated after 2022)

None

Kiddie Tax

Taxed at the parent’s rate

Taxed at trust rates (without the 12% bracket)

Taxed at trust rates (with only the 24%, 35%, and 38.5% brackets)

Itemized Deduction Limitation

No limit, but a phase-out for high-income individuals

No limit; phase out repealed

No limit; phase out repealed

Medical and Dental Expenses

Deduction over 7.5-10% of adjusted gross income

Repealed

No change

State and Local Taxes

Deduction allowed

Only real property taxes allowed (but limited to $10,000)

No deduction

Foreign Taxes

Deduction for real property and income taxes allowed

Only income tax deduction allowed

Only income tax deduction allowed

Mortgage Interest

Deduction on first $1.1 million of principal (on up to two residences)

Deduction on first $500,000 of principal on a single residence; existing debt grand-fathered

Deduction for home equity interest repealed; otherwise, no change

Investment interest

Deduction (but limited to investment income)

No change

No change

Charitable contributions

Deduction (but limited to 50% of adjusted gross income)

Limitation increased to 60%

Limitation increased to 60%

Teacher expenses

Up to $250

No deduction

Up to $500

Miscellaneous itemized deductions

Deduction over 2% of adjusted gross income

No change in limit, but some deductions repealed

No deduction

Penalty under Individual Healthcare Insurance Mandate

$695 or less

No change

Reduced to zero after 2018

Effect of Death on Basis

Step-up to fair market value

No change

No change

Estate Tax

Rate of 18-40%

Repealed after 2023

No change

Gift Tax

Rate of 18-40%

After 2023, maximum rate drops to 35%

No change

Estate and Gift Tax Lifetime Exclusion Amount

$5 million

$10 million

$10 million

Rate Brackets. The Senate Bill would not change the number of brackets. However, the rates and bracket thresholds would change significantly under the proposal. The rates under the Senate Bill and current law are as follows:

Married Couples Filing a Joint Return

Taxable Income

2018 – Current Law

The Senate Bill

$19,050 or less

10%

10%

$19,050 to $77,400

15%

12%

$77,400 to $140,000

25%

22%

$140,000 to $320,000

25-33%

24%

$320,000 to $400,000

33%

32%

$400,000 to $1,000,000

33-39.6%

35%

More than $1,000,000

39.6%

38.5%

 

Single Individuals

Taxable Income

2018 – Current Law

The Senate Bill

$9,525 or less

10%

10%

$9.525 to $38,700

15%

12%

$38,700 to $70,000

25%

22%

$70,000 to $160,000

25-28%

24%

$160,000 to $200,000

28-33%

32%

$200,000 to $500,000

33-39.6%

35%

More than $500,000

39.6%

38.5%

Under both versions of the Bill, the largest decrease in tax would potentially go to high-income married taxpayers. Under current law, the 39.6% rate applies to taxable income over $480,050. The increase to $1 million for the highest rate bracket would provide a significant benefit to this group. The benefit to high-income single taxpayers is not as great, as the highest rate bracket threshold only moved from $426,700 to $500,000. In the Senate Bill, the high rate drops from 39.6% to 38.5%. There is no reduction in rates under the House Bill.

The rates in the Senate Bill for low and middle-income taxpayers are lower than in the House Bill. The Senate Bill retains the 10% rate (which increases to 12% under the House Bill).

Under the House Bill, high-income taxpayers can also be subject to a phase-out of the benefits of the 12% rate. The Senate Bill did not include such a proposal.

AMT. The Bill would repeal the AMT. Most taxpayers who are currently subject to AMT are in that position because the AMT does not permit any deduction for taxes (other than business taxes). At first blush, the repeal of the deduction for state and local taxes under the Bill would not seem to impact AMT taxpayers since they were not receiving the benefit of such a deduction. However, the Senate Bill effectively repeals the AMT exemption (of up to $86,200 for joint taxpayers and $55,400 for single taxpayers) and does not allow a deduction for state and local taxes in its place. As a result, many AMT taxpayers that are in the 24% bracket under the Bill will see a tax increase (compared to their combined liability under current law).

Business Income. At present, individual rates on business income can go as high as 39.6%. The House Bill imposes a limitation on the tax rate on “qualified business income” of 25%.

The Senate Bill adopts a different approach to reducing the taxes owed by business owners. The Bill allows individuals to deduct an amount equal to 17.4% of domestic business income from a partnership, S corporation, or sole proprietorship. This provision reduces the rates on domestic qualified business income to a range of approximately 8.3 to 31.8%. The benefit of the 17.4% deduction does not apply to trusts and estates.

The Senate Bill only takes into account taxable income items that are effectively connected with a US trade or business. The House Bill did not impose such a limitation.

The deduction is generally limited to 50% of the W-2 wages (including elective deferrals and deferred compensation) paid during the calendar year that ends during the taxable year. Only wages that are allocable to qualified business income are taken into account. The wage limit will not apply to a taxpayer with taxable income of $500,000 or less ($250,000 in the case of a single individual) and is phased-in for taxpayers over the taxable income threshold.

Wages and guaranteed payments received by an equity-holder in a business will not be taken into account in determining the amount of qualified business income. This is a difference from the House Bill.

A qualified business loss is carried forward to reduce the amount of qualified business income in a future taxable year (solely for purposes of determining the amount of income that is eligible for the deduction). Such qualified business losses can be carried forward for an indefinite amount of time.

Qualified business income generally does not include investment-related income. In addition, service income earned by professionals or consultants will not generally be treated as qualified business income. However, taxpayers with taxable income of $500,000 ($250,000 for single taxpayers) or less will be able to treat service income as qualified business income. The benefit of the deduction is phased-out for taxpayers over the taxable income threshold.

Dividends received from a real estate investment trust (REIT) that does not qualify (under current law) for the lower tax rate for capital gains and dividends are treated as qualified business income. Similarly, patronage dividends received from a cooperative will also be treated as qualified business income.

The deduction of the 17.4% is not taken into account in determining the amount (or usage) of a net operating loss (NOL).

Excess Business Losses. At present, individuals can generally deduct active business losses. However, net losses from passive activities are carried forward indefinitely.

The Senate Bill would impose a limitation on all net business losses of an individual, estate, or trust. The House Bill has no such limitation.

Under the Senate Bill, net losses of an individual from a trade or business (including from a partnership or S corporation) in excess of $500,000 ($250,000 in the case of a single taxpayer) would be disallowed. The disallowed loss could be carried forward indefinitely. However, the proposed limit on NOL deductions of 80-90% of taxable income would also apply to the carryforward of excess business losses. The existing limit on passive losses would continue to apply.

Sales of Investments. If an investor acquires shares or securities on different dates or at different prices and sells some (but not all) of the shares or securities, the investor is required to determine which shares or securities were sold and which ones were retained. The basis of the shares or securities sold are taken into account in determining the gain or loss realized. Presently, there are several methods available to taxpayers to determine which shares or securities were sold. They can use: (i) the first-in, first out approach (i.e., the longest held are treated as sold first), (ii) the specific identification approach (i.e., taxpayer chooses), or (iii), in the case of shares in mutual funds, the average cost method. The Senate Bill would eliminate the specific identification approach for sales or other dispositions after December 31, 2017. The proposed change will not apply to mutual funds themselves, only the shareholders.

Carried Interests. Investment managers frequently get a share of profits in investment vehicles that relate to the capital contributed by investors. The economics of such a carried interest bears resemblance to compensation for services. However, under current law, income from a carried interest is typically taxed at capital gains rates (up to 20%) if an underlying investment is held for at least one year.

The Bill would change the holding period for long-term capital gain treatment attributable to carried interests (i.e., a profits interest in a fund partnership that is received for services) from one year (the general requirement) to three years. This provision applies to gain on the sale or exchange of an interest in the fund partnership, as well as to gain recognized by a partnership from the sale or exchange of an asset held by the partnership for portfolio investment on behalf of third-party investors (e.g., securities, commodities, real estate, and options or derivatives with respect to the foregoing).

Gain that does not meet the proposed three year holding period requirement would be treated as short-term capital gain (even if the gain would otherwise be treated as ordinary compensation income pursuant to section 83).

This change may have limited effect on the tax treatment of employees and partners of private equity and real estate funds, since such funds frequently hold investments for more than three years. It may affect the employees and partners of hedge funds with respect to gain from the windup of the fund (but not gain from the underlying investments, which are typically held for less than one year).

The provision on carried interests does not apply to a partnership interest that is held by a corporation. It is possible that the provision provides an unintended exemption from the rule for carried interests that are held by S corporations.

A special rule applies if a carried interest is transferred to a member of the taxpayer’s family. In such case, the gain that is attributable to assets that are held by the partnership for less than three years is included in gross income by the transferor as short-term capital gain. A similar rule applies if the carried interest is reallocated by the partnership to another service provider.

Like many of the provisions in the Bill, the proposed changes to the taxation of carried interests apply to taxable years beginning after 2017. As a result, existing carried interests would potentially be subject to the new rules.

Deferred Compensation. Under current law, employers are able to offer compensation plans to their employees that allow them to defer the receipt of cash to future taxable years. If properly structured, the income is not subject to tax until the employee receives the amount in cash (actually or constructively). These plans are generally referred to as nonqualified deferred compensation plans, to distinguish them from plans that are considered qualified pension and profit-sharing plans (such as section 401(k) plans). Early versions of both the House and Senate Bills, proposed eliminating any deferral under deferred compensation plans. Such provisions are not in the current versions of either bill, but could be added back in the future.

The Bill provides for a new deferred compensation program for qualified equity grants. Under this new program, employees that receive employer stock will able to elect to defer the income for five years after vesting. This program will only apply to employers that are privately-held corporations if the plan provides that at least 80% of the US employees have a right to receive stock under the plan.

Other Personal Deductions. The Senate Bill would also repeal the following personal tax benefits:

  • Deduction for personal casualty losses (other than with respect to a federally designated disaster),
  • Charitable deduction of college athletic event seating rights,
  • Deduction for moving expenses (other than for members of the armed forces),
  • Exclusion for moving expense reimbursements, and
  • Exclusion for bicycle commuting reimbursements.

Taxpayers are able to exclude up to $500,000 of gain ($250,000, in the case of a single taxpayer) with respect to the sale of a principal residence. Under the Bill, a taxpayer must own and use the residence for at least five out of eight years ending on the date of the sale (as opposed to the current rule of two out of five years). The exclusion can only be claimed once during a five-year period (up from the current two years). The House Bill provides a phase out of the benefit of the exclusion for high income taxpayers. The Senate Bill does not provide for a phase out.

Business Taxation

C corporations are currently subject to tax under the greater of two income tax regimes (the income tax and the AMT). Under the regular tax, the rates range from 15-35%. Under the corporate AMT, the rate is 20%, but there is a broader base.

Under the Bill, the corporate tax rate will be reduced to 20%. In addition, the corporate AMT will be repealed. The tax rate on personal service corporations is also reduced to 20% (from 35%). The House Bill would impose a tax rate of 25% on personal service corporations.

The corporate tax provisions of the Senate Bill are proposed to apply to taxable years beginning after December 31, 2018 (e.g., calendar 2019). The House Bill proposed to lower the rates for taxable years beginning after December 31, 2017.

Integration. C corporations are subject to two layers of tax (once at the corporate level and once at the shareholder level when dividends are paid). The Bill, as currently drafted, does not provide for relief for the current double taxation. However, the Senate Bill does provide for a dividends paid deduction at a zero percent rate. This appears to be intended to put a mechanism in place for a later provision.

Current law does provide a measure of integration where one corporation is a shareholder in another corporation. In such case, 70% of any dividends are not generally subject to tax (80%, if the shareholder owns 20% or more, by vote and value, of the corporation paying the dividend). The Bill would change these exclusion amounts to 65% and 50%, respectively. The 100% exclusion for dividends from a member of the same affiliated group is preserved.

The Senate Bill imposes a new information return requirement on corporations that pay dividends to shareholders. These returns are to be attached to the corporation’s income tax return. There is an exemption from the filing requirement for mutual funds, REITs, S corporations, tax-exempt organizations, cooperatives, and a domestic international sales corporations (DISCs). A penalty of $1,000 per day is proposed to apply for late filings of the return (with a maximum of $250,000).  

Cost Recovery of Tangible Assets. The Bill provides for businesses to fully expense tangible assets that would otherwise be subject to depreciation (other than buildings and structures). Currently, the bonus depreciation rules allow taxpayers to expense 50% of the costs of depreciable assets placed in service before January 1, 2020. The Bill would allow taxpayers to take bonus depreciation of 100% of the costs of assets placed in service after September 27, 2017 and before January 1, 2023. Unlike the House Bill, the Senate Bill does not allow taxpayers to take bonus depreciation for used property (which is not currently allowed).

At present, expensing under section 179 is limited to $500,000, but phases out at certain levels. This would be changed to $1 million for assets placed in service in taxable years beginning after 2017. The phase-out amount would increase to $2.5 million (from $2 million). The House Bill provided a limit of $5 million and a phase-out amount of $20 million. Section 179 expensing would be expanded to cover certain real estate improvements.

The Senate Bill increases the depreciation limitations on passenger automobiles to approximately 300% of the limitations that would otherwise have applied. The new limit for the year placed in service is $10,000 ($16,000 in the second year, $9,600 in the third year, and $5,760 in the fourth and subsequent years). The House Bill, instead, increases the amount of basis limit under the bonus depreciation rules for automobiles to $16,000 (from $8,000).

The Senate Bill shortens the recovery period for real estate to generally 25 years (from 39 years for nonresidential property and 27.5 years for residential rental property). The recovery period under the alternative depreciation system (ADS) is shortened to 30 years for residential rental property (from 40 years). The recovery period for nonresidential property remains at 40 years for ADS purposes. Certain improvements to real estate will be depreciable over 10 years (as opposed to the current 15-year recovery period).

Many states do not follow the federal rules regarding expensing and depreciation of tangible assets. As a result, it is very possible that many of these proposed changes will not affect a business’ state tax liability.

Interest Deduction. Business taxpayers are generally allowed an interest deduction, as long as certain requirements and limitation rules are followed. The Bill proposes to further limit the deduction for net business interest expense (i.e., the excess of expense over income). The new limit will be 30% of adjusted taxable income (i.e., taxable income attributable to business activities before deductions for net interest, NOLs, and the 17.4% deduction for pass-through income). (The House Bill has an adjustment for depreciation and amortization that is not in the Senate Bill.) A similar provision currently applies (with a 50% limit) for corporate debt that is borrowed from certain related parties.

Business interest that is disallowed can be carried forward indefinitely (but, in the case of a corporation, subject to limitation under section 382 if an ownership change occurs). (The House Bill would only allow a carryforward of up to five taxable years.) Partnerships and S corporations will apply the new limit at the entity level. This new limit will not apply to small businesses.

Methods of Accounting. The Bill will allow small businesses to use simplified methods of accounting. These rules will apply to taxpayers with average annual gross receipts (over a three-taxable-year period) of less than $15 million (compared to the current $5 million and $25 million in the House Bill). Small businesses will generally be permitted to use the cash method, avoid uniform capitalization (UNICAP) and percentage of completion rules, and account for inventory as non-incidental materials and supplies (or in conformity with the financial accounting treatment). Small businesses will also be exempt from the new limitations on the deduction of business interest.

The Senate Bill changes the rules for recognition of gross income. An accrual method taxpayer who takes into account income on an applicable financial statement (e.g., audited by a CPA) will be required to recognize the income for tax purposes. Essentially the rule imposes a form of book-tax conformity. This would generally include any unbilled receivables for partially performed services if taken into account for accounting purposes. The book recognition rule would not apply to income from long-term contracts.

The Senate Bill also permits accrual method taxpayers to elect to defer a portion of an advance payment for up to one taxable year. Certain advance payments already receive this treatment under applicable regulations and other guidance, but the Senate provision would expand and codify the exception. The new rule would not apply to rents, interest, and other specified payments

Net Operating Losses. NOLs can generally be carried back two taxable years and carried forward twenty taxable years under current law. However, for AMT purposes, the NOL deduction is limited to 90% of AMT taxable income. The Bill would generally eliminate the ability to carry back a post-2017 NOL, but allow taxpayers to carryforward such NOLs indefinitely. Under the House Bill, small businesses (average annual gross receipts of $5 million or less) would be permitted to carry NOLs back one taxable year.

The NOL deduction in post-2017 taxable years would be limited to 90% of taxable income (before the NOL deduction). Under the Senate Bill, the limit drops to 80% in taxable years beginning after 2022. Under the House Bill, the amount of any post-2017 NOL carryforward would be adjusted each taxable year for inflation.

Research and Development. At present, research and experimental expenses can be deducted (or amortized over five years). Under the Bill, such costs (including software development costs) can only be amortized over five years (fifteen years with respect to foreign research), applying a half-year convention. This change applies to costs that are paid or incurred during taxable years beginning after 2025 (2023 in the House Bill).

The Bill does not make any changes to the research credit.

Like-Kind Exchanges. Taxpayers can exchange real and personal property that are held for business or investment (other than financial assets) for property of a like-kind on a tax-deferred basis. The Bill would limit the like-kind benefits to exchanges of real property.

Partnerships. Under current law, a partnership is deemed to terminate (and re-form as a new partnership) if there is a sale or exchange of 50% or more of the partnership interests (by capital and profits) over a one-year period. The House Bill proposes to repeal these provisions. The Senate Bill does not propose to change the law.

A partner is not permitted to deduct partnership losses and deductions that are in excess of the partner’s basis. Currently, there is some uncertainty as to whether this rule applies to charitable and foreign income tax deductions. The Senate Bill clarifies that the basis limitation applies to both such deductions. However, no limitation will be applied to any built-in gain (i.e., the excess of fair market value over basis) on property contributed by a partnership to a charity.

Excessive Officer Compensation. There is a limitation on compensation deductions with respect to publicly-held corporations. The deduction is limited to $1 million per employee and the limitation applies to the chief executive officer (CEO) and the four highest paid officers. Under the Bill, the provision will now cover the CEO, the chief financial officer (CFO), and the three highest paid officers. In addition, once an employee is covered, he/she is covered forever (including the period after termination and/or death).

In the past, companies have been able to take deductions in excess of $1 million by applying statutory exceptions for performance-based compensation and commissions. The Bill repeals these two exceptions. The Bill also increases the reach of the deduction limitation by expanding the number of companies that are potentially covered.

The changes to the compensation deduction under the Senate Bill are intended to only be prospective. The changes are not proposed to apply to compensation under a written binding contract that was in effect on November 2, 2017, and not modified afterwards.

The rules on excessive officer compensation do not currently affect tax-exempt organizations since they typically do not benefit from tax deductions. Under the Bill, tax-exempt organizations will be subject to a $1 million limitation. Compensation in excess of that amount will be subject to a 20% excise tax. The new rules will apply to compensation paid to the five highest paid employees of the organization. Tax-exempt organizations will also be subject to a 20% excise tax on severance payment made to such employees over a certain amount.

Worker Classification. An earlier version of the Senate Bill would have made it easier for businesses to treat their workers as independent contractors (instead of as employees). The provision is not included in the current versions of either the House or Senate Bills.

Other Business Deductions. The Senate Bill would also repeal the following business tax benefits:

  • section 199 deduction for domestic production activities (after 2018),
  • deduction for entertainment, amusement, or recreational activities (including club dues),
  • deduction for tax-free employee fringe benefits for parking, transportation, and meals provided for the convenience of the employer,
  • deduction for amounts paid to a governmental entity in relation to a violation of any law (or a governmental investigation or inquiry) after the date of enactment,
  • deduction for payments (including attorney’s fees) related to sexual harassment or abuse (if subject to a nondisclosure agreement) after date of enactment,
  • deduction for unused business credits, and
  • deduction for local lobbying expenses after the date of enactment.

The House Bill has a provision that would require entities to take subsidies from third parties (including governmental entities) into gross income (ending the exclusion for contributions to capital). The Senate Bill has no such provision.

International Taxation

Under existing rules, the US technically taxes corporations and businesses on their world-wide income. However, the tax on income earned by foreign subsidiaries can generally be deferred indefinitely if the earnings are kept off-shore.

The Bill will replace the global model for international taxation of corporations with a partial territorial model. Income earned offshore through foreign corporate subsidiaries generally will no longer be subject to current US tax. However, foreign income earned through foreign branches (or indirectly through disregarded entities and partnerships) will continue to be subject to US tax.

Individuals who are citizens and legal residents (green card holders) are taxed on their world-wide income, even if they are residents of another country. There has been a movement by some to have the Bill change the tax regime for individuals to a territorial system. This idea has not been incorporated in the Bill.

Individuals that own foreign businesses are treated particularly harshly under the Bill. Dividends received by individuals from foreign corporations will continue to be subject to tax. Such dividends do not receive any of the benefits of the new territorial regime. In addition, individuals will pay tax on their share of deferred foreign income of a controlled foreign corporation (CFC) as a result of the transition to the territorial regime.

The Bill does not make significant changes in how most foreign investors in the US are taxed.

Dividends. Dividends received by a US corporation from a foreign corporate subsidiary are currently subject to tax. However, the tax can be reduced by tax credits for taxes paid by the foreign subsidiary.

Under the Bill, dividends received by US corporations from foreign corporate subsidiaries will generally be exempt from tax if the taxpayer owns at least 10% of the subsidiary (by vote or value). The portion of any dividend that is attributable to US source earnings of the subsidiary is not eligible for the exclusion. The exemption will not apply if the subsidiary is a passive foreign investment company (PFIC) (that is not also a CFC) or if the shareholder did not own the stock for at least one year (out of a two-year period beginning one year before the dividend is effective). The House Bill required only a six-month holding period out of a one-year period. The exemption is also not available under the Senate Bill if the foreign corporation received a dividends paid deduction (or other tax benefit) in a foreign country.

Under the Senate Bill, gain recognized from the sale or exchange of stock of a foreign corporation is exempt from tax if the gain is treated as a dividend under section 1248. Gain that is treated as capital gain will continue to be subject to tax. In contrast, if a CFC recognizes gain from the sale or exchange of stock in another foreign corporation and the gain is treated as a dividend under section 964, the US shareholder will include the deemed dividend in income (to the extent the dividend is treated as from foreign sources).

The rules allowing for a deemed paid foreign tax credit on dividends would be repealed. In addition, foreign taxes that are paid with respect to exempt dividends will not be eligible for a deduction or foreign tax credit.

If a US corporation receives an excluded dividend from a foreign subsidiary, the basis in the stock of the foreign subsidiary will be reduced for purposes of a realized loss (but not for purposes of a gain). As a result, the shareholder will have a different basis for gain and loss purposes.

The Senate Bill’s change to the treatment of dividends is proposed to be effective for taxable years of foreign corporations beginning after 2017 (and to taxable years of US shareholders which include the end of such foreign corporation taxable years).

Deferred Foreign Income. There are currently trillions of dollars of earnings that have been deferred under the existing global regime. The Bill would tax the entire amount currently (or in installments). As a result, a domestic 10% shareholder of a foreign corporation will generally include in gross income the deferred foreign income of the corporation. The amount will be includable for the taxable year which includes the last taxable year of the foreign corporation that begins before January 1, 2018. For a calendar year foreign corporation, the amount would be includable on the tax return that includes December 31, 2017.

The amount included is the accumulated foreign earnings of the corporation that was not previously subject to US tax (determined as of November 9, 2017, or December 31, 2017 if the amount is greater). Earnings that were deferred before 1986 are not taken into account. In addition, earnings that accrued during a period in which the foreign corporation had no 10% US shareholders are not taken into account. Deficits from one foreign corporation are allowed to offset deferred foreign income of another foreign corporation held by the same taxpayer (or members of an affiliated group). There is no exclusion from the tax for earnings that accrued before the US shareholder acquired the shares. For example, if a US person acquired 100% of a foreign corporation from another US shareholder in 2016, the purchasing shareholder would include 100% of the corporation’s post-1986 earnings.

US shareholders are entitled to exclude some of the deferred foreign income. Under the Senate Bill, US shareholders can exclude 71.4% of so much of the deferred foreign income that is held in liquid assets (e.g., cash, accounts receivables (reduced by accounts payables), and securities). Of the remaining deferred foreign income, a US shareholder can exclude 85.7% of the income. The exclusion amounts of 71.4% and 85.7% produce an effective tax rate of 10% and 5% for a C corporation that pays tax at the 35% rate. For other taxpayers (e.g., individuals) the actual tax rate will differ depending on the actual marginal rate. (The House Bill used rates of 14% and 7% for all taxpayers.) Taxpayers will have the ability to elect to avoid utilizing NOLs to offset deferred foreign income.

Taxpayers can elect to pay this tax in eight annual installments (starting in the taxable year in which the tax would otherwise be due). No interest is charged on the installments if paid on time. The future installments will come due immediately if the taxpayer misses a payment (or sells or ends his business).

The tax on the deferred foreign income incurred by a US corporation (but not other taxpayers) can be reduced by tax credits for foreign taxes that were paid or accrued by the foreign corporation. However, the amount of the foreign tax credit (or foreign tax deduction) will be reduced to take into account the fact that the income is being taxed at a lower rate than the normal corporate tax rate of 35%.

The requirement to include the deferred foreign income of foreign corporations applies to any 10% US shareholder (individual, partnership, or corporation) of a CFC and any US corporation that is a 10% shareholder in a corporation that is not a CFC. For this purpose, a person is a 10% shareholder if he owns 10% of the stock (by vote), directly or indirectly by attribution. The requirement to include deferred foreign income will not apply to a foreign corporation that is a PFIC that is not also a CFC.

The requirement that non-corporate shareholders pay tax on the post-1986 earnings of a CFC seems particularly unfair as these taxpayers do not benefit from the new territorial system. It may be possible for individuals to reduce the tax on the deferred foreign income by making an election to be taxed at corporate rates.

The enactment of the tax on deferred foreign income could have a significant effect on the financial statements of multi-national companies. Many companies do not currently accrue the potential future US tax on deferred foreign income since, under current law, the tax can be deferred indefinitely. When the Bill is enacted into law, many such companies will need to change their accounting treatment of the tax and provide for a current expense on their financials.

Subpart F. US persons that own at least 10% of a CFC are subject to income inclusion rules in certain circumstances. The Bill makes several modifications to the subpart F rules in the nature of cleaning up the provisions.

The de minimis exception of $1 million will now be adjusted for inflation. The look-thru rule for related CFCs (which was scheduled to expire in 2019) is now made permanent. The stock attribution rules are modified to allow attribution from a foreign person to a US person. The exemption from subpart F income for corporations that were not controlled for at least thirty days within a taxable year is repealed.

The Senate Bill would expand the subpart F rules to cover US shareholders that own at least 10% of a CFC (by vote or value). Under current rules, only the vote is relevant. As a result, a foreign corporation will be treated under the Senate Bill as a CFC if a US shareholder owns more than 50% of the stock (by value), even if the shareholder has no voting rights.

US corporations that include subpart F income are entitled to a tax credit for foreign taxes paid by the CFC (or a subsidiary). The Senate Bill would simplify these rules.

The Bill also repeals the requirement that a US corporation include amounts in gross income if a 10%-owned CFC has an investment in US property. The requirement will still apply to individuals (and other non-corporate shareholders).

Foreign Tax Credit Rules. Taxpayers that pay foreign taxes (or are deemed to pay such taxes through a subsidiary) are entitled to apply a credit against the taxes otherwise owed (subject to limitations). The Senate Bill makes some changes to the foreign tax credit rules.

The Senate Bill would change the way the foreign tax credit limitation rules apply to foreign branches. Currently, the income is treated as general limitation basket income. Under the proposal, net income from a foreign branch (other than passive income) would be allocated to a separate bracket.

Interest expense is currently apportioned between US and foreign sources based on either fair market value or adjusted tax basis of assets. The Senate Bill would eliminate the ability to apportion based on fair market value.

An election is provided for in the tax rules to allow companies to allocate interest expense for foreign tax credit purposes on a worldwide basis. The election can only be made in taxable years beginning after December 31, 2020. The Senate Bill would accelerate the effective date of the election to taxable years beginning after December 31, 2017.

Sales of Partnerships. There is presently a controversy as to whether foreign partners are subject to US tax upon the sale of a partnership interest (where the partnership has a US trade or business). The long-standing position of the Internal Revenue Service (IRS) is that such partners are taxable on the gain. The Tax Court recently held that foreign partners are not generally subject to tax.

The Senate Bill would impose a tax on such sales. In addition, a person acquiring a partnership interest will be required to withhold 10% of the amount realized if the partnership has a US trade or business. A transferor that is a US person will be permitted to avoid withholding by submitting an affidavit as to their tax status. If the transferee fails to withhold, the partnership will be required to make up for the failure by withholding on distributions to the new partner. The change in the tax treatment for dispositions of partnership interests is proposed to apply to transactions that take place on or after November 27, 2017.

Export Subsidies. Presently, taxes on exports can be reduced by using a DISC. These provisions are proposed to be repealed by the Senate Bill effective for taxable years beginning after December 31, 2018.

The DISC rules would be replaced in the Senate Bill by a partial exclusion for foreign exports under a very complicated formula. The proposal would allow for an exclusion of 37.5% of foreign-derived intangible income of a US corporation. This exclusion cannot be used to create an NOL. The effect of the exclusion is to provide for an effective rate for C corporations of 12.5%, This lower rate is intended to compare favorably to Ireland which imposes a 12.5% rate on headquarter companies. Foreign-derived intangible income is generally the excess return on investment (i.e., exceeds a target 10% return on investment in tangible property) to the extent attributable to foreign source sales of property and services to unrelated persons.

Unlike the DISC rules, the foreign-derived intangible income provisions would not require US corporations to set up a separate subsidiary to benefit from the exclusion. Some commentators have expressed a view that this exclusion for foreign-derived intangible income may be an export subsidiary that violates rules and obligations with respect to the World Trade Organization (WTO) and various treaties. The new provisions bear some resemblance to prior export subsidies that were ruled to be illegal (e.g., foreign sales corporation rules and the extraterritorial income system).

Anti-abuse Rules. The Bill has several provisions that are designed to prevent abuses by US multinational corporations.

Currently, US persons are generally able to transfer a foreign branch to a foreign subsidiary on a tax-deferred basis under the active trade or business exception. The Senate Bill repeals the active trade or business exception. The proposed change applies to transfers after December 31, 2017.

In addition, the Bill provides that if a US corporation transfers the assets of a foreign branch to a foreign subsidiary, the US corporation is required to recapture previously-deducted losses of the foreign branch. Only losses incurred by the branch after December 31, 2017 are taken into account for this purpose. The amount of losses recaptured are generally reduced by (i) taxable profits in later taxable years, and (ii) gain recognized by the US corporation on the transfer. The amount taken into account is limited to the aggregate dividends from foreign corporations that are excluded from gross income in the taxable year of transfer. Any amount in excess of the limitation is carried forward indefinitely.

US corporations frequently reduce US tax by transferring intellectual property offshore. The Senate Bill places limits on income shifting through intellectual property transfers. First, existing rules on transfers of intellectual property will now apply to workforce in place, goodwill (both foreign and domestic), going concern value, and similar items. Second, the proposal would clarify that the IRS has the authority to specify the methods used to determine the value of intellectual property (both for transfer pricing and outbound transfer purposes).

Under the proposals described in the previous paragraph (and the lower tax rates), having intellectual property offshore may no longer be desirable. As a result, the Senate Bill would allow US corporations to bring intangible property, held by a CFC on the date of enactment, back to the US on a tax-deferred basis. To benefit from this provision, the property must be distributed by the last day of the taxable year of the CFC beginning in 2020.

One effective means of international tax planning is to take advantage of situations where two countries treat the same entity or transaction differently (e.g., one country treats the entity as a branch and the other treats it as a corporation). The Senate Bill would disallow deductions for interest and royalties to a related party pursuant to a hybrid transaction (tax treatment is different in the other country) or to a hybrid entity (tax classification is different in the other country). These provisions would generally apply if the payment is not taken into account as taxable income in the other country. The Treasury Department is to be granted broad authority to provide regulations or other guidance to carry out the purposes of these rules.  

The Senate Bill would limit the deduction of interest for US corporations that are members of a “worldwide affiliated group.” For a US corporation that is a member of such a group, any net interest deduction is reduced to take into account differences in the debt-equity ratio of the US corporation and the worldwide affiliated group. For this purpose, a worldwide affiliated group is a group of controlled corporations, applying an ownership standard of more than 50% (by vote and value). Under this proposal, the US members of the group are permitted a net interest deduction equal to 110% of the amount of interest they would have been entitled to if their debt-equity ratio were the same as the global ratio for the group. Any disallowed interest can be carried forward indefinitely. This limitation for worldwide affiliated groups is in addition to the general limitation of 30% of adjusted taxable income. As a result, taxpayers subject to both limits would be allowed the lower of the two.

The House Bill would apply a similar limit on the deduction of net interest to groups that file a consolidated financial statement (without regard to statutory related party rules). The House Bill has an exemption for groups with gross receipts of $100 million or less over a three-year period. The House Bill also differs from the Senate Bill in that the limitation is based upon the US corporation’s share of the group’s worldwide net interest.

The Senate Bill would impose a 10% minimum tax on C corporations. For purposes of the minimum tax, taxable income is recomputed to disallow the tax benefit of any base erosion payment. A base erosion payment is an amount paid to a related foreign party for which a deduction is allowable, other than certain service costs with no markup. A base erosion payment also includes an amount paid that is taken into account in determining cost of goods sold if the payee participated in an inversion transaction after November 9, 2017. Any NOL deduction is reduced by the portion that is attributable to base erosion payments. The tax benefit of a base erosion payment is allowed if the payment is subject to US withholding tax at a 30% rate (and a lesser benefit is allowed if a lower withholding tax rate applies).

The minimum tax does not apply to mutual funds, REITs, and S corporations. It also does not apply if the corporation has average annual gross receipts of less than $500 million (including the gross receipts of related persons), over a three-taxable-year period. Additionally, there is an exception if the base erosion percentage is less than 4% for the taxable year. The base erosion percentage is determined by dividing the amount of the base erosion tax benefits by the aggregate deductions for the taxable year.

The House Bill does not provide for a minimum tax. Instead, their version imposes a 20% excise tax on base erosion payments (other than interest and certain service costs with no markup). The House Bill’s gross receipts exception applies a $100 million standard and there is no 4% de minimis exception.             

Special rules are provided in the Senate Bill for global intangible low-taxed income (GILTI). This provision is an attempt to combat situations where US corporations have transferred intellectual property (e.g., patents) to foreign subsidiaries in jurisdictions with low tax rates. It is not clear as to why the GILTI provisions make reference to low-taxed income since the provision (like the equivalent House Bill) seems to effect high foreign returns and seems to apply regardless of whether the income is subject to a low or high foreign income tax.

A 10% US shareholder of a CFC (by vote or value) will be required to include an amount in income under the proposed GILTI rules to the extent the income of one or more CFC exceeds a target 10% return on investment in tangible property The amount of income is determined on an aggregate basis (i.e., combining the pro rata share of activity of all CFCs for which the US shareholder has at least a 10% interest). The GILTI provisions are extremely complicated and there is no exemption for small taxpayers.

A US corporation (but not other taxpayers) is permitted to exclude 50% of the income under the GILTI provisions. This reduces the effective corporate rate to 10%. This exclusion cannot be used to create an NOL.

A US corporation that includes an amount in gross income under the GILTI provisions is permitted to reduce the tax paid on the amount by a tax credit with respect to foreign income taxes paid by the CFC. However, the amount of taxes taken into account are reduced by 20% and reduced further to the extent some of the income was excluded from gross income. The foreign tax credit limitations are determined by treating the inclusion under the GILTI provisions as a separate basket. Any foreign tax credits that are not used in the year of inclusion cannot be carried back or forward.

The House Bill takes a different approach to dealing with attempts to improperly push profits offshore. Under their provision, 50% of a CFC’s income would be taken into account by a 10% US shareholder if the CFC has a high return on its investment.

Inversions. In recent years, several multinational companies with headquarters in the US have tried to move their headquarters to a foreign country to avoid US tax on foreign earnings. The Bill does not provide any general rules to prevent further attempts at so-called “inversions,” but does provide rules to take some tax benefits away from companies that invert. It is possible that inversions may no longer provide a benefit once the US adopts a low rate and a territorial system.

The Senate Bill does provide that if a US corporation undergoes an inversion within ten years of the enactment of the Bill, then the deferred foreign income is taxed at 35% (instead of 5% or 10%), without any reduction for foreign tax credits. Any additional tax will be reported in the taxable year of the inversion.

Dividends received by individuals are generally subject to a maximum tax of 20% if paid by US corporations or foreign corporations that are eligible for benefits under a double tax treaty with the US (other than PFICs) . The Senate Bill would eliminate the special rates for dividends received from corporations that have inverted. As a result, such dividends could be taxed as a rate as high as 38.5%. There is an exception for situations in which the inverted corporation is treated as a US corporation for US income tax purposes.

Employees of an inverted company are currently subject to a 15% excise tax on stock compensation received. The Senate Bill would increase the tax rate to 20%.

Other Provisions. Sales of inventory are generally sourced based on the place where title passes between buyer and seller. However, a different rule applies if the goods are produced by the taxpayer. In such case, profit is sourced in part to the US and in part abroad if the goods are produced by the taxpayer in the US and sold abroad (or vice versa). Under the Bill, the profits will be sourced solely on the basis of where the production activities occur. As a result, goods that are produced in the US and sold abroad will now be considered entirely US source income (and vice versa).

There is a penalty imposed on the late filing (or non-filing) of Form 5472, an information return with respect to US corporations that are 25% foreign-owned. The penalty is currently imposed at the rate of $10,000 per filing. The Senate Bill proposes to increase the penalty to $25,000 per filing.

WTS Observation

The Bill presents a major overhaul of many longstanding aspects of US taxation. Even though the Republican Party controls the Presidency and both houses of Congress, there is a great deal of uncertainty as to whether the Bill will become law (and how many of the proposals in the Bill will be retained in final legislation). Leaders of the House and Senate would like to have the Bill enacted into law before Christmas.

One surprising aspect of the Bill is that there are so many taxpayers whose taxes will increase as a result (either in 2018 or several years later). The individuals whose taxes will increase are in all income brackets. That being said, businesses seem to generally do the best under the proposed changes.

The Bill is estimated to cut taxes by approximately $1.4 trillion over ten years (and will increase the deficit by approximately $1.6 trillion due to additional interest charges). The proponents of the Bill believe that the increased economic growth caused by the tax reductions will provide extra tax revenue for the government and will pay for some or all of the projected increase in the deficit. Time will tell if they are correct.

Contact:

Lee G Zimet  Francis J. Helverson    
+1 973 871 2043 - lzimet@wtsus.com    +1 973 401 1141 - fhelverson@wtsus.com

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The foregoing information is provided by WTS LLC for educational and informational purposes only and does not constitute tax advice. This information may be considered advertising under applicable state laws.

WTS LLC © 2017

US Tax Reform – Senate Bill would Tax Foreign Partners on the Sale of Partnership Interests

US Tax Reform – Senate Bill would Tax Foreign Partners on the Sale of Partnership Interests

November 16, 2017

As discussed in our client alert of July 14, in the Grecian Magnesite case, the United States Tax Court ruled that, under the facts presented, a foreign partner could sell its interest in a domestic (US) partnership tax-free even though the partnership was engaged in a US trade or business (USTB) and generated income effectively connected with a US trade or business (ECI).  This was contrary to a long-standing position taken by the IRS as set forth in Revenue Ruling 91-32.  The Court’s ruling has caused many foreign partners to consider the structure and timing of dispositions of their US partnership interests.

On November 9, the Senate released its version of the tax reform bill, which effectively calls for the codification of Revenue Ruling 91-32.  It would be effective for partnership dispositions occurring after December 31, 2017.  This would mean that the Tax Court’s ruling in Grecian Magnesite could no longer be relied upon to support tax-free treatment after year-end.  The Bill also imposes a 10% withholding tax on the transferee (or the partnership, if the transferee fails to withhold)

WTS Observations

Foreign partners considering a transaction involving the disposition of a US partnership with a USTB should consider implementing the transaction prior to December 31, 2017.  As noted in our July 14 alert, the Tax Court ruling did not exempt dispositions of partnerships holding so-called “hot assets” or US real estate (due to the FIRPTA rules).  However, qualified foreign pension funds (QFPFs) are no longer subject to FIRPTA.  As such, QFPFs could be particularly motivated to consider dispositions prior to year-end.

Contact:

Lee G Zimet  Francis J. Helverson            
+1 973 871 2043 - lzimet@wtsus.com      +1 973 401 1141 - fhelverson@wtsus.com

    

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The foregoing information is provided by WTS LLC for educational and informational purposes only and does not constitute tax advice. This information may be considered advertising under applicable state laws.

WTS LLC © 2017

Cut Cut Cut – An Analysis of the House Tax Reform Bill

On November 2, 2017, the long-awaited tax reform legislation was introduced in the House of Representatives by Kevin Brady, the Chairman of the House Ways and Means Committee. The package is being called the “Tax Cuts and Jobs Bill” (the “Bill”) and has received the designation of HR 1. A version of the Bill was approved by the Ways and Means Committee on November 9, and sent to the full House of Representatives for consideration.

On November, 9, a description of the Senate version of the Bill was released by the staff of the Joint Committee on Taxation. However, statutory language has not been released. The Bill is scheduled for consideration by the Finance Committee starting on November 13.

The Bill is generally proposed to be effective starting in calendar year 2018 (or fiscal years that begin after December 31, 2017).

Below is a summary of the provisions of the House Ways and Means version of the Bill. The Senate version varies significantly from the House version and will be the subject of a subsequent client alert.

Individual Taxes

Below is a summary of the provisions of the Bill that relate to the income tax liability of individuals.

 

2018 – Current Law

The Bill

Ordinary Income Rate

Seven rate brackets ranging from 10-39.6%

Four rate brackets ranging from 12-39.6%

Long-term Capital Gains and Dividend Rate

Three rate brackets ranging from zero to 20%

Slight change in thresholds, but no change in rates

Maximum Rate on Business Income

None

25%

Alternative Minimum Tax (AMT)

Rate of 26-28%

Repealed

Net Investment Income Tax

Rate of 3.8%

No change

Personal Exemption

$4,150 per dependent, but a phase-out for high income individuals

Repealed, but replaced with a credit

Basic Standard Deduction

$6,500 – single

$13,000 – joint

$12,200 – single (no children)

$18,300 – single with children

$24,400 – joint

Child Tax Credit

$1,000 per child, but a phase-out for middle income taxpayers

$1,600 per child, but a phase-out for high income taxpayers

Dependent Credit

None

$300 per person, but a phase out for high income taxpayers (eliminated after 2022)

Family Flexibility Credit

None

$300 per taxpayer, but a phase out for high income taxpayers (eliminated after 2022)

Kiddie Tax

Taxed at the parent’s rate

Taxed at trust rates (without the 12% bracket)

Itemized Deduction Limitation

No limit, but a phase-out for high income individuals

No limit; phase out repealed

Medical and Dental Expenses

Deduction over 7.5-10% of adjusted gross income

Repealed

State and Local Taxes

Deduction allowed

Only real property taxes allowed (but limited to $10,000)

Foreign Taxes

Deduction for real property and income taxes allowed

Only income tax deduction allowed

Mortgage Interest

Deduction on first $1.1 million of principal (on up to two residences)

Deduction on first $500,000 of principal on a single residence; existing debt grand-fathered

Investment interest

Deduction (but limited to investment income)

No change

Charitable contributions

Deduction (but limited to 50% of adjusted gross income)

Deduction (but limited to 60% of adjusted gross income)

Other itemized deductions

Deductions (but subject to limitations)

Repealed

Effect of Death on Basis

Step-up to fair market value

No change

Estate Tax

Rate of 18-40%

Repealed after 2023

Gift Tax

Rate of 18-40%

After 2023, maximum rate drops to 35%

Estate and Gift Tax Lifetime Exclusion Amount

$5 million

$10 million

Rate Brackets. The House version of the Bill would consolidate the individual rates from seven brackets to four. The rates under the Bill and current law are as follows:

Married Couples Filing a Joint Return

Taxable Income

2018 – Current Law

The Bill

$90,000 or less

10-25%

12%

$90,000 to $260,000

25-33%

25%

$260,000 to $1,000,000

33-39.6%

35%

More than $1,000,000

39.6%

39.6%

Single Individuals

Taxable Income

2018 – Current Law

The Bill

$45,000 or less

10-25%

12%

$45,000 to $200,000

25-33%

25%

$200,000 to $500,000

33-39.6%

35%

More than $500,000

39.6%

39.6%

Under the Bill, the largest decrease in tax would potentially go to high-income married taxpayers. Under current law, the 39.6% rate applies to taxable income over $480,050. The increase to $1 million would provide a significant benefit to this group. The benefit to high-income single taxpayers is not that great as the 39.6% rate threshold only moved from $426,700 to $500,000.

High-income taxpayers can also be subject to a phase-out of the benefits of the 12% rate. The benefit starts to phase out for joint taxpayers with adjusted gross income over $1,200,000 ($1,000,000 for single taxpayers). The additional tax applies at the rate of up to 6% of excess adjusted gross income.

The lowest tax rate increases from 10% to 12%. The drafters of the Bill believe that the increase in rates will be more than offset by the increase in the standard deduction.

AMT. The Bill would repeal the AMT. Most taxpayers who are currently subject to AMT are in that position because the AMT does not permit any deduction for taxes (other than business taxes). At first blush, the repeal of the deduction for state and local taxes under the Bill would not seem to impact AMT taxpayers since they were not receiving the benefit of such a deduction. However, the Bill effectively replaces the AMT exemption (of up to $86,200 for joint taxpayers and $55,400 for single taxpayers) with a real property deduction (of up to $10,000). As a result, many AMT taxpayers that are in the 25% bracket under the Bill will see a tax increase (compared to their combined liability under current law).

Lower Rate for Business Income. Generally, individual rates can go as high as 39.6%. However, the Bill imposes a limitation on the tax rate on “qualified business income” of 25%.

Qualified business income includes 100% of net taxable income derived from a passive business activity (i.e., a business activity in which the taxpayer does not materially participate) and, generally, any rental activity (real estate or equipment).

Qualified business income also includes the percentage of net taxable income derived from an active business activity (i.e., a business activity in which the taxpayer materially participates) that is attributable to capital (as opposed to labor) (the “capital percentage”). For many active businesses, the capital percentage will equal the default percentage of 30%. However, taxpayers can elect to determine the capital percentage based upon the business’ return on capital.

Wages, director’s fees, and guaranteed payments received by an equity-holder in a business will be taken into account in determining the amount of qualified business income. For example, if an individual is both a shareholder and an employee in an S corporation, the individual takes into account his share of the corporation’s taxable income and his wages in determining the qualified business income. However, the amount of such service payments is taken into account in determining the capital percentage and can result in a percentage below 30%. For example, if an individual receives a share of S corporation profits of $25 and wages of $75, the capital percentage would be reduced to 25% or less.

A qualified business loss is carried forward to reduce the amount of qualified business loss in a future taxable year (solely for purposes of determining the amount of income that is eligible for the 25% maximum rate). Such qualified business losses are carried forward for an indefinite amount of time.

Qualified business income generally does not include investment income (even if earned from an active business activity). In addition, service income earned by professionals or consultants in an active business will not generally be treated as qualified business income. However, there is an exception for service income received in capital-intensive businesses (e.g., dealers in securities).

The Bill provides for a lower rate for the first $75,000 ($37,500 for single taxpayers) of net business taxable income of an active owner or shareholder. The benefit phases out for taxpayers with taxable income of $150,000 ($75,000 for single taxpayers) or more. In 2018 and 2019, the tax rate on such business income will be 11% (instead of the normal rate of 12%). The rate will drop further in 2020 and 2021 to 10% and to 9% in 2022 and later.

Real Estate Professionals. Individuals who invest or develop real estate do particularly well under the Bill. First, 100% of net rental income will generally qualify for the 25% rate. Second, as described in more detail below, the ability to make tax-deferred exchanges of property is retained for real estate. This allows taxpayers to permanently avoid paying income tax on real estate gains since the basis is stepped-up to fair market value on death. When the estate tax is repealed in 2023, the property will then also avoid estate tax, as well as income tax.

Carried Interests. Investment managers frequently get a share of profits in investment vehicles created by them that is in excess of the amount contributed. The economics of such a carried interest bears resemblance to compensation for services. However, it appears that, under current law, income from a carried interest is taxed at capital gains rates (up to 20%).

The Bill would change the holding period for long-term capital gain treatment for carried interests from one year (the general requirement) to three years. This provision applies if a partnership interest is transferred to a taxpayer (or related person) in connection with the performance of services related to a business of raising or returning capital. For gains that do not meet the three-year holding period, the gain is treated as short-term capital gain (that does not qualify for the preferred rates).

25% Rate on Dividends. The Bill provides for a 25% tax rate for dividends received from a real estate investment trust (REIT) that does not qualify (under current law) for the lower tax rate for capital gains and qualified dividends. Similarly, dividends received from a cooperative will also qualify for the 25% tax rate.

Deferred Compensation. The Bill provides for a new deferred compensation program for qualified equity grants. Under this new program, employees that receive employer stock will able to elect to defer the income for five years after vesting. This program will only apply to employers that are privately-held corporations if the plan provides that at least 80% of the US employees have a right to receive stock under the plan.

Other Personal Deductions and Credits. The bill would also repeal the following personal tax benefits:

  • Deduction for personal casualty losses (other than from hurricanes Harvey, Irma, or Maria),
  • Charitable deduction of college athletic event seating rights,
  • Deduction for tax preparation expenses,
  • Deduction for alimony payments (and corresponding income inclusion),
  • Deduction for moving expenses (other than for members of the armed forces),
  • Deductions for expenses of elementary and secondary school teachers,
  • Deductions for employee business expenses (other than expenses reimbursed by an employer),
  • Exclusion for employee achievement awards,
  • Exclusion for dependent care assistance programs,
  • Exclusion for moving expense reimbursements,
  • Exclusion for adoption assistance programs,
  • Credit for the elderly and the permanently and totally disabled,
  • Credit for home mortgage interest, and
  • Credit for plug-in electric drive motor vehicles.

Currently, there are numerous tax provisions that provide subsidies for education. The Bill would replace these provisions with a single credit (the American opportunity tax credit). Under the proposed new rules, a credit is allowed for up to 100% of the first $2,000 of expenses, plus 25% of the next $4,000 of expenses. The credit begins to phase-out for taxpayers with modified adjusted gross income of $160,000 ($80,000 for single taxpayers).

Taxpayers are able to exclude up to $500,000 of gain ($250,000, in the case of a single taxpayer) with respect to the sale of a principal residence. Under the Bill, a taxpayer must own and use the residence for at least five out of eight years ending on the date of the sale (as opposed to the current rule of two out of five years). The exclusion can only be claimed once during a five-year period (up from the current two years). The exclusion starts to phase out if the taxpayer has adjusted gross income in excess of $500,000 ($250,000, in the case of a single taxpayer), excluding gain from the sale. For this purpose, adjusted gross income is measured using the average of over three taxable years (the year of sale, plus two prior years).

Business Taxes

C corporations are currently subject to tax under the greater of two income tax regimes (the income tax and the AMT). Under the regular tax, the rates range from 15-35%. Under the corporate AMT, the rate is 20%, but there is a broader base.

Under the Bill, the corporate tax rate will be reduced to 20%. In addition, the corporate AMT will be repealed. The tax rate on personal service corporations is reduced to 25% (from 35%).

Integration. C corporations are subject to two layers of tax (once at the corporate level and once at the shareholder level when dividends are paid). The Bill, as currently drafted, does not provide for relief for the current double taxation. It is possible that relief will be provided in subsequent versions of the Bill.

Current law does provide a measure of integration where one corporation is a shareholder in another corporation. In such case, 70% of any dividends are not generally subject to tax (80%, if the shareholder owns 20% or more, by vote and value, of the corporation paying the dividend). The Bill would change these exclusion amounts to 65% and 50%, respectively. The 100% exclusion for dividends from a member of the same affiliated group is preserved.

Expensing of Tangible Assets. The Bill provides for businesses to fully expense tangible assets that would otherwise be subject to depreciation (other than buildings and structures). Currently, the bonus depreciation rules allow taxpayers to expense 50% of the costs of depreciable assets placed in service before January 1, 2020. The Bill would allow taxpayers to take bonus depreciation of 100% of the costs of assets placed in service after September 27, 2017 and before January 1, 2023. The Bill also allows taxpayers to take bonus depreciation for used property (which is not currently allowed), if acquired in an arms-length purchase from an unrelated party. The Bill increases the amount of basis limit for automobiles to $16,000 (from $8,000). Any net operating loss (NOL) created by the change in the bonus depreciation rules by the Bill cannot be carried back for a refund.

At present, expensing under section 179 is limited to $500,000, but phases out at certain levels. This would be changed to $5 million for assets placed in service in taxable years beginning from 2018 through 2022. The phase-out amount would increase to $20 million (from $2 million).

Many states do not follow the federal rules regarding expensing and depreciation of tangible assets. As a result, it is very possible that many of these proposed changes will not affect a business’ state tax liability.

Interest Deduction. Business taxpayers are generally allowed an interest deduction, as long as certain requirements and rules are followed. The Bill proposes to further limit the deduction for net business interest expense (i.e., the excess of expense over income). The new limit will be 30% of adjusted taxable income (i.e., taxable income attributable to business activities before deductions for NOLs, net interest, and depreciation and amortization). A similar provision currently applies (with a 50% limit) for corporate debt that is borrowed from certain related parties. Business interest that is disallowed can be carried forward for up to five taxable years (but, in the case of a corporation, subject to limitation under section 382 if an ownership change occurs). Partnerships and S corporations will apply the new limit at the entity level. This new limit will not apply to small businesses.

Methods of Accounting. The Bill will allow small businesses to use simplified methods of accounting. These rules will apply to taxpayers with average annual gross receipts (over a three-taxable-year period) of less than $25 million (up from the current $5 million). Small businesses will be permitted to use the cash method, avoid UNICAP (in the case of producers or resellers) and percentage of completion rules, and account for inventory as non-incidental materials and supplies (or in conformity with the financial accounting treatment). Small businesses will also be exempt from the new limitations on the deduction of business interest.

Net Operating Losses. NOLs can generally be carried back two taxable years and carried forward twenty taxable years under current law. However, for AMT purposes, the NOL deduction is limited to 90% of AMT taxable income. The Bill would generally eliminate the ability to carry back a post-2017 NOL, but allow taxpayer to carryforward such NOLs indefinitely. Small businesses (average annual gross receipts of $5 million or less) would be permitted to carry NOLs back one taxable year.

In addition, the deduction in post-2017 taxable years would be limited to 90% of taxable income (before the NOL deduction). The amount of any post-2017 NOL carryforward will be adjusted each taxable year for inflation.

Research and Development. At present, research and experimental expenses can be deducted (or amortized over five years). Under the Bill, such costs (including software development costs) can only be amortized over five years (fifteen years with respect to foreign research), applying a half-year convention. This change applies to costs that are paid or incurred during taxable years beginning after 2023.

The Bill does not make any changes to the research credit.

Like-Kind Exchanges. Taxpayers can exchange real and personal property that are held for business or investment (other than financial assets) for property of a like-kind on a tax-deferred basis. The Bill would limit the like-kind benefits to exchanges of real property.

S Corporation Terminations. Based on the new lower tax rates for C corporations, many S corporations may choose to terminate their status and pay tax as C corporations. Special rules will apply to companies that are S corporations on the day the Bill is enacted and revoke their election within two years. In such case, any adjustments to methods of accounting caused by the change in status are taken into account over six taxable years. In addition, distributions will be treated as paid from the accumulated adjustment account and earnings and profits on a pro-rata basis.

Subsidies. At present, corporations are permitted to receive subsidies (from governmental and other persons) as tax-free contributions to capital. The Bill eliminates this exclusion. In addition, any contribution to the capital of any entity (including partnerships and trusts) will be included in gross income. If an entity receives property in exchange for issuing its stock (or equity), the transaction will be treated as a taxable contribution to capital to the extent the value of the property contributed (or cash) exceeds the value of the stock exchanged therefor. This provision is proposed to apply to transactions entered into after the date of enactment of the Bill.

The intent of this provision of the Bill is to end the ability to avoid tax on subsidies. However, the text of the provision would subject a large number of transactions with shareholders, partners, trust grantors to tax at the entity level. This appears to be an unintended result. Hopefully, it will be fixed before the Bill becomes law.

Technical Terminations of Partnerships. Under current law, a partnership is deemed to terminate (and re-form as a new partnership) if there is a sale or exchange of 50% or more of the partnership interests (by capital and profits) over a one-year period. The Bill proposes to repeal these provisions.

Excessive Officer Compensation. There is a limitation on compensation deductions with respect to publicly-held corporations. The deduction is limited to $1 million per employee and the limitation applies to the chief executive officer (CEO) and the four highest paid officers. Under the Bill, the provision will now cover the CEO, the chief financial officer (CFO), and the three highest paid officers. In addition, once an employee is covered, he is covered forever (including the period after termination and/or death).

In the past, companies have been able to take deductions in excess of $1 million by applying statutory exceptions for performance-based compensation and commissions. The Bill repeals these two exceptions. The Bill also increases the reach of the deduction limitation by expanding the number of companies that are potentially covered.

The rules on excessive officer compensation do not currently affect tax-exempt organizations since they typically do not benefit from tax deductions. Under the Bill, tax-exempt organizations will be subject to a $1 million limitation. Compensation in excess of that amount will be subject to a 20% excise tax. The new rules will apply to compensation paid to the five highest paid employees of the organization. Tax-exempt organizations will also be subject to a 20% excise tax on severance payment made to such employees over a certain amount.

Other Business Deductions and Credits. The bill would also repeal the following business tax benefits:

  • section 199 deduction for domestic production activities,
  • deductions for entertainment, amusement, or recreational activities (including club dues),
  • deductions for tax-free employee fringe benefits for parking and transportation,
  • deductions for on-premises athletic facilities (or gyms),
  • deduction for unused business credits,
  • employer-provided child care credit,
  • credit for rehabilitating real estate,
  • work opportunity tax credit,
  • new markets tax credit,
  • credit for access to disabled individuals, and
  • credit for electricity produced from renewable resources.

The Bill would extend certain energy credits that otherwise expired in 2016 until 2021. The extended credits include (i) the energy investment credit, (ii) the credit for residential energy efficient property

International Taxes

Under existing rules, the US technically taxes corporations and businesses on their world-wide income. However, the tax on income earned by foreign subsidiaries can generally be deferred indefinitely if the earnings are kept off-shore.

The Bill will replace the global model for international taxation of corporations with a territorial model. Income earned offshore through foreign corporate subsidiaries generally will no longer be subject to current US tax. However, foreign income earned through foreign branches (or indirectly through disregarded entities and partnerships) will continue to be subject to US tax.

Individuals who are citizens and legal residents (green card holders) are taxed on their world-wide income, even if they are residents of another country. There has been a movement by some to have the Bill change the tax regime for individuals to a territorial system. This idea has not been incorporated in the Bill. However, it is possible that it could be incorporated in later versions.

Individuals that own foreign businesses are treated particularly harshly under the Bill. Dividends received by individuals from foreign corporations will continue to be subject to tax. Such dividends do not receive any of the benefits of the new territorial regime. In addition, individual pay tax on their share of deferred foreign income of a CFC as a result of the transition to the territorial regime.

The Bill does not make significant changes in how foreign investors in the US are taxed.

Dividends. Dividends received by a US corporation from a foreign subsidiary are currently subject to tax. However, the tax can be reduced by foreign tax credits for taxes paid by the foreign subsidiary (and deemed to be paid by the shareholder).

Under the Bill, dividends received by US corporations from foreign subsidiaries will generally be exempt from tax if the taxpayer owns at least 10% of the subsidiary (by vote). The portion of any dividend that is attributable to US source earnings of the subsidiary is not eligible for the exclusion. The exemption will not apply if the subsidiary is a passive foreign investment company (PFIC) or if the shareholder did not own the stock for at least six months (out of a one-year period beginning six months before the dividend is effective).

The rules allowing for a deemed paid foreign tax credit on dividends would be repealed.

If a US corporation receives an excluded dividend from a foreign subsidiary, the basis in the stock of the foreign subsidiary will be reduced for purposes of a realized loss (but not for purposes of a gain). As a result, the shareholder will have a different basis for gain and loss purposes.

The dividend received from a foreign subsidiary may be subject to foreign withholding or income tax. The recipient will not be entitled to a foreign tax credit or deduction with respect to the foreign taxes paid or accrued.

The Bill’s changes to the treatment of dividends is proposed to be effective for distributions made after December 31, 2017.

Subpart F. US persons that own at least 10% (by vote) of a CFC are subject to income inclusion rules in certain circumstances. The Bill makes some changes to these rules.

Currently, if a CFC has investments in US property (tangible or intangible), a 10% US shareholder is required to include such amounts in gross income to the extent of the CFC’s earnings. Under the Bill, the provision will no longer apply to US shareholders that are corporations.

In addition, the Bill makes several modifications to the subpart F rules in the nature of cleaning up the provisions. The de minimis exception of $1 million will now be adjusted for inflation. The look-thru rule for related CFCs (which was scheduled to expire in 2019) is now made permanent. The stock attribution rules are modified to allow attribution from a foreign person to a US person. The exemption from subpart F income for corporations that were not controlled for at least thirty days within a taxable year is repealed.

Deferred Foreign Income. There are currently trillions of dollars of earnings that have been deferred under the existing global regime. The Bill would tax the entire amount currently (or in installments). As a result, a domestic 10% shareholder of a foreign corporation will generally include in gross income the deferred foreign income of the corporation. The amount will be includable for the taxable year which includes the last taxable year of the foreign corporation that begins before January 1, 2018. For a calendar year foreign corporation, the amount would be includable on the tax return that includes December 31, 2017.

The amount included is the accumulated foreign earnings of the corporation that was not previously subject to US tax (determined as of November 2 or December 31, 2017, whichever is greater). Earnings that were deferred before 1986 are not taken into account. Deficits from one foreign corporation are allowed to offset deferred foreign income of another foreign corporation held by the same taxpayer (or members of an affiliated group). There is no exclusion from the tax for earnings that accrued before the US shareholders acquired the shares. For example, if a US person acquired 100% of a foreign corporation in 2016, the shareholder would include 100% of the corporation’s post-1986 earnings.

Deferred foreign income that is held in liquid assets (e.g., cash, accounts receivables (reduced by accounts payables), securities) will be taxed at a 14% rate. The remaining deferred foreign income will be taxed at a 7% rate. Taxpayers can elect to pay this tax in eight equal annual installments (starting in the taxable year in which the tax would otherwise be due). The future installments will come due immediately if the taxpayer misses a payment (or sells or ends his business).

The tax on the deferred foreign income can be reduced by foreign tax credits. However, the amount of the foreign tax credit (or foreign tax deduction) will be reduced to take into account the fact that the income is being taxed at a lower rate than the normal tax rate of up to 35%. In addition, if a foreign tax credit carryforward had previously expired, the credit carryforward period is extended for this purpose from ten to twenty years.

The requirement to include the deferred foreign income of foreign corporations applies to any 10% US shareholder (individual, partnership, or corporation) of a CFC. In addition, the requirement applies if a US corporation owns 10% or more (by vote) of a foreign corporation that is not a CFC. The requirement to include deferred foreign income will not apply to a foreign corporation that is PFIC that is not also a CFC. The requirement that non-corporate shareholders of a CFC pay tax on the post-1986 earnings seems particularly unfair as these taxpayers do not benefit from the new territorial system.

The enactment of the tax on deferred foreign income could have a significant effect on the financial statements of multi-national companies. Many companies do not currently accrue the potential future US tax on deferred foreign income since, under current law, the tax can be deferred indefinitely. When the Bill is enacted into law, many such companies will need to change their accounting treatment of the tax and provide for a current expense on their financials.

Source of Inventory. Sales of inventory are generally sourced based on the place where title passes between buyer and seller. However, a different rule applies if the goods are produced by the taxpayer. In such case, profit is sourced in part to the US and in part abroad if the goods are produced by the taxpayer in the US and sold abroad (or vice versa). Under the Bill, the profits will be sourced solely on the basis of where the production activities occur. As a result, goods that are produced in the US and sold abroad will now be considered entirely US source income (and vice versa).

Anti-abuse Rules. The Bill has several provisions that are designed to prevent abuses by US multinational corporations.

If a US corporation transfers the assets of a foreign branch to a foreign subsidiary, the US corporation is required to recapture previously-deducted losses of the foreign branch. Only losses incurred by the branch after December 31, 2017 are taken into account for this purpose. The amount of losses recaptured are generally reduced by (i) taxable profits in later taxable years, and (ii) gain recognized by the US corporation on the transfer.

US persons that own at least 10% of a CFC will be required by the Bill to include an amount in gross income if the CFC receives a high return on its investment (computed under a very complicated formula). If the CFC has a high return on its investment, the US shareholder will include 50% of the excess return. Shareholders that are US corporations will be permitted to offset some of the additional gross income with foreign tax credits with respect to taxes paid by the CFC.

The Bill limits the deduction of interest for US corporations (and partnerships) that are members of an “international financial reporting group.” A US corporation will generally be a member of such a group if its activities are reported on consolidated financial statements. The deduction limit will only apply if the group includes (i) one or more foreign corporations engaged in a US trade or business, or (ii) at least one US corporation and at least one foreign corporation. In addition, the rules will only apply if the group reports average annual gross receipts in excess of $100 million over a three-year period. If this provision applies the amount of interest income allowed will be based on the US corporation’s share of the amount of the global interest expense of the group. Any amount disallowed can be carried forward for up to five years (but, in the case of a corporation, subject to limitation under section 382 if an ownership change occurs).

The Bill imposes an excise tax on amounts paid by US corporations to a foreign corporation if both corporations are members of the same international financial reporting group. The amount of the excise tax is 20% and is imposed on the US corporation. The excise tax is not deductible.

The excise tax generally applies to amounts that are deductible (or provide a tax benefit) in the US, other than interest and certain service costs with no markup. The excise tax will not apply if the aggregate amounts that are subject to the tax are $100 million or less over a three-year period. There is no exemption from the excise tax for amounts that are subject to the 30% withholding tax.

The excise tax can be avoided if the foreign corporation elects to treat all amounts otherwise subject to the excise tax as effectively connected income (i.e., subject to the US corporate tax at a 20% rate and the branch profits tax). The election, once made, applies to the current and subsequent taxable years and can only be revoked with the consent of the Treasury Department. Each domestic corporation that is a member of the same group as an electing foreign corporation will be jointly and severally liable for the foreign corporation’s tax liability.

If an electing foreign corporation receives a taxable amount that is subject to withholding tax at a 30% rate, the amount will be exempt from the net income tax. If the amount is subject to withholding tax at a reduced rate (due to a treaty or other reason), a partial exemption is allowed.

A reason why a foreign corporation might want to make the election to be taxable is that the excise tax of 20% is imposed on the gross amount and the corporate tax under the election is imposed on the net amount (reduced by deductible expenses). However, the amount of deductible expenses will only be the allocable portion of the group’s worldwide expenses. In addition to being able to deduct expenses, the foreign corporation will also be allowed to reduce the tax by a foreign tax credit for up to 80% of taxes paid or accrued on the income.

Inversions. In recent years, several multi-national companies with headquarters in the US have tried to move their headquarters to a foreign country to avoid US tax on foreign earnings. The Bill does not provide any rules to prevent further attempts at so-called “inversions.” It is possible that inversions may no longer provide a benefit once the US adopts a low rate and a territorial system.

WTS Observation

The Bill presents a major overhaul of many longstanding aspects of US taxation. Even though the Republican Party controls the Presidency and both houses of Congress, there is a great deal of uncertainty as to whether the Bill will become law (and how many of the proposals in the Bill will be retained in final legislation). Leaders of the House and Senate would like to have the Bill enacted into law before Christmas. That timetable maybe overly optimistic.

The Republican Party is attempting to get the Bill passed in the Senate by a simple majority vote. For this to happen, the Bill has to meet certain procedural rules surrounding the potential effect of the Bill on the federal deficit. Many do not believe that the Bill in its current form meets these requirements. There is a great deal of uncertainty as to what changes will be made to allow the Bill to meet these procedural requirements.

One surprising aspect of the Bill is that there are so many taxpayers whose taxes will increase as a result (either in 2018 or several years later). The individuals whose taxes will increase are in all income brackets. That being said, businesses and the very wealthy seem to generally do the best under the proposed changes.

The Bill is estimated to cut taxes by approximately $1.44 trillion over ten years (and will increase the deficit by approximately $1.6 trillion due to additional interest charges). The proponents of the Bill believe that the increased economic growth caused by the tax reductions will provide extra tax revenue for the government and will pay for some or all of the increase in the deficit. Time will tell if they are correct.

Contact:

Lee G Zimet  Francis J. Helverson       
+1 973 871 2043 - lzimet@wtsus.com     +1 973 401 1141 - fhelverson@wtsus.com

* * * * *

The foregoing information is provided by WTS LLC for educational and informational purposes only and does not constitute tax advice. This information may be considered advertising under applicable state laws.

WTS LLC © 2017

Treasury Report on Reducing Regulatory Burdens

On October 2, 2017, the Treasury Department issued a report to the President entitled “Identifying and Reducing Tax Regulatory Burdens” (the “Report”). Notice 2017-38, had previously provided a list of eight proposed, final, and temporary regulations (“regulations”) that were subject to further review. The Report describes Treasury’s intentions with respect to these eight regulations regarding whether to retain, modify, or rescind them.

Executive Order 13789 required Treasury to review all significant tax regulations that were issued from January 1, 2016 through April 21, 2017. Under the order, Treasury was required to issue two reports. An interim report, that identified regulations for which modification or rescission should be considered, and a final report. The Report is the final report that recommends specific actions with respect to the identified regulations.

The Report states that Treasury is continuing to analyze recently issued regulations and is considering possible additional reforms of regulations that were not included in the original list of eight. Possible action could be taken with respect to regulations under (i) section 871(m) (recharacterization of dividend equivalent payments), and (ii) the Foreign Account Tax Compliance Act (FATCA).

Treasury and the Internal Revenue Service (IRS) have begun a comprehensive review of all regulations, regardless of when issued. This review will identify regulations “that are unnecessary, create undue complexity, impose excessive burdens, or fail to provide clarity and useful guidance.” Included in this review are longstanding temporary and proposed regulations that have not expired or been finalized.

The Report states that Treasury and the IRS will reform, revoke or streamline regulations that are identified in this next review. Already, over 200 regulations have been identified for future revocation as no longer serving their original purpose. Later reports and guidance will provide details on regulations that have been identified as requiring modification or revocation. The rulemaking process to revoke unnecessary regulations are scheduled to begin before the end of 2017.

The Hateful Eight

 The eight regulations that were identified in Notice 2017-38 (and their anticipated resolution) are:

  • Temporary Section 337(d) Regulations. These regulations provide guidance on recently-enacted legislation intended to prevent certain spin-off transactions involving transfers of property by a C corporation to a real estate investment trust (REIT).
    • There is a concern that the regulations could result in the over-inclusion of gain (e.g., where a large corporation acquires a small corporation that engaged in a section 355 spin-off and the large corporation subsequently makes an election to be treated as a REIT). The Treasury is considering a revision to the existing rule that would limit the gain recognition in such circumstance to the value of the assets of the smaller corporation.
  • Final and Temporary Section 385 Regulations. These regulations require large taxpayers to meet a documentation requirement in order to treat a related-party obligation as debt. In addition, the regulations recharacterize certain related-party obligations as stock (even if the documentation requirement is met) if they were issued as part of a specified transaction (including, an issuance for no consideration (other than stock) or to fund a dividend to a related party).
    • There is an expressed concern that the documentation rules place an undue compliance burden on taxpayers with respect to ordinary course transactions. The effective date of the documentation rules was recently postponed until 2019. Notice 2017-36. Treasury and the IRS are considering revoking the documentation rules and replacing them with revised rules that are simpler and streamlined. These revised rules would have a prospective effective date.
    • There are concerns with respect to the transactional rules related to (i) their complexity (requiring tracking multiple transaction through a group of companies), and (ii) the increased tax burden on inbound investments. Treasury has acknowledged that the existing rules are a “blunt instrument” for accomplishing tax policy objectives. However, it believes that the existing rules are necessary to combat inversion transactions. There is a hope that tax reform legislation will eliminate the tax benefits of inversions and the need for the transactional rules. If future legislation does not entirely eliminate the benefits of inversions, then Treasury and the IRS will propose streamlined targeted regulations to replace the existing transactional rules.
  • Final Section 367 Regulations. These regulations eliminate the ability of taxpayers to transfer foreign goodwill and going concern value to a foreign corporation on a tax-free basis.
    • There is an expressed concern that this change in the rules would inappropriately increase the tax burden on certain taxpayers (since the legislative history to section 367 contemplated an exception for goodwill and going concern value). Treasury and the IRS are actively working on a proposal to provide for an exception for non-abusive transactions. It is anticipated that regulations will be proposed in the near term.
  • Temporary Section 752 Regulations. These partnership regulations provide rules for (i) how liabilities are allocated with respect to disguised sales, and (ii) whether “bottom-dollar” guarantees provide economic risk of loss (that are treated as a recourse liability).
    • There is an expressed concern regarding the new disguised sales rules that they would negatively impact ordinary partnership transactions. Treasury and the IRS believe that the approach taken in the temporary regulations merits further study. However, since the new rules are a significant departure from the prior rules, they are considering whether to revoke the temporary rules and replace them with the prior regulations.
    • Critics have claimed that the bottom-dollar guarantee rules expand the reach of the rules in a way that would prevent many business transactions. However, Treasury and the IRS believe these rules effectively prevent abuses and do not expect to make significant changes to the rules. Treasury and the IRS are studying ways in which the overall rules governing liabilities and allocations impose an unnecessary compliance burden on taxpayers, especially the ways in which the rules in different sections of the tax code interact. As a result, changes to the partnership liability and allocation rules may be proposed in the future.
  • Final Section 987 Regulations. These regulations provide rules for calculating foreign currency gain or loss from branch operations and translating taxable income from branch operations into functional currency. The effective date of these regulations was recently postponed until 2019 (for calendar year taxpayers). Notice 2017-57.
    • The rules have been criticized as unduly complex and costly to comply with, especially where the rules differ from financial accounting rules. The Report states that modifications to the existing rules will be proposed to permit taxpayers to adopt a simplified method. Under a methodology that is being considered, all items of income and expense would be translated at the average exchange rate for the taxable year and all balance sheet items would be marked-to-market. It is believed that such a methodology would be consistent with applicable financial accounting rules.
    • The Treasury and the IRS are considering various alternative rules regarding recognition of section 987 gain or loss. Under one possible elective regime, net losses would be allowed to the extent gains were recognized in prior or subsequent taxable years. Alternatively, all section 987 gains and losses could be deferred until the branch is no longer operated by the taxpayer or a related party.
    • The rules have also been criticized for disallowing existing built-in losses that were not previously recognized. Treasury and the IRS are considering various alternative transition rules that would be fairer to taxpayers.
  • Proposed Section 2704 Regulations. These proposed regulations provide rules for determining the fair market value of businesses for estate, gift, and generation-skipping tax purposes.
    • The proposed rules have been criticized as unnecessarily restricting common discounts to fair market value (e.g., minority ownership and marketability). In addition, appraisals would be more difficult to perform if the proposed regulations are finalized. As a result, the IRS withdrew these rules in their entirety effective as of October 20, 2017. The Report acknowledges the need to have the existing rules revised to take into account the prevalence of limited liability companies (LLCs). However, the Report does not mention an intention to revise the rules to take into account this need.
  • Final Section 7602 Regulations. These regulations allow the IRS to hire outside attorneys (who would have the ability to participate in the taking of compulsory testimony). These rules have been criticized as infringing on the rights of taxpayers. These rules will be revised to take into account these concerns.
  • Proposed Section 103 Regulations. These proposed regulations would revise the rules concerning which entities can qualify as a political subdivision of a state (allowing them to issue tax-free bonds). Treasury and the IRS plan to withdraw these rules in their entirety. More targeted guidance may be issued in the future.

WTS Observations

The release of the Report eliminates a great deal of uncertainty regarding the status of the eight regulations that were identified in Notice 2017-38. However, the Report creates additional uncertainty regarding, what appears to be, a massive project to streamline the existing tax regulations and eliminate “deadwood”  and problematic provisions. While the goals are meritorious, it may create challenges for planning for transactions in the interim. 

Contact:

Lee G Zimet  Francis J. Helverson       
+1 973 871 2043 - lzimet@wtsus.com     +1 973 401 1141 - fhelverson@wtsus.com

   

* * * * *

The foregoing information is provided by WTS LLC for educational and informational purposes only and does not constitute tax advice. This information may be considered advertising under applicable state laws.

WTS LLC © 2017

 

Tax Reform Framework

On September 27, 2017, the Trump Administration and select members of Congress released a “framework” for tax reform legislation (the “Framework”). The document, entitled “United Framework for Fixing Our Broken Tax Code,” outlines many features of the legislative proposal.

Many portions of the Framework are based on previous proposals made by President Trump (as a candidate) and by House Speaker Ryan in his Better Way Tax Plan.

The intent of the Framework is to:

  • Make the tax code simple, fair, and easy;
  • Provide a tax reduction for working Americans;
  • Allow the vast majority of Americans to file a tax return on a postcard;
  • Increase the number of US jobs by reducing business tax rates;
  • Bring back trillions of dollars that are kept offshore for reinvestment in the US economy;
  • End incentives to ship jobs, capital, and tax revenue overseas; and
  • Close special interest tax breaks and loopholes.

Individual Taxes

Below is a summary of the provisions of the Framework that relate to the income tax liability of individuals.

 

2017 – Current Law

Framework

Ordinary Income Rate

7 rate brackets ranging from 10-39.6%

3 rate brackets ranging from 12-35%; but an additional rate for the wealthy may be added

Capital Gains Rate

Maximum 20% rate

No change

Alternative Minimum Tax

Rate of 26-28%

Repealed

Net Investment Income Tax

Rate of 3.8%

No change

Personal Exemption

$4,050 per dependent, but a phase-out for high income individuals

Repealed

Basic Standard Deduction

$6,350 – single

$12,700 – joint

$12,000 – single

$24,000 – joint

Itemized Deduction Limitation

No limit, but a phase-out for high income individuals

No change

Medical and Dental Expenses

Deduction over 7.5-10% of adjusted gross income

Repealed

State, Local, and Foreign Taxes

Deduction

Repealed

Mortgage Interest

Deduction on first $1.1 million of principal

No change

Investment interest

Deduction (but limited to investment income)

Repealed

Charitable contributions

Deduction (but subject to limitations)

No change

Other itemized deductions

Deductions (but subject to limitations)

Repealed

Child Tax Credit

$1,000 per child, but a phase-out for middle income individuals

$1,000 per child, but a phase-out at a higher level

Dependent Care Credit

None

$500 per dependent, but a possible phase-out

Estate Tax

Rate of 18-40%

Repealed

Gift Tax

Rate of 18-40%

No change

The Framework would consolidate the individual rates from seven brackets to three or four. The Framework is silent as to cut-offs for the new brackets. However, President Trump’s campaign tax reform plan had similar rates as in the Framework and did propose the bracket cut-offs. If we assume that the Framework were to use the Trump campaign rate brackets, the rates would be as follows:

Married Couples Filing a Joint Return

Taxable Income

2017 – Current Law

Framework

Less than $75,000

10-15%

12%

More than $75,000, but less than $225,000

15-28%

25%

More than $225,000

28-39.6%

35%

Single Individuals

Taxable Income

2017 – Current Law

Framework

Less than $37,500

10-15%

12%

More than $37,500, but less than $112,500

15-28%

25%

More than $112,500

28-39.6%

35%

Under the Framework, the largest decrease in tax rate would potentially go to those currently in the 39.6% bracket. The rate decrease for such taxpayer would potentially be 4.6%. The decrease in rates potentially may be offset by the elimination of certain deductions.

The lowest tax rate increases from 10% to 12%. The drafters of the Framework believe that the increase in rates will be more than offset by the increase in the standard deduction.

Business Taxes

Currently, corporations are subject to tax under the greater of two income tax regimes (the income tax and the alternative minimum tax). Under the regular tax, the rates range from 15-35%. Under the corporate alternative minimum tax, the rate is 20%, but there is a broader base.

Under the Framework, the corporate tax rate will be reduced to 20%. In addition, the corporate alternative minimum tax will be repealed.

Currently, corporations are subject to two layers of tax (once at the corporate level and once at the shareholder level when dividends are paid). The Framework mentions the possibility of some form of relief for the current double taxation.

Currently, individuals that operate a business (directly, or indirectly through a partnership or S corporation) are taxed at the rates that would otherwise apply (10-39.6%). The Framework proposes to impose a maximum rate of 25% on business income. It is possible that provisions will be added to prevent individuals from converting personal income into business income. For example, final legislation may prevent employees from incorporating to apply the 25% rate.

The Framework provides for businesses to fully expense assets that would otherwise be subject to depreciation (other than buildings and structures). Currently, expensing is limited to $500,000, but phases out at certain levels. The proposed change would apply for investments made after September 27, 2017 (and for at least five years thereafter). The final legislative proposal may allow for the ability to expense business investments.

Currently, C corporations can deduct interest expense, as long as certain rules are followed. The Framework proposes to further limit the deduction for net interest expense (i.e., the excess of expenses over income). A similar limitation may apply to other taxpayers.

Other business deductions and credits will be eliminated under the Framework (including the section 199 manufacturing deduction). However, the research and development and low-income housing credits will be retained.

Currently, the US technically taxes corporations and businesses on their world-wide income. However, the tax on income earned by foreign subsidiaries can be deferred indefinitely if the earnings are kept off-shore.

The Framework will replace the global model for international taxation with a territorial model. Income earned offshore will be subject to current US tax (but at a reduced rate). In addition, dividends from foreign subsidiaries will be exempt from tax if the taxpayer owns at least 10% of the subsidiary.

There are currently trillions of earnings that have been deferred under the existing global regime. The Framework would tax the entire amount upon enactment. Accumulated earnings that are held in illiquid assets (as opposed to cash) will be taxed a lower rate. Corporations will have the ability to spread out the tax on repatriated earnings over several years.

In recent years, several multi-national companies with headquarters in the US have tried to move their headquarters to a foreign country to avoid US tax on foreign earnings. The Framework suggests that rules will be enacted that will eliminate incentives to move headquarters abroad.

WTS Observation

The Framework presents a major overhaul of many longstanding aspects of US taxation. However, the Framework is lacking in specificity in many respects and its ultimate impact on individuals, businesses and US tax revenue is uncertain. At this point, the Framework is a plan that needs to be converted into detailed legislative language. It is anticipated that this process will take several weeks.

Even though the Republican Party controls the Presidency and both houses of Congress, there is a great deal of uncertainty as to whether the proposals in the Framework will become law (and how many of the proposals in the Framework will be retained in final legislation).

Contact:

Lee G Zimet  Francis J. Helverson            
+1 973 871 2043 - lzimet@wtsus.com      +1 973 401 1141 - fhelverson@wtsus.com

* * * * *

The foregoing information is provided by WTS LLC for educational and informational purposes only and does not constitute tax advice. This information may be considered advertising under applicable state laws.

WTS LLC © 2017

Update on US Tax Reform

August 2, 2017

Since our last update in April on efforts to reform the US federal tax system, there has not been a great deal of activity. The President and Congress have largely focused on healthcare reform. However, with the recent defeat of the healthcare bill in the Senate, there is a renewed emphasis on tax reform.

Some of the more recent developments include:

  • Over the last few months, there have been on-going discussions among a group that has been nicknamed the “Big Six” over the direction of tax reform legislation. The Big Six consists of two leaders each from the House of Representatives, the Senate, and the Executive Branch. On July 27, 2017, the Big Six issued a statement of principles. This statement announced that the border adjustment tax (a consumption based tax system) would not be included in future tax reform legislation. There were no other concrete proposals.
  • On August 1, 2017, Ian Read, the CEO of Pfizer, Inc., stated that his company is putting off engaging in a major M&A deal until there is more clarity on US tax reform. A change to a territorial tax system in the US could fundamentally change the valuation of potential acquisition targets. Although the announcement by Mr. Read has garnered a fair amount of attention, it should be kept in mind that US deal activity in 2017 has been reported as being slower than in recent years. 

WTS Observation

There is a great deal of uncertainty as to the future direction of US tax reform. As a result, it may be prudent to suspend any significant tax planning actions that are in process until there is a better idea of what tax rules will be in effect for 2017.

Contact:

Lee G Zimet  Francis J. Helverson            
+1 973 871 2043 - lzimet@wtsus.com      +1 973 401 1141 - fhelverson@wtsus.com

    

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The foregoing information is provided by WTS LLC for educational and informational purposes only and does not constitute tax advice. This information may be considered advertising under applicable state laws.

WTS LLC © 2017

Delayed Effective Date for the Section 385 Documentation Rules

On July 28, 2017, the IRS announced in Notice 2017-36 that the effective date of the section 385 documentation rules will be delayed for one year. These rules were originally to apply to debt obligations that are issued after December 31, 2017. Based upon the change, the rules will apply to debt obligations that are issued after December 31, 2018.

The section 385 regulations were issued in 2016 to determine the character of certain corporate financial obligations as debt or stock. The documentation rules of the section 385 regulations require large taxpayers to meet a documentation requirement in order to treat a related-party obligation as debt. In addition, the section 385 regulations recharacterize certain related-party obligations as stock (even if the documentation requirement is met) if they were issued as part of a specified transaction (including, an issuance for no consideration (other than stock) or to fund a dividend to a related party).

The recharacterization rules have already come into effect. These rules generally apply to taxable years ending on or after January 19, 2017. The documentation rules have not yet come into effect.

The IRS stated in Notice 2017-36 that the originally scheduled effective date for the documentation rules may not give taxpayers adequate time to develop systems and processes that would be required to comply. As a result, the effective date was postponed. The Treasury Department and the IRS intend to amend the section 385 regulations to change the effective date. In the meantime, taxpayers have been told that the effective date announced in Notice 2017-36 can be relied upon.

The Treasury Department recently issued Notice 2017-38, which provides a list of eight proposed, final, and temporary regulations (“regulations”) that are being subjected to further review. These eight regulations potentially may be modified or rescinded in the future in order to reduce the financial burden on taxpayers or the complexity of the tax rules. The section 385 regulations were one of the eight regulations that were included in the Notice 2017-38 as subject to further review.

WTS Observation

The recharacterization rules are already effective. Taxpayers should consider the potential effect of these rules on transactions that are being contemplated (and those that have occurred in the past). It would not be prudent to count on the rules being revoked in full.

The documentation rules do not come into effect until 2019. Conceivably, taxpayers could wait to start setting up the methods and procedures to implement these rules (to see if there are further changes in the rules). However, since many parts of these rules represent best practices for related-party debt, it may be prudent to implement the documentation rules now (even if on a less formal basis).

Contact:

Lee G Zimet  Francis J. Helverson                                                    
+1 973 871 2043 - lzimet@wtsus.com                      +1 973 401 1141 - fhelverson@wtsus.com   

                  

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The foregoing information is provided by WTS LLC for educational and informational purposes only and does not constitute tax advice. This information may be considered advertising under applicable state laws.

WTS LLC © 2017

Tax Court Holds That Foreign Partners Can Sell Partnership Interests Tax-Free

July 14, 2017

On July 13, 2017, the United States Tax Court issued an important ruling on the US federal income tax treatment of foreign partners. The case, Grecian Magnesite Mining, Industrial & Shipping Co. v. Commissioner, involved a redemption of a partnership interest that was held by a foreign partner. The partner recognized capital gain on the redemption but took the position that the gain was exempt from tax. The court agreed with the taxpayer.

The Tax Court decision went against a long-standing position of the Internal Revenue Service (IRS). In Revenue Ruling 91-32, the IRS ruled that a foreign partner was subject to tax on the gain recognized with respect to the sale or exchange of a partnership to the extent that gain was attributable to a US trade or business (USTB) conducted by the partnership.

Under the relevant statutory provisions, the gain in Grecian Magnesite was only subject to tax if the gain was effectively connected with the conduct of a USTB. In the IRS view, this determination is made based on the activities of the partnership (the “aggregate approach”). The Tax Court held that the determination is made based on the activities of the partner (the “entity approach”). Since all of the partner’s material activities with respect to the sale took place outside the US, the Tax Court held that the gain was not effectively connected with a USTB.

The taxpayer in Grecian Magnesite did have to pay US federal income tax on some of the gain recognized. Under the so-called FIRPTA rules, a foreign partner is required to treat gain from the sale of a partnership as subject to US federal income tax to the extent that the gain is attributable to US real property held by the partnership. The partnership held some US real property and the taxpayer was required by the Tax Court to pay tax on the portion of the gain attributable to the real property.

WTS Observations

At this writing, it is not known whether the IRS will appeal Grecian Magnesite or acquiesce in the decision. Until the IRS makes a determination, Revenue Ruling 91-32 represents the position of the IRS. In the meantime, taxpayers have specific authority supporting a position contrary to Revenue Ruling 91-32.

Foreign investors holding direct interests in investment partnerships that own USTB assets may be able to sell their interests largely tax-free – especially if the gain is attributable to intangible assets such as goodwill. This could give rise to tax-friendly exit structures, including dispositions involving USTB investments held by private funds. Investor dispositions of partnership interests on the secondary market could also become more attractive. Although gain attributable to US real estate is generally taxable for foreign investors, since December 2015 “qualified foreign pension funds” (QFPFs) are exempt from the FIRPTA tax. As such, holding structures and disposition planning involving US real estate investments may be of particular interest to QFPFs.     

It should be noted that before the Tax Court ruled in Grecian Magnesite, the Treasury Department and the IRS had been working on proposed regulations regarding the treatment of foreign partner gains from the sale or exchange of partnerships. The status of the guidance project is not known.

Grecian Magnesite did not determine the appropriate taxation of partnership gain that is attributable to “hot assets.” Internal Revenue Code Section 751 treats some or all of the gain or loss from the sale or exchange of a partnership interest as ordinary income or loss to the extent the gain or loss is attributable to hot assets (generally inventory, receivables, and ordinary income recapture items). It is not clear whether a foreign partner can exclude such ordinary income under Section 751.

Contact:

Lee G Zimet  Francis J. Helverson            
+1 973 871 2043 - lzimet@wtsus.com      +1 973 401 1141 - fhelverson@wtsus.com

    

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The foregoing information is provided by WTS LLC for educational and informational purposes only and does not constitute tax advice. This information may be considered advertising under applicable state laws.

WTS LLC © 2017

Treasury Issues List of Regulations Under Review

On July 7, 2017, the Treasury Department issued Notice 2017-38, which provides a list of eight proposed, final, and temporary regulations (“regulations”) that are subject to further review. These eight regulations potentially may be modified or rescinded in the future in order to reduce the financial burden on taxpayers or the complexity of the tax rules.

Executive Order 13789 requires the Treasury Department to review all significant tax regulations that were issued from January 1, 2016 through April 21, 2017. Under the order, the Treasury Department was required to issue two reports. An interim report, identifying regulations for which modification or rescission should be considered, was due by June 20, 2017. A final report recommending specific actions with respect to these identified regulations is due by September 18, 2017.

Notice 2017-38 summarizes the Treasury Department’s findings with respect to regulations issued during the review period. The Treasury Department reviewed 105 regulations. Of these 105, eight regulations were identified as either (i) imposing an undue financial burden on US taxpayers, or (ii) adding undue complexity to the US federal tax rules. None of the regulations reviewed were found to exceed the statutory authority of the Internal Revenue Service (IRS).

In the final report, the Treasury Department intends to propose reforms to these eight regulations. This could include anything from streamlining problematic rules to full repeal. It is also possible that the effective date of some of the eight regulations could be extended. The Treasury Department has requested comments on whether the identified regulations should be modified or rescinded (and if modification is recommended how it should be modified). Comments are due by August 7, 2017.

The Hateful Eight

 The eight regulations that were identified in Notice 2017-38 are:

  • Temporary Section 337(d) Regulations. These regulations provide guidance on recently-enacted legislation intended to prevent certain spin-off transactions involving transfers of property by a C corporation to a real estate investment trust (REIT). There is a concern that the regulations could result in the over inclusion of gain (e.g., where a large corporation acquires a small corporation that engaged in a section 355 spin-off and the large corporation subsequently makes an election to be treated as a REIT).
  • Final and Temporary Section 385 Regulations. These regulations require large taxpayers to meet a documentation requirement in order to treat a related-party obligation as debt. In addition, the regulations recharacterize certain related-party obligations as stock (even if the documentation requirement is met) if they were issued as part of a specified transaction (including, an issuance for no consideration (other than stock) or to fund a dividend to a related party). There is an expressed concern that the (i) documentation rules place an undue compliance burden on taxpayers with respect to ordinary course transactions, and (ii) effective date of the documentation rules (debt issued after December 31, 2017) do not leave taxpayers with enough time to implement the rules. In addition, there are concerns with respect to the transactional rules related to (i) their complexity (requiring tracking multiple transaction through a group of companies), and (ii) the increased tax burden on inbound investments.
  • Final Section 367 Regulations. These regulations eliminate the ability of taxpayers to transfer foreign goodwill and going concern value to a foreign corporation on a tax-free basis. There is an expressed concern that this change in the rules would inappropriately increase the tax burden on certain taxpayers (since the legislative history to section 367 contemplated such an exception). It is possible that this regulation might be modified to allow an exception for non-abusive transactions.
  • Temporary Section 752 Regulations. These partnership regulations provide rules for (i) how liabilities are allocated with respect to disguised sales, and (ii) whether “bottom-dollar” guarantees provide economic risk of loss (that are treated as a recourse liability). There is an expressed concern regarding the disguised sales rule in that the new rule would negatively impact ordinary partnership transactions. In addition, the bottom-dollar guarantee rules expand the reach of the rules in a way that would prevent many business transactions.
  • Final Section 987 Regulations. These regulations provide rules for calculating foreign currency gain or loss from branch operations and translating taxable income from branch operations into functional currency. The rules have been criticized as unduly complex and costly to comply with, especially where the rules differ from financial accounting rules.
  • Proposed Section 2704 Regulations. These regulations provide rules for determining the fair market value of businesses for estate, gift, and generation-skipping tax purposes. The proposed rules have been criticized as unnecessarily restricting common discounts to fair market value (e.g., minority ownership and marketability). In addition, appraisals would be more difficult to perform if the proposed regulations are finalized.
  • Final Section 7602 Regulations. These regulations allow the IRS to hire outside attorneys (who would have the ability to participate in the taking of compulsory testimony). These rules have been criticized as infringing on the rights of taxpayers.
  • Proposed Section 103 Regulations. These proposed regulations would revise the rules concerning which entities can qualify as a political subdivision of a state (allowing them to issue tax-free bonds).

WTS Observations

The Treasury Department has not indicated in Notice 2017-38 any initial thoughts as to whether the identified regulations will be modified or rescinded. As a result, taxpayers will need to wait until the final report is issued in September to find out the outcome.

Once the final report is issued in September, it is our understanding that the Treasury Department and the IRS will start drafting proposed (or temporary) regulations to modify or rescind the identified regulations (according to the plan indicated in the final report). As a result, it would not be surprising if few regulations actually get changed before 2018.

Six of the eight regulations are final or temporary regulations. As a result, the six are already in effect and need to be complied with (unless or until a change is made). For example, the transaction rule of the section 385 regulations is in effect for taxable years ending after January 19, 2017 (including, 2017 calendar years). It would not be prudent for taxpayers to assume the rules will be repealed or the effective date changed so that the effect of the rules on the current taxable year can be ignored.

Contact:

Lee G Zimet  Francis J. Helverson       
+1 973 871 2043 - lzimet@wtsus.com     +1 973 401 1141 - fhelverson@wtsus.com

   

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The foregoing information is provided by WTS LLC for educational and informational purposes only and does not constitute tax advice. This information may be considered advertising under applicable state laws.

WTS LLC © 2017

BEA Requires Disclosure of Foreign Investments in the US

Few people have heard of the US Bureau of Economic Analysis (BEA), an agency of the Commerce Department. The BEA provides the US government with statistical information regarding the US economy. To aid in this endeavor, it does periodic surveys of cross-border investments (US investments abroad and foreign investments in the US).

Since 2014, the BEA has required US entities to report certain transactions if a foreign person owns a 10% or more voting interest in the entity, directly or indirectly by attribution. These forms are generally required to be filed by the US entity when (i) a foreign person crosses the 10% threshold, (ii) the US entity forms or acquires a new US subsidiary, or (iii) expands its operations to include a new facility.

Additionally, the BEA requires foreign persons to file in certain instances. One such situation is where the foreign person forms or acquires a US branch (or the branch expands its operations to include a new facility). Foreign persons are also generally required to file if the person acquires a 10% or more interest in US real estate that is held for profit (or begins significant construction on such real estate).

A US entity or foreign person meets the reporting requirements by filing a Form BE-13 within 45 days of the reportable transaction. Technically, there is an exemption for transactions that are $3 million or less. However, a form must be filed to establish the exemption. The BEA will entertain reasonable requests for extension. Extensions are available by calling the BEA.

Respondents who fail to file a required report are potentially subject to a civil penalty of $4,450-44,539. Injunctive relief is also available to the BEA. Criminal penalties are only available in the case of a willful failure. BEA personnel have stated informally that it is rare for them to invoke penalties (civil or criminal).

The filings with the BEA are confidential and cannot be shared with other government agencies. They can only be used by the BEA for analytical or statistical purposes. The information cannot be used in a manner that would allow a respondent to be identified without the respondent’s prior written permission. The information collected by the BEA cannot be used for the purposes of taxation, investigation, or regulation and are immune from legal process.

10%-Owned US Entities

Filings are required if a foreign person owns at least 10% of the voting interests in a “US business enterprise.” A business enterprise is defined as “any organization, association, branch, or venture that exists for profit-making purposes or to otherwise secure economic advantage, and any ownership of any real estate.” 15 CFR § 801.2(f).

Based upon the above, a US business enterprise is defined to include a US corporation, unincorporated entity (such as an LLC, partnership, joint venture), or branch. A US business enterprise is treated as having a 10% foreign owner if a foreign person owns 10% or more of the equity (by vote) directly, or indirectly through a US business enterprise by attribution.

For a partnership (general or limited), the voting interests are presumed to be divided equally among the general partners (with the limited partners presumed to have zero voting rights), unless otherwise stated in the partnership agreement. With respect to an LLC, the voting interests are presumed to be divided equally among the members, unless otherwise stated in the articles of organization or the operating agreement.

New rules apply to US hedge funds starting on January 1, 2017. Such funds will no longer be required to file Forms BE-13 if the fund does not own a 10% voting interest in an operating company.

The definition of US business enterprise includes the direct ownership of US real estate (including land) that is intended by the foreign owner to be used in a business or for sale or lease. The purchase of US real estate to be held exclusively for personal use (and not for profit-making purposes) is not considered a US business enterprise.

In determining whether an individual is a US or foreign person, generally the person’s country of citizenship will control. However, the country of residence will control, if different, if the individual resides, or expects to reside, in a different country for one year or more. There are exceptions to this residence rule if an individual has a business reason for residing in a country that is different from his country of citizenship.

Filing Requirements

There are five different types of Forms BE-13. Below is list of the forms and a discussion of which ones apply to given transections:

  • Form BE-13A –
    • Filed by US business enterprises to report the acquisition of a 10% voting interest by a foreign person.
    • Filed to report the creation of a new US business enterprise for the sole purpose of acquiring another US business enterprise within 30 days of the formation.
    • Filed to report the purchase of US real estate that is intended for sale or lease (and no significant added construction is expected).
    • The form does not need to be filed if the total cost of the acquisition is $3 million or loss.
  • Form BE-13B –
    • Filed to report the creation of a new US legal entity (or branch), including an entity with no physical operations, that meets the 10% foreign ownership requirement after formation. There is an exemption for certain entities that were formed to facilitate acquisitions.
    • Filed to report the purchase of US real estate (or construction of previously owned US real estate) for which significant added construction is expected (other than for expansion purposes).
    • The form does not need to be filed if the total cost is $3 million or loss.
  • Form BE-13D –
    • Filed by an existing US business enterprise when it expands its operations to include a new business facility.
    • Filed to report the purchase of US real estate (or construction of previously owned US real estate) for expansion purposes.
    • The form does not need to be filed if the total cost of the expansion is $3 million or loss.
  • Form BE-13E – The form is filed by a US business enterprise that previously filed a Form BE-13B or BE-13D and the project is still under construction. This form is used to report annual cost updates. It appears that this form is only required if the BEA sends a request to the respondent.
  • Form BE-13 Claim for Exemption – Filed if one of the above forms would have been required to be filed if the $3 million reporting requirement had been met.

Consolidated reporting is required by a group of US business enterprises. Two or more US business enterprises are considered to be part of a group if one enterprise owns, directly, more than 50% of one or more other enterprises (by vote). Chains of US business enterprises are included in the group to the extent a member of a group meets the more than 50% ownership requirement with respect to other US business enterprises. Minority-owned US business enterprises are excluded from consolidated filing group, as are foreign business enterprises that are owned by a US business enterprise (i.e., a foreign subsidiary).

WTS Observation

The requirements to file Forms BE-13 will come as a surprise to many people. The requirements have never been heavily publicized.

Completing the forms can be quite onerous. For example, Form BE-13A is thirteen pages long and contains 38 questions. The BEA estimates that it will take the average respondent 2.5 hours to complete the form. In our experience, it is more time-consuming then that.

Contact:

Lee G Zimet  Francis J. Helverson            
+1 973 871 2043 - lzimet@wtsus.com      +1 973 401 1141 - fhelverson@wtsus.com

     

* * * * *

The foregoing information is provided by WTS LLC for educational and informational purposes only and does not constitute tax advice. This information may be considered advertising under applicable state laws.

WTS LLC © 2017