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Repealed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Repealed, but replaced with a credit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No limit; phase out repealed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

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