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Repealed

Repealed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Repealed, but replaced with a credit

Repealed, but replaced with a credit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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