On December 20, 2017, the legislation that is informally known as the Tax Cuts and Jobs Act (the “Act”) was passed by the United States Congress. The President is expected to sign it into law in early January.
The Act is generally effective starting in calendar year 2018 (or fiscal years that begin after December 31, 2017). 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.
This client alert only discusses the provisions of the Act that affect businesses. The individual provisions of the Act are discussed in a separate client alert).
Several provisions that were included in the House or Senate versions of the tax bill (or both) were dropped at the Conference Committee level. Our understanding is that several of these provisions may be included in a potential 2018 tax bill.
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Under the Act, the corporate tax rate will be reduced to 21% and the corporate AMT will be repealed. The tax rate on personal service corporations is also reduced to 21% (from 35%).
AMT. The corporate AMT is repealed for taxable years beginning after December 31, 2017.
When a corporation pays AMT in a taxable year, the corporation is allowed a credit to offset against the regular tax incurred in future taxable years (subject to limits). For corporations that have existing AMT credits, the credits will continue to be allowable against the regular tax liability (subject to existing limitations).
In addition, the AMT credits will be refundable in the 2018 through 2021 taxable years. The amount refundable in the 2018 through 2020 taxable years equals 50% of the excess of the AMT credit over the amount that is otherwise allowable. In 2021, the remaining AMT credits are refundable.
Under prior law, corporations could elect to accelerate AMT credits in lieu of bonus depreciation. The Act repeals this provision.
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 Act does not provide for relief for double taxation.
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 Act changes these exclusion amounts to 65% and 50%, respectively. The 100% exclusion for dividends from a member of the same affiliated group is preserved.
Cost Recovery of Tangible Assets. The Act 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 Act 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. A smaller percentage is allowed for asset placed in service in 2023 through 2026. For the first taxable year ending after September 27, 2017, taxpayers can elect to expense 50% of the costs, instead of 100%.
The changes to the bonus depreciation rules will also apply to previously-used property. Previously, bonus depreciation was only available for new property. Bonus depreciation will not be available for used property if it is acquired from a related person or in a tax-deferred transaction.
The Act provides a special rule for assets that were acquired before September 28, 2017, but placed in service after September 27, 2017. In such case, only 50% of the costs are eligible for bonus depreciation if placed in service in 2017 (40% in 2018, 30% in 2019, and zero thereafter).
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). Section 179 expensing would be expanded to cover certain real estate improvements.
The Act 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 Act shortens the recovery period under the alternative depreciation system (ADS) to 30 years for residential rental property (from 40 years). The recovery period for nonresidential property remains at 40 years for ADS purposes.
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 Act further limits the deduction for net business interest expense (i.e., the excess of expense over income). The new limit will not apply to small businesses (see below discussion under “Methods of Accounting”). A similar provision currently applies (with a 50% limit) for corporate debt that is borrowed from certain related parties.
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 20% deduction for business income). Before 2022, adjusted taxable income will be adjusted for depreciation, amortization, and depletion. Adjusted taxable income will not include wages from performing services as an employee. The IRS is permitted to provide for additional adjustments in computing adjusted taxable income.
Taxpayers that are engaged in a real property trade or business (e.g., development, construction, leasing, or operation) are permitted to elect out of the limitation on the deduction of business interest. The cost of such an election is that the taxpayer is required to depreciate assets under ADS.
Partnerships and S corporations will apply the new limit at the entity level. However, excess interest of a partnership or S corporation is allocated to the partners and shareholders, as the case may be, and is deductible in the subsequent taxable year of the partner or shareholder. The limitation in the subsequent taxable year is the excess of 30% of adjusted taxable income over net business interest (computed at the partnership or S corporation level).
For taxpayers that invest in partnerships and S corporations, adjusted taxable income is determined without taking into account their distributive share of items from partnerships and S corporations. This rule is designed to prevent double counting.
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 limitations on the deductibility of business interest will apply after all other provisions that subject interest to deferral, capitalization, or limitation. Examples of such provisions include (i) deferral under sections 163(e) or 267(a)(3)(B), (ii) capitalization rules of section 263A, and (iii) disallowance rules of sections 265 and 279.
Methods of Accounting. The Act will allow small businesses (that are not considered to be tax shelters) 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 (compared to the current $5 million). 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. Any change in treatment caused by the small business rules is considered a change in method of accounting that is eligible for the automatic consent procedures.
The Act 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), or a financial statement designated by the IRS, 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 when taken into account for accounting purposes.
The book recognition rule will not apply to income for which a special method of accounting applies. Examples of such special methods include (i) the installment method under section 453, (ii) long-term contract methods under section 460, and (iii) the treatment of mortgage servicing rights. The rules for accounting for bonds and other debt obligations (e.g., original issue discount (OID), market discount, and short-term obligation rules) are not treated as special methods of accounting. As a result, the drafters of the Act intend that the book recognition rule will apply to late-payment fees, cash-advance fees, and interchange fees.
The legislative materials provide additional examples of situations in which the new book recognition rule will not apply. These examples include: (i) the recharacterization of a transaction from sale to lease, or vice versa, (ii) gain or loss from securities that are marked to market for book purposes, and (iii) income from investments in corporations or partnerships that are accounted for under the equity method for book purposes.
Any change in the recognition of gross income caused by the new book recognition rule is considered a change in method of accounting that is eligible for the automatic consent procedures. Any changes with respect to the OID rules will only apply to taxable years beginning after December 31, 2018 and any section 481 adjustments will be taken into account over six taxable years.
The Act also permits accrual method taxpayers to elect to defer a portion of an advance payment of goods and services (and other items identified by the IRS) for up to one taxable year. Certain advance payments already receive this treatment under applicable regulations and other guidance, but the provision would expand and codify the exception. The new rule only applies to taxpayers that report income on an applicable financial statement (or financial statement designated by the IRS) and the deferral is limited to the revenue that is deferred for financial reporting purposes. The new rule would not apply to rents and interest. The election once made applies to that taxable year and all subsequent taxable years (unless the IRS consents to revoke the election). If a taxpayer ceases to exist during a taxable year, the income can no longer be deferred. Any change in the recognition of gross income caused by the new advance payment rule (including a change from a method that was prohibited before this change in law) is considered a change in method of accounting that is eligible for the automatic consent procedures.
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 (before the NOL deduction).
The Act would generally eliminate the ability to carry back a post-2017 NOL, but allow taxpayers to carryforward such NOLs indefinitely. In addition, the deduction for post-2017 taxable years would be limited to 80% of taxable income (before the NOL deduction). NOL carryforwards from pre-2017 taxable years would not be so limited.
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 Act repeals these provisions.
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 Act 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 currently 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 other highest paid officers. Under the Act, the provision will now cover the principal executive officer, the principal financial officer, and the three other 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 Act repeals these two exceptions. The Act 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 Act 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 is 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 Act, tax-exempt organizations will be subject to a $1 million limitation. Compensation in excess of that amount will be subject to a 21% 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 21% excise tax on severance payment made to such employees over a certain amount.
Other Business Deductions. The Act would also repeal the following business tax benefits:
- section 199 deduction for domestic production activities,
- 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 (other than restitution payments to come into compliance with any law),
- deduction for payments (including attorney’s fees) related to sexual harassment or abuse (if subject to a nondisclosure agreement) after the date of enactment, and
- deduction for local lobbying expenses after the date of enactment.
Other Provisions. Under current law, corporations are permitted to exclude contributions to capital by shareholders, as well as non-shareholders. The Act repeals the exclusion for (i) contributions in aid of construction, (ii) contributions from customers (and potential customers), and (iii) contributions by any governmental entity or civic group (other than by a shareholder in that capacity). This change generally applies to contributions that occur after the date of enactment.
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 Act 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.
At present, research and experimental expenses can be deducted (or amortized over five years). Under the Act, 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 2021).
Currently, 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 Act would limit the like-kind benefits to exchanges of real property.
The Act 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. This new provision is very complicated and several commentators have expressed doubt as to whether a meaningful number of employers will make qualified equity grants to employees.
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 Act 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 when repatriated. However, foreign income earned through foreign branches (or indirectly through disregarded entities and partnerships) will continue to be subject to US tax.
The new partial territorial regime will allow US multinational corporations to bring back cash and other assets from their foreign subsidiaries as dividends on a tax-free basis. However, the regime leaves in place the subpart F rules that are designed to prevent corporations from avoiding dividend treatment. As a result, corporations will continue to be subject to tax on deemed dividends under the subpart F rules, even though an actual dividend would not be subject to 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 change the tax regime for individuals to a territorial system. This idea has not been incorporated in the Act.
Individuals that own foreign businesses are treated particularly harshly under the Act. 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 Act 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 Act, 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), directly or indirectly by attribution. 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 (i) the subsidiary is a passive foreign investment company (PFIC) (that is not also a CFC), (ii) the shareholder is an S corporation, mutual fund, or REIT, or (iii) 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 exemption is also not available if the foreign corporation received a dividends-paid deduction (or other tax benefit) in a foreign country.
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.
Under the Act, 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 Act’s change to the treatment of dividends is 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 Act 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, 2017, or December 31, 2017 if the amount is greater). Earnings that accrued 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. The requirement to include deferred foreign income will not apply to a foreign corporation that is a PFIC that is not also a CFC.
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. US shareholders can exclude 55.7% 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 77.1% of the income. The exclusion amounts of 55.7% and 77.1% produce an effective tax rate of 15.5% and 8% for a C corporation that pays tax at the 35% rate. The actual effective rate for taxpayers that pay tax at a rate that is other than 35% will differ. In determining the portion of liquid assets that are held by a foreign corporation, a partnership interest (or interest in any other non-corporate entity) is not generally treated as a liquid asset unless the US shareholder owns 10% of more of the entity, directly or indirectly by attribution. If the US shareholder owns 10% or more of the entity, then liquid assets held by the entity are taken into account in determining the exclusion amount. Taxpayers will have the ability to elect to avoid utilizing NOLs to offset deferred foreign income.
A US shareholder can generally increase the basis of the CFC stock (or an interest in a foreign partnership, estate, or trust, if held indirectly) by the net amount that is taken into income. (i.e., the amount after the exclusion).
Taxpayers can elect to pay this tax in eight annual installments (starting in the taxable year in which the tax would otherwise be due). In such case, 60% of the tax owed is deferred until the last three of the eight annual payments. 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 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 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% (i.e., reduced by 55.7% or 77.1%). Individuals, trusts, and estates can elect to be taxed at corporate rates with respect to the tax on the deferred foreign income (and other subpart F inclusions). If such an election is made, the taxpayer can reduce the tax with indirect foreign tax credits. The cost of making such an election is that the step-up in basis that would normally occur will be limited to the tax paid on the income that is included in gross income.
The requirement to include the deferred foreign income of foreign corporations applies to any 10% US shareholder (including individual, partnership, trusts, and estates) of a CFC and any US corporation that is a 10% shareholder in a foreign corporation that is not a CFC. In addition, if a US corporation is a 10% shareholder in a foreign corporation that is not a CFC, the provision will apply to all other US shareholders. 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 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. 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 Act makes several modifications to the subpart F rules in the nature of cleaning up the provisions.
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 Act 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 as a CFC if a US shareholder owns more than 50% of the stock (by value), even if the shareholder has no voting rights.
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 Act makes some changes to the foreign tax credit rules.
The Act would change the way the foreign tax credit limitation rules apply to foreign branches. Currently, the income is treated as general limitation basket income. Going forward, 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 Act would eliminate the ability to apportion based on fair market value.
US corporations that include subpart F income are entitled to a tax credit for foreign taxes paid by the CFC (or a subsidiary). The Act simplifies these rules.
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 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 Act would impose a tax on such sales. The taxable gain or loss would be determined based on a hypothetical sale of all of the assets of the partnership. The partner will take into account their distributive share of the hypothetical gain or loss that is effectively connected with a US trade or business of the partnership. The change in the tax treatment for dispositions of partnership interests will apply to transactions that take place on or after November 27, 2017.
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 (when required), the partnership will be required to make up for the failure by withholding on distributions to the new partner. The withholding provisions apply to sales or exchanges after December 31, 2017.
Export Subsidies. The Act provides for a provision that is intended to provide tax breaks for foreign exports under a very complicated formula. The provision would allow for an exclusion of 37.5% of the foreign-derived intangible income (FDII) 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 13.1%, This lower rate is intended to compare favorably to Ireland which imposes a 12.5% rate on headquarter companies. FDII 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. The exclusion is only available to C corporations that are not mutual funds or REITs.
The US currently has an existing regime designed to encourage exports. A portion of exports can be excluded by setting up a domestic international sales corporation (DISC). 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. However, the DISC rules are relatively simple and the foreign-derived intangible income provisions are very complicated.
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).
Outbound Transactions. 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 Act repeals the active trade or business exception. The change applies to transfers after December 31, 2017.
In addition, the Act 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 recaptured income is treated as from US sources.
US corporations frequently reduce US tax by transferring intellectual property offshore. The Act 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, workforce in place, 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).
Anti-abuse Rules. The Act has several provisions that are designed to prevent abuses by US multinational corporations.
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 Act 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 is to be granted broad authority to provide regulations or other guidance to carry out the purposes of these rules.
The Act would impose a 10% minimum tax on C corporations (5% for 2018). 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 3% 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.
Special rules are provided in the Act 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 apply to high foreign returns (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 GILTI rules to the extent the income (before net interest expense) of one or more CFC exceeds a target 10% return on investment in tangible property. The amount of income and the target 10% return 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 is permitted to exclude 50% of the income under the GILTI provisions. This reduces the effective corporate rate to 10.5%. This exclusion cannot be used to create an NOL. The exclusion is only available to C corporations that are not mutual funds or REITs.
A US shareholder can generally increase the basis of the CFC stock (or an interest in a foreign partnership, estate, or trust, if held indirectly) by the net amount that is taken into income under the GILTI rules. (i.e., the amount after the exclusion).
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. It appears that individuals may be able to take the tax credit for deemed foreign taxes if the individual makes an election to be taxed at a corporate rate on the GILTI inclusion.
Example. USCo, a domestic corporation, owns 100% of ForCo, a CFC. ForCo has gross income of $100 million, interest expense of $30 million, and foreign income taxes of $10 million. ForCo has a basis in its assets of $200 million.
ForCo’s tested income equals $70 million ($100 million less $30 million). ForCo’s target return is $20 million ($200 million times 10%). As a result, USCO’s GILTI equals $50 million.
USCo has gross income under the GILTI rules of $50 million. However, USCo can exclude $25 million of that amount (50%).
USCo would ordinarily be deemed to have paid the $10 million of foreign income taxes, which is treated as a deemed dividend from ForCo to USCo. However, this amount is reduced by the 50% exclusion and the 20% reduction to $4 million ($10 million times 50% times 80%).
USCo would include $29 million in gross income ($50 million times 50%, plus $4 million). The US tax (before credits) on the gross income equals $6.09 million ($29 million times 21%). The net US tax equals $2.09 million ($6.09 million less $4 million).
If USCo were an individual in the highest rate bracket, the tax would equal $18.5 million ($50 million times 37%). If the individual were to elect to be taxed at the highest corporate rate, the tax would be $4.18 million (since the 50% exclusion would not apply).
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 Act 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 Act does provide that if a US corporation undergoes an inversion within the ten years after enactment of the Act, then the deferred foreign income is taxed at 35% (instead of 8% or 15.5%), 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 Act would eliminate the special rates for dividends received from corporations that have inverted after the enactment of the Act. As a result, such dividends could be taxed at a rate as high as 37%. 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 Act would increase the tax rate to 20% for corporations that invert after the enactment of the Act.
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 Act, 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 Act proposes to increase the penalty to $25,000 per filing.
The Act presents a major overhaul of many longstanding aspects of US taxation. One surprising aspect of the Act 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 Act is estimated to cut taxes by approximately $1.5 trillion over ten years. The proponents of the Act 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.
The Act will possibly be the first of several pieces of tax legislation that will be signed into law in 2018. Other significant tax bills that are expected to receive serious consideration, include:
- repeal of Obamacare taxes that have not yet become effective (e.g., the medical device and “Cadillac” healthcare plan excise taxes),
- technical corrections to the new partnership audit rules (and other recently-enacted tax laws), as well as the Act itself,
- extension of tax provisions that recently expired (or are due to expire in the near future), and
- enactment of tax reform provisions that were dropped from the Act.
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