November 3, 2017
On November 2, 2017, House Republicans released their much anticipated tax reform proposal, entitled the Tax Cuts and Jobs Act (the “Act”). (On November 3, 2017, Chairman Brady released a “Chairman’s mark” that removed one international tax provision and made several technical and conforming changes.)
The Act must be approved by both the House and the Senate and signed by the President in order to become law, so there is significant uncertainty as to whether some or all of the provisions in the Act will take effect, and, if they do, in what form.
If enacted, the Act would make a number of major changes to the U.S. federal taxation of businesses and individuals, including lowering the corporate income tax rate to 20%, introducing a 25% individual income tax rate for certain income from passthrough entities and personal service corporations, changing the treatment of interest and certain other business expenses, moving toward a territorial system of international taxation, introducing new provisions designed to combat base erosion, streamlining individual income tax rates, repealing the alternative minimum tax, subjecting “super tax-exempt” investors to the unrelated business income tax and raising the financing costs for future infrastructure transactions. We summarize below certain provisions of the Act.
Corporate graduated tax rates of up to 35% would be replaced with a 20% flat rate, with one exception: personal service corporations would be subject to a 25% flat rate.
“Business income” from sole proprietorships and passthrough entities (i.e., entities classified as partnerships and S corporations) would be subject to a maximum tax rate of 25%, instead of the applicable individual rates.
The amount of income derived from a sole proprietorship or passthrough entity that would be treated as “business income” eligible for the 25% maximum tax rate would depend, in part, on whether the individual owner is actively involved in the business (determined under the existing passive activity loss rules). Generally, where an individual owner is actively involved in the business, 30% of the income derived from the business would be treated as “business income” subject to the maximum 25% rate, and 70% of the income would be treated as non-business income taxed at applicable individual rates. Taxpayers would have the option to elect out of the default rule to treat more than 30% of their income as “business income” based on the income of the business and the amount of capital invested in the business. The election would be binding for five years. Absent such an election, 100% of the income of personal service businesses, such as law firms, accounting firms, and professional service firms, would be treated as non-business income not eligible for the 25% rate. Individuals who are actively involved in the business would also be subject to self-employment tax on their distributive shares of non-business income, and the exemption from self-employment tax for limited partners would be eliminated.[1] In contrast to income generated from businesses in which a taxpayer is actively engaged, all of the income derived from business activities in which the taxpayer is not active (i.e., passive activities) would be eligible for the 25% maximum rate.
Income already subject to preferential rates, such as net capital gains and qualified dividend income, would not be affected by these rules. However, dividends from real estate investment trusts that are not qualified dividends generally would be eligible for the 25% rate.
In general, a taxpayer would not be permitted to deduct business interest in excess of its business interest income and 30% of its “adjusted taxable income” (generally income before interest income and expense, net operating losses, depreciation, amortization, and depletion). For partnerships, the limitation would be determined at the partnership level. Any interest amount disallowed may be carried forward to the succeeding five taxable years, subject to certain limitations. This rule would apply to taxable years beginning after December 31, 2017.
The limitation on interest deductions would not apply to real property trades or businesses (as currently defined under section 469[2]) or certain public utilities. The limitation also would not apply to “small businesses” (i.e., businesses with average gross receipts of $25 million or less).
Due to the limitation on interest deductions, the “earnings stripping” rules of section 163(j) would be repealed. Those rules generally limit the deductibility of interest by a thinly capitalized corporation where the interest is paid to certain related party lenders.
The Act would make substantial changes to the net operating loss (“NOL”) rules. First, deductions arising from NOLs generated in taxable years beginning after December 31, 2017, would not be allowed to be carried back to offset income in prior years (with a narrow exception for small businesses and farms). Second, NOLs would be able to be carried forward indefinitely, instead of being limited to a 20-year period. Finally, NOLs would be permitted to offset only 90% of taxable income, instead of all taxable income as current law generally permits.
The Act would replace the current 50% bonus depreciation deduction for “qualified property” placed in service before January 1, 2020, with a 100% deduction for such property that is acquired and placed in service after September 27, 2017, and before the end of 2022 (or 2023 for certain long-life property). In addition, the Act would allow the deduction for taxpayers acquiring used property, which is currently excluded from the bonus depreciation rule. “Qualified property” for this purpose generally would include most tangible personal property, but would not include property used by certain utility companies or in a real property trade or business.
The Act also would expand immediate expensing of any “section 179 property” (including certain tangible property) placed in service in any taxable year by increasing the amount a business is entitled to expense from $500,000 to $5 million, with the phase-out amount increasing from $2 million to $20 million.
Among the Act’s changes to the renewable energy-related tax credit provisions of the Code are modifications to the production tax credit (“PTC”) (generally relevant to wind energy projects) and the investment tax credit (“ITC”) (generally relevant to solar energy projects).
For the wind PTC, the Act would reduce from 2.3 to 1.5 cents per kWh of qualified production for facilities the construction of which begins after the Act’s enactment. In addition, the Act would modify the beginning of construction rules (which determine whether a facility is eligible for PTCs) by adding a “continuous construction” requirement. This modification, which is proposed to be retroactive, could have a substantial, negative impact on wind project sponsors that undertook some construction activities before 2017, but have not maintained a continuous program of construction in the meantime.
The modifications to the ITC are less material. The existing 30% ITC for utility scale solar projects (including the rules for its gradual phase-out) is left untouched by the Act. The permanent 10% ITC, however, would be completely eliminated under the Act.
The Act would make a number of other significant business tax reforms: (i) self-created patents and copyrights for musical compositions would no longer be treated as capital assets or eligible for long-term capital gain treatment; (ii) a sale or exchange of 50% or more of the total interest in partnership capital and profits within a 12-month period would no longer cause a “technical termination” of a partnership; (iii) section 1031 like-kind exchanges would be limited to exchanges of real property; (iv) multiple business tax credits would be repealed (e.g., the credit for qualified clinical testing expenses for certain drugs, the new markets tax credit, and the historic rehabilitation credit); and (v) the Act would repeal the exclusion from gross income for interest earned on certain types of bonds, including certain private activity bonds, advance refunding bonds, certain tax credit bonds, and bonds for professional sports stadiums, increasing significantly the borrowing cost for infrastructure and other projects that have historically relied on tax-exempt financing.
The Act would substantially limit the amount of non-qualified deferred compensation on which taxes can be deferred by taxing employees on compensation as soon as such compensation is no longer subject to an obligation to perform future substantial services. The scope of the provision is very broad, going well beyond section 409A to include stock options and various other types of compensation that are not “deferred compensation” under current law. In addition, the Act would expand section 162(m) so that performance-based compensation would not be excluded from the $1 million limit on deductions for compensation paid by public companies to certain high-ranking employees, and amounts paid after termination of employment to covered employees would be subject to the deduction limit.
The Act also would repeal or limit various exemptions from employees’ gross income, such as employer-provided housing, employee achievement awards, dependent care assistance programs, qualified moving expense reimbursements, and adoption assistance programs.
The Act would fundamentally alter the current international tax regime by moving the United States from a worldwide tax system to a partial territorial tax system.
Under existing law, the United States generally taxes U.S. multinational corporations on their worldwide income, which includes income earned by foreign subsidiaries abroad, but generally only when the income is repatriated to the United States. To reduce the impact of double taxation, current law allows for certain credits or deductions with respect to foreign taxes paid by foreign subsidiaries.
The Act would generally exempt from U.S. taxation any income earned abroad by foreign subsidiaries beginning in 2018, through a newly established participation exemption. In general, under the participation exemption, foreign-source dividends paid by a foreign corporation to a U.S. corporate shareholder that owns at least 10% of the foreign corporation (a “U.S. Corporate Shareholder”) would be exempt from U.S. tax. However, the Act would not exempt from U.S. taxation gain from the sale of the foreign corporation’s stock. The U.S. Corporate Shareholder would no longer be entitled to a deduction or credit for foreign taxes paid or accrued with respect to the dividend.
Other rules would be modified as a result of the move to a territorial tax system. First, the Act would modify the rules applicable to controlled foreign corporations (“CFCs”), which include foreign subsidiaries of U.S. corporations. U.S. Corporate Shareholders would no longer be taxed if a foreign subsidiary makes an investment in “U.S. property” (which generally includes tangible personal property in the United States, stock of U.S. corporations, obligations of U.S. persons, and certain types of U.S. intellectual property). Second, solely for purposes of calculating losses with respect to a sale or exchange of stock of a foreign subsidiary, a U.S. Corporate Shareholder would reduce its basis in the stock by the amount of any exempt foreign-source dividends.
A transitional rule would address existing earnings held offshore by foreign subsidiaries. Under this rule, U.S. Corporate Shareholders would essentially be required to pay U.S. tax on those earnings as if the earnings had been repatriated to the United States. In particular, a U.S. Corporate Shareholder would include in income for the last taxable year of the foreign subsidiary beginning before 2018 its pro rata share of net earnings and profits (“E&P”) accumulated by the foreign subsidiary after 1986, to the extent that the E&P had not already been subject to U.S. tax. The E&P would be subject to a one-time tax of 12% for E&P held as cash (or cash equivalents) or 5% for E&P held as property. U.S. Corporate Shareholders would be permitted to pay the tax liability in 8 annual instalments of 12.5% of the total amount due.
The Act would introduce several new rules to combat U.S. base erosion, including new section 951A, which would require certain U.S. shareholders to include in their taxable income for the year 50% of their “foreign high return amount,” even if the amount remained offshore. The Act defines the “foreign high return amount” as the excess of a CFC’s aggregate net income over a return (equal to the short-term AFR plus 7%) on the CFC’s aggregate adjusted bases in depreciable tangible property, adjusted downward for interest expense. Foreign high returns would not include certain income, including income effectively connected with a U.S. trade or business, subpart F income, financing income exempt from subpart F, and certain related-party payments. This provision is essentially designed to tax income earned from intangible assets held in a foreign subsidiary. Foreign tax credits generated during one taxable year would be available (subject to an 80% limitation) to offset U.S. tax on foreign high return inclusions for that year.
A second provision designed to combat base erosion would introduce a worldwide thin-cap rule that limits the deductible net interest expense of a U.S. corporation that is a member of an international financial reporting group to the extent the U.S. corporation’s share of the group’s global net interest expense exceeds 110% of the U.S. corporation’s share of the group’s EBITDA. For this purpose, an “international financial reporting group” is any group of entities that includes at least one foreign corporation engaged in a U.S. trade or business, or at least one domestic and one foreign corporation that prepares consolidated financial statements and has annual gross receipts in excess of $100 million. This 110% limitation would apply to the extent it would disallow a greater amount of interest deductions than would the proposed limitation on business interest expense discussed above. Any disallowed interest could be carried forward up to five years.
The final base erosion provision would impose a 20% excise tax on payments (other than interest) that are deductible or includible in either the cost of goods sold or the basis of a depreciable or amortizable asset and that are made by a U.S. corporation to a related foreign corporation, unless the related foreign corporation elects to treat the payments as income effectively connected with a U.S. trade or business. Subject to certain exceptions, this provision generally would have the effect of subjecting the foreign corporation’s net profits (or gross receipts) with respect to the payments to full U.S. income taxation. This provision would apply only to international financial reporting groups with payments from U.S. corporations to their foreign affiliates totaling at least $100 million annually. It is similar in concept to certain aspects of prior border adjustment proposals, except that it is only applicable to related parties, and seems designed to apply to certain “principal” structures that have been used by multinational groups to attract group profits to offshore cost centers.
The Act would replace the existing seven individual income tax brackets with four brackets: 12%, 25%, 35%, and 39.6%. However, the Act would phase out the 12% bracket for certain high-income taxpayers. The Act also would roughly double the size of the standard deduction, reduce certain deductions such as the mortgage interest deduction, and repeal or revise other deductions, exemptions, and credits. In particular, the Act would eliminate the deduction for state and local income taxes, although property taxes of up to $10,000 would remain deductible. The limitation on itemized deductions for upper-income taxpayers would be repealed. No changes are proposed to the net investment income tax of 3.8% that is used to finance the provisions of the Affordable Care Act, so the top individual tax rate on certain investment income would remain at 43.4%.
The Act also would repeal the alternative minimum tax (“AMT”). Taxpayers would be entitled to claim a refund of unused AMT credit carryforwards.
The Act would double the exemption for the estate and gift tax from $5 million to $10 million (indexed for inflation). Beginning after 2023, the Act would eliminate the estate tax while continuing to give beneficiaries a stepped-up basis in inherited property.
The Act would make a number of changes that would adversely affect the taxation of exempt organizations and private foundations, as well as sponsors in the private equity sector. Notably, the Act would subject all entities that are exempt from tax under section 501(a) to the unrelated business income tax (“UBIT”), including state pension plans that are exempt from tax under section 115(l) (i.e., “super tax-exempt” investors) and historically have taken the position that they are not subject to any UBIT. This amendment could have a significant impact on the future structuring considerations for private equity funds as well as the willingness of super tax-exempt investors to make a direct investment in a partnership or other passthrough entity that generates unrelated business taxable income.
Gibson, Dunn & Crutcher is focused on the Act and how it would affect our clients, and we will continue to provide updates as more information about the Act or tax reform in general becomes available.
[1] The Act appears to make all passthrough income, even for “passive” owners, subject to self-employment tax, but we believe this is a drafting error that will be corrected.
[2] Unless indicated otherwise, all “section” references are to the Internal Revenue Code of 1986, as amended (the “Code”).
The following Gibson Dunn lawyers assisted in the preparation of this client alert: Benjamin Rippeon, James Chenoweth, Brian Kniesly, Arthur Pasternak, David Sinak, Eric Sloan, Jeffrey Trinklein, Romina Weiss, Arsineh Ananian, Vanessa Grieve, Kathryn Kelly, Lorna Wilson, and Daniel Zygielbaum.
Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these developments. For further information, please contact the Gibson Dunn lawyer with whom you usually work or any of the following members of the Tax Practice Group
Art Pasternak – Co-Chair, Washington, D.C. (202-955-8582, [email protected])
Jeffrey M. Trinklein – Co-Chair, London/New York (+44 (0)20 7071 4224 +1 212-351-2344), [email protected])
Brian W. Kniesly – New York (+1 212-351-2379, [email protected])
David B. Rosenauer – New York (+1 212-351-3853, [email protected])
Eric B. Sloan – New York (+1 212-351-2340, [email protected])
Romina Weiss – New York (+1 212-351-3929, [email protected])
Benjamin Rippeon – Washington, D.C. (+1 202-955-8265, [email protected])
James Chenoweth – Houston (+1 346-718-6718, [email protected])
Hatef Behnia – Los Angeles (+1 213-229-7534, [email protected])
Paul S. Issler – Los Angeles (+1 213-229-7763, [email protected])
Dora Arash – Los Angeles (+1 213-229-7134, [email protected])
Scott Knutson – Orange County (+1 949-451-3961, [email protected])
David Sinak – Dallas (+1 214-698-3107, [email protected])
© 2017 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.