December 8, 2009
Gibson, Dunn & Crutcher is closely tracking key legislative matters as the first session of the 111th Congress draws to a close. This update focuses on H.R. 4213, the Tax Extenders Act of 2009, which was considered by the House Committee on Rules today, and is moving to the House floor tomorrow.
The Tax Extenders Act would tax income and gains associated with "carried interests" as ordinary income and would expand reporting obligations and penalties to curb foreign tax evasion and fraud. Although these proposals have been proposed previously in separate bills, they are being incorporated into the Tax Extenders Act as a means of financing the $31 billion price tag for extending expiring tax provisions through 2010.
Analysts note that the bill is expected to pass the House easily, but its future in the Senate is unclear. While it is likely that the Senate Finance Committee will take up an extenders bill, it may not do so until next year–after the Senate finishes its work on health care legislation–and it may well include a different set of offsets. It is possible that Congress could delay resolution of the bill, because most of the provisions can be extended retroactively in 2010.
Taxation of Carried Interest
The Tax Extenders Act would tax income and gains associated with certain "carried interests" as ordinary income. These provisions are substantially identical to those in H.R. 1935 [111th], which was introduced earlier this year by Congressman Sander Levin.
Managers of investment services partnerships typically receive a "carried interest" in the partnership entitling them to share in the gains and profits of the partnership. Currently, a holder of this kind of interest is taxed on its allocable share of the partnership’s taxable income. The character of that income to the manager is generally the same as it is to the partnership. This means that in the many cases where the underlying income is long term capital gain, the manager is taxed at the long term capital gains preference rate, which is currently 15 percent. Under the proposed legislation, all such income allocated to the managers generally would be taxed as ordinary income, regardless of the character of the income to the partnership. Similarly, gains on the disposition of such interests would be taxed as ordinary income. But, to the extent any allocable income or gain is properly attributable to an interest received in respect of contributed money or property, it will continue to be taxed under the existing rules.
The bill generally would make these provisions effective for tax years ending after 2009. It was previously expected that these provisions would not be effective until 2011.
Please refer to our April 7, 2009, update, "Legislation Reintroduced to Tax Carried Interests as Ordinary Income," for further detail on this proposal.
The Joint Committee on Taxation estimates that this provision will raise more than $24.6 billion over the next 10 years. Legislation with similar provisions has previously passed the House of Representatives in two instances, as part of H.R. 3996 [110th], the Temporary Tax Relief Act of 2007, and H.R. 6275 [110th], the Alternative Minimum Tax Relief Act of 2008. In both of these cases, however, the provisions faced substantial opposition in the Senate and were not enacted.
Foreign Tax Compliance
The legislation also draws provisions from the Foreign Account Tax Compliance Act of 2009, H.R. 3933 and S. 1934 (the "FATCA") that would crack down on the use of foreign financial institutions, trusts, and corporations by U.S. individuals to evade U.S. taxes and eliminate what some consider to be loopholes in the foreign tax regime.
The scope of withholding obligations would be expanded under the FATCA provisions to include certain "withholdable payments" made to accounts in foreign financial institutions, unless those institutions agree to comply with certain information gathering and reporting procedures with respect to those accounts. The universe of payments subject to withholding is expanded in these cases (through the definition of withholdable payments) to include payments of gross proceeds from the disposition of any property that can produce U.S.-source interest or dividends.
The FATCA provisions would also require individuals to disclose information with respect to their foreign financial assets and impose a penalty equal to 40 percent of the amount of any understatement that is attributable to an undisclosed foreign financial asset. With respect to foreign trusts, the bill would clarify certain provisions, established a presumption with respect to transfers to foreign trusts, and strengthen the minimum penalty for failure to report on certain foreign trusts.
The legislation would also eliminate the exception from the registration requirements for debt obligations for foreign-targeted debt. This change would generally eliminate deductions for interest paid with respect to such unregistered debt and subject interest payments on such debt to U.S. withholding tax. These provisions generally would not be effective for obligations issued on or before the second anniversary of the enactment of the legislation.
In addition, the legislation would treat certain "dividend equivalent" payments as dividends for tax purposes. This would generally subject to U.S. tax certain notional principal contract (swap) payments and other substitute payments that are economically similar to dividends but currently avoid U.S. tax.
According to the Joint Committee on Taxation, these provisions of the FATCA would prevent U.S. individuals from evading $7.7 billion in U.S. taxes over the next ten years.
Extensions of Individual and Business Tax Relief
The carried interest provisions and the Foreign Tax Compliance provisions are aimed at offsetting the costs of extending expiring tax relief and incentive provisions. The extensions in the legislation include more than $5 billion in individual tax relief and $17 billion in business tax relief, as well as $7 billion of tax provisions that encourage charitable contributions, provide community development incentives, provide tax relief in the event of a Presidentially declared disaster, and support the development of alternative vehicles and fuels.
The bill extends four individual tax credits: (1) the provision that allows residents of states without income taxes to deduct state and local sales taxes from their federal income taxes as well; (2) the additional standard deduction for State and local real property taxes; (3) the above-the-line deduction for qualified tuition and related expenses; and (4) the above-the-line deduction for certain expenses of elementary and secondary school teachers.
Among the larger business tax provisions covered by the Act are the one-year extensions of the research and development tax break, a fifteen-year straight-line cost recovery for qualified leasehold and restaurant improvements, and a statute that allows look-through treatment of payments between related controlled foreign corporations.
A number of expiring community assistance programs, such as the tax incentives for Empowerment Zones, tax incentives for Renewal Communities, the new markets tax credit, the tax incentives for the New York Liberty Zone, and the program that allows state housing agencies to elect to receive a payment in lieu of a portion of the State’s allocation of low-income housing tax credits, will also be extended. Additionally, the bill extends a number of general disaster tax relief provisions, such as the deductibility of personal casualty losses attributable to federally declared disasters and the five-year carry-back period for certain losses relating to federal disasters.
Finally, the Act extends energy tax credits, including tax incentives for biodiesel and renewable diesel, the alternative motor vehicle credit for heavy hybrids, and the tax incentive for natural gas and propane used as fuel in transportation vehicles.
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