Obama Administration 2011 Budget Tax Proposals

February 3, 2010

On February 1, 2010, the Obama Administration released the fiscal year 2011 Budget of the United States. This update summarizes the principal tax provisions identified in the Budget. The prospects for passage of these proposals is uncertain and depends in large part on the priorities of Congress and the Administration and the need for specific revenue offsets. Moreover, the inclusion of a proposal in the Budget does not necessarily provide a clear path to enactment. We invite your questions about specific details of these and any other tax-related provisions of the Budget.

The update will cover the following topics:

Financial Crisis Recovery Fee
Taxing Carried Interests as Ordinary Income
International Tax Reforms
Elimination of Fossil Fuel Tax Preferences
Codification of "Economic Substance" Doctrine
Upper-Income Taxpayer Rate Changes and Limitations
Extension of Expiring Tax Provisions
Miscellaneous Business Tax Provisions
Miscellaneous Provisions

Financial Crisis Recovery Fee

The Budget proposes to impose a Financial Crisis Recovery Fee (the "Fee," also referred to as the "Bank Tax") of 0.15% on the "Covered Liabilities" of certain financial institutions. The Fee is intended to recover a portion of the government funds provided to the banking sector as a part of the Troubled Asset Relief Program (TARP), and to serve as a deterrent against excessive leverage.

The institutions covered by the Fee would include banks, thrifts, bank and thrift holding companies, brokers, dealers, and U.S. and foreign companies owning such entities. The Fee would apply only to firms with at least $50 billion in assets worldwide (for foreign institutions, only U.S. assets would count toward the $50 billion threshold). The Fee is expected to target about 35 U.S. firms and 10 to 15 U.S. subsidiaries of foreign institutions. It will apply regardless of whether the firms received financial assistance through TARP.

The assessable base of the Fee would be a firm’s Covered Liabilities, defined as the firm’s assets, less Tier 1 Regulatory Capital, less FDIC-insured deposits and/or insurance policy reserves, as appropriate (for foreign institutions, only U.S. liabilities would be used to determine the base). Adjustments would be provided to prevent avoidance and appropriately account for risk. Covered Liabilities would be determined with reference to balance sheets filed with the appropriate federal or state regulators.

The effective date of the Fee would be July 1, 2010. The Fee would be collected by the IRS and reported on federal income tax returns. Estimated payments of the Fee would be made on the same schedule as estimated income tax payments.

Taxing Carried Interests as Ordinary Income

The Budget proposes to tax income and gains associated with certain "carried interests" as ordinary income.

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 proposal, all such income allocated to the managers generally would be taxed as ordinary income, regardless of the character of the income to the partnership, and subject to self-employment tax. Similarly, gains on the disposition of such interests would be taxed as ordinary income and subject to self-employment tax. 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. These rules are expected to apply to partnership interests held by persons providing investment advisory or management services with respect to a variety of investment assets, such as securities, partnership interests, investment real estate, commodities, and options and derivatives with respect to such assets.

The Budget proposes to make this provision effective for taxable years beginning after 2010, although pending legislation would make these provisions effective for tax years ending after 2009.

Legislation (H.R. 1935 [111^th] and H.R. 4213 [111^th]) is currently pending that would implement this proposal. Please refer to our April 7, 2009, update, "Legislation Reintroduced to Tax Carried Interests as Ordinary Income," and our December 8, 2009, update, "House Moving Quickly on Tax Extenders Bill That Would Tax Carried Interests as Ordinary Income and Crack Down on Foreign Tax Evasion," for further detail on the pending legislation.

International Tax Reforms

Deferral of Interest Expense Deductions Related to Deferred Income

The Budget proposes to defer deduction of interest expenses attributable to deferred foreign income.

U.S. taxpayers can defer recognition of some foreign income earned by foreign subsidiaries until that income is repatriated to the United States. In the meantime, the taxpayer does not pay U.S. taxes on the accrued foreign earnings. However, U.S. taxpayers may generally deduct all interest expenses currently, even the interest expense paid in the U.S. but allocable to debt incurred to finance the foreign income that has been deferred. Furthermore, the interest paid in the U.S. is deductible regardless of whether the expense exceeds the foreign earnings, or even whether there are foreign earnings at all.

Under the proposal, deductions from interest expenses related to deferred foreign income can only be taken as the deferred income is recognized. A taxpayer can deduct such interest expenses in proportion to the amount of previously-deferred foreign-source income that becomes subject to U.S. tax. Treasury regulations may provide exceptions for the deduction of previously deferred interest expenses.

When this proposal was introduced previously, the Joint Committee noted that this proposal might lead to distortions if Congress delayed the effective date of certain legislation that adjusted the method for allocating interest expense to domestic and foreign source income. We caution clients that the recent Affordable Health Care for America Act (H.R. 3962 111^th) passed by the House would delay the effective date of that interest allocation legislation to taxable years beginning in 2019.

This provision would be effective for taxable years beginning after 2010.

Foreign Tax Compliance Measures

The scope of withholding obligations would be expanded under the Budget 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.

In addition, the Budget would expand reporting obligations with respect to foreign assets. Individuals would be required to file information returns disclosing certain interests in foreign accounts and assets. It would also impose a penalty of up to 40 percent of the amount of any understatement that is attributable to an undisclosed foreign financial asset. The statute of limitations would be extended to six years in certain cases relating to financial assets required to be disclosed. These reporting obligations and penalty provisions would generally apply upon the enactment of the provisions.

Beginning in 2013, the Budget would require individuals to report certain transfers of money or property to or from foreign financial accounts. U.S. financial institutions would similarly be required to report certain such transfers made on behalf of U.S. individuals.

The Budget 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.

Certain "dividend equivalent" payments would be treated as dividends for tax purposes under the Budget. This provision 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. This change is proposed to be effective for payments made after 2010.

Legislation (H.R. 3933 [111^th], S. 1934 [111^th]. and H.R. 4213 [111^th]) is currently pending that would implement some of these proposals. Please refer our December 8, 2009, update, "House Moving Quickly on Tax Extenders Bill That Would Tax Carried Interests as Ordinary Income and Crack Down on Foreign Tax Evasion," for further detail on the pending legislation.

Transfer Pricing of Intangibles

In an effort to enhance the enforcement and effective application of the transfer pricing rules, the Budget proposes two new rules targeting transfers of intangibles.

First, transfers of intangible assets by U.S. persons to related controlled foreign corporations (CFCs) would be scrutinized. The IRS will no longer need to rely on IRC Section 482 to reapportion income in cases of transfer pricing abuse. If the CFC is subject to a lower effective tax rate and circumstances indicate that there is excessive income shifting, the excessive return will be treated as subpart F income in a separate foreign tax credit limitation basket.

Second, the proposed budget attempts to clarify the definition of intangible property to include goodwill, going concern value, and workforce in place. Furthermore, the Commissioner may consider prices or profits of a taxpayer’s alternative transactions and also may value multiple intangible properties on an aggregate basis if doing so would achieve a more reliable result.

Both provisions would be effective for tax years beginning after 2010.

Miscellaneous International Tax Reforms

Other foreign tax related proposals include the following:

A matching rule that would prevent separation of creditable foreign taxes from the associated foreign income. Furthermore, when a domestic corporation receives a dividend from a foreign subsidiary, the proposed rule would require that the resulting deemed-paid foreign tax credit be computed on an aggregate basis. A taxpayer’s deemed paid foreign tax credit will be calculated based on the amount of the repatriated consolidated earnings and profits of the taxpayer’s foreign subsidiaries.
Disallow U.S. insurance companies from taking deductions for reinsurance premiums paid to affiliated foreign insurance companies if the foreign reinsurers or their parents are not subject to U.S. income tax with respect to those premiums or if the amount of the premiums exceeds 50% of the total direct insurance premiums received by the U.S. insurance company and its U.S. affiliates for a line of business.
Limit the ability of expatriated entities to deduct interest paid to related persons by amending IRC Section 163(j) to eliminate the debt-to-equity safe harbor, reduce the interest deduction to 25% of adjusted taxable income, limit the carryforward of disallowed interest to ten years, and eliminate the carryforward of excess limitations.
80/20 company provisions would be repealed in their entirety.
Dual capacity taxpayers, instead of following prior regulatory provisions, would be permitted to treat a foreign levy as creditable tax so long as it does not exceed the foreign levy the taxpayer would pay were it not a dual capacity taxpayer.
Any U.S. person who directly or indirectly transfers property to a foreign trust will face a rebuttable presumption of being a U.S. beneficiary for the purposes of grantor trust rules. Furthermore, any such beneficiary’s use of trust property will be deemed a distribution or payment unless the trust is paid fair market value.

These provisions would generally be effective beginning after 2010.

Elimination of Fossil Fuel Tax Preferences

The Budget proposes to eliminate the following oil and gas tax preferences:

The Enhanced Oil Recovery investment tax credit will be repealed.
The production tax credit for oil and gas produced from marginal wells will be repealed.
The expensing of intangible drilling costs (IDCs) and 60-month amortization of capitalized drilling costs will no longer be allowed. These costs will need to be capitalized as either depreciable or depletable property.
The deduction for qualified tertiary injectants will be repealed.
The exemption from the passive loss rules for working interests in oil and gas properties will be repealed.
Percentage depletion with respect to oil and natural gas wells will no longer be allowed. Taxpayers will be allowed to claim cost depletion on these assets.
The domestic manufacturing deduction for oil and gas production activities will be repealed.
The geological and geophysical expenditures amortization period for independent producers will be increased from two to seven years.

The Budget proposes to eliminate the following coal tax preferences:

The expensing and 60-month amortization of exploration and development costs related to coal and other hard mineral fossil fuels will no longer be allowed. These costs will need to be capitalized as depreciable or depletable property.
Percentage depletion with respect to coal and other hard mineral fossil fuels (including lignite and oil shale) will no longer be allowed. Taxpayers will be allowed to claim cost depletion on these assets.
The capital gains treatment of coal and lignite royalties will be repealed, and these royalties will be taxed as ordinary income.
The domestic manufacturing deduction for coal and other hard mineral fossil fuels (including lignite and oil shale) will be repealed.

The elimination of these preferences would generally apply beginning after 2010.

Codification of "Economic Substance" Doctrine

Economic Substance

The Budget proposes codifying the existing common-law "economic substance" doctrine that generally denies a taxpayer tax benefits from a transaction that does not meaningfully change the taxpayer’s economic position, other than tax consequences. A transaction would satisfy the economic substance requirement only if (1) the transaction changes in a meaningful way (apart from federal tax effects) the taxpayer’s economic position, and (2) the taxpayer has a substantial purpose (other than a federal tax purpose) for entering into the transaction. Furthermore, under the new provision, a transaction would not be treated as having economic substance solely by reason of a profit potential unless the reasonably expected pre-tax profit is substantial in relation to the net federal tax benefits arising from the transaction.

New Understatement Penalty

In addition, the Budget would impose a penalty on an understatement of tax attributable to a transaction that lacks economic substance. The penalty would be equal to thirty percent of the tax underpayment, but would be reduced to twenty percent if the taxpayer provides adequate disclosure of the relevant facts in its tax return. This economic substance understatement penalty would be in addition to the existing twenty percent penalty for a substantial understatement of tax.

The Budget proposal states that the I.R.S. could assert and abate the new economic substance penalty. The I.R.S. could assert the penalty even if a court had not determined that the economic substance doctrine was applicable to the transaction. Any abatement of the penalty must be proportionate to the abatement of the underlying tax liability.

New Denial of Interest Deduction

The new law would also deny any interest deduction attributable to an understatement of tax arising from the application of the economic substance doctrine.

Effective Date

The proposal states that the new economic substance law and the related penalty would apply to transactions entered into after the date of enactment of the new law. The new law regarding the denial of interest deductions would be effective for taxable years ending after the date of enactment with respect to transactions entered into after the enactment date.

Upper-Income Taxpayer Rate Changes and Limitations

The Budget proposes the following changes to the tax rules that would govern taxpayers with income over $200,000 ($250,000 for married taxpayers filing jointly):

The top tax rate will be raised to 39.6% for taxable income over $373,650 for married taxpayers filing jointly.
The second-highest marginal tax rate will be increased from 33% to 36% on taxable income of over $200,000 ($250,000 for married taxpayers filing jointly), less the standard deduction and 1 personal exemption (2 for married taxpayers filing jointly).
Itemized deductions would be reduced by 3% of the amount by which a taxpayer’s adjusted gross income exceeds $200,000 ($250,000 for married taxpayers filing jointly), up to 80% of otherwise allowable deductions.
The personal exemption would be phased out for taxpayers with an adjusted gross income that exceeds $200,000 ($250,000 for married taxpayers filing jointly).
Long term capital gains and qualified dividend income will be taxed at a 20% rate for taxpayers with taxable income of over $200,000 ($250,000 for married taxpayers filing jointly), less the standard deduction and 1 personal exemption (2 for married taxpayers filing jointly). The 0% and 15% capital gains rates will be made permanent for all other taxpayers.
The value of all itemized deductions will be limited to 28% for taxpayers in the new 36% and 39.6% tax brackets. Similar rules will apply for the alternative minimum tax.

The thresholds for these provisions will be indexed for inflation in subsequent years and will be effective for taxable years beginning after 2010.

While the Budget does not identify it as a "proposal," it assumes a baseline that includes an annual "patch" of the alternative minimum tax based on the 2009 alternative minimum tax exemption and indexed for inflation.

Extension of Expiring Tax Provisions

A number of temporary tax provisions scheduled to expire before the end of 2011 would be extended by the Budget through 2011. Among the provisions targeted for extension are

the optional deduction for state and local sales taxes;
Subpart F "active financing" and "look-through" exceptions;
the exclusion from unrelated business income of certain payments to controlled foreign corporations;
a fifteen-year straight-line recovery for qualified leasehold and restaurant improvements;
incentives for empowerment and community renewal zones; and
several trade agreements.

Miscellaneous Business Tax Provisions

The Budget proposes a variety of additional business tax measures, including the following:

Authorizing an additional $5 billion of tax credits for investments in eligible property used in a qualifying advanced energy project.
Extending the current limit and phase-out level regarding the deduction for the cost of placing qualifying property in service under IRC Section 179.
Extending the current additional first-year depreciation deduction for qualified property for one year. The election for claiming additional research or minimum tax credits for eligible qualified property in lieu of the additional depreciation deduction would also be extended by one year.
Permanently expand IRC Section 1202 to exclude 100 percent of capital gain on the sale of certain small business stock acquired at issue and held for at least five years. The current tax preference subject to the alternative minimum tax, equal to seven percent of the excluded gain, would be eliminated.
Make the current research and experimentation tax credit permanent effective as of January 1, 2010.
Remove cell phones (and other similar telecommunications equipment) from the definition of "listed property," effectively removing the current requirement of strict substantiation of use and the limitation on depreciation deductions. The fair market value of personal use of a cell phone provided primarily for business purposes would be excluded from gross income.
Make the current unemployment insurance surtax permanent.
Exclude from the definition of "cellulosic biofuel" any fuels that are more than four percent (by weight) water or sediment in any combination, or have an ash content of more than one percent (by weight). This change would exclude black liquor from eligibility for the credit.
Repeal of the LIFO inventory accounting method for federal income tax purposes. Taxpayers currently using the LIFO method would be required to write up their beginning LIFO inventory to its FIFO value in the first taxable year beginning after December 31, 2011. This one-time increase in gross income would be taken into account ratably over ten years.
Repeal of the Lower-of-Cost-or-Market and subnormal goods accounting methods. Taxpayers currently using these accounting methods would be required to change their method, and any resulting IRC Section 481(a) adjustment would generally be included in income ratably over a four-year period. Wash-sale rules would also be included to prevent taxpayer circumvention of the new prohibition.

Miscellaneous Provisions

Among the other tax proposals included in the Budget are the following:

A corporation that enters into a forward contract to issue stock would be required to treat a portion of the payment received as a payment of interest. This would apply to forward contracts entered into after 2011.
Dealers in commodities, commodities derivatives, securities, and options would be required to treat income from their "day-to-day" dealer activities in IRC Section 1256 contracts as ordinary income rather than capital gain.
The definition of "control" for the purposes of disallowing deductions on repurchase premiums under IRC Section 249 would be expanded to incorporate certain indirect control relationships.
Superfund excise taxes on domestic crude oil and imported petroleum products, certain hazardous chemicals, and substances that use such hazardous chemicals in their production would be reinstated for 2011-2020.
Corporate environmental income tax of 0.12% would be imposed on the amount by which the modified alternative minimum taxable income of a corporation exceeds $2 million.
Repeal the "boot-within-gain" limitation in the case of any reorganization transaction that has the effect of a distribution of a dividend under IRC Section 356(a)(2).
Extend the Making Work Pay credit through 2011.
Extend the COBRA premium assistance eligibility period for qualified individuals whose employment is involuntarily terminated prior to 2011.
Allow states to elect to receive cash in lieu of low-income housing tax credits for 2010.
Expand the Earned Income Tax Credit, the Child and Dependent Care Tax Credit, and Saver’s Credit beginning in 2011.
Provide for automatic enrollment in IRAs and double the tax credit for small employer plan startup costs beginning in 2012.
Provide for a $250 payment or credit to eligible retired adults.

In addition, the Budget would provide for a variety of reforms designed to reduce the tax gap. These measures include revisions to information reporting obligations, increased or expanded penalties, extending certain statutes of limitations where state adjustments affect federal tax liability, and increasing certain IRS administrative powers.

Finally, the Budget assumes gift, estate, and generation-skipping-tax rates and lifetime exemptions in place in 2009 (45% top rate and $3.5 million exemption) will be extended. It would also modify certain rules dealing with valuations for these transfer tax purposes and the grantor retained annuity trusts (GRATS).

Source Documents

Fiscal Year 2011 Budget of the U.S. Government:
http://www.whitehouse.gov/omb/budget/fy2011/assets/budget.pdf

Department of Treasury’s General Explanations of the Administration’s Fiscal Year 2011 Revenue Proposals:
http://www.treas.gov/offices/tax-policy/library/greenbk10.pdf

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To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any matters addressed herein.

Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding these developments. If you have any questions, please contact the Gibson Dunn attorney with whom you work or one of the following members of the firm’s Tax Practice Group:

New York
Charles F. Feldman (212-351-3908, [email protected])
David B. Rosenauer (212-351-3853, [email protected])
Jeffrey M. Trinklein (212-351-2344, [email protected])
Romina Weiss (212-351-3929, [email protected])

Washington D.C.
Art Pasternak (202-955-8582, [email protected])
Benjamin Rippeon (202-955-8265, [email protected])

Los Angeles
Hatef Behnia (213-229-7534, [email protected])
Stephen L. Tolles (213-229-7502, [email protected])
Paul S. Issler (213-229-7763, [email protected])
Dora Arash (213-229-7134, [email protected])
J. Nicholson Thomas (213-229-7628, [email protected])

Orange County
Gerard J. Kenny (949-451-3856, [email protected])
Scott Knutson (949-451-3961, [email protected])

Dallas
David Sinak (214-698-3107, [email protected])

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.