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By: Jerred Blanchard Baker & McKenzie LLP
On December 20, 2017, for the first time in 30 years, Congress passed major tax legislation in the form of the Tax Cuts and Jobs Act of 2017, Pub. Law No. 115-97 (Act), signed into law by President Donald J. Trump on December 22, 2017. The legislative text and a joint explanatory statement (Conference Agreement or Conference Report) were released by the Conference Committee on December 15, 2017. From a business point of view, the Act is best known for its reduction of the maximum corporate tax rate from 35% to 21% and its shift to a territorial system for taxing earnings of multinationals.
On balance, it can be said that the Act is a laudatory piece of legislation that goes a long way toward encouraging both business investment in the United States and private-sector employment in the United States. However, many commenters have observed that the Act was quickly drafted and has not been fully vetted by stakeholders, which means that the Act may contain drafting errors that lead to unintended consequences. Thus, a 2018 technical corrections bill likely will be drafted, although it will be very hard to pass since it would require affirmative votes of Democrats in the Senate to reach the 60-vote threshold needed for legislation for which reconciliation is not available. In the meantime, regulatory guidance from the U.S. Department of the Treasury will need to be swift and comprehensive. In addition, the Joint Committee on Taxation (JCT) is preparing a bluebook describing the legislation, yet to be released. Doubtless, taxpayers will want to forward comments to the Treasury Department, their representatives in the House and Senate, and JCT pointing out errors and unintended consequences that affect them and encouraging the enactment of technical corrections or Treasury regulations to solve those problems.
What follows is a short summary of key provisions of the Act of interest to taxpayers doing business in the United States, with occasional observations or planning thoughts. The summary is divided into two segments, the first addressing key provisions primarily affecting C corporations doing business in the United States, and the second more briefly addressing key provisions primarily affecting all other taxpayers doing business in the United States. Provisions addressing special industries, such as banks and insurance companies, are beyond the scope of this article.
Corporate tax rate reduction and alternative minimum tax (AMT) repeal. The maximum corporate tax rate imposed on a domestic C corporation is reduced from 35% to 21% for tax years beginning after December 31, 2017, with partial benefit for corporations having fiscal years beginning in 2017. Also, the Act repeals the AMT for corporate taxpayers, substituting the Senate’s Base Erosion and Anti-Abuse Tax (BEAT).
Expensing. For depreciable property with a life of 20 years or less, if the property is acquired and placed in service on or after September 27, 2017, and on or before December 31, 2022, 100% of the cost of the property is deductible. This temporary 100% expensing regime phases out over the five years beginning after December 31, 2022.
Elimination or reduction of other domestic tax benefits.
To partially pay for the foregoing tax benefits and achieve other goals (e.g., inhibit earnings stripping or base erosion):
Like-kind exchanges under I.R.C. § 1031 are eliminated for property other than real estate, effective for exchanges completed after December 31, 2017.
For most accrual method taxpayers, effective for tax years beginning after December 31, 2017, (1) income received in a tax year cannot be deferred beyond the tax year in which the income is included on a taxpayer’s financial statement, and (2) advance payments for goods, services, or other specified items may not be deferred beyond the close of the tax year of receipt unless the income is also deferred for financial statement purposes.
In the case of a net operating loss (NOL) described in I.R.C. § 172, for NOLs arising in tax years beginning after December 31, 2017, (1) the carryback is repealed, (2) the carryover limitation is repealed (i.e., the NOL can be carried forward indefinitely), and (3) an NOL carried over to a tax year cannot be used to offset more than 80% of the taxable income earned in that year. Note that, unlike the Conference Report, the statutory language states that the modifications to the carryovers and carrybacks apply to NOLs arising in tax years ending after December 31, 2017.
Effective for tax years beginning after December 31, 2017, I.R.C. § 163(j)’s limitation on the deductibility of interest is significantly expanded.
The Act makes fundamental and sweeping changes to the U.S. taxation of international businesses. The overarching purposes of this new international tax regime include making U.S. multinationals more competitive with companies based in other countries, removing impediments to the repatriation of profits to the United States, reducing opportunities to shift income offshore to low-tax jurisdictions, incentivizing exports of products and services from the United States, and preventing erosion of the U.S. tax base by foreign companies. The following is a summary of the key changes to the system.
Forced deemed repatriation. Generally, new I.R.C. § 965 increases the Subpart F income of a CFC (controlled foreign corporation), or a foreign corporation with at least one 10% U.S. shareholder that is a domestic corporation, for its last tax year ending before January 1, 2018, by the greater of (1) the CFC’s “accumulated post-1986 deferred foreign income” determined as of November 2, 2017, without regard to distributions, or (2) such income determined as of December 31, 2017.
Participation exemption. In at least one important respect, the Act generally brings the U.S. foreign tax system in line with international norms by providing a participation exemption. Under the participation exemption in new I.R.C. § 245A, eligible dividends a U.S. corporation receives from an eligible foreign corporation qualify for a deduction equal to the full amount of the dividend sourced to foreign earnings. As a result, qualifying dividends are only subject to foreign tax and are effectively exempt from U.S. tax.
Deduction for foreign-derived intangible income (FDII). New I.R.C. § 250 provides a special deduction for a domestic corporation’s FDII. In summary, the provision provides a lower rate of tax on a portion of profits derived from sales into foreign markets. In the language of the Conference Report, a domestic corporation’s FDII is the portion of its income “that is derived from serving foreign markets,” in excess of a deemed return on tangible assets (the “applicable deemed tangible income return”). Broadly speaking, a domestic corporation is allowed a deduction under new I.R.C. § 250 in an amount equal to 37.5% of its FDII, resulting in an effective tax rate on FDII of 13.125%. The deductible percentage of FDII declines to 21.875% in tax years beginning in 2026 and beyond, resulting in an effective tax rate on FDII of 16.406%.
Global intangible low-taxed income (GILTI). In addition to the new FDII regime, the Senate bill introduced a new category of income, GILTI, similar to Subpart F income. This provision is the stick designed to encourage U.S. multinationals to move foreign operations into the United States, made more difficult by the Act’s failure to include the carrot (I.R.C. § 966), which generally would have allowed a CFC to distribute its intangible assets to its U.S. shareholders without recognizing I.R.C. § 311(b) gain. In broad strokes, GILTI taxes the aggregate net income of all of a U.S. shareholder’s CFC income not otherwise captured under the Subpart F and ECI (effectively connected income) provisions of the Internal Revenue Code’s net CFC tested income, less a return on the tangible assets held by those CFCs used for the production of tested income in a trade or business (deemed tangible income return).
Base erosion. The Conference Agreement adopted in large part the BEAT, an AMT found in new I.R.C. § 59A designed to prevent base erosion through deductible payments. The BEAT will apply to base erosion payments paid or accrued in taxable years beginning after December 31, 2017. Under the BEAT, an applicable taxpayer is required to pay a tax equal to the base erosion minimum tax amount for the taxable year. The BEAT applies to corporations with average annual gross receipts for a three-taxable-year period of at least $500 million and a “base erosion percentage” for the taxable year of at least 3% (2% for banks and registered securities dealers).
Foreign tax credits. Under the territorial taxation regime of new I.R.C. § 245A, earnings of foreign subsidiaries of a U.S. corporation are no longer subject to U.S. income taxation when distributed as a dividend to the U.S.-resident shareholder. Consequently, the deemed-paid credit of I.R.C. § 902 is no longer required to prevent double taxation of these earnings and has therefore been repealed in its entirety in Section 14301 of the Act. In contrast to the treatment of actual dividends, Subpart F income inclusions under I.R.C. § 951 are still subject to full income taxation in the United States. I.R.C. § 960 will be amended to deem a U.S. corporate shareholder to have borne its pro rata share of the foreign income taxes imposed on the Subpart F income of its CFC without relying on repealed I.R.C. § 902. The U.S. corporate shareholder is also deemed to bear any additional foreign income taxes imposed on an actual distribution of earnings described in I.R.C. § 959 as having been previously taxed under I.R.C. § 951 and is entitled to a foreign tax credit equal to 80% of foreign income tax imposed on its GILTI inclusion. Under the new territorial regime, the CFC no longer tracks a pool of earnings and taxes. Instead, the deemed-paid taxes under I.R.C. § 960 are those that are allocated to the Subpart F income of the CFC, under rules similar to those that currently govern the allocation of taxes to the separate foreign tax credit baskets. Conforming amendments have been made to other sections of the I.R.C., including the I.R.C. § 78 gross-up.
Tax rate reduction. The bill reduces the maximum marginal tax rate for individuals from 39.6% to 37%. The maximum 37% rate applies in 2018 to married individuals filing joint returns with income over $600,000 and single individuals with income over $500,000. The Act also effectively doubles the amount of the standard deduction and makes changes to many popular deductions, such as the state and local tax deduction and the mortgage interest deduction. Unlike the income tax rate reduction for corporations, which is permanent, the income tax rate reduction and other changes for individual taxpayers are temporary and scheduled to expire in 2026. The Act maintains the AMT for individuals but increases the exemption amount and the threshold amount after which the exemption is phased out for tax years 2018 through 2025. For tax year 2018, the exemption amounts and phase-out thresholds would be $109,400 and $1,000,000 for joint filers and $70,300 and $500,000 for single filers, respectively.
Expensing. For depreciable property with a life of 20 years or less, if the property is acquired and placed in service on or after September 27, 2017, and on or before December 31, 2022, 100% of the cost of the property is deductible. The provisions (including the phase-out) are the same as for corporate taxpayers.
Special deduction for sole proprietorships and pass-through entities. The Conference Agreement largely followed the Senate bill and provides that a non-corporate taxpayer (such as an individual, estate, or trust) doing business via a partnership, S corporation, or sole proprietorship is entitled to a potential deduction based on newly defined “qualified business income” such that a full deduction effectively reduces the maximum marginal tax rate from 37% to 29.6%. Non-corporate taxpayers may deduct, in any tax year beginning after December 31, 2017, and before January 1, 2026, the lesser of (1) 20% of the taxpayer’s combined qualified business income or (2) the greater of 50% of the W-2 wages paid with respect to the qualified trade or business, or the sum of 25% of the W-2 wages with respect to the qualified trade or business plus 2.5% of the unadjusted basis, immediately after acquisition, of all qualified property (i.e., property used and depreciated in a qualified business).
Special limitation on active business losses. Effective for tax years beginning after December 31, 2017, and before January 1, 2026, under new I.R.C. § 461(l), a taxpayer’s excess aggregate trade or business losses are disallowed for the current taxable year and not usable against other non-business income, such as wages, dividends, and interest income. This limitation is applied after the I.R.C. § 469 passive loss limitations and is applied at the partner or S corporation shareholder level.
New three-year holding period for carried interest. After many prior attempts to tax service partner carried interests as compensation income, the Conference Agreement reached a compromise that retained the capital nature of the income but requires a three-year holding period to obtain the benefits of long-term capital gain rates. Specifically, this rule applies to taxpayers receiving partnership interests in connection with the performance of substantial services in any applicable trade or business consisting of (1) raising or returning capital and (2) either investing in (or disposing of) specified assets (or identifying specified assets for investing or disposition) or developing specified assets. Specified assets generally means securities; commodities; real estate held for rental or investment; cash or cash equivalents, options or derivative contracts with respect to such securities, commodities, real estate, cash or cash equivalents; as well as an interest in a partnership to the extent of the partnership’s proportionate interest in the foregoing. Holders of partnership interests that transfer their interests to related parties prior to three years in certain instances will trigger immediate gain taxed as shortterm capital gain. The provision applies to tax years beginning after December 31, 2017.
Elimination or reduction of other domestic tax benefits. Non-corporate taxpayers engaged in business will suffer the same eliminations or reductions in domestic tax benefits as corporate taxpayers, including the limitation on interest deductions in new I.R.C. § 163(j).
Most of the international provisions (other than the participation exemption and the BEAT, which are limited to corporations) apply to non-corporate taxpayers. However, high net worth individuals, estates, and trusts may want to focus on the following international provisions, effective for tax years beginning after December 31, 2017.
Elimination of CFC 30-day rule. The Act eliminates the requirement that a U.S. shareholder must control a non-U.S. corporation for an uninterrupted 30-day period before Subpart F inclusions apply.
CFC downward attribution. Further, the bill eliminates I.R.C. § 958(b)(4), which prevents downward attribution of stock from certain non-U.S. partnerships, estates, trusts, and corporations to U.S. persons for purposes of determining whether the CFC and U.S. shareholder tests are satisfied. This repeal may result in unintended tax and reporting consequences. For example, by eliminating this provision, a domestic corporation owned by a non-U.S. individual shareholder could be considered to own the shares of non-U.S. corporations owned by the non-U.S. individual shareholder. This could result in the non-U.S. corporations being constructively owned CFCs of the domestic corporation in certain circumstances. The domestic corporation may have a reporting obligation or an income inclusion if it directly or indirectly owns shares in the foreign corporation under I.R.C. §958(a).
Expansion of U.S. shareholder definition. . The bill expands the definition of a U.S. shareholder to include any U.S. person who owns 10% or more of the total vote or value of all shares of all classes of stock of a foreign corporation. Under current law, the definition of a U.S. shareholder required the shareholder to hold 10% or more of the voting power of the CFC. Therefore, individuals who own non-voting shares in a foreign corporation that were not previously considered U.S. shareholders should determine if their non-voting shares will cause them to become U.S. shareholders and also cause the entity to become a CFC.
Repeal of indirect foreign tax credit (FTC) for non-corporate shareholders. Taxpayers that are individuals, estates, or trusts are no longer entitled to claim indirect FTCs under I.R.C. §§ 902 (also repealed for corporations) and 960 (not repealed for corporations). For example, unlike a U.S. shareholder that is a domestic corporation, an individual’s Subpart F inclusion under I.R.C. § 951(a) will not entitle the individual to a FTC under I.R.C. § 960.
GILTI. . The GILTI regime may cause income of a CFC (including a foreign corporation with a 10% shareholder that is a domestic corporation) that is not otherwise caught by the existing Subpart F rules to be includable in the gross income of its U.S. shareholders. This regime will affect almost all U.S. individuals, estates, and trusts that own CFCs, unless the CFC has a significant investment in tangible assets. This regime would apply to U.S. shareholders of foreign IP-rich CFCs, service provider CFCs, and CFCs with low-basis assets, and which otherwise would not cause Subpart F inclusions for its U.S. shareholders. That said, the GILTI regime should not apply if the CFC’s foreign income is subject to foreign tax at a rate of 13.125% or more for C corporation shareholders and 18.9% or more for non-C corporation shareholders.
No participation exemption. . The provision that exempts 100% of foreign source dividends paid by a specified 10%-owned foreign corporation would apply only to U.S. C corporation shareholders. When a U.S. shareholder that is an individual, estate, or trust receives a dividend from a foreign corporation, the dividend is includable in the shareholder’s gross income. These U.S. shareholders of CFCs cannot claim indirect FTCs for foreign income taxes paid by the CFC
Forced deemed repatriation. New I.R.C. § 965’s forced deemed repatriation rule applies to a U.S. individual, estate, or trust that owns 10% or more of the stock of a CFC or foreign corporation that has at least one 10% shareholder that is a U.S. corporation. In simple terms, the tax applies as a Subpart F inclusion on all of the CFC’s pre-effective date foreign earnings at a rate of approximately 8% for non-cash earnings and profits and 15.5% for earnings and profits held in cash. Individuals, estates, and trusts will not be afforded the benefit of FTCs for any foreign tax imposed on the CFC’s earnings. That said, individuals may be afforded a partial tax credit for any foreign withholding tax imposed on the distribution of any of the foreign corporation’s earnings that was subject to the forced repatriation tax. Furthermore, the new provision will allow for an eight-year deferral on payment of the tax owed, meaning the majority of payments will be owed in the later part of the eight-year period. Finally, if the CFC was owned by an S corporation, there is an indefinite deferral of the tax that may apply until one of three triggering events is met. The first triggering event is a change in the status of the corporation as an S corporation. The second category includes liquidation, sale of substantially all corporate assets, termination of business, or any similar event, including reorganization in bankruptcy. The third is a transfer of shares of stock in the S corporation by the electing taxpayer, whether by sale, death, or otherwise, unless the transferee of the stock agrees with the Secretary of the Treasury to be liable for net tax liability in the same manner as the transferor.
Sale of interest in partnership engaged in a U.S. business. The Conference Agreement codifies the aggregate theory of Rev. Rul. 91-32, to the effect that a foreign partner’s gain on a sale of a partnership interest is effectively connected income to the extent the partner’s distributive share of gain on a sale of partnership assets would be ECI. Additionally, a new withholding rule is enacted that requires the transferee of the partnership interest to withhold 10% of the amount realized on the sale or exchange of a partnership interest absent certification that the transferor is exempt from withholding. Congress intends for the provision to apply to a broad range of transactions, including many tax-free transfers in which taxpayers continue to retain indirect interests in the partnership interest. As a backup enforcement mechanism, failure to withhold imposes an obligation on the partnership to deduct and withhold from distributions to the transferee partner those amounts that should have been withheld by the transferee, plus interest.
Although many taxpayers have been focused on immediate planning, such as deferring income beyond 2017 or accelerating deductions into 2017, it is important not to lose sight of additional legislative and regulatory events. Enacting a significant tax act is often only the first step in a prolonged process. Although Congressional leadership intends to pursue a technical corrections bill, taxpayers should not count on the passage of a technical corrections bill to correct any errors in the Act or unintended consequences caused by the Act. Instead, taxpayers should focus their energy on understanding the new provisions and determining how to comply with them in a timely fashion. Moreover, taxpayers should not be coy about contacting the Treasury Department to alert them to challenges and ambiguities that they have identified in the Act. Because many of the provisions in the Act are effective for tax years beginning after December 31, 2017, the Treasury Department will need to issue guidance on a variety of topics with great dispatch. Thus, taxpayers can provide valuable insight from the beginning of that process, helping to smooth the implementation of the Act for all parties involved.
Jerred G. Blanchard Jr. is counsel in the Houston office of Baker & McKenzie LLP and a member of the firm’s tax practice group. He is a coauthor of a well-known consolidated return treatise, has written numerous articles in various professional journals on multiple corporate tax topics, and is a frequent speaker at various legal and professional programs across the country. Prior to joining the firm, Mr. Blanchard was a principal at a Big Four accounting firm. He is one of 813 professionals recommended by The International Who’s Who of Corporate Tax Lawyers.
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