Tax Law Update
On November 2, 2017, House Ways and Means Committee Chairman Kevin Brady (R-TX) introduced a tax bill entitled the Tax Cuts and Jobs Act (“H.R. 1”), and later proposed amendments to the bill on November 3, November 6, and November 9, 2017. H.R. 1, if passed, would make certain fundamental changes to the taxation of financing transactions.
Most notably, if enacted in its current form, H.R. 1 would:
Because it is so early in the legislative process, this Tax Law Update provides a summary overview only of certain provisions in H.R. 1 that could impact on financing transactions. A few of these provisions are also addressed in more detail in separate Tax Law Updates.
The deduction for business interest may now be limited.
Under current law, “earnings stripping rules” in Section 163(j) of the Internal Revenue Code of 1986, as amended (the “Code”), limit the deductibility of net interest expense with respect to interest paid or accrued by a corporation to a related party when no U.S. federal income tax is imposed with respect to the interest if (1) the corporation’s debt-to-equity ratio exceeds 1.5 to 1.0 and (2) net interest expense of the corporation exceeds the sum of 50% of the adjusted taxable income of the corporation for such year plus any excess limitation that was carried forward from any of the three previous taxable years. Adjusted taxable income is defined as taxable income before any deductions for non-business items, interest income or expense, any net operating loss deduction, and any deduction or depreciation, amortization or depletion.
H.R. 1 Would Limit Business Interest Deductions to 30% of Adjusted Taxable Income
Applicable to taxable years beginning after 2017, H.R. 1 would replace the current “earnings stripping rules” of Section 163(j) of the Code with a new limitation that generally applies to all businesses, regardless of their form. Under revised Section 163(j) of the Code, the deduction of any net business interest expense would be limited to an annual amount equal to 30% of the adjusted taxable income of the taxpayer. Any disallowed business interest would be carried forward for five taxable years (but may not be carried back) and would be re-tested in such subsequent years. Under special rules applicable to pass-through entities, owners of a pass-through entity may be able to use the pass-through entity’s excess interest limitation for the taxable year and net income from the pass-through entity would not be double counted at the owner level. This limitation only applies to interest paid or accrued on indebtedness properly allocable to a trade or business. As under current law, adjusted taxable income is defined as taxable income before any deductions for non-business items, interest income or expense, any net operating loss deduction, and any deduction or depreciation, amortization or depletion. Businesses with average gross receipts of $25 million or less, as well as certain regulated public utilities and real property trades or businesses, would not be subject to the new limitation.
It is unlikely that the new limitation would affect most structured finance transactions since (1) it would apply to net business interest expense only and (2) most structured finance transactions either use securitization vehicles that are not engaged in a trade or business or otherwise do not incur net interest expense in the transaction. However, this limitation could affect certain structured finance transactions where the securitization vehicle is engaged in a trade or business and has net business interest expense (e.g., certain lease or whole business securitization transactions).
Notably, H.R. 1 does not address the debt versus equity rules under Section 385 of the Code.
In addition to the general limit on the deductibility of interest described above, H.R. 1 would limit the deductibility of net interest expense by a U.S. corporation that is a member of an international financial reporting group to 110% of the U.S. corporation’s share of the group’s global earnings before interest, taxes, depreciation and amortization (“EBITDA”). This provision is designed to prevent a U.S. corporation from deducting interest paid to a non-U.S. affiliate that is not taxed on such interest and, thereby, may reduce the overall amount of income tax paid by such corporate group.
Currently, subject to the general limitations on the deductibility of interest, interest expense of a U.S. corporation that is owed to a non-U.S. affiliate generally is deductible for U.S. federal income tax purposes, other than in the case of original issue discount that is owed to a related non-U.S. party, which only is deductible when paid. As noted above, this permits a U.S. corporation to deduct certain interest that is paid to a non-U.S. affiliate that is not taxed on such interest and, thereby, may reduce the overall amount of income tax paid by such corporate group.
Limit on the Deduction of Interest Paid by a U.S. Corporation that is a Member of an International Financial Reporting Group
H.R. 1 would limit the deductibility of net interest expense by a U.S. corporation that is a member of an international financial reporting group to 110% of the U.S. corporation’s share of the group’s EBITDA. This rule would apply in addition to the general limitation on the deductibility of interest described above by applying the greater limitation under each set of rules. For this purpose, an international financial reporting group would be a group of entities that includes at least one non-U.S. corporation that is engaged in a trade or business in the United States, or at least one U.S. corporation and one non-U.S. corporation, prepares consolidated financial statements, and has annual global receipts of more than $100 million. The limitation would also apply to a partnership which is a member of any international financial reporting group under rules similar to the new “earnings stripping rules” of Section 163(j) of the Code described above, except as otherwise provided in regulations. This provision would be effective for taxable years beginning after 2017.
The rules for the exclusion from gross income of contributions to the capital of corporations would be limited significantly.
Under current law, contributions to the capital of a corporation (including the contribution of a corporation’s debt to such corporation) generally not taxable to such corporation.
Tax-Free Contributions to the Capital of a Corporation Would be Limited to the Value of Stock Received in Exchange Therefor
H.R. 1 would require the inclusion of a contribution to the capital of a corporation in exchange for stock of such corporation in the gross income of such corporation to the extent that the value of the contributed property exceeds the value of such stock received therefor. Moreover, the exception to cancellation of indebtedness income for contributions of a corporation’s debt to the capital of such corporation would no longer apply. H.R. 1 also provides that a similar rule would apply to contributions to entities other than corporations (e.g., partnerships). While a summary of H.R. 1 released by Chairman Brady notes that “[t]his provision would remove a Federal tax subsidy for State and local governments to offer incentives and concessions to businesses that locate operations within their jurisdiction (usually in lieu of locating operations in a different State or locality),” its reach is much broader and could create complications in restructuring transactions.
A new excise tax on certain payments to non-U.S. affiliates could complicate cross-border transactions, including certain financing transactions.
Under current law, there generally is no excise tax on deductible payments by U.S. corporations to non-U.S. affiliates. Therefore, as long as payments are set at arm’s length amounts, generally, the non-U.S. affiliate would not be subject to tax on the receipt of a payment from a U.S. affiliate (including from a sale), even if such non-U.S. affiliate is resident in a jurisdiction that imposes income taxes at a lower rate than the United States, and the U.S. corporation would reduce its U.S. federal income taxes by the amount of such payment.
The 20% Excise Tax Could Apply in Certain Structured Transactions Where Receivables or Assets are Transferred to the United States
H.R. 1 imposes a 20% excise tax on certain payments by a U.S. corporation (including payments by a partnership owned by such corporation) to a non-U.S affiliate which is a member of the same international financial reporting group as such U.S. corporation, unless the non-U.S. affiliate agrees to treat the payment by the U.S. corporation as U.S. effectively connected income. Covered payments for these purposes would include “amounts allowable as a deduction or included in cost of goods sold, inventory or the [tax] basis of a depreciable or amortizable asset,” but would exclude interest, payments for certain services provided at cost and payments in certain commodities and securities transactions.
Due to the interest exclusion, this rule should not be applicable to most financing transactions. However, taxpayers should be mindful of the rule when structuring purchases of certain receivables or other assets by U.S. affiliates from non-U.S. affiliates in connection with a financing transaction.
The drafters of H.R. 1 recognized that owners of businesses in pass-through form would be disadvantaged as compared to businesses in C corporation form if the C corporation rate were reduced significantly (which they propose to reduce to 20%) without a comparable rate drop for pass through entities. Therefore, H.R. 1 offers a special tax rate of 25% to business income received by taxpayers from a pass-through entity.
Under current law, businesses organized as partnerships, most LLCs, S corporations and sole proprietorships are generally treated for U.S. federal income tax purposes as “pass-through” entities that are subject to tax at the individual owner or shareholder level rather than the entity level. The owners then report the income on their own returns and pay tax (generally) at ordinary income rates, the top current rate being 39.6%.
Owners Active in the Pass-Through Business Apply the 25% Rate to Only Part of Their Income
Each owner would separately determine its proportion of business income received from the pass-through entity. If the income is derived from a passive business activity it would be treated entirely as business income and all subject to the 25% rate. If the income is considered to be active income, and thus raises a question as to the appropriate amount to be treated as compensation and subjected to regular rates, then only a portion of the income would be eligible for the 25% rate. As a default rule, 30% of the income would be subject to the 25% rate, while the other 70% would be treated as wages or compensation and taxed at regular, graduated ordinary income rates.
A higher percentage of such active income could be subject to the 25% rate, depending on a deemed return calculation. In the deemed return calculation, the taxpayer would apply a rate of return (the U.S. federal short-term rate plus 7%) to the cost basis of the assets of the business as of the end of the tax year. That amount of the taxpayer’s total income from the pass-through would be subject to the 25% rate. Depending upon the asset base and the rate applied, the percentage of total income receiving the benefit of the 25% rate could exceed the default percentage of 30%. The effect of such a provision would be that those businesses in pass-through form that are heavily invested in equipment or other assets, such as manufacturers, would generate income that is taxed to their active owner recipients at a significantly lower rate. However, assets that have been expensed under the new rules under H.R. 1 would not provide any cost basis for purposes of this rule.
This 25% rate is unlikely to apply in most structured finance transactions since securitization vehicles typically are not engaged in a business or would otherwise have a zero capital percentage under the proposed rules for purposes of the deemed return calculation. However, equity investors in structured finance transactions involving active securitization vehicles with collateral that might be included in the asset base for purposes of the deemed return calculation (e.g., certain lease or whole business securitization transactions) should consider whether and how they might take advantage of the 25% rate on income earned through the securitization vehicle.
Preferential Rate would Apply to Certain Dividends from REITs
Under H.R. 1, certain dividends from real estate investment trusts (“REITs”) also would be eligible for the preferential 25% rate for income from pass-through entities. The 25% rate would not apply to capital gain and qualified dividend dividends from REITs, to which the capital gains rates would apply.
H.R. 1 would limit the popular like kind exchange rules to exchanges of real property only.
Currently, the exchange of property for property of like kind is not taxable for U.S. federal income tax purposes. While popular in connection with exchanges of real property, such provision is not limited to exchanges of real property. Such exchanges may be facilitated through so-called qualified intermediaries.
Like Kind Exchange Rule Limited to Real Property
Under H.R. 1, the like kind exchange rules would be limited to exchanges of real property. In addition, property located in the United States and property located outside the United States would not be treated as property of a like kind. While the like kind exchange rules typically are not used in connection with financing transactions, they sometimes are used by manufacturers (e.g., automobile manufacturers) in connection with lease securitization transactions.
New limitations on the deductibility of mortgage interest and real property taxes and the exclusion of a portion of any gain from the sale or exchange of a principal residence could depress U.S. real estate values.
Under current law, homeowners may claim itemized deductions for mortgage interest paid with respect to their principal residence and one additional residence on acquisition indebtedness of up to $1 million ($500,000 for married individuals filing separate returns) and on home equity indebtedness of up to $100,000 ($50,000 for married individuals filing separate returns), as well as for real property taxes paid. Under current law, there is no cap on the deductibility of real property taxes, other than the general limit on itemized deductions based on a taxpayer’s adjusted gross income and the add back of real property taxes for purposes of calculating the alternative minimum tax. In addition, under current law, $250,000 of any gain from the sale of a principal residence ($500,000 for joint filers) may be excluded from gross income. This exclusion is available only for properties used as a principal residence for at least two years in a five-year period, and may be used only for one sale every two years.
H.R. 1 would Impose New Limits on the Deductibility of Mortgage Interest and Real Property Taxes and Limit the Availability of the Exclusion of a Portion of any Gain from the Sale or Exchange of a Principal Residence, and Phase out such Exclusion based on the Taxpayer’s Adjusted Gross Income
For new indebtedness incurred after November 2, 2017, H.R. 1 would reduce the cap on acquisition indebtedness to $500,000 ($250,000 for married taxpayers filing separate returns) and eliminate the deduction for interest on home equity indebtedness. In addition, H.R. 1 would limit the deduction for interest on mortgages on the taxpayer’s principal residence only. In addition, H.R. 1 would limit the deduction for taxes not paid or accrued in a trade or business to U.S. real property taxes only and cap such deduction at $10,000 a year ($5,000 a year for married taxpayers filing separate returns).
H.R. 1 would also limit the exclusion for gain from the sale of a principal residence to gain from the sale or exchange of a residence used as a principal residence for at least five years in an eight-year period and the taxpayer would be able to use this exclusion only once every five years. It also would reduce the amount of such exclusion by the amount by which the taxpayer’s adjusted gross income exceeds $250,000 ($500,000 for joint filers). The provision would apply to sales and exchanges of principal residences after December 31, 2017.
The potential limitations on the deductibility of mortgage interest and real property taxes, and limitations and phase out of the exclusion of a portion of gain from the sale of a principal residence, each could depress real estate values and, therefore, indirectly affect the securities markets that involve U.S. real estate assets and mortgages with respect to such assets.