Tax Law Update
On November 2, 2017, the House of Representatives (the “House”) introduced the Tax Cuts and Jobs Act (“H.R. 1”), and as amended through November 9, 2017. H.R.1, if passed, would make fundamental changes in the taxation of U.S. corporations. The Senate Finance Committee has issued its own tax bill, which will be addressed in a separate update.
Most notably, if enacted in its current form, H.R. 1 would:
H.R. 1 also contains provisions that (1) would allow businesses greater access to the cash method of accounting, other simplifying accounting method rules, and an exemption from the complex uniform capitalization rules, (2) cut the tax rate on income received by owners of certain entities taxed as partnerships to 25% (see our update “The Impact on Taxation of Pass-Throughs if House’s ‘Tax Cuts and Jobs Act’ Passes” for more detail), and (3) would make significant modifications to the taxation of foreign income and foreign persons (see our update “The International Tax Impact if the House’s ‘Tax Cuts and Jobs Act’ Passes”). Please see our update “How the Tax Cuts and Jobs Act Will Radically Alter Executive Compensation” for more detail regarding changes to the taxation of executive compensation. Unlike earlier versions of H.R. 1, no changes would be made to the taxation of nonqualified deferred compensation arrangements.
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 have an impact on U.S. corporations. A few of these provisions are also addressed in more detail in separate Tax Law Updates.
The drafters of H.R. 1 believe that U.S. multinational corporations are at a competitive disadvantage against their global competitors because U.S. companies are subject to the highest combined U.S. federal and state tax rate in the industrialized world. Lowering the corporate rate from 35% to 20% would increase the competiveness of U.S. corporations internationally and provide greater resources to grow domestically.
Under current law, a corporation is subject to income tax rate brackets of 15%, 25%, 34%, and 35% based on the amount of its taxable income. The 15% and 25% rates are phased out for corporations with taxable income between $100,000 and $335,000, resulting in a corporation with taxable income between $335,000 and $10,000,000 effectively being subject to a flat tax rate of 34%.
Under H.R. 1, the corporate tax rate would be a flat 20% rate beginning in 2018. Generally, this would result in a reduced income tax rate for corporations with taxable income greater than $84,000. Corporations with taxable income less than $84,000 generally would be subject to a lower tax rate under current law and would see their tax liability increase under H.R. 1.
H.R. 1 lowers the dividends received deduction, preserving the current law effective tax rates on income from such dividends.
Under current law, corporations are generally allowed a deduction for dividends received (i.e., the dividends-received deduction, or DRD) that is intended to eliminate triple taxation of the same income. A corporation that owns 20% or more of a domestic corporation distributing dividends may, subject to certain limits, deduct 80% of the dividends received. A corporation that owns less than 20% of a U.S. corporation distributing dividends may, subject to limits, deduct 70% of the dividends received.
H.R. 1 lowers the 80% dividends received deduction rate to 65% and the 70% dividends received deduction rate to 50%.
The drafters of H.R. 1 believe that the requirement that taxpayers compute their income for purposes of both the regular income tax and the AMT is one of the most far-reaching complexities of the current tax law. The AMT is believed to be particularly burdensome for small businesses, which often do not know whether they will be affected until they file their taxes and, therefore, must maintain a reserve that cannot be used to grow the business.
Under current law, taxpayers must compute their income for purposes of both the regular income tax and the alternative minimum tax (the “AMT”), and their tax liability is equal to the greater of their regular income tax liability or AMT liability. In computing the AMT, only alternative minimum taxable income (“AMTI”) above an AMT exemption amount is taken into account, but AMTI represents a broader base of income than regular taxable income. For example, many business tax preferences that are allowed for regular taxable income are not allowed in determining AMTI, including accelerated depreciation. Corporations receive a credit for AMT paid, which they may carry forward and claim against regular tax liability in future tax years (to the extent such liability exceeds AMT in a particular year), and which never expire.
The corporate AMT rate is 20% and the exemption amount is $40,000, though corporations with average gross receipts of less than $7.5 million for the preceding three tax years are exempt from the AMT. The exemption amount for corporations phases out at a 25% rate starting at $150,000.
Under H.R. 1, the AMT would be repealed. If a taxpayer has AMT credit carryforwards, the taxpayer would be able to claim a refund of 50% of the remaining credits (to the extent the credits exceed regular tax for the year) in tax years beginning in 2019, 2020, and 2021. Taxpayers would be able to claim a refund of all remaining credits in the tax year beginning in 2022. The provision would generally be effective for tax years beginning after 2017.
The drafters of H.R. 1 believe that businesses face complex systems of cost recovery for their investments in tangible and intangible assets to maintain and grow their operations. As a result, businesses are taxed today on the earnings they reinvest in growing their operations and can recover the cost of that investment only many years later. Additionally, current depreciation rules imperfectly measure the actual decline in the value of the asset in comparison to economic depreciation. The result effectively is different tax rates on different forms of investment, which distorts the allocation across asset classes. Today’s cost recovery rules also fail to take into account inflation. This means that investors do not recover the full value of their investments, because inflation erodes the value of their deductions over time. Immediately writing off (or “expensing”) the cost of investments represents a 0% marginal effective tax rate on new investment and elimination of the tax on business investment as a means to drive growth.
Under current law, a taxpayer may take additional depreciation in the year in which it places certain “qualified property” in service through 2019 (with an additional year for certain qualified property with a longer production period). The amount of this additional depreciation is 50% of the cost of such property placed in service during 2017 and phases down to 40% in 2018 and 30% in 2019. “Qualified property” is tangible personal property with a depreciation recovery period of 20 years or less, certain off-the-shelf computer software, and qualified improvement property. To be eligible for this additional depreciation, the original use of the property must begin with the taxpayer. Taxpayers may elect to accelerate the use of their AMT credits in lieu of this additional depreciation.
Under H.R. 1, a taxpayer would be able to fully and immediately expense 100% of the cost of qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023 (with an additional year for certain qualified property with a longer production period). The requirement that the original use of the property must begin with the taxpayer would be repealed and, instead, property would be eligible for the additional depreciation if it is the taxpayer’s first use. Thus, the proposal applies to purchases of used as well as new items. To prevent abuses, the additional first-year depreciation deduction applies only to property purchased in an arm’s‑length transaction and does not apply to property acquired in a nontaxable exchange such as a reorganization, nor to property bought from certain related parties.
Under H.R. 1, the election by a taxpayer to use AMT in lieu of the additional depreciation would be repealed. The repeal of this election would be effective for tax years beginning after 2017.
As discussed above, the drafters of H.R. 1 believe expensing the cost of investments eliminates a tax on business investment and will act as a means to drive growth. While the increased expensing discussed above would sunset after five years, expensing under this provision would continue beyond that time, although with decreased limits.
Under current law, businesses may immediately expense up to $500,000 of the cost of any “section 179 property” placed in service each taxable year. “Section 179 property” includes tangible personal property with a depreciation recovery period of 20 years or less, certain off-the-shelf computer software, and qualified leasehold improvement property. If the business places in service more than $2 million of section 179 property in a taxable year, then the $500,000 limit is reduced by the amount by which the cost of such property exceeds $2 million. Additional limitations on the ability to immediately expense this amount may apply based on the business’s taxable income for the year.
Under H.R. 1, the small business expensing limitation for section 179 property would be increased to $5 million and the phase-out amount would be increased to $20 million of section 179 property placed in service in a taxable year. The provision would modify the expensing limitation by indexing both the $5 million and $20 million limits for inflation. The provision would modify the definition of section 179 property to include qualified energy efficient heating and air-conditioning property permanently. The provision to modify the definition of section 179 property to include qualified energy efficient heating and air-conditioning property would be effective for property acquired and placed in service after November 2, 2017. This provision is temporary and would be effective for tax years beginning after 2017 through tax years beginning before 2023.
Under current law, qualifying business-related research and experimental expenditures can be treated as deductible expenses, or they can be deferred and amortized. If a taxpayer chooses to capitalize the expenses and they are not chargeable to depreciable or depletable property, then the taxpayer can elect to amortize the expenses over a period of not less than 60 months, beginning with the month in which benefits are first realized. Expenses that are not treated as deductible expenses or as deferred expenses that are amortized are capitalized.
Under H.R. 1, “specified research or experimental expenditures” are required to be capitalized and amortized over a 5-year period (15 years in the case of expenditures attributable to research conducted outside the United States). “Specified research or experimental expenditures” means research or experimental expenditures which are paid or incurred by the taxpayer in connection with the taxpayer’s trade or business. Any amount paid or incurred in connection with the development of any software shall be treated as a research or experimental expenditure. The amendment provides that this rule applies to research or experimental expenditures paid or incurred during taxable years beginning after 2023.
The drafters of H.R. 1 believe that the benefit of immediate expensing of business investment (discussed above) operates as a more beneficial and more neutral substitute for the deduction of interest expense associated with debt incurred to finance such investment. Allowing investments to be immediately written off provides a greater incentive to invest than is provided through interest deductions under current law; however, allowing both together would be distortive as it would result in a tax subsidy for debt-financed investment (and, therefore, interest deductions would be partially disallowed under H.R. 1).
Under current law, “earnings stripping rules” limit the deductibility of net interest expense with respect to interest paid or accrued by a corporation to a related party when no 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 replace the current “earnings stripping rules” with a new limitation that generally applies to all businesses, regardless of their form. Under the new law, 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 apply in most structured finance transactions since (1) it is limited to net business interest expense 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 apply to 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 the tax law.
As discussed above, the drafters of H.R. 1 believe that allowing both investments to be immediately written off and deductions for interest would result in a distortive tax subsidy for debt-financed investment. Nevertheless, the drafters of H.R. 1 believe that it is necessary to preserve the deduction for business interest expense for small businesses, which generally struggle to finance their business operations and growth through equity capital. Under H.R. 1, businesses with average gross receipts of $25 million or less would be exempt from the new interest limitation rules contained in H.R. 1. This provision would be effective for tax years beginning after 2017.
In addition to the general limit on the deductibility of interest described above, H.R. 1 proposes a limit on the deductibility of net interest expense by a U.S. corporation that is a member of an international financial 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 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.
H.R. 1 proposes a limit on the deductibility of net interest expense by a U.S. corporation that is a member of an international financial 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 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. This provision would be effective for tax years beginning after 2017.
While this provision would be unlikely to apply to structured finance transactions, domestic corporations would have to be mindful of any structure that involves an international financial reporting group.
A new excise tax on certain deductible payments to non-U.S. affiliates could complicate cross-border transactions, including certain financing transactions.
Currently, there 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.
H.R. 1 imposes a 20% excise tax on certain deductible payments by a U.S. corporation (including payments by a partnership owned by such corporation) to a non-U.S affiliate, unless the non-U.S. affiliate agrees to treat the payment by the U.S. corporation as U.S. effectively connected income. H.R. 1 states that deductible payments for this purposes would include “cost of goods sold, inventory or the [tax] basis of a depreciable or amortizable asset.”
While, generally, this rule should not be applicable to financing transactions, 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 provide little discussion of the provision to modify the deduction of net operating losses (“NOLs”). It is likely that this provision was primarily included as a revenue raiser; it is estimated the provision would raise $156 billion over 10 years.
Under current law, an NOL generally is the amount by which a taxpayer’s current-year business deductions exceed its current-year gross income. NOLs may not be deducted in the year generated, but may be carried back two years and carried forward 20 years to offset taxable income in such years. The AMT rules provide that a taxpayer’s NOL deduction may not reduce the taxpayer’s alternative minimum taxable income by more than 90%. Different rules apply with respect to NOLs arising in certain circumstances, including special rules that apply to specified liability losses (10-year carryback) and excess interest losses (no carryback to any year preceding a corporate equity reduction transaction).
Under H.R. 1, taxpayers would be able to deduct an NOL carryover or carryback only to the extent of 90% of the taxpayer’s taxable income (determined without regard to the NOL deduction). H.R. 1 also would generally repeal all carrybacks but provide a special one-year carryback for small businesses in the case of certain casualty and disaster losses. H.R. 1 generally would be effective for losses arising in tax years beginning after 2017. In the case of any NOL, specified liability loss, excess interest loss or eligible loss, carrybacks would be permitted in a taxable year beginning in 2017, as long as the NOL is not attributable to the increased expensing that would be allowed as discussed above. Additionally, the provision would allow NOLs arising in tax years beginning after 2017 and that are carried forward to be increased by an interest factor to preserve its value.
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) are not taxable to such corporation.
H.R. 1 provides that the contribution to the capital of a corporation in exchange for stock of such corporation would not be includible in the gross income of such corporation to the extent that the value of the contributed property does not exceed 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 this provision presumably was intended to limit the availability of the contribution of capital exception for certain payments to entities by state and local governments whereby no stock is received by such governments, its reach is much broader and could create complications in restructuring transactions.