In November, the Republicans in Congress moved with remarkable speed to rewrite the US Tax Code. At the end of October, they had yet to make public the text of a tax bill. Now, though, they have one version of a bill which has sailed through the House of Representatives along party lines; and another version which the Senate Finance Committee has reported out (also along party lines) and which is being debated this week on the floor of the Senate. There are still several potential hurdles for the Republicans to overcome, particularly in the Senate where the Republican leadership has not yet locked down the 50 votes needed (together with the tie-breaking vote of the vice president) to pass the bill there. But as a result of the fresh momentum created during November, the Republicans do seem to have their goal of passing tax reform before Christmas within reach.
All of a sudden, the Republicans are making quick progress in transforming the US tax code, report Donald L. Korb and Andrew Solomon (Sullivan & Cromwell).
The most important tax debate in the United States in more than a generation is in full swing. The tax reform process started to gain momentum on 2 November, when congressman Kevin Brady, the chair of the House Ways and Means Committee, released the long awaited text of his Committee’s tax bill. Subsequently, over a four day period the following week, the 36 members of the Ways and Means Committee debated the bill and made several significant amendments. Then on 9 November, the Committee voted by 24 to 16 on a strict party line vote to move the bill to the House floor. Only a week later on 16 November, the bill was passed by a vote of 227 to 205, without a single Democrat supporting the legislation.
In the meantime, on the other side of Capitol Hill, on the same day that the House Ways and Means Committee reported its bill out of committee, senator Orrin Hatch, the Chair of the Senate Finance Committee, released the text of his Committee’s bill, which contained important differences from the House bill. The Senate Finance Committee began its deliberations of its bill on 13 November. Four days later on 16 November, after rejecting a host of amendments proposed by the Democrats on the Committee, the Committee reported out its version of the tax bill, also on a strict party line vote of 14 to 12 – the same day that the House voted to approve its bill. The next step for the Senate bill is consideration by the full Senate, which began earlier this week on 27 November. These two tax bills, when ultimately combined into one piece of legislation, will represent the most significant change to the US Tax Code since 1986.
For the tax reform process to have progressed this far, the Republicans have had to successfully overcome several of the legislative hurdles that we described in our last article (see Tax Journal, 8 September 2017). Most important, in October the Republicans created the opportunity for them to pass tax reform by a simple majority vote in each house of Congress, which means that the legislation could be enacted without a single vote by a Democrat representative in the House or senator in the Senate. The future of the tax legislation is still very much in doubt because there are a number of legislative and political hurdles that still need to be overcome; yet as a result of all this legislative activity, the odds of success for US tax reform have increased from those of just two months ago.
The parameters of the both the House and Senate tax reform packages came into sharp focus on 27 September, when the so-called ‘Big Six’ negotiators (Treasury secretary Steven Mnuchin, National Economic Council director Gary Cohn, House speaker Paul Ryan, Senate majority leader Mitch McConnell, House Ways and Means Committee chair Brady and Senate Finance chair Hatch) unveiled what they called a ‘unified framework for tax reform’. While at that time the framework was still a high-level document, it did flesh out some of the more nebulous principles set forth in an earlier July ‘joint statement’, also the combined product of the Big Six (see Tax Journal, 8 September 2017).
However, the real significance of the framework document was that it enabled the Republican leadership in Congress to obtain the votes needed in both houses to pass a budget resolution that would, if necessary, allow the Republicans to pass a tax reform bill with only Republican support in the Senate. The reason that the budget resolution was such a critical element in the process is that it gave Congressional tax writers a significant amount of leeway in drafting their bill. The key event in the budget process occurred on 19 October, when the Senate agreed in its budget resolution to allow a $1.5 trillion increase in the amount of the federal budget deficit over the next ten years. The budget resolution, which passed by a narrow margin of 51 to 49 in the Senate, also allowed the tax plan to be debated and voted on in the Senate using the ‘reconciliation’ process, which prevents a dilatory Democrat led ‘filibuster’ during the debate on the floor of the Senate (again, see Tax Journal, 8 September 2017). By successfully employing the reconciliation process, Republicans gained the opportunity to pass a tax bill with only Republican votes in the Senate (which is divided by 52 to 48 in favour of the Republicans).
The budget reconciliation process is a double-edged sword, however, in that it also forbids an increase in the budget deficit outside a ten year budget window. Likewise, the strategy of relying solely on Republican votes in the Senate poses significant risks to the legislation, as more than two Republican senators have indicated that they may not vote with the rest of their party unless changes are made.
The budget resolution passed the House a week later, without any Democrat support, by a vote of 216 to 212 vote, even though some fiscally conservative Republicans and Republicans from so-called ‘swing districts’ either voted against the resolution or abstained from voting. Both the permitted $1.5 trillion increase in the federal deficit and the need not to increase the deficit above that amount will play important roles in the final shape of any tax bill sent to the president for his signature.
The House bill is 116 pages long and the report describing its contents contains another 376 pages.
Business tax reform
In general, the House bill would significantly reduce the tax rates applicable to businesses and business income. The highlights of the changes to taxes on businesses in the House bill are:
· The corporate tax rate (currently at a maximum of 35%) would be reduced to a flat 20% tax rate. US corporate tax rates would thus be nearly on a par with the UK corporation tax rate and significantly lower than the Japanese, French and German rates (including, in the case of Germany, the effect of the trade and solidarity taxes). European businesses that have structured their operations on the assumption that US corporate tax rates will be higher than European tax rates will need to reconsider many of their strategies, which may no longer be tax efficient at a 20% US rate.
· Generally, the House bill would allow an immediate deduction for the cost of capital expenditures for property (other than real estate) acquired or placed in service after 27 September 2017 and before 1 January 2023. While this change may provide significant cash tax relief, it is only a timing change and may not have any material effect for financial reporting purposes on large multinational enterprises. Nonetheless, as it would affect the cash taxes payable by businesses, this change is important to many small and privately owned businesses.
· Under the House bill, most businesses, regardless of their form, would be subject to a disallowance of the deduction for net interest expense to the extent that it exceeds 30% of the business’s adjusted taxable income (i.e. a business’s taxable income computed without regard to business interest expense, business interest income, net operating losses and depreciation, amortisation and depletion). Any interest amounts disallowed under this new rule would be carried forward to the succeeding five taxable years. The limitation applies on a consolidated group level to US corporate taxpayers; and at the partnership level to partnerships and other pass-through entities. For pass-through entities, special rules will apply at the owner level to avoid double counting income and to allow additional interest deductions by the owner if the pass-through entity has excess limitation. There are exceptions from the disallowance rule for: interest incurred by a small businesses (less than $25m gross receipts, aggregated); the interest income and expense of any ‘real property trade or business’ (i.e. any real property development, construction, acquisition, conversion, rental, operation, management, leasing or brokerage business); and certain regulated public utilities.
This limitation on interest expense, together with the limitation described below for businesses that are part of an international financial reporting group, will have a considerable effect on the existing US operating subsidiaries of non-US parent corporations (as well as non-US subsidiaries of US parent corporations), particularly newly acquired US businesses with pushed-down acquisition indebtedness. In response to these changes, together with the lowering of the US corporate tax rate, European businesses will need to reconsider the financing of their US operations. They may need to deleverage or recapitalise their US affiliates to achieve maximum tax efficiency for their interest expense.
· Net operating losses (NOLs) would be deductible only to the extent of 90% of the taxpayer’s taxable income and could be carried forward indefinitely but generally could not be carried back. Amounts carried forward would be increased by an interest factor to preserve the value of those amounts.
· Under the House bill, a US corporation would only be able to deduct 65% (down from 80% under current law) of the amount of dividends received from domestic corporations in which the receiving corporation owned 20% or more and less than 80% of the stock. It would also only be able to deduct 50% (down from 70% under current law) of the amount of dividends received from domestic corporations in which the receiving corporation owned less than 20% of the stock.
· The corporate alternative minimum tax (AMT) would be repealed.
· Many business tax incentives (for example, the domestic production deduction) would be eliminated by the House bill. A notable exception to this rule is the R&D credit. There would also be additional limitations on the deductibility of entertainment expenses.
· Individual owners of pass-throughs (e.g. partnerships, LLCs and S corporations) who do not materially participate in the business as well sole proprietorships would be taxed at a maximum tax rate of 25%. Under a series of default rules, those actively involved in the business would qualify for the 25% tax rate for 30% of their share of the pass-through’s income. The remaining 70% would be taxed at the owner’s ordinary individual income tax rate. Certain owners of capital-intensive businesses would be able to apply a larger percentage to determine the portion of income subject to the reduced 25% tax rate, using a ratio based upon a return of capital (deemed to be the Federal short-term rate, plus 7%). However, the default rule for active owners of professional services firms (e.g. accounting, law, health, financial services and investing, trading or dealing in securities) would tax 100% of income at the owner’s individual income tax rate.
Taxation of non-US income and non-US persons
The House bill would make fundamental changes to the US rules for taxing international investment, both inbound and outbound, and also contains provisions specifically designed to combat ‘base erosion’.
With respect to the taxation of outbound US corporate investment, highlights include the adoption of a largely ‘territorial’ system of corporate taxation.
Under current law, US citizens, resident individuals and domestic corporations generally are taxed on all income, whether earned in the US or abroad. Foreign income earned by a foreign subsidiary of a US corporation generally is not subject to US tax until the income is ‘repatriated’ to the US corporation, unless it is so-called ‘Subpart F’ income (in general, passive and other mobile income), in which case it is taxed to the US parent when earned by the non-US subsidiary. To mitigate the double taxation of earnings, the US allows a credit for foreign income taxes paid or deemed paid, which generally is available to offset, in whole or in part, the US tax that otherwise would be due on foreign income.
The House bill would shift the taxation of US corporations from this ‘worldwide’ system to a modified system of ‘territorial’ taxation. (Note that the House bill does not change the current rules for US citizens and individual residents, who will remain subject to tax on their worldwide income.) Under the House bill, the current system of taxing US corporations on dividends from non-US subsidiaries would generally be replaced with a dividend-exemption system. Under the exemption system, a dividend received deduction would be allowed for 100% of the foreign source portion of dividends paid by a foreign corporation to a US corporate shareholder, if that shareholder owns 10% or more of the foreign corporation. No foreign tax credit or deduction would be allowed for any foreign taxes (including withholding taxes) actually or deemed paid with respect to the exempt portion of any dividend; and the shareholder’s tax basis in the stock on which the exempt dividend would be received is reduced by the amount of the exempt dividend for purposes of computing the loss on any sale of the shares. (Note that the territorial principle does not exempt foreign branch income and losses of US corporations; nor does it exempt capital gain on the sale of the stock of a foreign subsidiary, although existing provisions of US tax law will treat any gain on sale of shares as a dividend to the extent of the seller’s share of the subsidiary’s accumulated earnings and profits (E&P).)
With respect to E&P accumulated in foreign subsidiaries under the existing ‘worldwide’ system, the House bill provides for a one-time, mandatory deemed repatriation of offshore E&P. Under the House bill:
· US shareholders directly or indirectly owning at least 10% of a foreign subsidiary would be required to include in income for the subsidiary’s last tax year beginning before 2018: the shareholder’s pro rata share of the net post-1986 accumulated E&P of the foreign subsidiary, determined as of 2 November 2017 or 31 December 2017 (whichever is higher), to the extent that such E&P has not been previously subject to US tax.
· The net E&P would be determined by taking into account the US shareholder’s proportionate share of any E&P deficits of foreign subsidiaries of the US shareholder or members of the US shareholder’s affiliated group.
· The E&P would be classified as either: E&P that has been retained in the form of cash or cash equivalents; or E&P that has been reinvested in the foreign subsidiary’s business (e.g. property, plant and equipment).
· The portion of the E&P comprising cash or cash equivalents would be taxed at a reduced rate of 14%, while any remaining E&P would be taxed at a reduced rate of 7%.
· Foreign tax credit carry-forwards would be fully available, and foreign tax credits for taxes deemed paid by the relevant subsidiaries that would be triggered by the deemed repatriation would be partially available to offset the US tax.
· Also at the election of the US shareholder, the tax liability would be payable over a period of up to eight years, in equal annual installments of 12.5% of the total tax liability due.
With respect to outbound investment, the House bill contains two anti-base erosion provisions which effectively limit the ability of a US parent corporation to claim the full exemption from US tax for dividends attributable to intangibles exported from the US and other lightly taxed intangible income:
· As described above, US source income is not included in the exempt portion of any dividend received from a foreign corporation. US source royalty and similar income earned by the foreign subsidiary from expatriated intangibles would therefore not be exempt from dividend taxation.
· The House bill also contains a minimum tax provision which subjects a US parent corporation of one or more foreign subsidiaries to US tax on 50% of the US parent’s ‘foreign high returns’, whether or not distributed. In effect, this is a 10% minimum tax (assuming that the top corporate rate would be 20%) on income that otherwise would be entitled to exemption. In general, ‘high returns’ would be measured as the US parent corporation’s share of all of its subsidiaries’ net ‘tested’ income, less the excess of:
(i) a routine return (7% plus the Federal short-term rate) on the subsidiaries’ adjusted tax bases in their tangible property; over
(ii) the subsidiaries’ interest expense.
· Because the provision exempts only the deemed return on the tax basis of tangible assets, the provision will have a significant effect on US multinationals that have expatriated ownership of intangibles or that otherwise have significant intangible assets located in foreign subsidiaries.
The US parent would be allowed a foreign tax credit equal to 80% of the foreign taxes paid or accrued by its subsidiaries, which is allocated (under a formula) to the high-taxed amount it includes in income for that year. Taxes allocable to other income could not be used to offset the amount included in income under this rule, and any excess credits allocated to such high-taxed income could not be used to offset tax on other income.
With respect to the taxation of inbound US investment by foreign corporations and inbound transactions by foreign subsidiaries of US corporations, the House bill includes a significant new excise tax and additional limitations on the deductible interest expense:
· Payments (other than interest) made by a US corporation to a related foreign corporation that are deductible, and can be included in the costs of goods sold or in the basis of a depreciable or amortisable asset, would be subject to a new 20% excise tax. (This is unless the related foreign corporation elects to treat the payments as income effectively connected (ECI) with the conduct of a US trade or business; and, if relevant, attributable to a US permanent establishment.)
· Consequently, the foreign corporation’s net profits (or gross receipts if no election is made) with respect to those payments would be subject to full US tax, eliminating the potential US tax benefit otherwise achieved.
· Note that the excise tax, in a certain respect like FATCA, effectively forces the recipient to elect to pay tax on the net profits attributable to the receipt. A 20% tax on net profits will almost always be significantly less than a 20% tax on gross receipts.
· Exceptions would apply for: payments of interest; certain purchases of commodities or securities; services (if the services are eligible, under the relevant transfer pricing rules, for the ‘services cost method’ and, in fact, the payee charges no markup on cost); and payments subject to the ‘normal’ 30% gross-basis withholding tax (or, if the rate is reduced by treaty, to the extent of the ratio of the reduced tax rate/30%).
· To determine the net taxable income that is to be deemed ECI and attributable to a permanent establishment, deemed (not actual) expenses are allocated to that ECI/deemed PE on the basis of a ‘net income’ ratio based on profit margins reported on the group’s financial statements: the ratio of foreign consolidated financial statement net income to foreign consolidated financial statement revenues. Foreign tax credits are allowed for actual non-US income taxes paid or accrued with respect to the receipt, but only 80% of the amount that would otherwise be allocated to such income under the standard US foreign tax credit rules. Further, in the event that no election is made, no deduction would be allowed for the US corporation’s excise tax liability. The rule would apply only to international financial reporting groups with payments from US corporations to their foreign affiliates totalling at least $100m annually.
This proposal is not as extreme as the border adjusted tax (BAT), which would have denied importers deductions for the cost of any imported inputs, whether in the form of goods, services or otherwise (see Tax Journal, 5 May 2017). Nevertheless, the House bill is effectively a ‘BAT-lite’ that applies to related-party transactions and has similar effects on the supply chain. Even if almost all persons subject to the tax elect to pay tax on the net profits attributable to the cross-border payment, the proposal will almost necessarily lead to double taxation. First, it is unlikely that the deemed expense allocation to the payment under the House bill will correspond with the expenses taken into account in determining the foreign payment recipient’s non-US tax. Second, even assuming that the deemed allocation of expenses reached the same net result as the non-US taxing jurisdiction, the House bill’s 20% hair-cut on foreign tax credits will result in residual US tax on the foreign recipient unless the non-US tax rate is at least 25%.
· The deductible net interest expense of a US corporation that is a member of an international financial reporting group would be limited to the sum of the member’s interest income plus the ‘allowable percentage’ of 110% of its net interest expense. The allowable percentage is the ratio of a corporation’s allocable share of the international financial reporting group’s reported net interest expense (determined based on the corporation’s share of the group’s earnings before net interest expense, taxes, depreciation and amortisation) over the corporation’s reported net interest expense. This limitation would apply in addition to the general rules for disallowance of certain interest expense described above.
· Any disallowed interest expense would be carried forward for up to five tax years, with carry-forwards exhausted on a first in, first out basis.
· For this purpose, an international financial reporting group is: a group of entities that includes at least one foreign corporation engaged in a trade or business in the US; or at least one domestic corporation and one foreign corporation, which prepare consolidated financial statements and which have annual global gross receipts of more than $100m.
Changes to the individual income tax
The highlights of the changes for individual taxpayers contained in the House bill are:
· The current seven individual tax brackets would be consolidated and simplified into four brackets: 12%, 25%, 35% and 39.6%. The threshold for the top individual bracket would be $500,000 for individuals and $1m for married couples. A special ‘catch-up’ provision would phase out the benefit of the 12% rate on the lowest tranche of income for the highest earners.
· The standard deduction, taken by most Americans in lieu of taking itemised deductions, would be almost doubled to $24,400 for joint filers and $12,200 for individual filers.
· Under current law, a taxpayer generally claims personal exemptions for the taxpayer, the taxpayer’s spouse and any dependents. The House bill would change that by consolidating the personal exemption for the taxpayer and the taxpayer’s spouse into the larger standard deduction, while the personal exemption for children and dependents would be consolidated into an expanded child tax credit and a new family tax credit.
· Under current law, an individual taxpayer is allowed to claim an itemised deduction of up to $1m for mortgage interest payments made with respect to a principal residence and one other residence. The House bill retains the deduction, but reduces the maximum amount of the deduction from $1m to $500,000 (for debt incurred after 2 November 2017); and allows the deduction only for interest on a loan on the taxpayer’s principal residence.
· Under current law, an individual may claim an itemised deduction for state and local government income and property taxes. Under the House bill, individuals would no longer be allowed an itemised deduction for state and local income taxes (except for state and local income taxes paid or accrued in carrying on a trade or business or producing income, which will continue to be deductible). However, individuals would continue to be allowed to claim an itemised deduction for real property taxes up to $10,000.
· The House bill repeals a number of other deductions for individuals, such as the deduction for student loan interest, personal casualty losses, tax preparation services, medical expenses, alimony payments, moving expenses, medical savings accounts and expenses attributable to the trade or business of performing services as an employee. However, the deduction for charitable contributions would remain, albeit with several minor changes.
· Under current law, there is an overall limit on the amount of otherwise allowable itemised deductions for certain upper-income taxpayers. The House bill would repeal the overall limitation on itemised deductions.
· The individual alternative minimum tax (AMT) would be repealed.
· The estate and generation-skipping transfer taxes would be repealed but not until 2025. Until then, the basic exclusion amount would be doubled from $5m to $10m. The gift tax would be lowered to a top rate of 35% for gifts made after 2024, with the current law basic exclusion amount of $10m and the annual exclusion of $14,000 remaining the same. Assets owed at death would continue to have a stepped-up basis (generally the date of death value) for the beneficiaries.
In many respects, the Senate bill mirrors the contours of the House bill (which is not surprising because they both were developed by their respective tax writing committee chairs from the same document – the 27 September Bix Six framework). However, there are some key differences. The Senate bill delays the corporate tax rate cut until 2019; while the House bill reduces the tax rate beginning in 2018. The Senate bill does not include the provision in the House bill that would impose a 20% excess tax on payments that US companies make to their foreign affiliates. Also, the deemed repatriation tax rates are lower in the Senate bill. In addition, the treatment of pass-through entities in the Senate bill differs substantially from that in the House bill. Finally, the House bill repeals the estate and generation-skipping taxes (albeit only after 2024), while the Senate bill does not.
In a surprising move, Senate Republicans decided to include in the Senate bill the repeal of the Obamacare requirement that most Americans must buy health insurance, effectively merging the fight over health care with the tax reform effort. Elimination of the so-called ‘individual mandate’ to purchase health insurance has the effect of reducing budget deficits over the ten year budget window by a total of $338bn, which means that such revenue can then be used by the Republicans to ‘pay for’ the reductions in the tax rates for both individuals and corporations. This decision, while helpful on the budgetary side, could conceivably end up derailing the whole process if it leads more than two Republican Senators to vote against the ultimate tax bill.
Business tax reform
The significant differences between the two bills with respect to taxes on businesses are:
· The maximum corporate tax rate would be permanently reduced from its current rate of 35% to a 20% rate; but (unlike in the House bill) the tax cut would be delayed by one year to 2019.
· Unlike the House bill, while there is a limitation on the use of carried-over NOLs after 2023, there is no time value adjustment to the NOLs that are carried forward.
· Like the House bill, the Senate bill includes a provision that limits interest deductions. Unlike the House bill, the limitation is 30% of EBIT not EBITDA; that is, net interest expense is deductible only to the extent that it is less than 30% of earnings before interest and taxes (depreciation and amortisation deductions are not added back into income for this purpose).
· With respect to the taxation of income earned through a pass-through, the Senate bill would allow an individual to deduct 17.4% of that individual’s share of any ‘domestic qualified business income’ of the pass-through. Subject to the wage limitation described below, the effective marginal rate would be 31.8% in respect of such income for the highest earners. The deduction would not apply to income from certain services businesses (e.g. businesses involving the performance of services in the fields of law, accounting, consulting, engineering, financial services or performing arts), except in the case of individuals whose taxable income would not exceed $150,000. Further, the amount of the deduction generally would be limited to 50% of the domestic wages received by the taxpayer from the pass-through paying the wages that are attributable to qualified business income of the pass-through. The deduction differs from the House bill, which favours capital owners and otherwise applies a default ‘70-30’ split for active owners; and which generally does not benefit individuals, who otherwise would not face a marginal rate higher than 25%. This special treatment would expire, however, at the end of 2025 (again done to fit within the budget resolution).
Taxation of non-US income and non-US persons
While the Senate bill also adopts a territorial tax regime similar to that in the House bill, there are very significant differences between the two bills with respect to the international taxation provisions:
· The Senate bill does not contain the 20% excise tax on deductible payments to foreign affiliates that is included in the House bill. Instead, the Senate bill includes a new minimum tax on US corporations – the ‘base erosion anti-abuse tax’ (BEAT), as well as a provision denying deductions for payments on hybrid instruments and for payments to or from a hybrid entity.
· The BEAT is essentially a 10% corporate minimum tax (12.5% after 2025) calculated on a base equal to the taxpayer’s income determined without tax deductions or other tax benefits arising from so-called ‘base erosion’ payments. A base erosion payment is generally an amount paid or accrued by a taxpayer to a related foreign person that is deductible by the taxpayer. It generally does not treat as a related payment those payments for the costs of goods sold; and it excludes payments for services for which ‘the services cost’ transfer pricing method is used and payments to the extent subject to a 30% withholding tax. On the other hand, unlike the House bill provision, it includes payments of interest to related parties as ‘base erosion’ payments. The related party definition is very broad for purposes of the BEAT. The definition would generally include, in addition to those ‘normally’ considered related for US tax purposes, a 25% owner of the corporation (with board constructive ownership rules) or any other person ‘owned or controlled directly or indirectly by the same interests’ as a taxpayer.
· This provision would only apply to corporations that have average annual gross receipts of at least $500m (for the three prior tax years) and that have a ‘base erosion percentage’ of at least 4%. The base erosion percentage means, for any taxable year, the percentage determined by dividing the aggregate amount of tax benefits arising from deductions for base erosion payments by the total deductions allowed with respect to the corporation for the year (ignoring net operating losses and the dividend received deduction for foreign dividends).
The Senate bill would deny a deduction with respect to certain payments of interest or royalties between related parties if the recipient: is not required to include the payment in income under the tax law of its country of residence; is allowed a deduction with respect to such amount; or is a ‘hybrid entity’ (i.e. is treated as a pass-through entity for US tax purposes but not for foreign tax purposes, or vice versa).
The disallowance would not apply if the payment is included in the income of a US shareholder of the recipient under the US CFC rules. The proposal also grants the IRS authority to issue regulations or other guidance, as may be necessary or appropriate to carry out the purposes of the proposal, including regulations or other guidance providing rules for, among other things:
· denying deductions for conduit arrangements;
· applying the rules to structured transactions;
· denying all or a portion of a deduction claimed for an interest or a royalty payment that is included in the recipient’s income under a preferential tax regime of the country of residence of the recipient, and has the effect of reducing the country’s generally applicable statutory tax rate by at least 25%; and
· denying all of a deduction claimed for an interest or a royalty payment, if such amount is subject to a participation exemption system or other system which provides for the exclusion of a substantial portion of such amount.
Note that these provisions would allow the IRS to treat as a non-deductible hybrid payment a royalty payment paid to a related foreign person that is eligible, under the tax law of its residence, for a patent box that would have the effect of reducing the applicable tax rate on such income to 75% or less of the statutory tax rate generally applicable in the jurisdiction.
Instead of the House bill’s minimum tax on 50% of ‘foreign high returns’, the Senate bill seeks to combat the exportation of US intangibles with a carrot-and-stick approach:
· First, the stick: The Senate bill has an ‘intangible’ exception to territoriality. A US corporate shareholder of a CFC would currently have to include in income its share of its CFC’s global intangible low-taxed income (GILTI), whether or not distributed. GILTI means the excess of the shareholder’s net CFC tested income over the shareholder’s net deemed tangible income return from its CFC. The shareholder’s net deemed tangible income return is an amount equal to 10% of the aggregate bases of its share of the aggregate bases of its CFC’s tangible property used in a qualified trade or business. The shareholder’s net tested income is essentially calculated in the same way as it is under House bill’s proposed ‘foreign high returns’ provision. The Senate bill allows a foreign tax credit to a US shareholder with respect to GILTI included in income equal to 80% of the foreign taxes deemed paid or accrued by the relevant CFCs with respect to GILTI, which is determined by an allocation formula.
· Second, the carrot: The Senate bill contains a ‘patent box-lite’ regime. A US corporation would be entitled to deduct 37.5% of the lesser of its taxable income or certain of its foreign-derived income attributable to intangibles (including GILTI), resulting in an effective 12.5% tax rate for such income. In addition to GILTI, income eligible for the deduction would generally include income derived in connection with: property that is sold by the taxpayer to any person who is not a US person that is for a foreign use; or services provided by the taxpayer to any person, or with respect to property, not located with the US; but only to the extent of the excess of a 10% return on the adjusted tax basis for the corporation’s tangible assets used to produce such income.
Under a special rule, intangibles transferred from a foreign subsidiary to a US parent company would not be subject to US tax, and certain case law that arguably limits the power of the IRS to redetermine income following an outbound transfer of intangibles would be overturned.
Effectively, the combination of all of these provisions would remove returns from intangible assets from the territorial regime and subject them (to the extent they give rise to non-US source income) to a net 12.5% tax, whether earned by a domestic US corporation or its foreign subsidiaries. The expectation is that this global tax would significantly reduce the incentive for US corporations to export intangible assets and/or develop intangible assets outside the US.
The provisions of the Senate bill for limiting the deductible interest expense of US corporations that are members of a worldwide affiliated group are also different from the House bill. First, payments of interest to related persons are included in base erosion payments for purposes of the BEAT minimum tax described above. Second, the general limitation on deductions for interest expense, as described above, would apply to 30% of EBIT rather that EBITDA. Third, there would also be a limitation on interest expense to the extent that debt was disproportionally borne by the US operations of the group. Interest deductions of US members of the group would be reduced by the product of the net interest expense of the US member multiplied by the debt-to-equity differential percentage of the worldwide affiliated group. The debt-to-equity differential percentage of the worldwide affiliated group means the amount by which the total indebtedness of the US members of the group exceeds 110% of the total indebtedness which those members would hold if their total indebtedness to total equity ratio were proportionate to the ratio of the total indebtedness to total equity of the worldwide group. Intragroup debt and equity interests are disregarded for purposes of this calculation.
This provision would serve both as a limit on the ability of a related foreign parent corporation to strip earnings out of a US subsidiary through debt capitalisation; and as a de facto ‘world-wide apportionment rule’ for the allocation of interest expense incurred by a US multinational between US earnings and exempt foreign-source dividend income.
In general, the Senate bill adopts a system for exempting dividends received by US corporations from 10% owned foreign subsidiaries that is similar to the House bill. Under the Senate bill, US corporation shareholders would not be eligible for the lower rates that apply to certain ‘qualified’ dividends, if those dividends were received from a corporation that had engaged in an inversion transaction (i.e. where US shareholder holds an inversion percentage in the 60-80% range); or if the dividend is received on a hybrid instrument for which the payor received a deduction.
Consistent with the House bill, the foreign earnings of subsidiaries of a US parent corporation that have not been repatriated to the US, and which have therefore not yet been subject to US taxation, would be deemed distributed to the US parent corporation. All earnings held in cash and cash equivalents would be taxed at a 10% rate (as opposed to a 14% in the House bill); and all other earnings would be taxed at a 5% rate (as opposed to 7% in the House bill). At the election of the taxpayer, this tax could be paid over a period of eight years. The amount of earnings would be determined as of 9 November 2017 (or other applicable measurement date). Foreign tax credits triggered by the deemed repatriation would be available to partially offset the tax resulting from the deemed repatriation. The benefits of the reduced rates upon repatriation would be recaptured if the US company engages in an inversion transaction within ten years (i.e. where US shareholders hold an inversion percentage in the 60-80% range).
Finally, the Senate bill broadens the definition of ‘US shareholder’ for the purposes of determining whether a foreign corporation is a CFC (in general, a foreign corporation more than 50% of whose shares (by vote or value) are owned directly, indirectly or constructively by ‘US shareholders’). A person would be treated as a ‘US shareholder’ only if that person owns 10% or more of a foreign company’s stock by value (in addition to those who own 10% or more by vote, which is the test under current law). This provision would also apply for the purposes of determining whether a foreign corporation is a CFC; and for purposes of the various changes described above. This change would take effect for taxable years beginning before 1 January 2018 (i.e. it would be effective for the purposes of the repatriation provisions described above).
Changes to the individual income tax
The significant differences between the two bills with respect to the individual income tax are:
· The Senate bill retains seven individual tax brackets but reduces some of the tax rates and modifies the amount of taxable income which falls within each bracket. The revised brackets are 10%, 22%, 24%, 32% and 35%, plus a top bracket of 38.5% for income in excess of $500,000 for individuals and $1m for married couples. Additionally, there would be no ‘catch-up’ provision to phase out the benefit of the 10% rate on the lowest tranche of income for the highest earners, as there is in the House bill. However, these tax cuts would expire at the end of 2025. This approach was used to keep the overall revenue impact of the Senate bill within the parameters of the budget resolution described above.
· The Senate bill, with some changes, would generally preserve in their current form itemised deductions for mortgage interest (for mortgages up to $1m), for medical expenses and for student loan interest.
· The Senate bill would not allow individuals to deduct any state and local income or property taxes, unless such taxes were paid or accrued in carrying on a trade or business.
· The Senate bill would double the estate and generation-skipping transfer tax exemption amount (to $11.2m per person or $22.4m for a married couple in 2018, adjusted annually for inflation), but would not repeal the estate and generation-skipping transfer taxes, as the House bill would do. No other changes would be made to the estate and gift tax regime.
Political necessity is what is driving the Republicans right now. They are very much motivated to bring a tax bill over the finish line by the end of this year, or early in 2018 at the latest, so that when they face the voters in the 2018 mid-term elections in November, they will be able to point to the tax bill as an economic policy legislative success.
The debate on the Senate floor began earlier this week, where the Senate bill still faces an uncertain future because the Republican leaders, working with only a two vote majority, are struggling to find enough support to pass their version of the bill there. Several Republican senators have expressed concerns about the Senate bill; in particular, some have focused on the inclusion of the repeal of the Obamacare individual mandate as a potential problem (arguing that repeal would undermine Obamacare), even though that difference from the House bill gives Senate leaders more revenue to work with in crafting the Senate’s final product in keeping with the budget reconciliation rules described above.
Consequently, the final version of the Senate bill could still change drastically, as Republican majority leader McConnell and Finance Committee chair Hatch agree to changes in order to meet individual member’s concerns.
In addition, while the Democrats in Congress have been totally ineffective so far as slowing down progress on the bills, they still have one potential card to play. On 9 December, the federal government runs out of money, and thus, the Democrats could force the Republicans to be responsible for shutting down the government unless significant changes are made to the tax bill.
Assuming that the full Senate does pass its bill, there would then be a conference between the two houses during which the two tax bills would be melded together. The Republican negotiators in the conference will have to be quite flexible in crafting the final tax bill. Reconciling the two versions will not be easy. Each bill already contains compromises that the chairs of the respective tax-writing committees have made in order to shore up support in their own respective chambers, and which could face problems in the other. Staying within the $1.5trn limit increase in the budget deficit over the ten-year budget window and not increasing the deficit further in the years following that ten year period will also weigh heavily on any trade-offs that need to be made. Finally, once the Conference Committee reaches agreement on a single tax bill, then each house would still have to vote one more time to approve that final version in order for it to go to the president’s desk for his signature.
Keep in mind that this whole effort could eventually come to nothing (particularly because all it would take is for three Republican senators to torpedo the effort). However, with momentum on their side and the risk of failure being potentially politically disastrous for the Republicans, in the 2018 mid-terms, it would not be smart to count them out as they sprint to the finish line.
The views above are those of the co-authors and do not necessarily represent the views of Sullivan & Cromwell LLP.
In November, the Republicans in Congress moved with remarkable speed to rewrite the US Tax Code. At the end of October, they had yet to make public the text of a tax bill. Now, though, they have one version of a bill which has sailed through the House of Representatives along party lines; and another version which the Senate Finance Committee has reported out (also along party lines) and which is being debated this week on the floor of the Senate. There are still several potential hurdles for the Republicans to overcome, particularly in the Senate where the Republican leadership has not yet locked down the 50 votes needed (together with the tie-breaking vote of the vice president) to pass the bill there. But as a result of the fresh momentum created during November, the Republicans do seem to have their goal of passing tax reform before Christmas within reach.
All of a sudden, the Republicans are making quick progress in transforming the US tax code, report Donald L. Korb and Andrew Solomon (Sullivan & Cromwell).
The most important tax debate in the United States in more than a generation is in full swing. The tax reform process started to gain momentum on 2 November, when congressman Kevin Brady, the chair of the House Ways and Means Committee, released the long awaited text of his Committee’s tax bill. Subsequently, over a four day period the following week, the 36 members of the Ways and Means Committee debated the bill and made several significant amendments. Then on 9 November, the Committee voted by 24 to 16 on a strict party line vote to move the bill to the House floor. Only a week later on 16 November, the bill was passed by a vote of 227 to 205, without a single Democrat supporting the legislation.
In the meantime, on the other side of Capitol Hill, on the same day that the House Ways and Means Committee reported its bill out of committee, senator Orrin Hatch, the Chair of the Senate Finance Committee, released the text of his Committee’s bill, which contained important differences from the House bill. The Senate Finance Committee began its deliberations of its bill on 13 November. Four days later on 16 November, after rejecting a host of amendments proposed by the Democrats on the Committee, the Committee reported out its version of the tax bill, also on a strict party line vote of 14 to 12 – the same day that the House voted to approve its bill. The next step for the Senate bill is consideration by the full Senate, which began earlier this week on 27 November. These two tax bills, when ultimately combined into one piece of legislation, will represent the most significant change to the US Tax Code since 1986.
For the tax reform process to have progressed this far, the Republicans have had to successfully overcome several of the legislative hurdles that we described in our last article (see Tax Journal, 8 September 2017). Most important, in October the Republicans created the opportunity for them to pass tax reform by a simple majority vote in each house of Congress, which means that the legislation could be enacted without a single vote by a Democrat representative in the House or senator in the Senate. The future of the tax legislation is still very much in doubt because there are a number of legislative and political hurdles that still need to be overcome; yet as a result of all this legislative activity, the odds of success for US tax reform have increased from those of just two months ago.
The parameters of the both the House and Senate tax reform packages came into sharp focus on 27 September, when the so-called ‘Big Six’ negotiators (Treasury secretary Steven Mnuchin, National Economic Council director Gary Cohn, House speaker Paul Ryan, Senate majority leader Mitch McConnell, House Ways and Means Committee chair Brady and Senate Finance chair Hatch) unveiled what they called a ‘unified framework for tax reform’. While at that time the framework was still a high-level document, it did flesh out some of the more nebulous principles set forth in an earlier July ‘joint statement’, also the combined product of the Big Six (see Tax Journal, 8 September 2017).
However, the real significance of the framework document was that it enabled the Republican leadership in Congress to obtain the votes needed in both houses to pass a budget resolution that would, if necessary, allow the Republicans to pass a tax reform bill with only Republican support in the Senate. The reason that the budget resolution was such a critical element in the process is that it gave Congressional tax writers a significant amount of leeway in drafting their bill. The key event in the budget process occurred on 19 October, when the Senate agreed in its budget resolution to allow a $1.5 trillion increase in the amount of the federal budget deficit over the next ten years. The budget resolution, which passed by a narrow margin of 51 to 49 in the Senate, also allowed the tax plan to be debated and voted on in the Senate using the ‘reconciliation’ process, which prevents a dilatory Democrat led ‘filibuster’ during the debate on the floor of the Senate (again, see Tax Journal, 8 September 2017). By successfully employing the reconciliation process, Republicans gained the opportunity to pass a tax bill with only Republican votes in the Senate (which is divided by 52 to 48 in favour of the Republicans).
The budget reconciliation process is a double-edged sword, however, in that it also forbids an increase in the budget deficit outside a ten year budget window. Likewise, the strategy of relying solely on Republican votes in the Senate poses significant risks to the legislation, as more than two Republican senators have indicated that they may not vote with the rest of their party unless changes are made.
The budget resolution passed the House a week later, without any Democrat support, by a vote of 216 to 212 vote, even though some fiscally conservative Republicans and Republicans from so-called ‘swing districts’ either voted against the resolution or abstained from voting. Both the permitted $1.5 trillion increase in the federal deficit and the need not to increase the deficit above that amount will play important roles in the final shape of any tax bill sent to the president for his signature.
The House bill is 116 pages long and the report describing its contents contains another 376 pages.
Business tax reform
In general, the House bill would significantly reduce the tax rates applicable to businesses and business income. The highlights of the changes to taxes on businesses in the House bill are:
· The corporate tax rate (currently at a maximum of 35%) would be reduced to a flat 20% tax rate. US corporate tax rates would thus be nearly on a par with the UK corporation tax rate and significantly lower than the Japanese, French and German rates (including, in the case of Germany, the effect of the trade and solidarity taxes). European businesses that have structured their operations on the assumption that US corporate tax rates will be higher than European tax rates will need to reconsider many of their strategies, which may no longer be tax efficient at a 20% US rate.
· Generally, the House bill would allow an immediate deduction for the cost of capital expenditures for property (other than real estate) acquired or placed in service after 27 September 2017 and before 1 January 2023. While this change may provide significant cash tax relief, it is only a timing change and may not have any material effect for financial reporting purposes on large multinational enterprises. Nonetheless, as it would affect the cash taxes payable by businesses, this change is important to many small and privately owned businesses.
· Under the House bill, most businesses, regardless of their form, would be subject to a disallowance of the deduction for net interest expense to the extent that it exceeds 30% of the business’s adjusted taxable income (i.e. a business’s taxable income computed without regard to business interest expense, business interest income, net operating losses and depreciation, amortisation and depletion). Any interest amounts disallowed under this new rule would be carried forward to the succeeding five taxable years. The limitation applies on a consolidated group level to US corporate taxpayers; and at the partnership level to partnerships and other pass-through entities. For pass-through entities, special rules will apply at the owner level to avoid double counting income and to allow additional interest deductions by the owner if the pass-through entity has excess limitation. There are exceptions from the disallowance rule for: interest incurred by a small businesses (less than $25m gross receipts, aggregated); the interest income and expense of any ‘real property trade or business’ (i.e. any real property development, construction, acquisition, conversion, rental, operation, management, leasing or brokerage business); and certain regulated public utilities.
This limitation on interest expense, together with the limitation described below for businesses that are part of an international financial reporting group, will have a considerable effect on the existing US operating subsidiaries of non-US parent corporations (as well as non-US subsidiaries of US parent corporations), particularly newly acquired US businesses with pushed-down acquisition indebtedness. In response to these changes, together with the lowering of the US corporate tax rate, European businesses will need to reconsider the financing of their US operations. They may need to deleverage or recapitalise their US affiliates to achieve maximum tax efficiency for their interest expense.
· Net operating losses (NOLs) would be deductible only to the extent of 90% of the taxpayer’s taxable income and could be carried forward indefinitely but generally could not be carried back. Amounts carried forward would be increased by an interest factor to preserve the value of those amounts.
· Under the House bill, a US corporation would only be able to deduct 65% (down from 80% under current law) of the amount of dividends received from domestic corporations in which the receiving corporation owned 20% or more and less than 80% of the stock. It would also only be able to deduct 50% (down from 70% under current law) of the amount of dividends received from domestic corporations in which the receiving corporation owned less than 20% of the stock.
· The corporate alternative minimum tax (AMT) would be repealed.
· Many business tax incentives (for example, the domestic production deduction) would be eliminated by the House bill. A notable exception to this rule is the R&D credit. There would also be additional limitations on the deductibility of entertainment expenses.
· Individual owners of pass-throughs (e.g. partnerships, LLCs and S corporations) who do not materially participate in the business as well sole proprietorships would be taxed at a maximum tax rate of 25%. Under a series of default rules, those actively involved in the business would qualify for the 25% tax rate for 30% of their share of the pass-through’s income. The remaining 70% would be taxed at the owner’s ordinary individual income tax rate. Certain owners of capital-intensive businesses would be able to apply a larger percentage to determine the portion of income subject to the reduced 25% tax rate, using a ratio based upon a return of capital (deemed to be the Federal short-term rate, plus 7%). However, the default rule for active owners of professional services firms (e.g. accounting, law, health, financial services and investing, trading or dealing in securities) would tax 100% of income at the owner’s individual income tax rate.
Taxation of non-US income and non-US persons
The House bill would make fundamental changes to the US rules for taxing international investment, both inbound and outbound, and also contains provisions specifically designed to combat ‘base erosion’.
With respect to the taxation of outbound US corporate investment, highlights include the adoption of a largely ‘territorial’ system of corporate taxation.
Under current law, US citizens, resident individuals and domestic corporations generally are taxed on all income, whether earned in the US or abroad. Foreign income earned by a foreign subsidiary of a US corporation generally is not subject to US tax until the income is ‘repatriated’ to the US corporation, unless it is so-called ‘Subpart F’ income (in general, passive and other mobile income), in which case it is taxed to the US parent when earned by the non-US subsidiary. To mitigate the double taxation of earnings, the US allows a credit for foreign income taxes paid or deemed paid, which generally is available to offset, in whole or in part, the US tax that otherwise would be due on foreign income.
The House bill would shift the taxation of US corporations from this ‘worldwide’ system to a modified system of ‘territorial’ taxation. (Note that the House bill does not change the current rules for US citizens and individual residents, who will remain subject to tax on their worldwide income.) Under the House bill, the current system of taxing US corporations on dividends from non-US subsidiaries would generally be replaced with a dividend-exemption system. Under the exemption system, a dividend received deduction would be allowed for 100% of the foreign source portion of dividends paid by a foreign corporation to a US corporate shareholder, if that shareholder owns 10% or more of the foreign corporation. No foreign tax credit or deduction would be allowed for any foreign taxes (including withholding taxes) actually or deemed paid with respect to the exempt portion of any dividend; and the shareholder’s tax basis in the stock on which the exempt dividend would be received is reduced by the amount of the exempt dividend for purposes of computing the loss on any sale of the shares. (Note that the territorial principle does not exempt foreign branch income and losses of US corporations; nor does it exempt capital gain on the sale of the stock of a foreign subsidiary, although existing provisions of US tax law will treat any gain on sale of shares as a dividend to the extent of the seller’s share of the subsidiary’s accumulated earnings and profits (E&P).)
With respect to E&P accumulated in foreign subsidiaries under the existing ‘worldwide’ system, the House bill provides for a one-time, mandatory deemed repatriation of offshore E&P. Under the House bill:
· US shareholders directly or indirectly owning at least 10% of a foreign subsidiary would be required to include in income for the subsidiary’s last tax year beginning before 2018: the shareholder’s pro rata share of the net post-1986 accumulated E&P of the foreign subsidiary, determined as of 2 November 2017 or 31 December 2017 (whichever is higher), to the extent that such E&P has not been previously subject to US tax.
· The net E&P would be determined by taking into account the US shareholder’s proportionate share of any E&P deficits of foreign subsidiaries of the US shareholder or members of the US shareholder’s affiliated group.
· The E&P would be classified as either: E&P that has been retained in the form of cash or cash equivalents; or E&P that has been reinvested in the foreign subsidiary’s business (e.g. property, plant and equipment).
· The portion of the E&P comprising cash or cash equivalents would be taxed at a reduced rate of 14%, while any remaining E&P would be taxed at a reduced rate of 7%.
· Foreign tax credit carry-forwards would be fully available, and foreign tax credits for taxes deemed paid by the relevant subsidiaries that would be triggered by the deemed repatriation would be partially available to offset the US tax.
· Also at the election of the US shareholder, the tax liability would be payable over a period of up to eight years, in equal annual installments of 12.5% of the total tax liability due.
With respect to outbound investment, the House bill contains two anti-base erosion provisions which effectively limit the ability of a US parent corporation to claim the full exemption from US tax for dividends attributable to intangibles exported from the US and other lightly taxed intangible income:
· As described above, US source income is not included in the exempt portion of any dividend received from a foreign corporation. US source royalty and similar income earned by the foreign subsidiary from expatriated intangibles would therefore not be exempt from dividend taxation.
· The House bill also contains a minimum tax provision which subjects a US parent corporation of one or more foreign subsidiaries to US tax on 50% of the US parent’s ‘foreign high returns’, whether or not distributed. In effect, this is a 10% minimum tax (assuming that the top corporate rate would be 20%) on income that otherwise would be entitled to exemption. In general, ‘high returns’ would be measured as the US parent corporation’s share of all of its subsidiaries’ net ‘tested’ income, less the excess of:
(i) a routine return (7% plus the Federal short-term rate) on the subsidiaries’ adjusted tax bases in their tangible property; over
(ii) the subsidiaries’ interest expense.
· Because the provision exempts only the deemed return on the tax basis of tangible assets, the provision will have a significant effect on US multinationals that have expatriated ownership of intangibles or that otherwise have significant intangible assets located in foreign subsidiaries.
The US parent would be allowed a foreign tax credit equal to 80% of the foreign taxes paid or accrued by its subsidiaries, which is allocated (under a formula) to the high-taxed amount it includes in income for that year. Taxes allocable to other income could not be used to offset the amount included in income under this rule, and any excess credits allocated to such high-taxed income could not be used to offset tax on other income.
With respect to the taxation of inbound US investment by foreign corporations and inbound transactions by foreign subsidiaries of US corporations, the House bill includes a significant new excise tax and additional limitations on the deductible interest expense:
· Payments (other than interest) made by a US corporation to a related foreign corporation that are deductible, and can be included in the costs of goods sold or in the basis of a depreciable or amortisable asset, would be subject to a new 20% excise tax. (This is unless the related foreign corporation elects to treat the payments as income effectively connected (ECI) with the conduct of a US trade or business; and, if relevant, attributable to a US permanent establishment.)
· Consequently, the foreign corporation’s net profits (or gross receipts if no election is made) with respect to those payments would be subject to full US tax, eliminating the potential US tax benefit otherwise achieved.
· Note that the excise tax, in a certain respect like FATCA, effectively forces the recipient to elect to pay tax on the net profits attributable to the receipt. A 20% tax on net profits will almost always be significantly less than a 20% tax on gross receipts.
· Exceptions would apply for: payments of interest; certain purchases of commodities or securities; services (if the services are eligible, under the relevant transfer pricing rules, for the ‘services cost method’ and, in fact, the payee charges no markup on cost); and payments subject to the ‘normal’ 30% gross-basis withholding tax (or, if the rate is reduced by treaty, to the extent of the ratio of the reduced tax rate/30%).
· To determine the net taxable income that is to be deemed ECI and attributable to a permanent establishment, deemed (not actual) expenses are allocated to that ECI/deemed PE on the basis of a ‘net income’ ratio based on profit margins reported on the group’s financial statements: the ratio of foreign consolidated financial statement net income to foreign consolidated financial statement revenues. Foreign tax credits are allowed for actual non-US income taxes paid or accrued with respect to the receipt, but only 80% of the amount that would otherwise be allocated to such income under the standard US foreign tax credit rules. Further, in the event that no election is made, no deduction would be allowed for the US corporation’s excise tax liability. The rule would apply only to international financial reporting groups with payments from US corporations to their foreign affiliates totalling at least $100m annually.
This proposal is not as extreme as the border adjusted tax (BAT), which would have denied importers deductions for the cost of any imported inputs, whether in the form of goods, services or otherwise (see Tax Journal, 5 May 2017). Nevertheless, the House bill is effectively a ‘BAT-lite’ that applies to related-party transactions and has similar effects on the supply chain. Even if almost all persons subject to the tax elect to pay tax on the net profits attributable to the cross-border payment, the proposal will almost necessarily lead to double taxation. First, it is unlikely that the deemed expense allocation to the payment under the House bill will correspond with the expenses taken into account in determining the foreign payment recipient’s non-US tax. Second, even assuming that the deemed allocation of expenses reached the same net result as the non-US taxing jurisdiction, the House bill’s 20% hair-cut on foreign tax credits will result in residual US tax on the foreign recipient unless the non-US tax rate is at least 25%.
· The deductible net interest expense of a US corporation that is a member of an international financial reporting group would be limited to the sum of the member’s interest income plus the ‘allowable percentage’ of 110% of its net interest expense. The allowable percentage is the ratio of a corporation’s allocable share of the international financial reporting group’s reported net interest expense (determined based on the corporation’s share of the group’s earnings before net interest expense, taxes, depreciation and amortisation) over the corporation’s reported net interest expense. This limitation would apply in addition to the general rules for disallowance of certain interest expense described above.
· Any disallowed interest expense would be carried forward for up to five tax years, with carry-forwards exhausted on a first in, first out basis.
· For this purpose, an international financial reporting group is: a group of entities that includes at least one foreign corporation engaged in a trade or business in the US; or at least one domestic corporation and one foreign corporation, which prepare consolidated financial statements and which have annual global gross receipts of more than $100m.
Changes to the individual income tax
The highlights of the changes for individual taxpayers contained in the House bill are:
· The current seven individual tax brackets would be consolidated and simplified into four brackets: 12%, 25%, 35% and 39.6%. The threshold for the top individual bracket would be $500,000 for individuals and $1m for married couples. A special ‘catch-up’ provision would phase out the benefit of the 12% rate on the lowest tranche of income for the highest earners.
· The standard deduction, taken by most Americans in lieu of taking itemised deductions, would be almost doubled to $24,400 for joint filers and $12,200 for individual filers.
· Under current law, a taxpayer generally claims personal exemptions for the taxpayer, the taxpayer’s spouse and any dependents. The House bill would change that by consolidating the personal exemption for the taxpayer and the taxpayer’s spouse into the larger standard deduction, while the personal exemption for children and dependents would be consolidated into an expanded child tax credit and a new family tax credit.
· Under current law, an individual taxpayer is allowed to claim an itemised deduction of up to $1m for mortgage interest payments made with respect to a principal residence and one other residence. The House bill retains the deduction, but reduces the maximum amount of the deduction from $1m to $500,000 (for debt incurred after 2 November 2017); and allows the deduction only for interest on a loan on the taxpayer’s principal residence.
· Under current law, an individual may claim an itemised deduction for state and local government income and property taxes. Under the House bill, individuals would no longer be allowed an itemised deduction for state and local income taxes (except for state and local income taxes paid or accrued in carrying on a trade or business or producing income, which will continue to be deductible). However, individuals would continue to be allowed to claim an itemised deduction for real property taxes up to $10,000.
· The House bill repeals a number of other deductions for individuals, such as the deduction for student loan interest, personal casualty losses, tax preparation services, medical expenses, alimony payments, moving expenses, medical savings accounts and expenses attributable to the trade or business of performing services as an employee. However, the deduction for charitable contributions would remain, albeit with several minor changes.
· Under current law, there is an overall limit on the amount of otherwise allowable itemised deductions for certain upper-income taxpayers. The House bill would repeal the overall limitation on itemised deductions.
· The individual alternative minimum tax (AMT) would be repealed.
· The estate and generation-skipping transfer taxes would be repealed but not until 2025. Until then, the basic exclusion amount would be doubled from $5m to $10m. The gift tax would be lowered to a top rate of 35% for gifts made after 2024, with the current law basic exclusion amount of $10m and the annual exclusion of $14,000 remaining the same. Assets owed at death would continue to have a stepped-up basis (generally the date of death value) for the beneficiaries.
In many respects, the Senate bill mirrors the contours of the House bill (which is not surprising because they both were developed by their respective tax writing committee chairs from the same document – the 27 September Bix Six framework). However, there are some key differences. The Senate bill delays the corporate tax rate cut until 2019; while the House bill reduces the tax rate beginning in 2018. The Senate bill does not include the provision in the House bill that would impose a 20% excess tax on payments that US companies make to their foreign affiliates. Also, the deemed repatriation tax rates are lower in the Senate bill. In addition, the treatment of pass-through entities in the Senate bill differs substantially from that in the House bill. Finally, the House bill repeals the estate and generation-skipping taxes (albeit only after 2024), while the Senate bill does not.
In a surprising move, Senate Republicans decided to include in the Senate bill the repeal of the Obamacare requirement that most Americans must buy health insurance, effectively merging the fight over health care with the tax reform effort. Elimination of the so-called ‘individual mandate’ to purchase health insurance has the effect of reducing budget deficits over the ten year budget window by a total of $338bn, which means that such revenue can then be used by the Republicans to ‘pay for’ the reductions in the tax rates for both individuals and corporations. This decision, while helpful on the budgetary side, could conceivably end up derailing the whole process if it leads more than two Republican Senators to vote against the ultimate tax bill.
Business tax reform
The significant differences between the two bills with respect to taxes on businesses are:
· The maximum corporate tax rate would be permanently reduced from its current rate of 35% to a 20% rate; but (unlike in the House bill) the tax cut would be delayed by one year to 2019.
· Unlike the House bill, while there is a limitation on the use of carried-over NOLs after 2023, there is no time value adjustment to the NOLs that are carried forward.
· Like the House bill, the Senate bill includes a provision that limits interest deductions. Unlike the House bill, the limitation is 30% of EBIT not EBITDA; that is, net interest expense is deductible only to the extent that it is less than 30% of earnings before interest and taxes (depreciation and amortisation deductions are not added back into income for this purpose).
· With respect to the taxation of income earned through a pass-through, the Senate bill would allow an individual to deduct 17.4% of that individual’s share of any ‘domestic qualified business income’ of the pass-through. Subject to the wage limitation described below, the effective marginal rate would be 31.8% in respect of such income for the highest earners. The deduction would not apply to income from certain services businesses (e.g. businesses involving the performance of services in the fields of law, accounting, consulting, engineering, financial services or performing arts), except in the case of individuals whose taxable income would not exceed $150,000. Further, the amount of the deduction generally would be limited to 50% of the domestic wages received by the taxpayer from the pass-through paying the wages that are attributable to qualified business income of the pass-through. The deduction differs from the House bill, which favours capital owners and otherwise applies a default ‘70-30’ split for active owners; and which generally does not benefit individuals, who otherwise would not face a marginal rate higher than 25%. This special treatment would expire, however, at the end of 2025 (again done to fit within the budget resolution).
Taxation of non-US income and non-US persons
While the Senate bill also adopts a territorial tax regime similar to that in the House bill, there are very significant differences between the two bills with respect to the international taxation provisions:
· The Senate bill does not contain the 20% excise tax on deductible payments to foreign affiliates that is included in the House bill. Instead, the Senate bill includes a new minimum tax on US corporations – the ‘base erosion anti-abuse tax’ (BEAT), as well as a provision denying deductions for payments on hybrid instruments and for payments to or from a hybrid entity.
· The BEAT is essentially a 10% corporate minimum tax (12.5% after 2025) calculated on a base equal to the taxpayer’s income determined without tax deductions or other tax benefits arising from so-called ‘base erosion’ payments. A base erosion payment is generally an amount paid or accrued by a taxpayer to a related foreign person that is deductible by the taxpayer. It generally does not treat as a related payment those payments for the costs of goods sold; and it excludes payments for services for which ‘the services cost’ transfer pricing method is used and payments to the extent subject to a 30% withholding tax. On the other hand, unlike the House bill provision, it includes payments of interest to related parties as ‘base erosion’ payments. The related party definition is very broad for purposes of the BEAT. The definition would generally include, in addition to those ‘normally’ considered related for US tax purposes, a 25% owner of the corporation (with board constructive ownership rules) or any other person ‘owned or controlled directly or indirectly by the same interests’ as a taxpayer.
· This provision would only apply to corporations that have average annual gross receipts of at least $500m (for the three prior tax years) and that have a ‘base erosion percentage’ of at least 4%. The base erosion percentage means, for any taxable year, the percentage determined by dividing the aggregate amount of tax benefits arising from deductions for base erosion payments by the total deductions allowed with respect to the corporation for the year (ignoring net operating losses and the dividend received deduction for foreign dividends).
The Senate bill would deny a deduction with respect to certain payments of interest or royalties between related parties if the recipient: is not required to include the payment in income under the tax law of its country of residence; is allowed a deduction with respect to such amount; or is a ‘hybrid entity’ (i.e. is treated as a pass-through entity for US tax purposes but not for foreign tax purposes, or vice versa).
The disallowance would not apply if the payment is included in the income of a US shareholder of the recipient under the US CFC rules. The proposal also grants the IRS authority to issue regulations or other guidance, as may be necessary or appropriate to carry out the purposes of the proposal, including regulations or other guidance providing rules for, among other things:
· denying deductions for conduit arrangements;
· applying the rules to structured transactions;
· denying all or a portion of a deduction claimed for an interest or a royalty payment that is included in the recipient’s income under a preferential tax regime of the country of residence of the recipient, and has the effect of reducing the country’s generally applicable statutory tax rate by at least 25%; and
· denying all of a deduction claimed for an interest or a royalty payment, if such amount is subject to a participation exemption system or other system which provides for the exclusion of a substantial portion of such amount.
Note that these provisions would allow the IRS to treat as a non-deductible hybrid payment a royalty payment paid to a related foreign person that is eligible, under the tax law of its residence, for a patent box that would have the effect of reducing the applicable tax rate on such income to 75% or less of the statutory tax rate generally applicable in the jurisdiction.
Instead of the House bill’s minimum tax on 50% of ‘foreign high returns’, the Senate bill seeks to combat the exportation of US intangibles with a carrot-and-stick approach:
· First, the stick: The Senate bill has an ‘intangible’ exception to territoriality. A US corporate shareholder of a CFC would currently have to include in income its share of its CFC’s global intangible low-taxed income (GILTI), whether or not distributed. GILTI means the excess of the shareholder’s net CFC tested income over the shareholder’s net deemed tangible income return from its CFC. The shareholder’s net deemed tangible income return is an amount equal to 10% of the aggregate bases of its share of the aggregate bases of its CFC’s tangible property used in a qualified trade or business. The shareholder’s net tested income is essentially calculated in the same way as it is under House bill’s proposed ‘foreign high returns’ provision. The Senate bill allows a foreign tax credit to a US shareholder with respect to GILTI included in income equal to 80% of the foreign taxes deemed paid or accrued by the relevant CFCs with respect to GILTI, which is determined by an allocation formula.
· Second, the carrot: The Senate bill contains a ‘patent box-lite’ regime. A US corporation would be entitled to deduct 37.5% of the lesser of its taxable income or certain of its foreign-derived income attributable to intangibles (including GILTI), resulting in an effective 12.5% tax rate for such income. In addition to GILTI, income eligible for the deduction would generally include income derived in connection with: property that is sold by the taxpayer to any person who is not a US person that is for a foreign use; or services provided by the taxpayer to any person, or with respect to property, not located with the US; but only to the extent of the excess of a 10% return on the adjusted tax basis for the corporation’s tangible assets used to produce such income.
Under a special rule, intangibles transferred from a foreign subsidiary to a US parent company would not be subject to US tax, and certain case law that arguably limits the power of the IRS to redetermine income following an outbound transfer of intangibles would be overturned.
Effectively, the combination of all of these provisions would remove returns from intangible assets from the territorial regime and subject them (to the extent they give rise to non-US source income) to a net 12.5% tax, whether earned by a domestic US corporation or its foreign subsidiaries. The expectation is that this global tax would significantly reduce the incentive for US corporations to export intangible assets and/or develop intangible assets outside the US.
The provisions of the Senate bill for limiting the deductible interest expense of US corporations that are members of a worldwide affiliated group are also different from the House bill. First, payments of interest to related persons are included in base erosion payments for purposes of the BEAT minimum tax described above. Second, the general limitation on deductions for interest expense, as described above, would apply to 30% of EBIT rather that EBITDA. Third, there would also be a limitation on interest expense to the extent that debt was disproportionally borne by the US operations of the group. Interest deductions of US members of the group would be reduced by the product of the net interest expense of the US member multiplied by the debt-to-equity differential percentage of the worldwide affiliated group. The debt-to-equity differential percentage of the worldwide affiliated group means the amount by which the total indebtedness of the US members of the group exceeds 110% of the total indebtedness which those members would hold if their total indebtedness to total equity ratio were proportionate to the ratio of the total indebtedness to total equity of the worldwide group. Intragroup debt and equity interests are disregarded for purposes of this calculation.
This provision would serve both as a limit on the ability of a related foreign parent corporation to strip earnings out of a US subsidiary through debt capitalisation; and as a de facto ‘world-wide apportionment rule’ for the allocation of interest expense incurred by a US multinational between US earnings and exempt foreign-source dividend income.
In general, the Senate bill adopts a system for exempting dividends received by US corporations from 10% owned foreign subsidiaries that is similar to the House bill. Under the Senate bill, US corporation shareholders would not be eligible for the lower rates that apply to certain ‘qualified’ dividends, if those dividends were received from a corporation that had engaged in an inversion transaction (i.e. where US shareholder holds an inversion percentage in the 60-80% range); or if the dividend is received on a hybrid instrument for which the payor received a deduction.
Consistent with the House bill, the foreign earnings of subsidiaries of a US parent corporation that have not been repatriated to the US, and which have therefore not yet been subject to US taxation, would be deemed distributed to the US parent corporation. All earnings held in cash and cash equivalents would be taxed at a 10% rate (as opposed to a 14% in the House bill); and all other earnings would be taxed at a 5% rate (as opposed to 7% in the House bill). At the election of the taxpayer, this tax could be paid over a period of eight years. The amount of earnings would be determined as of 9 November 2017 (or other applicable measurement date). Foreign tax credits triggered by the deemed repatriation would be available to partially offset the tax resulting from the deemed repatriation. The benefits of the reduced rates upon repatriation would be recaptured if the US company engages in an inversion transaction within ten years (i.e. where US shareholders hold an inversion percentage in the 60-80% range).
Finally, the Senate bill broadens the definition of ‘US shareholder’ for the purposes of determining whether a foreign corporation is a CFC (in general, a foreign corporation more than 50% of whose shares (by vote or value) are owned directly, indirectly or constructively by ‘US shareholders’). A person would be treated as a ‘US shareholder’ only if that person owns 10% or more of a foreign company’s stock by value (in addition to those who own 10% or more by vote, which is the test under current law). This provision would also apply for the purposes of determining whether a foreign corporation is a CFC; and for purposes of the various changes described above. This change would take effect for taxable years beginning before 1 January 2018 (i.e. it would be effective for the purposes of the repatriation provisions described above).
Changes to the individual income tax
The significant differences between the two bills with respect to the individual income tax are:
· The Senate bill retains seven individual tax brackets but reduces some of the tax rates and modifies the amount of taxable income which falls within each bracket. The revised brackets are 10%, 22%, 24%, 32% and 35%, plus a top bracket of 38.5% for income in excess of $500,000 for individuals and $1m for married couples. Additionally, there would be no ‘catch-up’ provision to phase out the benefit of the 10% rate on the lowest tranche of income for the highest earners, as there is in the House bill. However, these tax cuts would expire at the end of 2025. This approach was used to keep the overall revenue impact of the Senate bill within the parameters of the budget resolution described above.
· The Senate bill, with some changes, would generally preserve in their current form itemised deductions for mortgage interest (for mortgages up to $1m), for medical expenses and for student loan interest.
· The Senate bill would not allow individuals to deduct any state and local income or property taxes, unless such taxes were paid or accrued in carrying on a trade or business.
· The Senate bill would double the estate and generation-skipping transfer tax exemption amount (to $11.2m per person or $22.4m for a married couple in 2018, adjusted annually for inflation), but would not repeal the estate and generation-skipping transfer taxes, as the House bill would do. No other changes would be made to the estate and gift tax regime.
Political necessity is what is driving the Republicans right now. They are very much motivated to bring a tax bill over the finish line by the end of this year, or early in 2018 at the latest, so that when they face the voters in the 2018 mid-term elections in November, they will be able to point to the tax bill as an economic policy legislative success.
The debate on the Senate floor began earlier this week, where the Senate bill still faces an uncertain future because the Republican leaders, working with only a two vote majority, are struggling to find enough support to pass their version of the bill there. Several Republican senators have expressed concerns about the Senate bill; in particular, some have focused on the inclusion of the repeal of the Obamacare individual mandate as a potential problem (arguing that repeal would undermine Obamacare), even though that difference from the House bill gives Senate leaders more revenue to work with in crafting the Senate’s final product in keeping with the budget reconciliation rules described above.
Consequently, the final version of the Senate bill could still change drastically, as Republican majority leader McConnell and Finance Committee chair Hatch agree to changes in order to meet individual member’s concerns.
In addition, while the Democrats in Congress have been totally ineffective so far as slowing down progress on the bills, they still have one potential card to play. On 9 December, the federal government runs out of money, and thus, the Democrats could force the Republicans to be responsible for shutting down the government unless significant changes are made to the tax bill.
Assuming that the full Senate does pass its bill, there would then be a conference between the two houses during which the two tax bills would be melded together. The Republican negotiators in the conference will have to be quite flexible in crafting the final tax bill. Reconciling the two versions will not be easy. Each bill already contains compromises that the chairs of the respective tax-writing committees have made in order to shore up support in their own respective chambers, and which could face problems in the other. Staying within the $1.5trn limit increase in the budget deficit over the ten-year budget window and not increasing the deficit further in the years following that ten year period will also weigh heavily on any trade-offs that need to be made. Finally, once the Conference Committee reaches agreement on a single tax bill, then each house would still have to vote one more time to approve that final version in order for it to go to the president’s desk for his signature.
Keep in mind that this whole effort could eventually come to nothing (particularly because all it would take is for three Republican senators to torpedo the effort). However, with momentum on their side and the risk of failure being potentially politically disastrous for the Republicans, in the 2018 mid-terms, it would not be smart to count them out as they sprint to the finish line.
The views above are those of the co-authors and do not necessarily represent the views of Sullivan & Cromwell LLP.
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