The U.S. House of Representatives GOP conference released its long-awaited tax reform bill, the Tax Cuts and Jobs Act (the “House Bill”), on Thursday, November 2, 2017. The House Bill, if enacted in its current form, would produce significant changes to the U.S. taxation of corporations and individuals (including income received through pass-through entities) and would significantly alter the U.S. taxation of international operations of U.S. taxpayers. On Monday, November 6, 2017, House Ways and Means Committee Chairman Rep. Kevin Brady offered an amendment that was subsequently approved by the Ways and Means Committee (the “First Brady Amendment”). On Thursday, November 9, 2017, Chairman Brady released a second amendment (the “Second Brady Amendment”), with the House Ways and Means Committee approving the Second Brady Amendment and the overall House Bill on the same day. The House Bill remains subject to continuing negotiations within the U.S. House of Representatives GOP conference and needs to be reconciled with a separate U.S. Senate GOP tax reform bill expected to be released this week. Several of the important features of the House Bill are summarized below.
Corporate Tax Rate, Deductibility of Interest, NOLs, and Expensing
The House Bill would reduce the corporate income tax rate from 35% to 20% (with a 25% rate for personal service corporations).
The House Bill would significantly limit the deductibility of interest expense by a business, regardless of the form of the business. Interest deductions would be capped at the amount of the business’s interest income earned plus 30% of its annual adjusted taxable income. Adjusted taxable income, a proxy for EBITDA, generally would be determined by adding back to taxable income any (i) net operating loss (“NOL”) deduction, (ii) interest expense (but subtracting interest income), and (iii) depreciation and amortization. For businesses organized as partnerships, this limitation on the deductibility of interest expense would be determined at the partnership level. Interest deductions disallowed due to this limitation would be carried forward for up to 5 years but would remain subject to the overall calculation of the limitation on deductibility. Multinational corporate groups may be subject to an additional, more complex interest deduction limitation based on worldwide financial statement consolidated interest expense, including the interest expense of non-U.S. affiliates. The lower of the two limits will apply.
Practice Note: The proposed changes to corporate tax rates and the deductibility of interest expense described above may significantly offset one another, with the overall effect dependent upon the particular facts. For example, under current law a U.S. corporation with US$100 million of EBITDA, debt of 6x EBITDA (US$600 million) with a 10% interest rate (all allowed as a deduction), and no tax deduction for depreciation or amortization, would generally pay a tax rate of 35% on US$40 million of net income (US$100 million - US$60 million), for an overall federal tax bill of US$14 million. Under the proposed rules set forth in the House Bill, the same U.S. corporation would generally pay a tax rate of 20% on US$70 million of net income (US$100 million - US$30 million of allowed interest expense), and would therefore have exactly the same federal tax bill (US$14 million). If EBITDA is reduced in the example, the proposed rules would increase the tax burden on the business compared with current law. Using the same example, if EBITDA is reduced to US$80 million, under current law, the company would generally pay a tax rate of 35% on US$20 million of net income (US$80 million - US$60 million) for an overall federal tax bill of US$7 million. Under the House Bill, despite the already reduced cash flow, the federal tax bill would increase to US$11.2 million ((US$80 million - US$24 million) x 20%).
Under the House Bill, corporations would be prohibited from carrying back NOLs but would be allowed to carry forward NOLs indefinitely, and any unused NOLs would be increased by an interest factor to preserve their value. The House Bill limits the ability to reduce taxable income with an NOL deduction to 90% of taxable income.
The House Bill also would allow taxpayers to immediately expense 100% of the cost of qualified property, now including used property, placed in service before 2023. In addition, the deduction for domestic production activities, currently in Code Section 199, would be repealed.
The Second Brady Amendment would also reduce the amount of corporate dividend received deductions to reflect the lower corporate income tax rates for less than 80% owned corporate subsidiaries.
Taxation of Individuals
Lower Tax Rate on Pass-Through Income
The House Bill would provide owners of a pass-through entities, such as limited liability companies and S corporations, with a maximum tax rate of 25% on certain business income earned from such entities, subject to several limitations. This preferential rate generally applies to all business income derived from a business in which the owner does not materially participate (a “passive business activity”), including, for example, a passive private equity investment, but the preferential rate would generally apply to only 30% of business income from a business in which the owner materially participates (an “active business activity”). Assuming the owner of an active business activity would be eligible for the preferential rate on 30% of business income and would be subject to the highest individual marginal rate of 39.6% on the remaining 70% of taxable income, the blended marginal rate would be roughly 35%. However, where the active business activity is capital intensive, an individual would be able to apply the preferential rate to a percentage of income from the business in excess of 30%. Income from businesses primarily engaged in professional services (including financial services, law, accounting, consulting, engineering, or performing arts) would generally not be eligible for the 25% rate, subject in limited cases to an exception allowing partial access to the 25% rate when a threshold amount of capital is invested in the business. In connection with these changes, the House Bill (prior to its amendment by the Second Brady Amendment) would have repealed the “limited partner exception,” which generally excludes a limited partner’s income from self-employment tax, and would instead have generally subjected an individual partner to self-employment tax on the partner’s business income not subject to the preferential tax rate. The Second Brady Amendment restored the current-law treatment of the application of self-employment tax to amounts received through pass-through entities in the House Bill, including the “limited partner exception.”
Potential Limitation on Carried Interest
The First Brady Amendment would generally impose a new 3-year holding period requirement for service providers to receive long-term capital gain from carried interests granted with respect to real estate or investment businesses. This provision would not change the ability under current law for the carried interest to be received tax-free. Separately, U.S. Treasury Secretary Steven Mnuchin has indicated that the Trump Administration will pressure Congress to repeal the preferential tax treatment of carried interests.
Consolidation of Individual Tax Rates and Elimination of Deductions
The House Bill would consolidate the current seven individual income tax brackets on ordinary income into four brackets: 12%, 25%, 35% and 39.6%. Although the highest marginal rate of 39.6% would remain unchanged from current law, the threshold for income to be subject to this rate would increase (from roughly US$470,000 to US$1 million for married couples filing jointly). The benefit of the 12% rate would be phased out gradually for certain high-earning taxpayers, giving rise to a 45.6% marginal income tax rate on income between US$1.2 million and approximately US$1.6 million for married couples filing jointly, with the marginal income tax rate returning to 39.6% thereafter. The bill would roughly double the standard deduction to US$24,000 (for married couples filing jointly), while it would eliminate numerous existing deductions (including the deduction for personal exemptions and the deduction for state and local income taxes and property taxes in excess of US$10,000) and repeal the alternative minimum tax (for all taxpayers). The 3.8% Medicare tax on net investment income (including income from a passive business activity) would be retained, as would the current preferential individual tax rates for long-term capital gains and qualified dividend income, although the proposed increase in the highest marginal rate threshold would cause a corresponding increase in the threshold for long-term capital gains to be subject to the maximum 20% capital gains rate.
Prior to its amendment by the Second Brady Amendment, the House Bill would have imposed new rules on nonqualified deferred compensation, including stock options and stock appreciation rights, generally requiring that such compensation be included in income when an employee’s right to such compensation is no longer conditioned on the future performance of substantial services, without regard to payment or certain non-service related contingencies, such as change in control or satisfaction of a business performance goal. These new rules would not have applied to deferred compensation in respect of services performed before 2018; however, any such deferred compensation would be included in income no later than 2025. The Second Brady Amendment withdrew these proposed rules from the House Bill. Separately, the First Brady Amendment would amend Code Section 83 to allow, in certain circumstances, a qualified employee who receives qualified stock to elect to defer recognizing income in respect of the stock for a period of up to five years after the employee’s rights in the stock vest.
The House Bill makes explicit that all entities exempt from tax under Code Section 501(a) would be subject to the unrelated business taxable income (“UBTI”) rules, even if tax-exempt under another code section (e.g. Code Section 115), including state pension plans (so-called “super” tax-exempt investors). If enacted, it will be interesting to see if this provision is challenged on Constitutional grounds (i.e. federal taxation of a state sovereign).
Changes to International Tax Rules
By adopting a dividend exemption mechanism and other changes, the House Bill would move the U.S. closer to a territorial system. The dividend exemption would allow a U.S. corporate taxpayer a deduction for 100% of the foreign-source portion of the dividends the U.S. corporation received from foreign corporations in which it owned a 10% or greater interest, subject to holding period requirements. The bill also disallows a foreign tax credit for any foreign taxes paid or accrued with respect to foreign dividend for which the deduction is allowed. In addition, the bill deems all previously untaxed foreign earnings to be repatriated, and would subject such repatriated earnings to tax at reduced tax rates: 14% for earnings held in cash or cash equivalents and 7% for the remainder. Prior to adoption of the Second Brady Amendment, these rates were 12% and 5%, respectively. Taxpayers would be able to elect to pay those taxes over an eight year period in equal installments. Code Section 956, which currently treats U.S. shareholders of controlled foreign corporations (“CFCs”) with untaxed foreign earnings as receiving a dividend when the CFC invests in U.S. property, would be repealed. The House Bill also includes an excise tax on certain payments of specified amounts made by U.S. corporations to non-U.S. corporate affiliates. The existing CFC and passive foreign investment company (“PFIC”) regimes would for the most part be preserved, and a new CFC rule would be added which taxes currently income of a CFC that exceeds a certain rate of return on the tax basis of a CFC’s assets (the “High Return Amount”).