On Sept. 15, 2021, the Ways and Means Committee of the U.S. House of Representatives approved a proposed tax legislative package (the “W&M proposal”) to the Build Back Better Act reconciliation bill (the “Act”), which proposal contains a number of substantial proposed tax law changes for corporations, passthrough entities, and individuals. This alert summarizes some of the key elements of the W&M proposal.
The release of the W&M proposal represents one step in the legislative process. The proposed changes to the tax law are subject to further modification as the draft legislation progresses through Congress. It is unclear at this time what tax changes will be enacted in final form by Congress, and ultimately be signed into law.
Corporate Tax Proposals
i. Corporate Income Tax Rate
The W&M proposal would replace the flat 21% corporate tax rate enacted in 2017 as part of the “Tax Cuts and Jobs Act” (“TCJA”) with a graduated rate structure beginning at 18% for corporations with taxable income that does not exceed $400,000 and a maximum tax rate of 26.5% for corporations with taxable income over $5 million. This graduated rate structure would phase out for corporations with taxable income over $10 million. Personal service corporations would not be eligible for graduated rates and would be subject to a flat 26.5% income tax rate. In tandem with such corporate tax rate changes, the legislation would increase the dividends received deduction available for dividends received by corporations from 65% to 72.5% (for dividends received from 20% owned corporations) and from 50% to 60% (for dividends received from less than 20% owned corporations). These proposals, if enacted, would apply to taxable years beginning after Dec. 31, 2021.
ii. Limitation on the Deduction of Interest by “Specified Domestic Corporations”
The W&M proposal would add a new Section 163(n) to the Internal Revenue Code of 1986, as amended (the “Code”) to limit the amount of deductible interest expense of a “specified domestic corporation” that is a member of any “international financial reporting group” to an allowable percentage of 110% of the specified domestic corporation’s net interest expense. A specified domestic corporation’s allowable percentage (not to exceed 100%) is the ratio of such corporation’s allocable share of the group’s net interest expense over such corporation’s reported net interest expense (generally determined by allocating the group’s net interest expense to the U.S. members of the group based on the U.S. members’ share of the group’s earnings). For these purposes, a “specified domestic corporation” means any domestic corporation whose average excess interest expense over interest includible in income over a three-year period exceeds $12 million. This proposed limitation would apply only if it disallowed more interest expense deductions than the interest expense deductions disallowed under Section 163(j) of the Code. This limitation would not apply to certain small businesses.
iii. Worthless Securities Deduction
Under Section 165 of the Code, a taxpayer may claim a worthlessness deduction for certain securities that become worthless during the taxable year. Such loss is generally treated as a loss resulting from the sale or exchange of a capital asset unless certain requirements are satisfied to treat the loss as ordinary. The W&M proposal would amend Section 165(g)(1) of the Code to treat the loss as being realized at the time the “identifiable event establishing worthlessness” occurs rather than on the last day of the taxable year. The W&M proposal would provide for sale or exchange treatment on a worthless partnership interest loss, subject to any required recharacterization under Section 751 of the Code. These proposals, if enacted, would apply to losses arising in taxable years beginning after Dec. 31, 2021.
iv. Adjusted Basis Limitation for Divisive Reorganizations
The W&M proposal would amend Section 361 of the Code to enact a new Section 361(d) providing for a basis limitation in the case of a divisive “reorganization” or “spin-off” pursuant to Section 368(a)(1)(D) and Section 355 of the Code. Under the W&M proposal, the distributing corporation in the spin-off would be required to recognize gain to the extent (A) the sum of (i) the total amount of liabilities assumed by the controlled corporation, (ii) the amount of money and other property transferred to creditors, and (iii) the controlled corporation’s securities transferred to creditors exceeds (B) the total adjusted basis of the assets transferred to the controlled corporation in the spin-off. This amendment, if enacted, would apply to reorganizations occurring on or after the date of the enactment of the Act.
Passthrough Entity and Individual Tax Proposals
i. Carried Interests
Under Section 1061 of the Code, as originally enacted by the TCJA, long-term capital gains attributable to an “applicable partnership interest” or “API” may be recharacterized as short-term capital gain unless a three-year holding period is satisfied. As currently drafted, Section 1061 of the Code only applies to gain recognized with respect to the disposition of a capital asset. It does not apply to Section 1232 gain and other capital gain items not generated from such a disposition (including qualified dividend income and Section 1256 gain).
The W&M proposal targets carried interests held by fund managers in private equity funds and would extend the three-year holding period to a five-year holding required to qualify for long-term capital gains treatment, except that the three-year holding period would continue to apply in the case of income with respect to an applicable partnership interest that is attributable to (i) certain real property trades or businesses or (ii) taxpayers (other than trusts or estates) with an adjusted gross income of less than $400,000. The W&M proposal also sets forth additional proposed amendments to Section 1061 of the Code intended to target anti-avoidance measures, such as providing for regulatory authority to address carried interest waivers commonly used in private equity funds and expanding the application of Section 1061 of the Code to capture Section 1232 gain, qualified dividend income, Section 1256 gain and other long-term capital gain items, as well as to expand the general application of Section 1061 of the Code to financial instruments, contracts, or interests in entities other than partnerships. Another significant change made under the W&M proposal would apply the rules under Section 1061 of the Code to any transfer of an API without regard to any nonrecognition provisions that might otherwise apply. The W&M proposal would modify the provision such that any election in effect under Section 83(b) of the Code would not be taken into account. These changes, if enacted, would apply to taxable years beginning after Dec. 31, 2021.
ii. Individual Rate
The W&M proposal would increase the top marginal individual income tax rate from 37% to 39.6% beginning for calendar year 2022. Pursuant to the W&M proposal, the new 39.6% top marginal individual income tax rate would apply to married filing joint taxpayers with taxable income over $450,000 ($225,000 in the case of married filing separate taxpayers), head of household taxpayers with taxable income over $425,000 and single taxpayers with taxable income over $400,000. These proposals, if enacted, would apply to taxable years beginning after Dec. 31, 2021.
iii. Capital Gains & Dividends
Under current law, long-term capital gains and qualified dividends are subject to tax at a rate of 0%, 15%, or 20%, depending on the taxpayer’s taxable income and filing status. The W&M proposal would increase the top long-term capital gains and qualified dividend rates from 20% to 25%. This increased capital gain rate would generally apply for capital gains recognized after Sept. 13, 2021 (the date the W&M proposal was introduced). However, under a transition rule, the 20% capital gains rate would continue to apply to gains arising from transactions occurring after Sept. 13, 2021 pursuant to a binding written contract entered into before such date.
iv. Changes to Section 163(j)
Under current law, Section 163(j) of the Code, as enacted by the TCJA, applies to partnerships and S corporations at the entity level. The W&M proposal would modify these rules to apply the limitation on the deductibility of business interest under Section 163(j) of the Code at the partner or shareholder level. This proposal, if enacted, would apply to taxable years beginning after Dec. 31, 2021.
v. Net Investment Income Tax
Section 1411 of the Code imposes a 3.8% net investment income tax on certain taxpayers with a modified adjusted gross income over a threshold amount with respect to certain passive net investment income. The W&M proposal would expand the net investment income tax to cover net investment income derived in the ordinary course of a trade or business (regardless of whether the taxpayer materially participates) with respect to individuals with taxable income greater than $400,000 for single taxpayers or $500,000 for joint taxpayers, as well as trusts and estates. These proposals, if enacted, would apply to taxable years beginning after Dec. 31, 2021.
vi. Pass-Through Deduction
Section 199A of the Code permits a non-corporate taxpayer to take a potential deduction of up to 20% of such taxpayer’s “combined qualified business income,” subject to certain limitations. The W&M proposal would limit the Section 199A deduction on qualified business income to a maximum annual deduction based on filing status. Under the W&M proposal, the maximum annual Section 199A deduction would be $500,000 for married filing jointly taxpayers ($250,000 for married filing separate taxpayers), $400,000 for single taxpayers, and $10,000 for trusts and estates. This limitation, if enacted, would be applicable to taxable years beginning after Dec. 31, 2021.
vii. Excess Business Losses
Section 461(l) of the Code, originally enacted by the TCJA, imposes an “excess business loss” limitation, which limits a taxpayer’s ability to use trade or business losses of a non-corporate taxpayer to offset other ordinary income of such taxpayer for a given taxable year. This Section 469(l) excess business loss limitation is set to sunset after Dec. 31, 2025. Pursuant to the W&M proposal, the limitation on excess business losses of non-corporate taxpayers under Section 461(l) of the Code would be made permanent. Under the W&M proposal, any unutilized business losses carried forward would continue to be subject to the excess business loss limitation, rather than being carried forward as a net operating loss. This change, if enacted, would apply to taxable years beginning after Dec. 21, 2020, and would therefore apply to calendar year 2021.
viii. Temporary Rule for S-Corporation Conversions
The W&M proposal includes a special temporary rule that would permit certain “S-corporations” to reorganize or convert to a domestic partnership without the recognition of gain or loss. For an S-corporation to be eligible, among other requirements, such conversion or reorganization must occur within the two-year period beginning on Dec. 31, 2021, and the S-corporation must affirmatively elect to have this rule apply. The W&M proposal would also grant regulatory authority to the Secretary to prescribe regulations or other guidance as necessary to carry out the purposes of this rule.
ix. Section 1202 Gain Exclusion
Section 1202 of the Code provides certain taxpayers with a maximum 100% exclusion of “eligible gain” from the sale or exchange of “qualified small business stock” held for more than five years. The W&M proposal would amend Section 1202 of the Code to limit the eligible gain exclusion to 50%, instead of the available 75% or 100% exclusions, in the case of taxpayers with an adjusted gross income equal to or exceeding $400,000 and to taxpayers that are trusts or estates. This limitation applies without regard to filing status. Pursuant to the W&M proposal, this 50% gain exclusion limitation would apply to sales or exchanges occurring on or after Sept. 13, 2021, except for sales or exchanges occurring after such date pursuant to a binding contract entered into by Sept. 12, 2021, and not materially modified thereafter.
x. High-Income Surcharge
The W&M proposal would impose a new 3% surcharge on high-income individuals and trusts and estates with a modified adjusted gross income in excess of $5 million for both single and married filing joint taxpayers, $2.5 million for married filing separate taxpayers, or $100,000 for trusts and estates. This new provision, if enacted, would apply to taxable years beginning after Dec. 31, 2021.
International Tax Proposals
i. Global Intangible Low-Taxed Income (“GILTI”)
Under the current global blending GILTI regime, Section 951A of the Code requires each person who is a U.S. shareholder of a controlled foreign corporation (“CFC”) to include such CFC’s tested income currently in its gross income without taking into account the country of the CFC. A U.S. shareholder’s GILTI inclusion is calculated on an aggregate basis across all of its CFCs by reducing the U.S. shareholder’s pro rata share of CFC tested income by its pro rata share of CFC tested losses, regardless of the location of the CFC. The W&M proposal would require U.S. shareholders to calculate their GILTI inclusion separately with respect to each specific country and aggregate a CFC’s tested income, net deemed tangible income return, qualified business asset investment (“QBAI”) and interest expense. As a result of the country-by-country approach, tested losses of a CFC taxable unit in one country would only offset tested income in that same country, and a U.S. shareholder would be able to carry forward any unused net tested with respect to a particular country. Other modifications include the following: a reduction to the deduction with respect to GILTI and the corresponding “Section 78 gross-up” (from 50% to 37.5%); a reduction of the QBAI exemption (from 10% to 5%); and an increase of the deemed paid credit for taxes attributable to GILTI (from 80% to 95%). The W&M proposal would also remove the rule that limits the deduction under Section 250 of the Code to the current year’s taxable income, rather the excess of the Section 250 deduction over the current year’s taxable income would increase net operating losses for that year. These provisions, if enacted, generally would be applicable for taxable years beginning after Dec. 31, 2021, with certain specified exceptions.
ii. Foreign-Derived Intangible Income (“FDII”)
FDII is the portion of a domestic corporation’s intangible income derived from products tied to intangible assets located in the United States (such as patents, trademarks, and copyrights, etc.). Section 250 of the Code currently allows domestic corporations a deduction equal to 37.5% of its FDII. In contrast to earlier proposals that set out to repeal Section 250 of the Code, the W&M proposal would retain Section 250 of the Code, but reduce the amount of the Section 250 deduction from 37.5% to 21.875% of FDII. In addition, the W&M proposal would introduce as technical corrections a modification to the definition of “deduction eligible income” for FDII purposes, by excluding income which is personal holding company income earned by a CFC and any inclusion from a “qualified electing fund” under the passive foreign investment company rules. These changes, if enacted, would apply for calendar year taxpayers for taxable years beginning after Dec. 31, 2021; and, for fiscal year taxpayers, a blended rate would apply to the fiscal year that includes Dec. 31, 2021.
iii. The Base Erosion and Anti-Abuse Tax (“BEAT”)
BEAT under Section 59A of the Code imposes an additional tax (10% for 2019 through 2025, and 12.5% for years after 2025) on certain multinational corporations that make “base erosion payments” (which include deductible payments and other categories of payments) to certain foreign related parties. The W&M proposal would accelerate the increase in the BEAT rate to 12.5% for tax years beginning after December 31, 2023 and before January 1, 2026. The rate would be further increased to 15% for taxable years beginning after December 31, 2025. Other modifications include: (i) eliminating the base erosion percentage test while retaining (without modification) the gross receipts test; (ii) extending the one point higher BEAT rate to banks (including foreign banks operating a U.S. branch) and registered securities dealers that are applicable taxpayers, regardless of whether they are members of an affiliated group (including foreign corporations); and (iii) expanding the scope of base erosion payments to include indirect costs associated with certain costs of goods sold. These modifications, if enacted, would apply generally to taxable years beginning after Dec. 31, 2021, with certain exceptions.
iv. Portfolio Interest Exception
Section 871 of the Code provides an exception from the general 30% withholding tax on certain U.S. source income that is not effectively connected with U.S. trade or business for U.S. source interest received by certain non-U.S. persons (the “Portfolio Interest Exception”). However, the Portfolio Interest Exception generally does not apply to certain shareholders or partners owning 10% or more of the total combined voting power in the case of a corporation or 10% or more of the capital or profits interests in the case of a partnership (a “10-percent Shareholder”) of the obligor. The W&M proposal would expand the definition of 10-percent Shareholder to include non-U.S. persons that actually or constructively own (i) 10% or more of the total combined voting power or (ii) 10% or more of the total value of the stock of a U.S. corporate obligor. This proposal, if enacted, would apply to obligations issued after the date of the enactment of the Act.