Senate Finance Committee Releases Its Version of the Tax Cuts and Jobs Act
November 22, 2017
After releasing summaries and various Chairman's marks,1 the Senate Finance Committee ("SFC") approved its tax reform bill, the "Tax Cuts and Jobs Act," on November 16, 2017 and released the legislative text of the bill to the public on November 21, 2017 (the "SFC Bill").2
The full Senate is expected to consider the SFC Bill the week of November 27, 2017. If it is approved by the Senate, which is by no means a certainty, it will have to be reconciled with the tax reform legislation that was passed by the House of Representatives, H.R. 1 (the "House Bill"), on November 16, 2017.3 Reconciliation is typically achieved by a Conference Committee consisting of senior members of the House Ways and Means Committee and the Senate Finance Committee, with a final Conference Bill then sent to the House and Senate for an up or down vote (i.e., no amendments are allowed). If the full House and Senate approve the Conference Bill, it will be sent to the president for his approval or veto.4
As with the House Bill, the SFC Bill contains sweeping proposals that would significantly impact individuals, pass-through entities, and corporations, both domestically and abroad. The SFC Bill, however, departs from the House Bill in many key respects, with the more relevant provisions to WSGR clients summarized below. In addition, the SFC Bill does not affect many aspects of the current Internal Revenue Code of 1986, as amended (the "Code"), such as the preferential rates for long-term capital gains and qualified dividend income recognized by non-corporate taxpayers, and the gain exclusion for sale or disposition of "qualified small business stock." Furthermore, the SFC Bill does not address certain proposals in the House Bill, such as the repeal of Section 1235 of the Code (regarding the preferential tax treatment of patents), the taxation of certain contributions to capital, and the repeal of the "technical termination" rule applicable to partnerships.
While the below summaries are by no means comprehensive, we have sought to highlight the proposals in the SFC Bill and certain amendments reflected in the House Bill since our prior alert (the "House Amendments")5 that are most likely to be of interest to our clients.
Executive Summary of the SFC Bill and the House Bill
- Reduction in the corporate tax rate from 35% to 20% effective in 2019 in the SFC Bill (and 2018 in the House Bill). Both the SFC Bill and the House Amendments reduce the dividends-received deduction available to domestic corporations to reflect these lower tax rates.
- The House Bill provides for a maximum 25% rate on business income of individuals earned through pass-through entities, with the following updates in the House Amendments: (i) creating a new 9% tax rate for owners of pass-through small business entities, including personal service businesses, and (ii) maintaining the self-employment tax as it applies under current law. The SFC Bill allows individuals with business income earned through pass-through entities to deduct 17.4% of their qualified domestic income with limitations for specified service businesses and an anti-abuse rules for wages.
- The SFC Bill would tax dividends received by individuals from certain foreign corporations at ordinary income rates if the foreign corporation participated in a so-called "inversion" transaction that resulted in its being treated as a "surrogate foreign corporation" (but not as a domestic corporation under Section 7874(b) of the Code). The House Bill does not contain a similar proposal.
- The SFC Bill and House Bill include 100% bonus depreciation for qualified property placed in service after September 27, 2017, and prior to January 1, 2023, subject to certain transition rules and limitations.
- The deduction of business interest would be limited to 30% of taxable income (subject to certain adjustments) for businesses with average gross receipts of $15 million or more with an unlimited "excess interest" carryforward under the SFC Bill, or average gross receipts of $25 million or more with a five-year carryforward under the House Bill.
- The deduction for net operating loss ("NOL") carryovers would be limited to 90% of taxable income under the SFC Bill and House Bill, but would be reduced to 80% in taxable years beginning after December 31, 2022 under the SFC Bill. Subject to certain exceptions, neither the SFC Bill nor the House Bill would permit any NOL carrybacks. Both the SFC Bill and House Bill would repeal the corporate alternative minimum tax ("AMT").
- Both the SFC Bill and the House Bill would repeal the deduction for domestic production activities.
- The SFC Bill would introduce accelerated depreciation deductions for real property, which is not addressed in the House Bill.
- The SFC Bill proposes that taxpayers recognize income no later than the taxable year in which such income is taken into account as income on an "applicable financial statement" and codifies the current treatment of certain advance payment contracts for goods and services. The House Bill does not contain a similar proposal.
- Both the SFC Bill and the House Amendments propose a new three-year holding period requirement for long-term capital gain treatment of "carried interests."
- Both the SFC Bill and the House Amendments would create a five-year amortization period for specified research or experimental expenditures (15 years in the case of research conducted outside the United States).
- The House Bill would (i) significantly reduce the value of production tax credits ("PTCs") for projects that begin construction after enactment, (ii) eliminate the permanent 10% investment tax credit ("ITC"), (iii) impose a statutory "continuous program of construction" for ITC and PTC projects, and (iv) extend investment credits for so-called "orphaned" technologies. The SFC Bill contains no amendments to the ITC, PTC, or other energy credit provisions.
- Both the SFC Bill and House Bill would exempt certain dividends paid by foreign corporations to U.S. corporations from U.S. tax and would impose a one-time "deemed repatriation" tax on accumulated offshore earnings of U.S. shareholders. The House Amendments increase the tax rates applicable to such deemed repatriation, as discussed more fully below.
- Both the SFC Bill and House Bill contain several provisions intended to prevent erosion of the U.S. tax base in connection with these proposals.
- The SFC Bill proposes to apply a "look-through" rule to income recognized by a foreign person who sells an interest in a partnership that is engaged in a trade or business in the United States. The House Bill does not contain a similar proposal.
- Both the SFC Bill and House Bill would expand "controlled foreign corporation" ("CFC") status by expanding the definition of "U.S. shareholders" subject to the anti-deferral rules under subpart F of the Code and to the new anti-base erosion rules.
- The SFC Bill would apply certain deemed royalty and transfer pricing rules to outbound transfers of goodwill, going concern value and similar intangible property. The House Bill does not contain a similar proposal.
- The SFC Bill denies a deduction for certain interest or royalty payments to a "hybrid entity" or made pursuant to a hybrid transaction, which is not addressed in the House Bill.
Discussion of the SFC Bill and the House Bill
For each summary below, we describe material provisions of the SFC Bill as they compare to the relevant provisions of the House Bill, while identifying any material changes introduced in the House Amendments, followed by a summary of the provisions that are "New Proposals" introduced since our last alert.
Business Tax Rate Proposals
- Reduction in corporate tax rate
Similar to the House Bill, the SFC Bill would lower the corporate tax rate to 20%, but the SFC Bill excludes any special rate for personal service corporations, which means that such corporations' net income would be taxed at 20% versus 25% in the House Bill (and 35% under existing law). Unlike the House Bill, which lowered the corporate tax rates for taxable years beginning after December 31, 2017, the lower corporate tax rate in the SFC Bill would not be effective until tax years beginning after December 31, 2018.
In connection with the reduced corporate tax rate, the SFC Bill would also reduce the dividends-received deduction available to corporations for dividends received from other non-affiliated domestic corporations. The House Bill was amended to include a similar proposal subsequent to our prior alert. Both proposals would reduce the 80% dividends-received deduction to 65% for "20%-owned corporations" and the 70% dividends-received deduction to 50% for less than 20%-owned corporations.6
- Maximum rate on business income of individuals earned through pass-through entities and sole proprietors
In addition to the 25% maximum rate proposed in the original House Bill for "qualified domestic business income" ("QDBI") allocated to individual owners or shareholders of certain pass-through businesses, the House Amendments added a new tax rate of 9% for up to $75,000 of QDBI allocated to an active owner, partner or pass-thru shareholder that is a married taxpayer and files jointly (or $37,500 for unmarried taxpayers and married taxpayers filing separately) provided the taxpayer's taxable income does not exceed $150,000 for married taxpayers filing jointly (or $75,000 for unmarried taxpayers and married taxpayers filing separately), with net income between $75,000 and $150,000 taxed at 12% (or between $37,500 and $75,000 with respect to unmarried taxpayers and married taxpayers filing separately). Income eligible for the 9% rate would include personal service income and would be gradually phased in over five taxable years, and would be phased down as the taxpayer's net income exceeds $150,000 until it reaches $225,000, at which point the 9% rate would no longer be applicable. In addition, the House Amendments eliminated the proposed application of self-employment tax to shareholders of an S corporation and what appeared to be application of self-employment taxes to passive investors in the original House Bill.
In lieu of a preferential tax rate for QDBI of a pass-through entity or sole proprietor, the SFC Bill provides a deduction equal to 17.4% of QDBI allocated to individual owners of pass-thru entities and sole proprietors, subject to a 50% wage limitation described below (the "QDBI Deduction").7 Such calculation is made solely with respect to net taxable income and excludes from QDBI any amounts paid as reasonable compensation for services to an owner or shareholder of an S corporation or partnership.
The 17.4% QDBI deduction is generally limited to 50% of the W-2 wages with respect to the applicable pass-thru entity or sole proprietorship, except for taxpayers with income from such businesses whose taxable income does not exceed $500,000 for married taxpayers filing jointly (or $250,000 for unmarried taxpayers and married taxpayers filing separately). The application of the W-2 wage limit is phased in for taxpayers with taxable income exceeding the $500,000 amount (or $250,000 amount) over the next $100,000 of taxable income for married taxpayers filing jointly (or $50,000 for unmarried taxpayers and married taxpayers filing separately). For purposes of this provision, the W-2 wage limit is tested at the partner or shareholder level and each partner or shareholder of a pass-through entity is treated as having W-2 wages equal to such partner's or shareholder's allocable share of the W-2 wages of such entity for the taxable year (determined in the same manner as the partner's or shareholder's allocable share of wage expenses). The Secretary of the Treasury would be authorized to promulgate regulations regarding the W-2 wage limit, which would hopefully shed additional light on what we understand to be an anti-abuse provision, including treatment of "guaranteed payments" made by partnerships vis-à-vis the W-2 wage limit.
Income subject to preferential rates, such as long-term capital gains and qualified dividend income, would continue to be eligible for those rates and therefore would not be included in the calculation of the QDBI Deduction. Likewise, investment income that is taxable at ordinary rates, such as short-term capital gain, would be excluded from the calculation of the QDBI Deduction. However, interest income allocable to a trade or business would be included in QDBI and thus would be taken into account in calculating the QDBI Deduction.
The QDBI Deduction generally would not apply to certain specified personal service businesses, such as health, law, engineering, accounting, consulting, financial services or performing arts, except in the case of taxpayers with income from such businesses whose taxable income does not exceed $500,000 for married taxpayers filing jointly (or $250,000 for unmarried taxpayers and married taxpayers filing separately). The deduction would be phased out over the next $100,000 of taxable income for married taxpayers filing jointly (or $50,000 for unmarried taxpayers and married taxpayers filing separately).
The QDBI Deduction proposed in the SFC Bill would be effective for tax years beginning after December 31, 2017, but would expire after December 31, 2025, whereas the 25% rate applicable to pass-through entities in the House Bill would be permanent.
- New Proposal
- Dividends from inverted corporations
Under current law, dividends received by individuals from foreign corporations may be subject to U.S. federal income tax at rates applicable to long-term capital gains (i.e., the same rate that applies to dividends received from domestic "C" corporations) if certain requirements are met.8 However, the SFC Bill would tax any such dividends paid after December 31, 2017 at ordinary income rates if the foreign corporation participated in a so-called "inversion" transaction that resulted in its being treated as a "surrogate foreign corporation" under Section 7874 of the Code, other than a foreign corporation that is treated as a domestic corporation under Section 7874(b) of the Code. In general, this would occur where (i) the foreign corporation acquired substantially all the properties of a domestic corporation or partnership engaged in a trade or business, (ii) former owners of the domestic entity acquired 60% or more (by vote or value), but less than 80% (by vote or value), of the stock of the foreign corporation in exchange for their interests in the domestic entity, and (iii) the foreign corporation and certain of its affiliates did not have "substantial business activities" in the foreign corporation's country of incorporation. There is no corresponding provision in the House Bill.
Other Domestic Business Proposals
- Increased bonus depreciation and expansion of Section 179 expensing for small business
Similar to the House Bill, the SFC Bill (1) provides for 100% bonus depreciation for qualified property placed in service after September 27, 2017, and prior to January 1, 2023, with an additional year for certain qualified property with a longer production period and (2) provides for a transition rule for the first taxable year ending after September 27, 2017, which would allow taxpayers to claim 50% bonus depreciation. Unlike the House Bill, the SFC Bill does not require that the property be acquired after September 27, 2017 to be eligible for 100% bonus depreciation.
Also similar to the House Bill, the SFC Bill would expand the availability of Code Section 179 expensing, which currently allows businesses to elect to immediately expense up to $500,000 (adjusted for inflation beginning in 2016) of the cost of eligible property in the year the property is placed in service. The $500,000 limitation is reduced dollar-for-dollar to the extent a business places more than $2,000,000 of eligible property in service in any year (such amount is also adjusted for inflation beginning in 2016).
Under the SFC Bill, effective for property placed in service in taxable years beginning after December 31, 2017, the $500,000 limitation would be increased to $1,000,000 (as compared to an increase to $5,000,000 in the House Bill), and the phase-out amount would be increased from $2,000,000 to $2,500,000 (as compared to an increase to $20,000,000 in the House Bill). Inflation adjustments with respect to these amounts would apply beginning in 2019.
- Limitations on interest deductions
Similar to the House Bill, the SFC Bill generally would disallow a deduction for a taxpayer's net business interest expense to the extent it exceeds 30% of such taxpayer's adjusted taxable income. In contrast to the House Bill, however, which applies the limitation to businesses with average gross receipts of $25 million or more and limits the carry forward period for disallowed interest deductions to only five years, the SFC Bill would apply the limitation to businesses with average gross receipts of $15 million or more, but would allow businesses to carry forward their disallowed interest deductions indefinitely. The SFC Bill has a more restrictive definition of adjusted taxable income than the House Bill in that, in particular, it takes into account depreciation and amortization deductions, whereas the House Bill does not.
The SFC Bill also contains an "anti-base erosion" provision similar in purpose to one in the House Bill, by limiting the deductibility of the net interest expense of U.S. corporations that are members of a "worldwide affiliated group," which is generally defined as an affiliated group for U.S. federal income tax purposes using an ownership threshold of 50% rather than 80%, plus any foreign corporation that would be included if it were a domestic corporation. The SFC Bill would require the worldwide affiliated group to calculate the ratio of its total worldwide debt to its total worldwide equity and, to the extent the ratio of the U.S. group members' debt to equity exceeds 110% of the worldwide affiliated group's debt to equity ratio, the deductible U.S. interest would be reduced by that percentage. Any interest expense so denied could be carried forward indefinitely.
The SFC Bill proposals would be effective for taxable years beginning after December 31, 2017.
- NOLs and repeal of the corporate AMT
The SFC Bill would permit a corporate taxpayer to deduct an NOL carryover only to the extent of 90% of its taxable income effective for taxable years beginning after December 31, 2017 and 80% of its taxable income effective for taxable years beginning after December 31, 2022 (versus 90% of taxable income in the House Bill effective December 31, 2017). Both the SFC Bill and the House Bill would repeal the NOL carryback, except in the case of certain losses incurred in the trade or business of farming, but would allow an indefinite carryover period (versus the 20-year carryover period under current law). Notwithstanding the foregoing, under the SFC Bill, the use of NOL carryovers with respect to property and casualty insurance companies would be unchanged from current law and not subject to the above limitations.
The SFC Bill, like the House Bill, also repeals the corporate AMT for taxable years beginning after December 31, 2017.
- Repeal of deduction for income attributable to domestic production activities
Similar to the House Bill, the SFC Bill would repeal Section 199 of the Code (providing a deduction from taxable income for qualified domestic production activities, e.g., manufacturing, software development, electricity production). However, the SFC Bill would be effective for tax years beginning after December 31, 2018 (as compared to December 31, 2017 in the House Bill).
- New Proposals
- Modification to recovery period for real property
The SFC Bill would accelerate the modified accelerated cost recovery ("MACRS") depreciation deductions for real property by reducing the recovery period from 39 years for nonresidential real property and 27.5 years for residential rental property to 25 years for both types of property, effective for property placed in service after December 31, 2017.
There is no correlative provision in the House Bill.
- Special rules for taxable year of inclusion
Under current law, a taxpayer generally is required to recognize an item of income for U.S. federal income tax purposes no later than the time the taxpayer actually or constructively receives such item, unless the item properly is accounted for in a different period under the taxpayer's method of accounting. Certain exceptions permit deferral of income related to advance payments, for example taxpayers are generally allowed to defer recognition of income related to long term contracts for the provision of goods and services until the end of the tax year following the tax year of receipt pursuant to IRS Revenue Procedure 2004-34. The SFC Bill includes provisions requiring a taxpayer to recognize income no later than the taxable year in which such income is taken into account as income on an applicable financial statement (generally audited financial statement), unless such income is with respect to advance payments and the taxpayer makes an applicable election to defer recognition. The SFC Bill also generally codifies the treatment of certain advance payment contracts as currently provided under Revenue Procedure 2004-34. The proposal would apply to taxable years beginning after December 31, 2017, and is not included in the House Bill.
- Taxation of partnership "carried interests"
The SFC Bill and the House Amendments both provide new three-year holding period requirements for holders of "carried interests" in partnerships or entities treated as partnerships for U.S. federal income tax purposes in order for them to realize preferential long-term capital gain rates with respect to such interests.
Generally, an investment fund that is treated as a partnership for U.S. federal income tax purposes allocates to its partners any gain recognized when the partnership's investments are sold. Where the investments are capital assets (such as corporate stock) that have been held for more than one year, allocations of any resulting gain to the fund's partners, including to a general partner or fund manager with respect to its "carried interest" in partnership profits, may be eligible for taxation at preferential long-term capital gain rates. Similarly, subject to certain exceptions, gain recognized on the sale of a partnership interest by a partner is generally treated as capital gain that may be eligible for taxation at preferential capital gains rates.
The House Bill (as amended subsequent to our prior alert) and the SFC Bill generally would recharacterize long-term capital gains with respect to "applicable partnership interests" as short-term capital gains taxable at ordinary income rates unless a three-year holding period requirement has been met. The "carried interest" proposal contained in the SFC Bill is virtually identical to the proposal contained in the House Bill, introducing a new Code Section 1061 that applies to such so-called "applicable partnership interest," which is defined as any partnership interest transferred to or held by the taxpayer in connection with the performance of substantial services by the taxpayer (or any related person) to an applicable trade or business. An "applicable trade or business" is an activity conducted on a regular, continuous and substantial basis that consists of (i) raising or returning capital and (ii) either investing in (or disposing of) or developing specified assets (defined as securities, commodities, real estate held for rental or investment, cash or cash equivalents, and options or derivative contracts with respect to any of the foregoing, or an interest in a partnership to the extent of the partnership's proportionate interests in any of the foregoing). The SFC and House Bills would permit the Secretary of the Treasury to promulgate regulations exempting from recharacterization any gain that is attributable to assets not held for portfolio investment on behalf of third party (generally passive) investors.
An "applicable partnership interest" does not include (i) any interest in a partnership held by a corporation or (ii) any interest in a partnership that provides the taxpayer with a right to participate in partnership profits in proportion to (A) the amount of capital contributed by such taxpayer or (B) amounts included in the taxpayer's income as compensation for services upon receipt or vesting under Section 83 of the Code. In addition, an applicable partnership interest would not include an interest held by a person who is employed by another entity that is not conducting an "applicable trade or business" (as described above) who only provides services to the other entity.
By extending the requisite holding period for long-term capital gains, rather than taxing all related gains as ordinary income per prior legislative proposals, both the House Bill and SFC Bill would permit carried interest recipients to continue benefitting from preferential capital gains rates so long as the relevant investments are held for more than three years. As a result, the legislation, if enacted as proposed in the House Bill and SFC Bill, may lead fund managers with shorter holding periods to consider alternative exits (such as tax-free reorganizations or leveraged recapitalizations) or to take advantage of the "gain rollover" provisions applicable to qualified small business stock when possible. In addition, neither the House Bill nor SFC Bill clearly addresses the extent to which gain recognized upon the sale of all or a portion of a fund's carried interest would be recharacterized as short-term, such as where a portion of the fund's investments have been made within the three years preceding such sale.
The carried interest provisions of both the House Bill and the SFC Bill would be effective for tax years beginning after December 31, 2017.
- Amortization of research and experimental expenditures
Under current Section 174 of the Code, taxpayers may elect to (i) deduct currently the amount of certain deductible research and experimental expenditures paid or incurred in connection with a trade or business or (ii) capitalize such expenditures and either amortize the expenditures ratably over the useful life of the research (but in no case, less than 5 years) or amortize the expenditures over 10 years.
The House Amendments and the SFC Bill provide similar proposals that would require taxpayers to capitalize specified research or experimental expenditures and amortize such expenditures ratably over 5 years beginning with the midpoint of the taxable year in which such expenditures are paid or incurred. In the case of specified research or experimental expenditures attributable to research conducted outside the United States, such expenditures would be capitalized and amortized ratably over a period of 15 years, also beginning with the midpoint of the taxable year in which such expenditures are paid or incurred.
"Specified research or experimental expenditures" include research or experimental expenditures that are paid or incurred by the taxpayer during the taxable year in connection with the taxpayer's trade or business. The SFC Bill and the House Amendments explicitly include amounts paid or incurred in connection with development of any software as specified research or experimental expenditures, but similar to current Section 174 of the Code, exclude (i) expenditures for land or depreciable or depletable property used in connection with the research or experimentation (other than the depreciation and depletion allowances with respect to such property) and (ii) exploration expenditures for other minerals (including oil and gas).
Upon disposition, retirement or abandonment of any property to which specified research or experimental expenditures are paid or incurred, any remaining basis in the property may not be recovered in the year of disposition, retirement or abandonment, but must continue to be amortized over the remaining amortization period.
The SFC Bill would amend Section 174 of the Code for amounts paid or incurred in tax years beginning after December 31, 2025.9 The House Bill would amend Section 174 of the Code for tax years beginning after December 31, 2023.
Provisions Impacting Tax Equity and Renewables
The SFC Bill is largely silent on issues related to renewable energy, thereby leaving in place the renewable energy extenders legislation passed at the end of 2015. Therefore, unlike the House Bill, the SFC Bill does not eliminate the permanent 10% investment tax credit ("ITC"), eliminate the inflation adjustment factor for production tax credits ("PTCs"), or impose additional "begun construction" requirements on either ITC or PTC facilities.
While this is good news for wind and solar technologies generally, whereas the House Bill provided for extension of so-called "orphaned" technologies (e.g., fiber optic solar energy, qualified fuel cell property, qualified small wind energy property, qualified micro turbine property, combined heat and power systems, and thermal energy property) that are no longer eligible for the ITC and extension of the Section 25D 30% investment credit for residential energy efficiency property, the SFC Bill includes no such extensions.
Importantly, subsequent to our prior alert, the House Bill was passed along with a House report that included clarification with respect to the statutory imposition of a continuity requirement in determining "begun construction" and says, "[t]he provision includes a special rule for determining the beginning of construction, which is intended to codify Treasury guidance for determining when construction of a facility has begun, including the physical work test, the five percent safe harbor, and the continuity requirement."10
Furthermore, unlike the House Bill, the SFC Bill does not repeal the New Markets Tax Credit, nor, as discussed previously, does it repeal technical terminations under Section 708(b)(1)(B) of the Code and it does not include a provision that treats certain contributions to capital as taxable transactions.
As discussed in further detail below, the SFC Bill includes "base erosion" provisions. As drafted, these provisions could significantly reduce (or even eliminate) the value of tax credits (other than research and development credits) to multinational enterprises.
Like the House Bill, the SFC Bill would substantially alter the U.S. taxation of multinational enterprises by introducing a modified "participation exemption" on the one hand, while significantly curbing potential "base erosion" on the other. As described in our prior alert, under current law, U.S. citizens, resident individuals, and domestic corporations generally are subject to "residence-based" taxation, meaning that they are taxed on all income they recognize, whether earned in the United States or abroad. U.S. parent corporations, however, generally are not taxed on the income of their foreign corporate subsidiaries until the income is repatriated to the United States. At such time, the U.S. parent may be entitled to a credit for foreign income taxes paid by the foreign subsidiary, although such credits may not be sufficient to offset the parent's U.S. tax liability as a result of the repatriation. There are significant exceptions to the general rule permitting deferral of U.S. tax on the earnings of a domestic corporation's foreign subsidiaries, such as where a foreign subsidiary is a CFC that has earned so-called "subpart F income," or has invested its earnings in "United States property" within the meaning of Section 956 of the Code.
Several of the proposals contained in the SFC Bill are thematically similar to those contained in Title IV of the House Bill. A summary of certain key provisions in the SFC Bill and certain significant amendments to the House Bill since our prior alert follows.
- Participation exemption and transition tax
Effective for distributions by foreign corporations with taxable years beginning after 2017, the SFC Bill generally would exempt U.S. corporations from U.S. tax on the repatriated earnings of foreign corporations in which they have owned for more than one year at least 10 percent of the combined voting power or value, and would repeal the "deemed dividend" consequences of Section 956 of the Code to corporate U.S. shareholders where a CFC invests (or is treated as investing) in "United States property," such as where a CFC guarantees the indebtedness of its U.S. corporate parent. Like the House Bill, the SFC Bill would not exempt from U.S. tax any dividends received from a foreign corporation that is a "passive foreign investment company" but is not a CFC; however, unlike the House Bill, the SFC Bill would extend tax exemption to distributions from such a foreign corporation where a "purging" election under Section 1291 of the Code has been made. Furthermore, unlike the House Bill, the exemption from U.S. tax would not apply if the applicable dividend is a "hybrid dividend," which is generally a dividend for which a tax deduction (or other tax benefit) would be allowed to the foreign corporation.
Similar to the House Bill, the SFC Bill would deny a domestic corporation receiving a dividend from a foreign corporation any credit for foreign taxes paid by the foreign corporation and, consistent with the objective of permitting the repatriation of funds to the United States, would make permanent the subpart F "look-thru" rule for dividends received by CFCs from related CFCs. However, a CFC receiving a "hybrid dividend" (as defined above) from certain related CFCs would not be eligible for this look-thru rule and would be treated as recognizing "subpart F" income.
As part of the transition into a modified "participation exemption" regime, the SFC Bill would require a one-time "mandatory inclusion" of certain accumulated offshore earnings in a manner similar to the House Bill. This "mandatory inclusion" would apply to any "U.S. shareholders" of any foreign corporations (whether or not CFCs, but excluding "passive foreign investment companies" that are not CFCs) and would be treated as occurring in 2017 for foreign subsidiaries whose U.S. tax year is the calendar year. Similar to the House Bill, the amount of U.S. tax resulting from such deemed repatriation would depend on whether the related earnings have been retained in the form of cash or cash equivalents, or whether they have been reinvested in the applicable foreign subsidiary's business. Under the SFC Bill, the applicable tax rates on such earnings generally would be 5% and 10%, respectively, whereas under the amended House Bill, the applicable tax rates would be 7% and 14%, respectively (representing increases from the originally proposed 5% and 12% rates discussed in our prior alert). In addition, the SFC Bill provides that at the election of the U.S. shareholder, the tax liability generally would be payable over a period of up to eight years in increasing installments (beginning with 8% of the net tax liability, and increasing to 25% by the eighth year), whereas the House Bill provides for equal installments.
- Base erosion and related measures
Like the House Bill, the SFC Bill includes several provisions designed to prevent so-called "base erosion."11 First, beginning after 2017, any "U.S. shareholder" of a CFC would be required to include in income its "global intangible low-taxed income" ("GILTI") in a manner similar to a CFC's "subpart F income." GILTI is generally a CFC's gross income to the extent it exceeds 10% of the CFC's tax basis in its tangible assets. As a result, the SFC Bill generally would require U.S. parent corporations to recognize a portion of the earnings on their foreign subsidiaries' intangible property in a manner conceptually similar to the provisions addressing "foreign high returns" in the House Bill.
Like the House Bill, the SFC Bill would permit U.S. shareholders to take into account certain foreign tax credits on GILTI inclusions under this proposal, thereby mitigating current taxation on any such amounts. In addition, the SFC Bill would introduce a new deduction equal to 50% of a domestic corporation's GILTI and 37.5% of a domestic corporation's "foreign-derived intangible income" (generally based on income from exports of intangible property). Taking into account this deduction, GILTI would be taxed at a 10% rate for taxable years beginning before January 1, 2026, after which the effective tax rate would be increased to 12.5% due to a step-down in the amount of the deduction with respect to any GILTI inclusions. A similar step-down would apply to the 37.5% deduction for a domestic corporation's foreign-derived intangible income, which would decrease to 21.875% for taxable years beginning after December 31, 2025. While the House Bill does not contain similar deductions, it would only require U.S. shareholders to take into account 50% of their CFCs' "foreign high returns." In addition, unlike the House Bill, the SFC Bill does not exclude "look-thru" amounts received from related parties or certain "active finance income," insurance income or dealer income in calculating a U.S. shareholder's GILTI inclusions, resulting in a broader base on which any such inclusions would be determined.
Second, in lieu of the House Bill's 20% excise tax on certain "base erosion" payments (i.e., payments made to foreign affiliates that are deductible, included in the basis of depreciable assets or included in cost of goods sold), the SFC Bill would generally apply an effective tax rate of 10% (12.5% beginning in 2026) to any income that would have been subject to U.S. tax had the taxpayer not made certain payments that erode the U.S. tax base. This so-called "base erosion minimum tax" is determined with reference to the U.S. taxpayer's "modified taxable income," generally calculated as taxable income without taking into account any deductions attributable to payments made to any related foreign parties (including that portion of any depreciation or net operating loss deduction which relates to such payments). As a minimum tax, the calculation of the base erosion minimum tax amount subtracts the taxpayer's regular tax liability, offset by all credits (other than research and development credits before 2026).12 The base erosion minimum tax would apply to any domestic "C" corporation that has average annual gross receipts of at least $500 million over a three-year testing period and that has made certain specified payments that reduce their U.S. tax base exceeding a certain threshold. This proposal would be effective in taxable years beginning after December 31, 2017.
- New Proposals
- Tax gain on sale of a partnership interest on look-through basis
A foreign person engaged in a trade or business in the United States is generally subject to U.S. tax on its income that is effectively connected with the conduct of that trade or business (such income referred to as "effectively connected income" or "ECI"). In the case of a partnership, the partners of such partnership are generally treated as engaged in the conduct of a trade or business in the United States pursuant to Section 875 of the Code if the partnership is so engaged. In Revenue Ruling 91-32, the IRS applied asset-use and business activity tests at the partnership level to determine the extent to which income derived by a foreign person from the sale or exchange of a partnership interest would be treated as ECI. In the ruling, the IRS determined that some or all of the foreign person's gain or loss from such sale or exchange may be treated as ECI if there is unrealized gain or loss in the partnership assets that would be treated as ECI if those assets were sold by the partnership based on the fixed place of business of the partnership. In a recent case, Grecian Magnesite Mining v. Commissioner,13 however, the Tax Court rejected the IRS position. The Tax Court held that gain or loss on sale or exchange by a foreign person of an interest in a partnership that is engaged in a U.S. trade or business would generally be foreign source (and, thus, not ECI), based on the tax residence of the foreign person.
In an apparent response to the Grecian Mining case, the SFC Bill proposes a "look-through" approach consistent with Revenue Ruling 91-32 to determine whether the sale or exchange of a partnership interest will be treated as ECI. Under the SFC Bill, gain or loss from the sale or exchange of a partnership interest is effectively connected with a U.S. trade or business to the extent that the transferor would have had ECI had the partnership sold all of its assets at fair market value as of the date of the sale or exchange. In addition, the proposal requires the transferee of a partnership interest to withhold 10% of the amount realized on the sale or exchange of such interest, unless the transferor certifies that the transferor is not a non-resident alien individual or foreign corporation.
This proposal would be effective for sales and exchanges after November 27, 2017. The House Bill does not contain a similar provision.
- Expanding CFC status
As noted above, certain anti-deferral regimes, including the CFC rules of subpart F of the Code, may cause a U.S. owner of a foreign corporation to be taxed on a current basis in the United States on the foreign corporation's "subpart F income," regardless of whether the income has been distributed as a dividend to the U.S. owner. A CFC generally is defined as any foreign corporation if U.S. persons own (directly, indirectly, or constructively) more than 50 percent of the corporation's stock (measured by vote or value), taking into account only those U.S. persons that own such stock with at least 10 percent of foreign corporation's voting power. These U.S. persons, termed "U.S. shareholders," are taxed on their pro rata portion of a foreign corporation's subpart F income if such foreign corporation is a CFC for an uninterrupted period of 30 days or more during any taxable year.
The SFC Bill would make two changes to the CFC rules, generally effective for taxable years after 2017. First, like the House Bill, the SFC Bill would eliminate the requirement in Section 951(a)(1) of the Code that a foreign corporation be a CFC for 30 consecutive days in order for the anti-deferral regimes to apply; instead, these regimes would apply if a foreign corporation is a CFC at any time during the taxable year. Second, unlike the House Bill, the SFC Bill would modify Section 951(b) of the Code such that the term "U.S. shareholder" would be expanded to include any U.S. person who owns at least 10 percent of the total value (rather than exclusively 10% of the vote) of all classes of a foreign corporation's stock. The effect of these two changes would be to increase the number of U.S. persons subject to the anti-deferral rules under subpart F of the Code and to the proposed GILTI rules.
- Goodwill and "going concern" value subject to "deemed royalty" and transfer pricing rules
The SFC Bill includes two new proposals that would affect certain outbound transfers of goodwill, "going concern" value and similar intangible property. First, the SFC Bill would mandate that all outbound transfers of such property in otherwise tax-free transactions be subject to the rules of Section 367(d) of the Code, generally requiring the transferor to recognize the value of the transferred property over its useful life as deemed royalty payments. Second, the proposal codifies certain recently litigated transfer pricing regulations that permit the IRS to determine an arm's-length price under a "realistic alternative principle," i.e., by reference to a transaction (such as the owner of intangible property using it to make a product itself) that is different from the transaction that was actually completed (such as the owner of that same intangible property licensing the manufacturing rights and then buying the product from the licensee). These proposals, which are not contained in the House Bill, would be effective for transfers in taxable years beginning after December 31, 2017.
- Inbound intangible property transfers to CFCs
The SFC Bill contains a proposal that generally would permit CFCs to distribute certain intangible property to corporate U.S. shareholders without giving rise to U.S. tax. The proposal, for which there is no analogue in the House Bill, would exclude any gain on the distributed intangible property from the CFC's income. In addition, if such a distribution would not otherwise constitute a dividend for U.S. tax purposes, the distributee's basis in the CFC's stock would be increased so as to avoid gain recognition that might otherwise result from the distribution. The tax basis of the distributed property, however, would not be "stepped up" in the distribution, and may be decreased by the amount of any such increase in the distributee's basis in the CFC stock. The proposal would only apply to distributions made in taxable years of a CFC beginning after December 31, 2017 and before the last day of the CFC's third taxable year beginning after December 31, 2017.
- Hybrid transactions and entities
Beginning in 2018, the SFC Bill would generally deny a deduction for any interest or royalties paid or accrued to a hybrid entity14 or pursuant to a hybrid transaction15 to the extent that such amounts are paid or accrued to certain related parties that are not required to include such amount in (or are allowed to deduct such amount from) their taxable income. The House Bill does not contain a similar provision.
The SFC Bill grants the Treasury Department the authority to issue guidance applying this proposal in a variety of other circumstances, including in connection with conduit arrangements, foreign branches, and certain structured transactions, and where foreign preferential tax regimes may reduce or eliminate tax on interest or royalties received by the payee.
Wilson Sonsini Goodrich & Rosati will continue to monitor the progress of the House Bill and SFC Bill as they make their way through Congress.
For further information or to discuss any of the provisions described above, please contact Greg Broome (firstname.lastname@example.org, 415-947-2139); Nicole Gambino (email@example.com, 415-947-2117); Eileen Marshall (firstname.lastname@example.org, 202-973-8884); Sean Moran (email@example.com; 323-210-2916); Stuart Odell (firstname.lastname@example.org; 212-497-7711); Myra Sutanto Shen (email@example.com, 650-565-3815); Jonathan Zhu (firstname.lastname@example.org, 650-849-3388); or any member of the tax practice at WSGR.