Yesterday the House Ways & Means Committee released the Tax Cuts and Jobs Act, a bill that, for the first time in more than thirty years, attempts a complete overhaul of the Internal Revenue Code. After years of blueprints, frameworks, and speeches, Speaker Ryan and Chairman Brady will try to move the bill quickly through the legislative process, with the markup planned for Monday November 6th, and debate by the full House of Representatives planned for the following week.
Major changes are proposed to individual, corporate, pass-through, and international tax provisions, but unlike the more general discussions released earlier, the House bill provides specifics, such as phase-ins and effective dates. Two fundamental changes are the repeal of the alternative minimum tax, and an exemption for foreign-source dividends received by U.S. corporations from 10%-owned foreign subsidiaries, thereby moving the United States to a territorial tax system, which is used by a majority of the OECD. Plus the bill imposes a tax on high return income earned through foreign subsidiaries and a 20% excise tax on deductible payments (other than interest) made by U.S. corporations to foreign affiliates.
For individuals, the changes include a maximum 25% rate for qualified business income of partnerships, S corporations, and sole proprietorships. All passive business income is qualified business income. With respect to active income, taxpayers will have a choice between two methods of allocation: one based on their capital percentage in the business, and the other a bright line allocation of 30% of the income subject to the 25% rate and 70% of the income subject to ordinary rates. However, income from services such as accounting, law, consulting, engineering, financial services and performing arts would not be eligible for the 25% rate on any income, and all such income would be subject to the individual tax rates on ordinary income. The House Bill eliminates the individual income tax deduction for state and local income and sales taxes, but allows a deduction for property taxes up to $10,000.
For businesses, the key provisions include:
Corporate. The House bill reduces the corporate rate to 20% beginning in 2018. To pay for this, interest deductions are limited to 30% of "adjustable taxable income," and deductions of net operating loss carry forwards are limited to 90% of taxable income. The section 199 domestic production deduction is repealed, and most other tax credits are repealed or modified.
Cost-recovery. The House bill allows full expensing of capital assets except for structures starting September 27, 2017, for five years. This provision follows the bonus depreciation rules, including the ability to elect out of full expensing. The bill also repeals like kind exchange treatment for personal property, such as automobile and equipment lessors. With full expensing being allowed, this change may not have much impact.
Interest Expense. The House bill puts a limit on interest deductions of 30% of "adjusted taxable income," which is taxable income before deductions for interest, cost recovery and net operating loss carryovers. Public utilities and real estate businesses are not subject to the limitation on interest expense, but may not fully expense new capital assets, either. They remain under the current code provisions.
International. The House bill moves the United States to a territorial income tax system through a dividend exemption. Foreign-source dividends earned by a U.S. corporation from a foreign corporation in which the U.S. corporation owns a 10% or greater interest will be exempt from U.S. tax after 2017. No foreign tax credit will be allowed for any foreign taxes (including foreign withholding taxes) paid with respect to an exempt dividend. Earnings and profits held offshore today in cash positions through 10%-owned foreign corporations are generally subject to a one-time toll charge of 12%, payable over 8 years. Earnings and profits invested in other assets get a lower rate of 5%. This toll charge can apply to US shareholders other than C corporations, and the bill contains special deferral rules for shareholders that are S corporations.
U.S. Tax Base Erosion. The allocation of intellectual property and risk income by U.S. companies to low or no tax jurisdictions is viewed by the Ways & Means Committee as "an acute source of erosion of the U.S. tax base." A new provision designed to remove this incentive would subject 50% of a US parent company’s "foreign high returns" to U.S. tax. "Foreign high returns" are generally the excess of a U.S. parent’s foreign subsidiaries’ aggregate income over a routine return of 7% plus the Federal funds rate on the adjusted tax basis of its depreciable tangible assets, less interest expense. Such high return income will be treated similarly to Subpart F income. Another provision would impose a 20% excise tax on deductible payments (other than interest) made by a U.S. corporation to certain foreign affiliates if the U.S. withholding tax on such payments is otherwise reduced by a U.S. tax treaty.
State & Local Economic Development Incentives. The House Bill would require a taxpayer to include in its federal gross income transfer of money or property that it receives from state or local governments as consideration for locating operations within that jurisdiction.
It remains to be seen if this bill will stand up to political scrutiny. One major theme overlooked in the debate so far is the extent to which voters perceive that individual taxes are increased in order to reduce the tax rates for business. Many traditionally Republican-aligned associations oppose the bill, including the National Federation of Independent Business, the National Association of Home Builders, and the National Association of Realtors, so its future is uncertain. Similarly, if temporary rate cuts and expensing are being paid for with permanent tax increases through the loss of tax benefits, constituents may object. Some will recall that the base-broadening of the 1986 Tax Reform Act remained, while the lower rates disappeared.
The Senate is expected to release its bill on Thursday, November 9th, and may take a different approach than the House.
The provisions described herein are complex, and may change throughout the legislative process. Baker Botts tax attorneys will be tracking the legislation and ready to answer your questions as tax reform develops.
For a discussion of the executive compensation tax proposals of the House bill, please see here.
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