Senate Tax Proposal Includes Comprehensive Business Tax Reform Measures
On November 9, 2017, Senate Finance Committee Chairman Orrin Hatch released his Chairman’s Mark of the Tax Cuts and Jobs Act (Senate Proposal), a comprehensive tax reform proposal including extensive proposed changes to the corporate and international tax rules. Earlier that same day, the House Ways and Means Committee approved its own version of the legislation, based on the bill introduced by Ways and Means Committee Chairman Kevin Brady on November 2, 2017 (House Bill). Both of these developments mark major milestones in the tax reform process, but many obstacles remain.
The Senate Finance Committee is expected to begin its mark-up of the Senate Proposal on November 13, 2017, and the full House is expected to vote on the House Bill early that same week. This is a critical period in the legislative process, as the potential ramifications of the legislation begin to come into focus for affected taxpayers, difficult revenue puzzles remain for the tax writers to solve, and inevitable criticism of the various revenue-raising measures in the legislation pours in.
This article details several noteworthy provisions of the Senate Proposal in the areas of corporate and international business taxation, including some points of contrast with the House Bill as approved by the Ways and Means Committee.
General Business Taxation
- Corporate income tax rate reduced to 20 percent, with no expiration, but with a delayed effective date (2019)
- Reduced effective tax rate for pass-through businesses (sole proprietorships, subchapter S corporations and businesses taxed as partnerships), other than certain services businesses, implemented in the form of a 17.4 percent deduction for qualifying income
- Accelerated recovery of certain capital expenses, including full expensing for a five-year period
- Deductibility of net interest expense only up to 30 percent of “adjusted taxable income” (defined under the Senate Proposal roughly as earnings before interest and taxes, with certain other adjustments)
- Elimination of the section 199 deduction for domestic production activities, but not the R&D credit or the low-income housing credit
- Net operating loss deduction limited to 90 percent of taxable income
It is noteworthy that the Senate Proposal implements the corporate rate cut a year later than the House Bill does, while allowing many (but not all) of the associated revenue raisers to take effect a year before the rate cut. It was inevitable that a 15-point rate cut with no delay, phase-in or expiration would prove difficult to achieve within the revenue parameters of the current budget resolution, but the implementation of revenue raisers such as new interest limitations prior to the rate cut will prove controversial. Another obvious way to ease the revenue pressure on the legislation would be to settle on a rate slightly higher than 20 percent, but doing so would carry political challenges of its own. As the saying goes, “tax reform is hard.”
- Territorial dividend exemption for 100 percent of foreign-source dividends received from foreign subsidiaries (in which a US parent owns at least 10 percent of the stock)
- Transition tax on accumulated foreign earnings under a deemed-repatriation model, employing a bifurcated rate (10 percent for earnings considered as held in the form of cash or cash equivalents, and 5 percent for other earnings), with fixed determination dates designed to prevent manipulation of earnings and cash amounts, and payable over eight years
- Imposition of a minimum tax on above-routine foreign earnings (termed global intangible low-tax income, or GILTI) on a current basis, at the 20 percent rate, subject to a 37.5 percent deduction, as well as a reduced (80 percent) foreign tax credit
- Allowance of the aforementioned 37.5 percent deduction for income earned directly by US taxpayers from serving foreign markets, along with a measure reducing tax barriers to transferring intangible property from foreign affiliates to a US affiliate
- Preservation of most existing rules of Subpart F, including the foreign personal holding company income, foreign base company sales income and foreign base company services income rules, as well as the controlled foreign corporation look-through exception of section 954(c)(6) (which would be made permanent)
- Expansion of the definition of intangible property applicable for purposes of sections 367(d) and 482, as well as expansion of the Internal Revenue Service’s (IRS’s) authority to price related-party transactions on an aggregate basis and through the use of “realistic alternatives” theories
- Imposition of a new excess-leverage restriction that limits a US group member’s ability to deduct net interest expense if its debt is more than 110 percent of what its debt would have been if its debt-to-equity ratio were the same as that of the worldwide group (coordinated with the general 30 percent limit noted above, such that the provision resulting in the greater disallowance amount applies)
- Adoption of a new anti-hybrid rule denying deductions for interest and royalties paid to related foreign persons, where the payments either are not includible or are deductible in the hands of the recipient in its residence country
- Introduction of a new alternative minimum tax targeting “base erosion,” under which a US company of a certain size and making a certain level of deductible, depreciable or amortizable payments to foreign affiliates would have to pay the excess (if any) of 10 percent of its taxable income determined without reference to such payments over its tax liability as determined under the normally applicable rules
The international provisions of the Senate Proposal are broadly similar to those in the House Bill, with some notable exceptions. Whereas the House Bill as reported by the Ways and Means Committee has been modified to propose a 14 percent transition tax rate on earnings treated as held in the form of cash and cash equivalents, and a 7 percent rate on other earnings, the Senate Proposal includes lower rates of 10 and 5 percent, respectively. In addition, the Senate Proposal’s eight-year payment for the transition tax is back-loaded, with payments escalating over the eight-year period, unlike the ratable payment under the House Bill.
The Senate Proposal’s GILTI rules for premium income of foreign subsidiaries are generally more burdensome than the corresponding foreign high returns rules of the House Bill. Although the GILTI rules provide a sort of “minimum tax” like the House Bill’s foreign high returns rule, the amount of the minimum tax is higher under the Senate Proposal (even taking into account the 37.5 percent deduction). The Senate Proposal also provides an “innovation box” of sorts by allowing a partial deduction for US taxpayers serving foreign markets.
The Senate Proposal’s changes to the definition of intangible property and its expansion of the IRS’s ability to apply aggregation and “realistic alternatives” theories would allow the IRS to pursue transfer pricing theories that have been repeatedly rejected by the courts, and would introduce further uncertainty into the application of the arm’s length standard. The House Bill includes no such proposal.
The Senate Proposal does not include the controversial new 20 percent excise tax on certain payments to related foreign parties that was included in the House Bill. Instead the Senate Proposal includes the new base erosion alternative minimum tax, which would prove burdensome in many cases but is more narrowly drawn than the House Bill’s excise tax. For example, in most cases, the Senate Proposal would not apply to cross-border purchases of inventory includible in cost of goods sold. The Senate Proposal also includes anti-hybrid rules absent from the House Bill.
The Senate Proposal is sure to see significant changes going into and during the Senate Finance Committee mark-up and beyond, and the House Bill could even see a substantive manager’s amendment ahead of House floor action. Of particular note, it does not appear that either version of the legislation as currently conceived would pass muster under reconciliation procedures in the Senate, requiring that the legislation not add to federal budget deficits outside the 10-year budget window in order for the legislation to clear the Senate with only a simple majority vote.
Countless technical, political and revenue difficulties remain to be solved, and the outcome of the effort remains highly uncertain, but some important hurdles have been cleared in both the House and the Senate. The rest of 2017 will be a very interesting and possibly eventful time for taxpayers and tax policymakers alike.