“Should Five Percent Appear Too Small, Be Thankful I Don’t Take It All”: Ways and Means Committee Advances Tax Increase and Reform Proposals
Several tax reform proposals are under consideration as part of the “Build Back Better” reconciliation legislation. Set forth below is a summary of the key tax provisions in the proposed legislation advanced by the House Ways and Means Committee.
Notably absent from the Ways and Means Committee proposals was any mention of changes to the limitation on deductibility for state and local taxes (SALT) by individuals. House Democrats have stated publicly that they are committed to providing “meaningful” SALT relief and that they are working “daily” toward that goal.
Increases to Tax Rates
Corporate Income Tax. The draft bill proposes to replace the flat U.S. corporate federal income tax rate with a graduated U.S. corporate federal income tax rate. If passed, the provision would increase the U.S. corporate federal income tax rate from 21 percent to 26.5 percent for businesses with taxable income in excess of $5 million. Businesses with taxable income between $400,000 and $5 million would remain subject to the current 21 percent rate, and businesses with taxable income of less than $400,000 would be subject to an 18 percent rate. The proposed rates would be effective for tax years beginning after December 31, 2021.
Individual Income Tax and Surcharge. The proposals include an increase to the highest U.S. federal individual income tax rate from 37 percent to 39.6 percent, effective for tax years beginning after December 31, 2021. Additionally, the draft legislation proposes an additional 3 percent surtax on individuals, trusts, and estates with modified adjusted gross income in excess of $5 million, effectively creating another top tax bracket.
Capital Gains Rates. The draft legislation proposes an increase to the current top U.S. federal income tax rate for individuals on long-term capital gains and qualified dividend income from 20 percent to 25 percent. The new rate would be effective for tax years ending after September 13, 2021. A transition rule provides that the 20 percent rate would continue to apply for transactions entered into during the portion of the tax year prior to September 13, 2021, as well as to gains recognized between September 13, 2021 and December 31, 2021 that arise from a transaction pursuant to a written binding contract entered into on or before September 13, 2021 (and that is not materially modified thereafter).
Changes Affecting Business Owners
Section 1202 Qualified Small Business Stock Exclusion. The proposed legislation would eliminate the special 75 percent and 100 percent exclusion rates for gains from the sale of “qualified small business stock” under section 1202 of the Internal Revenue Code (the Code) for taxpayers with adjusted gross income equaling or exceeding $400,000 (determined without regard to section 1202, meaning that a taxpayer that realizes a gain from the sale of qualified small business stock under section 1202 in excess of $400,000 would not be eligible for the 75 percent / 100 percent exclusion rates, even if the taxpayer does not have other income). Under the proposed legislation, however, the baseline 50 percent exclusion would remain available to all taxpayers. This proposal would apply to sales and exchanges on or after September 13, 2021 unless taxpayers had entered into a binding commitment to sell stock prior to September 13, 2021.
R&E Expenditures. The 2017 Tax Cuts and Jobs Act (the TCJA) eliminated the immediate expensing of research and development costs, requiring capitalization of all research and development costs incurred in tax years beginning after December 31, 2021. Under the present provision, capitalized research and development costs will be deductible over five years if the research and development activities are performed in the United States or fifteen years if the activities are performed outside of the United States. The proposed provision would delay the amortization of the research and experimental expenditures from amounts paid or incurred in taxable years beginning after December 31, 2021 to take effect for amounts paid or incurred in taxable years beginning after December 31, 2025.
Net Investment Income Tax. Under current law, net investment income does not include income derived in the ordinary course of a trade or business for purposes of calculating the tax on net investment income. The proposed legislation would eliminate this exception as well as broaden the type of income subject to the net investment income tax. The provision would apply to taxpayers with taxable income greater than $400,000 (single filers) or $500,000 (joint filers) and for trusts and estates.
Section 199A Deduction for Pass-Through Business Income. The proposals include limiting the Section 199A deduction for pass-through business income to $400,000 (single filers) or $500,000 (joint filers). This deduction was a significant component of the TCJA and this limitation could significantly increase income taxes for business owners making more than these thresholds. If enacted, this will affect the relative benefits of investing through a “C” corporation or a pass-through entity for income tax purposes, and business owners may wish to take a fresh look at their structures as a result.
Excess Business Losses. The TCJA limited non-corporate taxpayers’ ability to deduct excess business losses—the excess of the aggregate business gross deductions over aggregate business gross income—to $250,000 per year (or $500,000 for joint filers), with unused excess business losses carried forward as net operating losses. Under The Coronavirus Aid, Relief, and Economic Security (CARES) Act, Congress delayed the effective date of the limitation until 2021 such that the limitation would apply for tax years 2021-2025. The proposed legislation would make permanent this rule for tax years beginning after December 31, 2021 (whereas it would otherwise expire in accordance with the TCJA after 2025). As a result, taxpayers may see a larger tax bill while they wait to deduct the excess losses.
Carried Interests. The holding period to obtain long-term capital gains treatment for gain allocated to certain carried interests treated as “applicable partnership interests” is currently three years. This proposal would extend the holding period from three to five years. The three-year holding period would remain in effect for real property trades or businesses and for taxpayers with an adjusted gross income of less than $400,000. The proposal would be effective for taxable years beginning after December 31, 2021.
Treatment of Certain Losses. By amending Section 165(g), the proposed legislation would treat losses with respect to securities as realized on the day that the event establishing worthlessness occurs instead of on the last day of such tax year. This change would also affect the treatment of partnership indebtedness with respect to worthless securities.
Adjusted Basis Limitation for Divisive Reorganizations. The proposals would amend Section 361 to provide that a distributing corporation in a divisive reorganization recognizes gain to the extent the distributing corporation distributes controlled corporation debt securities to its creditors in excess of its basis in the assets it transfers to the controlled corporation as part of the transaction.
Modification of REIT Constructive Ownership Rules. The proposed provision would modify the real estate investment trust (REIT) constructive ownership rules by providing that stock, assets, and net profits constructively owned by a partnership, estate, trust, or corporation by reason of the application of the “downward” attribution rule are not considered as owned by such entity for purposes of re-applying the applicable section of the Code to make another person the constructive owner of such stock, assets or net profits.
International Tax Proposals
Modifications to the Portfolio Interest Exemption. Under current law, interest payments on certain debt issued to non-U.S. persons may be eligible for a complete exemption from U.S. withholding tax under the “portfolio interest” exemption. The exemption is not available, however, with respect to interest payments made to a person who owns 10 percent or more of the total voting power of the issuer. The proposed legislation proposes to further limit the exemption so that it is not available to persons who own 10 percent or more of the total voting power or value of the issuer. As a result, a non-U.S. investor who holds a disproportionately high amount of the equity of an issuer but who holds less than 10 percent of the voting power in the equity of the issuer and who would otherwise be eligible for the portfolio interest exemption under current law would no longer be eligible for the exemption. This change would apply to obligations issued after the date of enactment. Accordingly, potentially affected taxpayers should consider whether existing debt arrangements could be modified before enactment and whether withholding obligations could be imposed on payers in respect of payments made after enactment.
Interest Expense of International Financial Reporting Groups. The Ways and Means Committee proposes the addition of a new section to the Code that would limit the interest deduction for certain domestic corporations that are part of an “international financial reporting group,” which is defined as a group of at least two members, one of which is foreign.
The provision would apply to domestic corporations whose average excess interest expense paid or accrued over a three-year period over the average interest includable in the gross income of the company for that period exceeds $12,000,000.
Any such corporations would only be permitted to deduct interest expense up to a limit of 110 percent of the group’s “net interest expense” (i.e., the ratio of such corporation’s allocable share of the group’s net interest expense over such corporation’s reported net interest expense).
Modifications to Treatment of Certain Losses. The proposed provision changes the treatment of taxable liquidations of corporate subsidiaries in a controlled group of corporations. Under the provision, a loss in a taxable liquidation is deferred until the property received in the liquidation is sold to a third party. This provision is applicable to liquidations after the date of enactment of the proposed legislation.
Thus, losses on liquidations of corporations where there is an in-kind distribution would be disallowed or deferred. This would make corporate liquidations more like partnership liquidations.
Tax Proposals Applicable to GILTI and FDII
Modifications to Deduction for FDII and GILTI. This proposed modification would reduce the section 250 deduction with respect to both Foreign-Derived Intangible Income (FDII) and Global Intangible Low-Taxed Income (GILTI). In combination with the proposed 26.5 percent corporate tax rate, this would yield an increased FDII rate of 20.7 percent (as opposed to the current 13.125 percent) and an increased GILTI rate of 16.5635 percent (as compared to the current rate of between 10 percent to 13.125 percent). Should the section 250 deduction with respect to either FDII or GILTI exceed taxable income, the excess is allowed as a deduction. This will increase the net operating loss for the taxable year. Presently, when taxable income is less than the deduction, the allowable deduction is reduced and the GILTI rate is increased when there are domestic losses. There is a transition rule for taxable years that include but do not end on December 31, 2021.
Country-by-Country GILTI Calculations. Under current law, the GILTI regime imposes a worldwide minimum tax on foreign earnings that is computed on a global approach. The proposed legislation would modify GILTI so that it is computed on a country-by-country basis, meaning that a United States shareholder’s GILTI would be the sum of the amounts of GILTI determined separately with respect to each country in which any controlled foreign corporation of the United States shareholder is a tax resident.
Other amounts, such as net controlled foreign corporation tested income, net deemed tangible income return, qualified business asset investment, and interest expense would also be determined on a country-by-country basis.
Modifications to “Deemed Paid Credit” Foreign Tax Credit Rules for GILTI. This provision would increase the “deemed paid credit” for taxes attributable to GILTI from 80 percent to 95 percent (and from 80 percent to 100 percent in the case of taxes paid or accrued to U.S. territories). Such modifications would apply to taxable years of foreign corporations beginning after December 31, 2021 and to taxable years of a United States shareholder in which or with which such taxable years of foreign corporations end.
Adjustments to Earnings & Profits of Controlled Foreign Corporations. Under current law, a dividend paid by a controlled foreign corporation to a domestic shareholder that has held the stock for less than two years in an amount in excess of a certain percentage of the shareholder’s basis in the stock is treated as an “extraordinary dividend,” which reduces the shareholder’s basis in such stock, and may give rise to a gain attributable to the amount deductible under the dividends received deduction. Under the proposed legislation, a dividend would be an “extraordinary dividend” regardless of how long the taxpayer held the stock if the dividend is paid out of earnings and profits while the corporation was not a corporation or while such stock was not owned by a domestic shareholder. This proposal could increase taxable dividend income to certain U.S. shareholders of foreign corporations.
Modifications to Foreign Tax Credit Calculations for “Dual Capacity Taxpayers.” Under the proposed legislation, any amount paid by a “dual capacity taxpayer” to a foreign country would not be considered a tax (for purposes of determining eligibility for U.S. foreign tax credits) to the extent that it exceeds the generally applicable income tax of that country. Dual capacity taxpayers are U.S. companies that are both subject to tax in, and receive certain benefits from, a foreign country or possession of the United States. “Generally applicable income tax” is defined as “an income tax which is generally imposed under the laws of a foreign country on income derived from the conduct of trade or business within such country, and has substantial applicability to persons who are not dual capacity taxpayers and to citizens or residents of that country.” The purported purpose of this provision is to prevent dual capacity taxpayers from claiming foreign tax credits for payments that are not deemed to be income taxes.
Deduction for Foreign Source Portion of Dividends. Section 245A of the Code provides a 100 percent participation exemption for the foreign portion of any dividends received from a specified 10-percent owned foreign corporation, even in cases where the foreign corporation is not a controlled foreign corporation (and thus not subject to subpart F and GILTI taxation). Under the proposed legislation, the exemption would only apply to foreign portions of dividends received from controlled foreign corporations. This provision would be effective retroactively for taxable years of foreign corporations beginning after December 31, 2017.
Modifications to BEAT. The proposed legislation makes several modifications to the Base Erosion and Anti-Abuse Tax (BEAT), including a scheduled rollout of an increased rate of tax. The BEAT rate would be amended to 10 percent in taxable years beginning after December 31, 2021 and before January 1, 2024; to 12.5 percent in taxable years beginning after December 31, 2023 and before January 1, 2026; and to 15 percent in any taxable year beginning after December 31, 2025.
The definition of “base erosion payments” would also be amended to include amounts paid to a foreign related party that is required to be capitalized in inventory under section 263A, as well as amounts paid to a foreign related party for inventory that exceeds the costs of the property to the foreign-related party (but not all costs of goods sold, as had been feared by some industry participants). However, a safe harbor would allow for taxpayers to deem base erosion payments attributable to indirect costs of foreign-related parties as 20 percent of the amount paid to the related party.
Further, the proposed legislation would also take into account tax credits and make other changes to the rules in calculating BEAT.
Former House Ways & Means member and U.S. Congressman Phil English remarked as follows regarding the proposed legislation:
“The Ways and Means Committee draft is a massive tax increase, but is a more sophisticated product than the original Biden Administration proposal. It makes the tax code significantly more progressive, but with less economic downside than the Treasury draft. I predict that it will require additional revision as the implications of these changes are better understood, and the Senate Finance Committee weighs in.
The net effect of this legislation would be to shift a larger tax burden to high earners and small businesses, while imposing uncompetitive corporate rates on domestic firms. The consequences for the national economy are likely to be enduring and negative. In the end, the odds are good that a major part of this legislation will become law, and for an extended period of time.”
– Phil English, Senior Government Relations Advisor
The Arent Fox tax team will continue to monitor for updates related to the proposals discussed above as well as any additional proposed tax reform. To discuss how these proposed changes may affect your business, please contact the tax professionals at Arent Fox.