Business Tax - 04 Dec 2017
IT’S TAX REFORM, JIM … (PART 2)
We last wrote on 8 November to report on the House of Representatives’ draft version of the “Tax Cuts and Jobs Act” (H.1), which was passed on November 16 by the House’s Republican majority, 227 votes to 205. The baton then passed to the Senate to adopt its own version of the bill (S.1). This was achieved in the early hours of Saturday morning by the slender margin of 51 votes to 49, with only one of the Senate’s 52 Republican members voting against.
In this process the Senate was obliged to observe budgetary constraints that have resulted in a reining in of many of the House’s measures, but without departing from the broad outlines. The staff of the Joint Committee on Taxation, Congress’ non-partisan “think tank” for evaluating tax legislation, issued a report projecting that the measures under consideration would increase the government’s budget deficit by over $1 trillion in the next 10 years, even after factoring in anticipated economic growth resulting from the changes. A net revenue projection from the IRS had also been promised by Treasury Secretary Mnuchin, but this has failed to materialize, leading to accusations that it has been suppressed because it doesn’t support the Administration’s claimed benefits of the proposed tax reform. This is being investigated by the independent Treasury Inspector General for Tax Administration.
The House of Representatives is scheduled to vote on December 4 to approve referring the legislation to a conference committee of representatives from the tax-writing committees of both houses, whose job it will be to eliminate differences between the two bills in time to pass final legislation before the end of 2017. Due to the Senate’s much smaller Republican majority, S.1 is likely to be the template for the final legislation, with any change that would cut tax in a particular area requiring a revenue-raising offset.
Following is a summary of the similarities and differences between S.1 and H.1.
a. Shift to a low-tax territorial system
The Senate has preserved the reduction in the rate of corporation tax from 35% to 20%, but for budgetary reasons has delayed its effective date for one year until January 2019. As before, a “participation exemption” will be introduced under which dividends received from 10%- or greater-owned foreign subsidiaries will be tax-free when distributed to the U.S. parent. The Senate has redrafted the provisions designed to tax domestic profits that are considered to have been shifted offshore, which would otherwise escape tax under the new regime. These are in the form of an add-on to the existing controlled foreign corporation rules.
The one-off tax on existing accumulated overseas profits of U.S. multi-nationals, on which U.S. tax is presently deferred, has been increased from 12% to 14.5%.
b. Major changes to corporate tax incentives
The reduction in the deductibility of interest expense by corporations, and the introduction of 100% expensing for most items of business property other than real property, are preserved. These changes would continue to take effect from the beginning of 2018.
a. Tax cuts and base broadening
While preserving cuts in individual tax rates, the Senate has increased the number of rate bands. Under S.1 there would be eight rate bands, including rates of 24% on taxable income between $140,000 and $320,000, 32% on taxable income between $320,000 and $400,000, 35% on taxable income between $400,000 and $1 million and a reduced rate of 38.5% applying to taxable income above $1 million (for married filing jointly). These cuts would continue to be effective from January 2018, but for budgetary reasons would expire in 2026.
The elimination of most itemized deductions, including the deduction for State and local income tax, is also preserved. This is continuing to draw protests from the higher taxing States, with predictions that some highly paid individuals (and their employers) in those States will move to States having lower or no income taxes. The House’s proposed repeal of the alternative minimum tax, which affects mainly taxpayers with disproportionately large itemized deductions or other “tax preference items”, has been reversed in the Senate, again as a cost-saving measure.
b. Reduced rates for flow-through business income
The reduction in the rate of tax for certain income from “pass-thru entities” (including sole proprietorships, partnerships and LLC’s), intended as a counterpart to the reduction in corporation tax, is provided in the form of a deduction equal to 23% of an individual taxpayer’s “qualified business income”. As under the House version, income from professional services does not qualify. For a top-rate taxpayer, the 23% deduction would reduce the effective rate of tax on qualified business income to 29.6%.
c. Estate tax reduction
For budgetary reasons, the Senate could not go along with the 2026 scheduled repeal of estate tax adopted in the House. However, it approved the House’s proposed doubling of the lifetime exemption from gift and estate tax (currently around $5.5 million per person, or $11 million for a married couple). This change, effective from January 2018, would currently benefit households with a combined net worth in excess of $11 million, producing savings of $4.4 million for any household having a combined net worth of $22 million or more.
Charities breathed a sigh of relief when the Senate backed off from outright repeal of the estate tax, as elimination of the estate tax would remove a major incentive for charitable giving by the very wealthy.
Funding the Reform
The 1.4% excise tax on net investment income of colleges which have large endowments relative to the number of students has been retained, with the level of endowment increased so that only approximately 30 U.S. colleges are expected to be subject to the levy. The requirement that “carried interest” holders hold their interests for a minimum of 3 years to obtain favourable long-term capital gain treatment has been retained. This is unlikely to have any impact on most recipients of such interests, but allows Congress to say that it has “dealt with” the issue of carried interests. Of interest to overseas investors into the U.S. will be the imposition of tax on gain from the disposal by a non-resident alien or foreign corporation of an interest in a partnership/LLC engaged in a U.S. trade or business, which as confirmed in a recent Tax Court decision currently escapes tax. This provision, which also imposes an obligation on the purchaser to withhold tax, is effective for disposals occurring after November 27, 2017.
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