House Bill Proposes Big Changes to Personal and Corporate Taxes

© 2017 The Texas Lawbook.

By Jeff Munk and Michael Bresson of Baker Botts

(Nov. 27) – The House Ways and Means Committee recently released the Tax Cuts and Jobs Act, a bill that attempts – for the first time in 30 years – a complete overhaul of the Internal Revenue Code.

After years of blueprints, frameworks and speeches, Speaker Paul Ryan and Chairman Kevin Brady will try to move the bill quickly through the legislative process, with the bill undergoing markup this week and debate by the full House of Representatives 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 percent-owned foreign subsidiaries. This would move the United States to a territorial tax system, which is used by a majority of Organization for Economic Cooperation and Development members.

Plus the bill imposes a tax on high return income earned through foreign subsidiaries and a 20 percent excise tax on deductible payments other than interest made by U.S. corporations to foreign affiliates.

For individuals, the changes include a maximum 25 percent rate for qualified business income from 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 percent of the income subject to the 25 percent rate and the remaining 70 percent 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 percent 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 bill reduces the corporate rate to 20 percent beginning in 2018. To pay for this, interest deductions are limited to 30 percent of “adjustable taxable income,” and deductions of net operating loss carry forwards are limited to 90 percent of taxable income. The Section 199 domestic production deduction is repealed, and most other tax credits are repealed or modified.

Cost recovery

The bill allows full expensing of capital assets except for structures for five years starting Sept. 27, 2017. 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 bill puts a limit on interest deductions at 30 percent 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 they may not fully expense new capital assets, either. They remain under the current code provisions.

International

The bill moves the U.S. 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 percent 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 percent-owned foreign corporations are generally subject to a one-time toll charge of 14 percent, payable over eight years.

Earnings and profits invested in other assets get a lower rate of 7 percent. This toll charge can apply to U.S. 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 and Means Committee as “an acute source of erosion of the U.S. tax base.” A new provision designed to remove this incentive would subject half of a U.S. 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 net income (other than Subpart F income, effectively connected income, active financing income, insurance income, certain income from commodities transactions, and certain income from transactions between related foreign subsidiaries) over a routine return of 7 percent 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 percent 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 and local economic development incentives

The bill would require a taxpayer to include in its federal gross income any 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 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 the 20th, and that there are some significant differences as compared to the House bill that will need to be worked out between the Chambers.

Jeff Munk is a partner at Baker Botts who specializes in high-stakes governmental relations matters, including corporate taxation and energy policy. Mike Bresson is a partner at Baker Botts whose practice focuses on federal income tax matters and publicly traded partnerships. He leads the firm’s MLP practice. Other Baker Botts lawyers who contributed to this article include Richard Husseini, Derek Green, Don Lonczak, Matt Hunsaker, Steve Marcus, Matt Larsen, Renn Neilson, Tamar Stanley, Bobby Phillpott, Jon Lobb, Josh Mandell, Jon Nelsen and Ron Scharnberg.

© 2017 The Texas Lawbook. Content of The Texas Lawbook is controlled and protected by specific licensing agreements with our subscribers and under federal copyright laws. Any distribution of this content without the consent of The Texas Lawbook is prohibited.

If you see any inaccuracy in any article in The Texas Lawbook, please contact us. Our goal is content that is 100% true and accurate. Thank you.