A “Tax Check-up” of Existing Arrangements and Proposed New Activities is Highly Recommended in Light of the Many New Changes Resulting from the 2017 US Tax Reform Legislation
09/06/2018In addition to the headline changes to both corporate and individual tax rates, the 2017 tax reform legislation has made numerous substantive changes to the manner in which business and investment income of US and non-US persons is taxed in the US and the amount of such US tax. For example, included among the new US tax rules is a revolutionary provision, IRC section 965, which, as described below, for the first time treats previously deferred overseas business profits of certain non-US corporations as if such profits had been distributed, taxes such deemed distributions currently at reduced rates and permits such tax to be paid over eight years. Certain of the technical and practical issues raised by that new provision are addressed in an article we authored that appears in Tax Notes, a copy of which article may be found nearby. In addition, substantial changes were made to the manner in which income earned abroad that under prior law could have been deferred until repatriation will be taxed going forward. These are but a few of the many changes that will have a significant impact on the US taxation of business and investment income, creating both opportunities and pitfalls. The most significant changes, and their likely impact, include (but are by no means limited to) the following:
1. Reduced tax rates should prompt a reconsideration of the optimal manner in which to conduct activities. The new tax law affords a substantial reduction in the corporate tax rate from 35% to 21%, and a more modest reduction in the maximum individual tax rate (but only through 2025) from 39.6% to 37%. These changes, together with other changes described below, require a reconsideration of whether activities are more optimally conducted in corporate form and indeed makes the choice of the type of entity for conducting business and investment activities a subject for renewed consideration. In addition to the effect on profits for financial purposes, the reduced corporate tax rate will have many other significant impacts on the manner in which business is conducted, including a reduction in the tax cost to issuers/employers of compensatory stock options and other methods of deferred compensation, rendering so-called “excessive compensation” issues moot as a practical matter in most cases, and in certain cases raising the issue of whether it is more cost-effective to pay less rather than more by way of deductible salaries and more rather than less by way of dividends.
2. The virtual elimination of the deduction for state and local taxes imposed on non-business income and non-business property may require a reconsideration of whether individuals should consider changes of residence. The new tax law effectively eliminates, for many, deductions for non-business state and local income and property taxes through 2025, raising the cost of residing in high-tax states such as New York, California, New Jersey and Connecticut. Certain states have introduced or are considering legislation the objective of which is to partially “work around” this new limitation, and the IRS in response has issued a notice and proposed regulations which, if finalized in their current form and upheld, would render a number (but not all) of the workarounds that have been introduced ineffective. As a result, since it is not clear whether certain of the workarounds will prove effective, individuals who are otherwise mobile and are so inclined may wish to consider whether continuing to be resident in a high-tax state meets their overall goals, whether a change in residence makes sense and whether their particular circumstances would permit any such change.
3. The significant increase in the standard deduction may limit the tax benefit of charitable contributions. The new tax law substantially increases the standard deduction that is available as an alternative to itemizing deductions. The reduction in the deduction for state and local income and property taxes, when combined with this substantial increase in the standard deduction, will for many limit the benefit of charitable deductions and as a result may well have a substantial practical impact on the ability of tax-exempt organizations to raise contributions from the general public. To avoid these limitations, charitably minded individuals may wish to consider forming private foundations to receive “bunched” contributions in sufficient amounts as to be unaffected by the practical effect of these rules.
4. The new deemed-repatriation tax raises technical issues and planning opportunities. The deemed repatriation of certain previously deferred post-1986 overseas profits under IRC section 965, which as noted above is the subject of our article referred to above that questions the validity of this new tax, is a required current inclusion by US shareholders of certain non-US corporations. This new current inclusion is not limited to income attribution from “controlled foreign corporations” (CFCs) and could in certain circumstances apply to individual and corporate shareholders alike who under broader attribution rules than applied in the past are considered to own as much as 10% of the shares of a non-US corporation. US shareholders subject to these provisions are effectively subject to a reduced rate of tax on the amounts deemed to be repatriated, and may generally pay this tax over an eight-year period (and in certain limited cases longer) if certain elections are timely made. These provisions raise a number of significant technical issues (certain of which are discussed in the article referred to above) and planning opportunities, including the possible application of the election afforded to individual shareholders by IRC section 962 that has the effect of permitting such shareholders to obtain the benefit of tax credits for non-US taxes paid by the non-US corporations in respect of the earnings deemed to be repatriated.
5. The new tax regime applicable to foreign business profits requires a reconsideration of existing arrangements and structures for proposed new activities.
a. New current tax on business profits. Going forward, there is a new regime for currently taxing US shareholders of CFCs owning as much as 10% of the shares on a significant portion of the business profits of the CFC that is layered on the existing complex rules applicable to “subpart F income” of CFCs. In the case of shareholders that are US corporations (and others who may elect to be treated as such), the applicable tax rate on the current inclusions required by the new provisions will generally be reduced to 10.5% (or 13.125% after 2025), against which 80% of attributable foreign taxes may be credited. As a result, at least until 2025: (a) to the extent the foreign business profits of a CFC are subject to foreign tax at an effective rate of at least 13.125%, there will be no residual US corporate tax to its US shareholders that are US corporations, and (b) the global tax burden on US corporations that are US shareholders of CFCs on their foreign business profits will range from a low of 10.5% (if the effective foreign tax rate is zero) to a high equal to the sum of 10.5% plus 20% of the first 13.125% of the effective foreign tax rate plus 100% of the effective foreign tax rate in excess of 13.125%. While US shareholders of CFCs who are individuals are taxable at the full individual rates on these required inclusions from CFCs, subject to further guidance it is possible that were such a shareholder to elect under IRC section 962 to be effectively treated as a corporation with respect to such inclusions, the lower corporate rate would apply. However, for many, and subject to other considerations such as the possible application of the accumulated earnings tax, it may be preferable to hold shares of non-US corporations the profits of which would be attributed under these new provisions through US corporations rather than individually or through unincorporated entities. In any case, this new regime requires a reconsideration of the benefits as compared with the cost of maintaining or altering existing structures for the conduct of non-US operations and a reappraisal of the most cost-effective methods for reducing global tax.
b. No tax on dividends attributable to foreign business profits. Further, a US corporation that owns at least 10% of the shares of a non-US corporation that is engaged in business activities abroad (whether or not a CFC) may receive dividends attributable to the foreign earnings tax-free. This 100% dividends-received deduction does not apply to US shareholders who are not corporations, whether or not an election under IRC section 962 is made. However, income attributed under the new provisions described above will not be taxed again when distributed. This change may result in much greater opportunities than under prior law, for example, for the conduct of non-US operations in low-tax jurisdictions through non-US corporations that are not CFCs.
c. Lower tax rate on certain foreign income of US corporations. The reduced 21% corporate tax rate is further reduced to 13.125% (16.40625% after 2025) (the effective US rate) on certain income attributable to property sold to non-US persons for a foreign use and the provision of services to a person, or with respect to property, not located within the US. One effect of these rules is that a US corporation would derive no tax benefit from conducting activities that will give rise to income subject to this special lower rate through a CFC rather than directly so long as the foreign profits to which this special rate applies are subject to non-US tax at a rate at least equal to the effective US rate.
d. Impact of these new rules on existing and new arrangements. In light of these new rules, considering the optimum structure for non-US activities, including whether such activities should be conducted by a US corporation (perhaps through foreign disregarded entities) or a foreign corporation, requires consideration not only of the above-described rules and the effective foreign tax rate imposed on income derived from such activities, but also of existing rules that continue to apply, such as the rules relating to required inclusions of subpart F income, the rules that, with certain conditions, permit previously-taxed income to be distributed without further tax on the distribution, the benefits and possible detriments to an individual shareholder of a CFC of making the IRC section 962 election and the possible application of the existing accumulated earnings tax provisions.
6. The new lower tax rate on certain US income of taxpayers other than corporations presents planning opportunities. The new tax law includes a new highly publicized, albeit limited, lower tax rate (as low as 80% of the otherwise applicable tax rate) on certain US business income of “pass-through entities” such as partnerships and S corporations and sole proprietors, but only through 2025. This special tax rate is not applicable to income from certain excluded service activities such as the conduct of a business involving the performance of services in fields such as law, health, performing arts, athletics, financial or brokerage services and business consulting in excess of an income threshold.
7. Stricter limits on interest deductions may affect the choice of debt or equity funding and raise liquidity concerns. The prior interest-stripping rules that applied to limit the current deductibility of interest paid to related persons that were not subject to full tax on the receipt of the interest have been replaced with rules disallowing a portion of otherwise-allowable interest deductions attributable to certain, but by no means all, business activities (for example, certain real estate activities may by election be, and certain other business activities are, excluded from the operation of this new limitation) of taxpayers with gross receipts in excess of $25 million. The new limitations apply regardless of the identity of the recipient of the interest or the relationship of that recipient to the debtor. Where applicable, this new limitation may raise liquidity issues for borrowers and lenders alike and may affect the choice of debt or equity funding.
8. New limits on the deduction of net operating losses could also raise liquidity concerns. The new law completely eliminates net operating loss carrybacks and limits the use of net operating loss carryforwards such that no more than 80% of taxable income may be offset by carryforwards. These new rules, too, could raise liquidity issues.
9. Longer holding period for “carried interests” may require careful planning. Under the new law, the holding period required in order for favorable long-term capital gains rates (generally reduced from 40.8% to 23.8%) to apply to a partner’s distributive share of the gains realized by a partnership (and perhaps to gain on the disposition of a partnership interest) is increased from more than one year to more than three years where the partner received or holds its partnership interest in connection with the performance of substantial services in the business of raising capital or investing in, disposing of or developing securities, commodities, real estate, cash, cash equivalents or derivatives, The longer holding period does not apply to partners that are corporations (but, according to the Treasury Department, is fully applicable to S corporations) or to a capital interest that is commensurate with capital contributed by the partner. Investment managers of hedge funds and other investment funds having investment horizons of three years or less may wish to consider alternative structures for their economic interests in the funds that may well mitigate the adverse effects of the new legislation.
10. New minimum corporate tax is applicable to certain large corporations. While the generally applicable corporate alternative minimum tax has been repealed and the individual alternative minimum tax has effectively been repealed for many individuals, a new “base erosion” minimum tax is imposed on corporations having gross receipts of at least $500 million.
11. Increased estate and gift tax exclusions present income, gift and estate tax planning opportunities. The new tax law significantly increases the amount of the exclusion for estates and gifts, but only through 2025, requiring a consideration of whether additional gifts might make sense. The new lower corporate tax rate and other changes in the income tax rules may also require a re-thinking of the manner in which non-US persons invest in US-situs assets such as US real estate.
The above is by no means an exhaustive list of the new tax provisions that could have a significant impact on the US taxation of businesses and investments. And since the US Treasury Department is still in early stages of the process of issuing what will no doubt be thousands of pages of guidance regarding the new provisions in the form of IRS notices and proposed regulations, it remains to be seen how numerous technical issues under these provisions will ultimately be resolved. In addition, the changes are layered on an already-complex tax code, the unaltered provisions of which, as they have been interpreted from time to time by the IRS and the courts, still apply, with the result that the new provisions cannot be read in isolation. Moreover, the changes made to the federal system of taxation will in a number of cases also have an indirect ripple effect at the state and local level, absent effective responsive changes by the states to their tax rules. These changes and many others embedded in the new provisions present both opportunities and pitfalls for taxpayers and require in a number of cases careful study and re-thinking whether existing structures and methods of conducting business or investment activities and current succession planning remain optimal in light of the new provisions.
It would be advisable for taxpayers and their advisers to obtain an independent review of their particular situations -- a tax check-up, if you will, by experienced tax professionals specializing in these matters -- to determine whether in a particular situation a change is warranted in light of the new tax landscape. This is particularly the case for (a) clients with overseas activities or interests, (b) clients who wish to avail themselves of the new law’s special deductions with respect to their domestic and foreign activities and who may or should be concerned with the various increased or relaxed limitations under the new rules and (c) more generally clients who are about to embark on new activities, acquisitions, restructurings and the like. If we can be of any assistance to you or your clients regarding the effect the new changes could have on a particular situation, please let us know. We look forward to being of service.
News & Notes