On January 25, 2022, the Internal Revenue Service (the “IRS”) and the Department of the Treasury (“Treasury”) released regulations (the “Final Regulations”) finalizing provisions in prior proposed regulations which generally would treat domestic partnerships as aggregates of their partners (rather than as entities) for purposes of determining income inclusions under the Subpart F provisions applicable to certain shareholders of controlled foreign corporations.[1] Under the aggregate approach, a partner in a domestic partnership would have a Subpart F inclusion from an underlying CFC only if the partner itself is a US shareholder of the CFC.
Senator Manchin Announces That He Will Not Support the Build Back Better Act – Where Things Stand Now
Today, December 19, 2021, Senator Joe Manchin (D., W.Va.) said that he opposes the Build Back Better Act, which effectively prevents its passage. While there are no immediate prospects for the Build Back Better Act to become law, future tax acts tend to draw upon earlier proposals. With a view to future tax proposals, this blog summarizes the final draft that was released by the Senate Finance Committee on December 11, 2021 (the “Build Back Better Bill”), and compares it to the bill passed by the House of Representatives (the “House Bill”) and the prior bill that was released by the House Ways and Means Committee in September 2021 (the “Prior House Bill”), which the House Bill was based on. In light of Senator Manchin’s announcement, this blog refers to the bills in the past tense.
Summary of Significant Changes to Current Law in the Build Back Better Bill
Individual taxation
- A 5% surtax would have been imposed on income in excess of $10 million ($5 million for a married individual filing a separate return) and a 3% additional surtax would have been imposed on income in excess of $25 million ($12.5 million for a married individual filing a separate return). The surtax would have also applied to non-grantor trusts but at significantly lower thresholds – the 5% surtax would apply to income in excess of $200,000 and the 3% surtax would apply to income in excess of $500,000. The individual income tax rates would have otherwise remained the same as under current law.
- The 3.8% net investment income tax would have been expanded to apply to the active trade or business income of taxpayers earning more than $400,000. As a result, active trade or business income allocated to a limited partner of a limited partnership or a shareholder of a subchapter S corporation would have been subject to the net investment income tax. Under current law, the tax applies only to certain portfolio and passive income. Under current law, a limited partner of a limited partnership and a shareholder of a subchapter S corporation is otherwise not subject to self-employment taxes. The Build Back Better Act would not have had otherwise imposed self-employment taxes on S corporation shareholders or limited partners.
- The exemption of gains on the disposition of “qualified small business stock” would have been reduced from 100% to 50% for taxpayers earning more than $400,000/year, and all trusts and estates.
- “Excess business losses” in excess of $250,000 ($500,000 in the case of a joint return) would have been carried forward as business losses (thus remaining still subject to the limitation) and would not have been converted to net operating losses, and the excess business loss provision would have been made permanent. It currently is scheduled to expire in 2026.
- Losses recognized with respect to worthless partnership interests would have been treated as capital losses (rather than ordinary losses as is often the case under current law), and would have been taken when the event establishing worthlessness occurs (rather than at the end of the year under current law).
- The wash sale rules would have been expanded to cover commodities, foreign currencies, and digital assets, like cryptocurrency, as well as dispositions by parties related to the taxpayer.
- The constructive ownership rules would have been expanded to cover digital assets, like cryptocurrency.
Business taxation
- A corporate minimum tax of 15% would have been imposed on “book income” of certain large corporations. But the corporate income tax rates would have remained unchanged at 21%.
- 1% excise tax would have been imposed on the value of stock repurchased by a corporation.
- The interest expense deduction of a domestic corporation that is part of an “international financial reporting group” and whose average annual net interest expense exceeds $12 million over a three-year period would have been disallowed to the extent its net interest expenses for financial reporting purposes exceeds 110% of its proportionate share (determined based on its share of either the group’s EBITDA or adjusted basis of assets) of the net interest expense for financial reporting purposes of the group. The disallowed interest deduction could be carried forward for subsequent years.
- Losses recognized by a corporate shareholder in liquidation of its majority owned corporate subsidiary would have been deferred until substantially all of property received in the liquidation is disposed of by the shareholder.
- Corporations spinning off subsidiaries would have been limited in their ability to use debt of the subsidiary to receive tax-free cash.
International taxation
- A foreign person who owns 10% or more of the total vote or value of the stock of a corporate issuer (as opposed to 10% or more of total vote under current law) would have been ineligible for the portfolio interest exemption.
- The Build Back Better Bill would have substantially revise the various international tax rules enacted as part of the Tax Cuts and Jobs Act (“TCJA”), including “GILTI”, “FDII” and “BEAT” regimes.
- Foreign tax credit limitation rules would have been applied on a country-by-country basis.
- Section 871(m), which imposes U.S. withholding tax on U.S.-dividend equivalent payments on swaps and forward contracts, would have been expanded to require withholding on swaps and forwards with respect to, or by reference to, interests in publicly traded partnerships.[1]
Proposals Not Included in the Build Back Better Bill
The Build Back Better Bill would not have:
- Increased individual and corporate income tax rates (other than the surtaxes);
- Changed the tax treatment of carried interests;
- Affected the “pass-through deduction” under section 199A;
- Affected “like kind” exchanges under section 1031;
- Increased the cap on social security tax withholding;
- Changed the $10,000 annual cap on state and local tax deductions;[2] or
- Treated death as a realization event.
Discussion
Individual Tax Changes
Surtax on individuals
The Build Back Better Bill would have added new section 1A, which would have imposed a tax equal to 5% of a taxpayer’s “modified adjusted gross income” in excess of $10 million (or in excess of $5 million for a married individual filing a separate return). Modified adjusted gross income would have been adjusted gross income reduced by any reduction allowed for investment interest expenses. Modified adjusted gross income would not have been reduced by charitable deductions and credits would not have been allowed to offset this surtax. An additional 3% tax would have been imposed on a taxpayer’s modified adjusted gross income over $25 million (or in excess of $12.5 mm for taxpayers filing as married filing separately). The surtaxes would also have applied to non-grantor trusts at significantly lower thresholds – the 5% surtax would apply to modified adjusted gross income in excess of $200,000 and the 3% additional surtax would have applied to modified adjusted gross income in excess of $500,000.
As a result, the top marginal federal income tax rate on modified adjusted gross income in excess of $25 million would have been 45% for ordinary income and 31.8% for capital gains (including the net investment income tax). Nevertheless, the Build Back Better Bill rate on capital gains would have remained meaningfully less than the 39.6% rate proposed by the Biden Administration.
The Build Back Better Bill did not include a change to the individual income tax rates, which was a major departure from the Prior House Bill. The Prior House Bill included a similar surtax on individual taxpayers, but the threshold was lower at $5 million for taxpayers that file joint returns and the surtax rate was 3%.
The surtax would have been effective for taxable years beginning after December 31, 2021.
Application of net investment income tax to active business income; increased threshold
The Build Back Better Bill would have expanded the 3.8% net investment income tax to apply to net income derived in an active trade or business of the taxpayer, rather than only to certain portfolio income and passive income of the taxpayer under current law.
As a result, the 3.8% net investment income tax would have been imposed on limited partners who traditionally have not been subject to self-employment tax on their distributive share of income, and S corporation shareholders who have not been subject to self-employment tax on more than a reasonable salary. This proposed change was generally consistent with the Biden administration’s proposal to impose 3.8% Medicare tax (although the additional net investment income tax proposed in the Build Back Better Bill would not be used to fund Medicare).
The Build Back Better Bill also would have limited the 3.8% net investment income tax so that it applies only to taxpayers with taxable income greater than $400,000 (and $500,000 in the case of married individuals filing a joint return), rather than $250,000 under current law.
These changes were consistent with the proposals in the Prior House Bill and would have applied in taxable years beginning after 2021.
Limitation on “qualified small business stock” benefits
The Build Back Better Bill would have limited the exemption of eligible gain for disposition of “qualified small business stock” (“QSBS”) to 50% for taxpayers with adjusted gross income of $400,000 or more, as well as all trusts and estates, and would have subjected the gain to the alternative minimum tax.
Very generally, under current law, non-corporate taxpayers are entitled to exclude from tax up to 100% of gain from the disposition of QSBS that has been held for more than 5 years.[3] In addition, gain from the sale of QSBS can potentially be deferred if proceeds are reinvested in other QSBS.
The same proposal was included in the House Bill and the Prior House Bill. The Prior House Bill contained a proposal to increase corporate tax rates, which together with the proposed changes to the QSBS rules, would have further limited desirability of investing in QSBS. The Build Back Better Bill, the House Bill and the Prior House Bill only addressed the rules applicable to exclusion of gain from the sale of QSBS, and did not alter the rules allowing for deferral of gains for proceeds invested in other QSBS. Although the benefits associated with ownership of QSBS would have remained significant, had the Build Back Better Bill passed, in light of the reduction in potential gain that would have been excluded, the Build Back Better Bill would have required a reevaluation of choice-of-entity decisions based on QSBS benefits.
The proposal would have been effective retroactively and apply to sales or exchanges of stock on or after September 13, 2021, which is the date that the Prior House Bill was released.
Excess business losses
Under current law, for taxable years that begin before January 1, 2027, non-corporate taxpayers may not deduct excess business loss (generally, net business deductions over business income) if the loss is in excess of $250,000 ($500,000 in the case of a joint return), indexed for inflation. The excess loss becomes a net operating loss in subsequent years and is available to offset 80% of taxable income each year. The Build Back Better Bill would have made this limitation permanent and would treat the losses carried forward to the next taxable year as deduction attributable to trades or businesses, which would have been subject to the excess business losses limitation under section 461(l). As a result, no more than $250,000/$500,000 in losses could be used in any year, and excess business losses would never have become net operating losses. Unlike deductions that are suspended under the passive activity rules and at-risk rules that become deductible upon a disposition of the interest in the relevant trade or business, the excess business losses continue to be limited after the sale of the relevant trade or business.
This proposal is consistent with the Prior House Bill and would have been retroactive and apply for taxable years beginning after December 31, 2020.
Worthless partnership interest and limitation on loss recognition in corporate liquidations
Under current law, if a partner’s interest in a partnership becomes worthless, in the taxable year of worthlessness the partner may take an ordinary loss if the partner receives no consideration and a capital loss in all other cases. As a practical matter, this rule allows for an ordinary loss if the partner has no share of any liabilities of the partnership immediately prior to the claim of worthlessness, or a capital loss if the partner has a share of any partnership liability immediately prior to the claim of worthlessness (because relief of partnership liabilities is treated as consideration received in a sale). Under current law, if a security (not including an obligation issued by a partnership) that is held as a capital asset becomes worthless, the loss is treated as occurring on the last day of the taxable year in which the security became worthless.
Under the Build Back Better Bill, if a partnership interest becomes worthless, the resulting loss would have been treated as a capital loss (and not an ordinary loss). Also, in the case of a partnership interest or a security that becomes worthless, the loss would have been recognized at the time of the identifiable event establishing worthlessness (and not at the end of the taxable year). The proposal would also have expanded the scope of securities subject to worthless securities rules to included obligations (bond, debenture, note, or certificate, or other evidence of indebtedness, with interest coupons or in registered form) issued by partnerships. These proposals were also included in the Prior House Bill and would apply to taxable years beginning after December 31, 2021.
The Build Back Better Bill would also have deferred the loss that is recognized by one corporate member of a controlled group[4] when a subsidiary merges into it in a taxable transaction under section 331 until substantially all of the property received in the liquidation is disposed to a third-party. This proposal would effectively have eliminated taxpayers’ ability to enter into Granite Trust transactions to recognize capital losses by liquidating an insolvent subsidiary.[5] A similar loss deferral rule would also have applied to dissolution of a corporation with worthless stock or issuance of debt in connection with which corporate stock becomes worthless. This proposal would have applied to liquidations occurring on or after the date of enactment.
Expansion of wash sale and constructive sale rules
The Build Back Better Bill would have expanded the application of wash sale rules and constructive sale rules to cryptocurrencies and other digital assets.
The Build Back Better Bill would also have expanded the wash sale rules to include transactions made by related parties. The wash sale rules disallow a loss from a sale or disposition of stock or securities if the taxpayer acquires or enters into a contract to acquire substantially similar stock or securities thirty days before or after the sale giving rise to the claimed loss. The basis of the acquired assets in the wash sale is increased to include the disallowed loss. Under the Build Back Better Bill, a wash sale would also have occurred when a “related party” to the taxpayer (other than a spouse) acquires the substantial similar stock or securities within the thirty day period.[6] More significantly, the disallowed loss in a wash sale triggered by a related party (other than a spouse) would have been permanently disallowed under the Build Back Better Bill. If the Build Back Better Bill had passed, it would have been challenging for certain taxpayers to comply with the related party provisions—and very difficult for the IRS to enforce it. Under the provision, if a parent were to sell stock at a loss and, within 30 days, her child were to purchase the same stock, the parent’s loss would have been denied, even if neither parent nor child knew about each other’s trades.
The Build Back Better Bill would have exempted from the wash sale rules foreign currency and commodity trades that were directly related to the taxpayer’s business needs (other than the business of trading currency or commodities). This exception would not have applied to digital assets.
Finally, the Build Back Better Bill would have provided that an appreciated short sale, short swap, short forward, or futures contract is constructively sold under section 1259 when the taxpayer enters into a contract to acquire the reference property (and not when the taxpayer actually acquires the reference property, as current law provides).
The changes were the same as those proposed in the Prior House Bill. The proposal would have applied after 2021.
SALT deductions
The Build Back Better Bill has a “placeholder for compromise on deduction for state and local taxes”. This is a key departure from the House Bill, which included an increase to the current annual $10,000 cap on SALT deductions to $80,000 until 2030, at which time the $10,000 annual limitation would apply again.
Business Tax Changes
Corporate alternative minimum tax
The Build Back Better Bill would impose a 15% minimum tax on “book income” of corporations with 3-year average book income in excess of $1 billion. A corporation’s book income would have been calculated based on the corporation’s audited financial statement (or if publicly traded, financial statement shown on SEC Form 10-K), but adjusted to take into account certain U.S. income tax principles.[7] Because this is a minimum tax, a corporation would have paid any excess amount of this minimum tax over its regular tax for the applicable tax year. This minimum tax would also have applied to a foreign-parented U.S. corporation if the U.S. corporation has an average annual book income of $100 million or above.
The Prior House Bill did not include this corporate minimum tax based on book income, but the Biden administration’s tax reform proposals included a similar corporate minimum tax for large corporations. The Build Back Better Bill does not otherwise provide for an increase in corporate income tax rates.
The corporate minimum tax would have been effective for tax years beginning after December 31, 2022.
Limitation on business interest expense deductions
The Build Back Better Bill would have introduced an additional interest deduction limitation for a U.S. corporate member of an international group that has disproportionate interest expense as compared to the other members of the group. New section 163(n) would generally have limited the interest deduction of a U.S. corporation that is part of an “international financial reporting group” and has net interest expense that exceeds $12 million (over a three-year period) if the ratio of its net interest expense to its EBITDA (or if an election is made, the aggregated bases of its assets)[8] exceeds by 110% of the similar ratio for the group.
Proposed section 163(n) was similar to what was included in the Prior House Bill, as well as a proposal that was included in the Senate and House bill for TCJA that was ultimately dropped in the conference agreement between the Senate and the House. This limitation appears to target base erosion interest payments that may not be captured under the BEAT regime (which is further discussed in detail below).
The Build Back Better Bill would also have revised section 163(j) to treat partnerships as aggregates for purposes of applying the business interest expense limitation. As a result, the section 163(j) limitation would have been applied at the partner level. Under current law, the limitation, which very generally limits business interest expense deduction to 30% of EBITDA, is applied at the partnership level. The interest deductions limited under section 163(j) or (n) (whichever imposes a lower limitation) would have continued to be allowed to be carried forward indefinitely (as opposed to 5 years under the Prior House Bill).
The proposals would have been effective for tax years beginning after December 31, 2022.
Limitation on using controlled corporation’s debt in a spin-off transaction
The Build Back Better Bill would have limited the ability of a U.S. “distributing corporation” to effectively receive cash tax-free from a spun-off “controlled corporation” subsidiary. Under current law, a controlled corporation can issue debt securities to its parent distributing corporation that the distributing corporation can then use to redeem its own outstanding debt on a tax-free basis in connection with the spin-off of the controlled corporation. The Build Back Better Bill would have required the parent distributing corporation to recognize gain in this transaction to the extent that the amount of controlled corporation debt it transfers to its creditors exceeds (x) the aggregate basis of any assets it transfers to its controlled corporation in connection with the spin-off less (y) the total amount of liabilities the controlled corporation assumes from it and (z) any payments that the controlled corporation makes to it. This effectively would have treated the debt securities issued by a controlled corporation as same as any other property distributed by the controlled corporation (which is commonly called as “boot”).
The proposal would have applied to reorganizations occurring on or after the date of enactment.
Excise tax on corporate stock buybacks
The Build Back Better Bill would have imposed a nondeductible 1% excise tax on publicly traded U.S. corporations engaging in stock buybacks. The tax was to be imposed on the value of the stock “repurchased” by the corporation during the tax year, reduced by value of stock issued by the corporation during the tax year (including those issued to the employees). The term “repurchase” is defined as a redemption within the meaning of section 317(b), which is a transaction in which a corporation acquires its stock from a shareholder in exchange for property. Repurchases that are (i) dividends for U.S. federal income tax purposes, (ii) part of tax-free reorganizations, (iii) made to contribute stock to an employee pension plan or ESOP, (iv) made by a dealer in securities in the ordinary course of business, or (v) made by a RIC or a REIT are not subject to the excise tax. Also, repurchases that are less than $1 million in a year are excluded.
It was unclear how the value of repurchased stock was to be determined in calculating the excise tax amount. The types of transactions that would have been covered under the proposed rule is also unclear. The term “repurchase” was very broad and it could have had applied to different types of transactions, such as redemption of redeemable preferred stocks or redemption of stock in a company’s acquisition transaction. The rule would also have had significant impact on de-SPAC transactions, which involve redemption rights for shareholders of the SPAC. The Treasury would also have been provided with a broad authority to issue regulations to cover economically similar transactions.
The proposal would have applied to repurchases of stock after December 31, 2021.
International Tax Changes
Portfolio interest exemption
Under current law, a foreign person that owns 10% or more of the total voting power of a corporate issuer of debt is not eligible for the “portfolio interest” exemption, which provides for exemption from withholding on interest paid on certain debt. Current law does not prohibit “de-control structures” under which the sponsor of a fund will typically invest a small percentage of the capital of a U.S. blocker in exchange for large percentage of its voting stock, thereby ensuring that no foreign investor will own 10% of the voting power of the U.S. blocker and permitting those foreign investors who own more than 10% of the value of the U.S. blocker to take the position that they may avoid U.S. withholding tax on interest received from the U.S. blocker. The Build Back Better Bill would have revised this exception so that any person who owns 10% or more of the total vote or value of the stock of a corporate issuer would have been ineligible for the portfolio interest exemption. This change would have prevented the de-control structures.
This proposal, which was also included in the Prior House Bill, would have applied to obligations issued after the date of enactment (i.e., all existing obligations would have been grandfathered). However, if a grandfathered obligation was “significantly modified” for U.S. federal income tax purposes, it might have lost its grandfathered status. Also, any subsequent draws on existing facilities that are made after the date of enactment would not have been grandfathered.
GILTI
The “global intangible low-taxed income” (“GILTI”) regime generally imposes a 10.5% minimum tax on 10-percent U.S. corporate shareholders of “controlled foreign corporations” (“CFCs”) based on the CFC’s “active” income in excess of a threshold equal to 10% of the CFC’s tax basis in certain depreciable tangible property (such basis, “qualified business asset investment”, or “QBAI”). GILTI is not determined on a country-by-country basis, and, therefore, under current law a U.S. multinational corporation may be able to avoid the GILTI tax with respect to its subsidiaries operating in low-tax rate countries by “blending” income earned in the low tax-rate countries with income from high-tax rate countries. Taxpayers are allowed 80% of the deemed paid foreign tax credit with respect to GILTI.
The Build Back Better Bill would have imposed GILTI on a country-by-country basis to prevent blending of income from a low tax-rate country with income from a high-tax rate country. This general approach would have been largely consistent with the prior proposals made by the Biden administration and the Senate Finance Committee.[9]
The Build Back Better Bill would have determined net CFC tested income and losses and QBAI on a country-by-country basis. The Build Back Better Bill would have achieved this by using a “CFC taxable unit” – net CFC tested income and loss would have been determined separately for each country in which CFC taxable unit is a tax resident. The Build Back Better Bill would have allowed a taxpayer to carryover country-specific net CFC tested loss to succeeding tax year to offset net CFC tested income of the same country. In addition, taxpayers would no longer have been able to offset net CFC tested income from one jurisdiction with net CFC tested losses from another jurisdiction. These proposed changes on determining net CFC tested income on a country-by-country basis were consistent with the Prior House Bill’s proposals.
The Build Back Better Bill would also have (i) reduced the exclusion amount from 10% to 5% of QBAI, (ii) increased the effective tax rate on GILTI for corporate taxpayers from 10.5% to 15%,[10] and (iii) helpfully reduced the “haircut” for deemed paid foreign tax credit for GILTI from 20% to 5% (i.e., 95% of GILTI amount would have been creditable as deemed paid credit).
The GILTI proposals would generally have been effective for taxable years beginning after December 31, 2022.
FDII
The “foreign-derived intangible income” (“FDII”) regime encourages U.S. multinational groups to keep intellectual property in the U.S. by providing a lower 13.125% effective tax rate for certain foreign sales and provision of certain services provided to unrelated foreign parties in excess of 10% of the taxpayer’s QBAI. The lower effective tax rate is achieved by 37.5% deduction allowed for FDII under section 250.
The Build Back Better Bill would have reduced the section 250 deduction for FDII from 37.5% to 24.8%, which would have had the effect of increasing the effective rate for FDII from 13.125% to 15.8%.[11] The Build Back Better Bill further provided that if a section 250 deduction actually exceeded the taxable income of the taxpayer, the deduction would have increased the net operating loss amount for the taxable year and could be used in subsequent years to offset up to 80% of taxable income.
This proposal generally would have been effective for taxable years beginning after December 31, 2021.
BEAT/SHIELD
The “base erosion and anti-abuse tax” (“BEAT”) generally provides for an add-on minimum tax, currently at 10%, on certain deductible payments that are made by very large U.S. corporations (generally, with at least $500 mm of average annual gross receipts) whose “base erosion percentage” (generally, the ratio of deductions for certain payments made to related foreign parties over all allowable deductions) is 3% or higher (or 2% for groups that include banks and securities dealers).
The Build Back Better Bill would have expanded the BEAT regime. The proposal would have increased the BEAT tax rate gradually from 10% up to 18% by the taxable year starting after December 31, 2024. The proposal would also have substantially revised the formula for calculating “modified taxable income”, which generally appeared to have increased the income amount that would have been subject to the BEAT regime. Finally, the Build Back Better Bill would have eliminated the 3%/2% de minimis exception. These proposals were generally consistent with the BEAT proposals in the Prior House Bill, but with different tax rates.
The Build Back Better Bill did not include the Biden administration’s “Stopping Harmful Inversions and Ending Low-Tax Developments” (“SHIELD”), which had been proposed to replace the BEAT regime.
Changes to Subpart F regime
The Build Back Better Bill would have significantly changed the subpart F regime. The Build Back Better Bill would have helpfully reinstated section 958(b)(4) retroactively. Section 958(b)(4) had prevented “downward” attribution of ownership of foreign person to a related U.S. person for purposes of applying subpart F regime. Section 958(b)(4) was repealed in the TCJA, which allowed stock owned by a foreign person to be attributed downward to a U.S. person for purposes of determining a foreign corporation’s CFC status.
To address the situation that had prompted the repeal of downward attribution, the Build Back Better Bill would have introduced a new section to apply the GILTI and subpart F regimes to a foreign corporation that would have been a CFC if the downward attribution rule had applied, but only if the U.S. shareholder held at least 50% of vote or value of the foreign corporation’s stock. This regime would have been effective for taxable years beginning after the date of the enactment.
The Build Back Better Bill would also have allowed a U.S. shareholder of a foreign corporation to elect to treat the foreign corporation as a CFC, which may have permitted a taxpayer to exclude foreign-source dividends received from the foreign corporation under the Build Back Better Bill’s amended section 245A (which is discussed below). The Build Back Better Bill also would have limited the scope of foreign base company sales and services income, which is includible as subpart F income, to sales and services provided to U.S. residents and pass-through entities and branches in the United States, which effectively would have subjected foreign base company sales and services income for non-U.S. sales and services to the GILTI regime. The Build Back Better Bill also would have amended section 951(a) so that a United States shareholder that receives a dividend from a CFC would have been subject to tax on its pro rata share of the CFC’s subpart F income (generally negating any deduction under section 245A with respect to the dividend), regardless of whether the shareholder held shares in the CFC on the last day of the taxable year. Current law requires a United States shareholder to include Subpart F income only if it owned shares of the CFC on the last day of the taxable year.
Foreign tax credits
The Build Back Better Bill would have imposed the foreign tax credit limitation on a country-by-country basis. Currently, foreign tax credits are calculated on an aggregate global basis and divided into baskets for active income, passive income, GILTI income, and foreign branch income. The revised rules would have calculated foreign tax credit limitations based on a country-by-country “taxable unit”, which is consistent with the “CFC taxable unit” used under the Build Back Better Bill’s GILTI rules. Together with the proposed amendments to the GILTI regime, this revision to the foreign tax credit limitation rules would have sought to prohibit taxpayers from using foreign tax credits from taxes paid in a high-tax jurisdiction against taxable income from a low-tax jurisdiction.
The Build Back Better Bill would have made a number of other changes to the foreign tax credit rules, including and repealing the carryback period (which, under current law, is 1 year, but retaining the current 10-year carryforward period for excess foreign tax credit limitation).
This proposal would have been generally effective for taxable years beginning after December 31, 2022.
Dividends from foreign corporations
The Build Back Better Bill would have amended section 245A so that the foreign portions of dividends received only from a CFC (rather than any specified 10-percent owned foreign corporation) would have qualified for the participation exemption (and not have been subject to U.S. federal income tax) under section 245A.[12] Currently, section 245A allows foreign-source dividends from any specified 10-percent owned foreign corporation (a broader concept than CFC) to be exempt from U.S. tax under section 245A. Although the provision appeared to narrow the scope of section 245A, as noted above, the Build Back Better Bill would have permitted a taxpayer and a foreign corporation to make an election to treat the foreign corporation as a CFC, in which case the benefits of section 245A would have been available to all dividends paid by the electing foreign corporation (even if U.S. shareholders own less than 10%). This provision was consistent with the proposal in the Prior House Bill and would have been effective for distributions made after the date of the enactment.
Anti-inversion rules
The Senate Finance Committee’s Build Back Better Bill would have significantly expanded the anti-inversion rules. Generally, under current law, a foreign acquirer of an inverted U.S. corporation – typically, an existing U.S. corporation that is acquired by a foreign acquirer and whose shareholders continue own the U.S. corporation indirectly through their ownership in the foreign acquirer – is treated as a U.S. corporation for U.S. federal income tax purposes, if the continuing ownership stake of the shareholders of the inverted U.S. corporation is 80% or more. If the continuing ownership stake of the shareholders of the inverted U.S. corporation is between 60% and 80%, certain rules designed to prevent “earnings stripping” – or deductible payments by the U.S. corporation to its foreign parent – apply.
The Build Back Better Bill would have lowered the 80% threshold in treating a foreign acquirer of an inverted U.S. corporation as a U.S. corporation for U.S. federal income tax purposes to 65%. The Build Back Better Bill would also have lowered the 60% threshold in applying the earnings stripping rules to 50%. Finally, the Build Back Better Bill would have expanded the scope of the anti-inversion rules to cover acquisitions of substantially all of the assets constituting (i) a trade or business of a U.S. corporation or partnership, or (ii) a U.S. trade or business of a non-U.S. partnership.
This provision was not included in the House Bill, but it did reflect some elements of an anti-inversion rule proposal by the Biden administration, such as the lowering of the 80% threshold to treat a foreign acquirer as a U.S. corporation for U.S. federal income tax purposes and the expansion of the scope of the rules to cover certain asset acquisitions. This proposal would have applied for taxable years ending after December 31, 2021.
[1] Unless otherwise noted, all section references are to the Internal Revenue Code of 1986, as amended.
[2] The House Bill contained a provision that would raise the $10,000 cap to $80,000 for 2021 through 2030.
[3] The amount of gain eligible to be taken into account for these purposes by any taxpayer and any corporation is subject to a cap generally equal to the greater of (i) $10 million cumulative exclusions of gain with respect to that corporation and (ii) 10 times the taxpayer’s aggregate adjusted tax bases of QSBS of the corporation disposed of in that year.
[4] Generally, corporations connected through stock ownership of more than 50%. Section 267(f).
[5] In a Granite Trust transaction, a corporate parent that owns a depreciated subsidiary reduces its ownership in the subsidiary to below 80% before liquidating the subsidiary so that the liquidation is taxable and any built-in loss of the parent in the subsidiary’s stock would have been recognized.
[6] A related party for this purpose includes (i) the taxpayer’s spouse, dependent, (ii) any corporation, partnership, trust or estate that is controlled by the taxpayer, and (iii) the taxpayer’s retirement account and certain other tax-advantaged investment accounts for which the taxpayer is the beneficiary or the fiduciary.
[7] For example, if a corporation owned foreign corporations that are “controlled foreign corporations” for U.S. federal income tax purposes, the corporation would have had to take into account its pro rata share of such foreign corporation’s book income. Also, prior year’s net operating losses (calculated for book purposes) could have been used to reduce the book income, but could have only offset 80% of the book income for the subsequent year.
[8] The election to use the aggregated bases of assets in lieu of EBITDA was added in the Senate Finance draft of the Bill.
[9] The Senate Finance Committee’s prior proposal (which included a draft legislation and a section-by-section explanation) provided for a mandatory exclusion of high-taxed income. This approach was different than the Build Back Better Bill, but the general approach of disallowing “blending” of income between high-tax jurisdiction and low-tax jurisdiction was the same.
[10] This would have been achieved by reducing the deduction provided to corporate taxpayers under section 250 from the current 50% level to 28.5%. The Build Back Better Bill would have not change the tax rate to be applied to a non-corporate taxpayer’s GILTI amount. This was a lower rate than what was proposed in the Prior House Bill (37.5%), but the effective tax rate under the Prior House Bill was higher due to the increased income tax rates.
[11] The FDII deduction was higher under the Prior House Bill (at 21.875%), with the effective tax rate of 20.7% (taking into account the increased corporate rate). The Senate Finance Committee’s prior proposal also stated that the FDII deduction would have been reduced, but did not commit to a specific percentage.
[12] The Build Back Better Bill would have also amended section 1059 so that if a corporation received dividend from a CFC that was attributable to earnings and profits of the foreign corporation before it was a CFC or before it was owned by the corporation, the non-taxed portion of that dividend would have reduced the basis of the CFC’s stock, regardless of whether the corporation had held the CFC’s stock for 2 years or less. Therefore, CFC’s dividends that are exempt from tax under section 245A could have been subject to the proposed expanded section 1059.
New Guidance Allows Publicly-Offered REITs and RICs to Issue up to 90% of Qualifying Dividends in the REIT or RIC’s Own Stock Through June 2022
On November 30, 2021, the IRS issued Revenue Procedure 2021-53, which temporarily allows publicly offered RICs and REITs to make distributions that are treated as dividends of up to 90% stock and the remainder in cash. Revenue Procedure 2020-19 closely follows the format of similar guidance issued during the 2008 financial crisis and in 2020, and applies to distributions declared on and after November 1, 2021, and on or before June 30, 2022.
For more information, see our prior post here.
A step closer to agreement on taxation of the digital world
On 8 October 2021, the OECD released a further statement in relation to the BEPS 2.0 proposals, aimed at addressing taxation of the modern digital economy. This is the latest development in the attempts to more equally share the tax revenue relating to digital services that have led to some jurisdictions, including the UK, introducing unilateral digital service taxes. The OECD’s proposals contain two “pillars”. The first (“Pillar 1”) seeks to shift tax on large digital service providers into the countries in which their sales take place. The second (“Pillar 2”) seeks to establish a minimum global tax rate. An important reason for this development has been the accession to the global minimum tax by the current US administration, as well as the last EU members previously opposed to Pillar 2.
The OECD’s statement itself does not offer substantive new information on how the proposals might operate in practice. However, its release follows a significant breakthrough in the four year negotiation process. Ireland, Estonia and Hungary had all previously opposed the introduction of an effective global minimum tax rate, as their corporate tax systems generally allowed for statutory or effective tax rates at or below the proposed global minimum rate. These nations have now agreed to support the proposals, having secured confirmation that the minimum tax rate stated in the proposals is a definite number rather than a tax of “at least” the rate stated. This means that all EU Member States have endorsed the OECD’s proposed reforms and that 136 of 140 OECD countries have now agreed to the deal (only Sri Lanka, Pakistan, Nigeria and Kenya have not yet acceded to Pillar 2). The United States Treasury Department generally has been a longstanding proponent of the Pillar 2 proposal. By contrast, previous United States presidential administrations objected to the Pillar 1 proposals as potentially disproportionately affecting US corporations. The changes to the Pillar 1 proposals, targeting only the largest and most profitable corporate groups until several years elapse after enactment of Pillar 1, have led to the Biden administration expressing support for Pillar 1. Importantly, the support of the US President and the US Treasury Department do not mean that the US Congress will necessarily enact enabling legislation.
Pillar 1
At a very high level, Pillar 1 is intended reallocate profits and related taxing rights from certain jurisdictions where multinational enterprises (MNEs) have physical substance to other countries where they have a market presence, regardless of whether or not they have a physical presence in that second jurisdiction. Pillar 1 will only apply to MNEs with turnover in excess of €20 billion and profitability before tax in excess of 10%. It is envisaged that this will operate a de facto digital sales/services tax (“DST”), with global technology giants falling within the rules. The Biden administration had previously stated that it could not accept any result which is discriminatory against US firms. However, the administration has more recently expressed support for the proposal in light of the fact that the rules as now formulated are aimed at a much smaller group of the world’s most profitable MNEs, at least for several years from introduction.
Despite the multilateral negotiations, several OECD countries have already decided to move ahead with or proposed unilateral measures to tax the digital economy. Austria, France, Hungary, Italy, Poland, Spain, Turkey, and the UK have all implemented some form of DST as at the time of writing ranging from 1.5% (in Poland) to 7.5% (in Turkey) subject to varying revenue thresholds. The EU also expressed an intention to impose a digital levy from 2023. These measures have created international tensions with the US, as there is a perception that US companies are disproportionately affect by the DST. This has resulted in the US formally investigating DSTs and threatening to retaliate with significant tariffs.
The recent OECD statement confirms that a multilateral convention will require countries to remove DSTs and similar measures and commit not to unilaterally introduce such measures. On 21 October 2021 the UK, Austria, France, Italy, Spain and the US announced the terms of an agreement providing for the transition from existing DSTs and similar measures to the new multilateral solution. The US and the UK have agreed that the existing UK DST, which was introduced in April 2020 and levies a 2% rate on certain digital service providers, will remain in place until 2023, when the Pillar 1 rules are expected to become effective. However, certain members of the US Congress have raised the possibility that this agreement might constitute a “treaty” within the meaning of the United States Constitution. This would mean that the US could not bring this agreement into force without a 2/3 majority of the United States Senate consenting, which could be difficult to achieve in the current US political environment.
Pillar 2
Broadly, Pillar 2 is the global anti-base-erosion (“GLOBE”) regime which proposes to implement to an agreed minimum effective tax rate of 15% in each county in which an MNE operates. The Pillar 2 minimum tax rate will only apply to MNEs that exceed a consolidated annual revenue threshold of €750 million.
There is some scepticism as to whether the GLOBE regime will have a meaningful impact on competiveness in the international tax landscape. Having the effective minimum rate set at 15% means that territories which already have tax rates in excess of this, like the US and the UK, are unlikely to be more attractive for large businesses as result of the rules. The 15% floor agreed to is well below average corporate tax rate in industrialised countries of about 23.5%. The agreed rate represents a victory for Ireland, which opposed anything in excess of 15%, and is well below the minimum rate of 21% proposed by the United States. Despite this, the Biden administration has indicated its support for the GLOBE regime. However, as noted above, the administration’s support does not directly translate into enactment of enabling legislation by the US Congress. Further, the same concerns about the Pillar 1 agreement constituting a treaty discussed above apply to the Pillar 2 agreement.
There has been some indication that investment funds, pension funds, governmental entities, international organisations, non-profit entities (which likely includes most tax-exempt organisations in the United States) and entities subject to tax neutrality regimes may be excluded from the scope of both Pillar 1 and Pillar 2 which will be important from the perspective of the funds industry.
Next steps and Implementation
With respect to Pillar 1, the OECD has stated that countries are aiming to sign a multilateral convention during 2022, with effective implementation in 2023. The convention will be the vehicle for implementation of the newly agreed taxing right under Pillar 1, as well as for the standstill and removal provisions in relation to all existing DSTs and other similar relevant unilateral measures.
Model rules to give effect to the GLOBE rules are set to be developed by the end of November 2021. These rules will define the scope and set out the mechanics of the regime. The OECD will develop further rules for bringing Pillar 2 into domestic legislation during 2022, to be effective in 2023.
Some concerns have already been raised about the implementation timetable. The Swiss finance ministry requested that the interests of small economies be taken into account and said that the 2023 implementation date was impossible. The proposals will also have to be enacted by the US Congress before ratification, and such enactment is subject to substantial political uncertainty.
We will wait with interest on the progress in this important area and will report on developments as they become clearer.
130 countries join the OECD’s framework for international tax reform
Significant progress has been made in the efforts of the OECD to reach international consensus on the BEPS 2.0 proposals. Broadly, the proposals are aimed at addressing challenges relating to taxation of the modern digital economy. The 139 country OECD Inclusive Framework meeting concluded on 1 July 2021, with 130 countries and jurisdictions, representing in aggregate over 90% of global GDP, agreeing to the two pillar approach to international tax reform. Among those to agree were the United Kingdom, the United States, the Cayman Islands, Jersey and Guernsey. Only 9 members of the Inclusive Framework have yet to agree to the proposals, including some low tax EU member states, namely Ireland, Estonia and Hungary.
The OECD framework for international tax reform aims to ensure that large multinational enterprises (“MNEs”) pay tax where they operate. It is also intended to increase certainty and add stability to the international tax landscape. The framework is comprised of two proposals, known as Pillar One and Pillar Two, which have been subject to protracted international negotiations over the last number of years.
Pillar One is aimed at the largest global MNEs. It is intended re-allocate profits and related taxing rights from certain jurisdictions where the MNEs have physical substance to other countries where they have a market presence, business activities or earn profits, regardless of whether or not they have a physical presence. This will have implications for large technology companies.
The main element of Pillar Two is the global anti-base-erosion (“GLOBE”) measure, designed to ensure that MNEs which surpass a certain consolidated revenue threshold are subject to a minimum effective tax rate in each county in which they operate. It was proposed at the recent Inclusive Framework meeting this minimum rate would be at least 15%. The OECD have stated that Pillar Two will seek to put a floor on the competition over corporation tax and allow countries to protect their tax bases.
The remaining elements of the framework, including the implementation plan, will be finalised in October 2021.
Treasury’s Green Book Provides Details on the Biden Administration’s Tax Plan
On May 28, 2021, the Biden Administration released the Fiscal Year 2022 Budget, and the “General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals,” which is commonly referred to as the “Green Book.” The Green Book summarizes the Administration’s tax proposals contained in the Budget. The Green Book is not a proposed legislation and each of the proposals will have to be introduced and passed by Congress.
The Green Book proposes to:
- Increase in the corporate tax rate to 28% from 21%. However, recent news reports suggest that President Biden may be willing to agree to maintain the corporate tax rate at 21%.[1]
- Increase in the top individual tax rate to 39.6% from 37%.
- Substantially change the international tax rules, as previously proposed in the Made in America Tax Plan (which was part of the American Jobs Plan) and summarized here.
- Impose a 15% minimum tax on the book earnings of certain large corporations.
- Increase the long-term capital gains rate and qualified dividend income rate to 39.6% (43.4% including the net investment income tax) from 20% (23.8% including the net investment income tax (“NIIT”)) to the extent the taxpayer’s income exceeds $1 million, indexed for inflation. This proposal is proposed to be effective retroactively for gains and income recognized after April 28, 2021.
- Treat death and gifts of appreciated property as realization events that require gain to be recognized as if the underlying property was sold, subject to a $1 million lifetime exclusion. Gains on gifts or bequests to charity would not be required to be recognized, and gains on gifts or bequests to a spouse would not be required to be recognized until the spouse dies or disposes of the asset, but basis would carry over.
- Treat all pass-through business income of high-income taxpayers as subject either to the 3.8% NIIT or the 3.8% Medicare tax under the Self-Employment Contributions Act (“SECA”). Accordingly, limited partners who provide services would be subject to self-employment tax on their distributive share of the partnership’s business income, and S corporation shareholders who materially participate in the corporation’s trade or business would be subject to SECA taxes on their distributive share of the S corporation’s business income to the extent it exceeds certain thresholds.
- Treat income from carried interests as ordinary income that is subject to self-employment tax.
- Impose a $500,000 per person limit ($1 million in the case of married individuals filing a joint return) on the aggregate amount of section 1031 like-kind exchange gain deferral for each year, with any excess recognized in the year of the exchange.
- Make permanent the excess business loss limitation.
- Mandate a comprehensive financial account information reporting regime beginning in 2023 that would require gross inflow and outflow reporting for all bank and other financial accounts with a gross flow threshold of $600 or a fair market value of $600.
Increase the Top Marginal Rate for Individuals and the Corporate Rate
The Green Book would increase the top individual income tax rate to 39.6% (from 37%) for taxable income over $509,300 for married individuals filing a joint return, $452,700 for unmarried individuals (other than surviving spouses), $481,000 for head of household filers, and $254,650 for married individuals filing a separate return. For years after 2022, the thresholds would be indexed for inflation using the C-CPI-U. The proposal would be effective for taxable years beginning after December 31, 2021.
Consistent with the proposal in the Made in America Tax Plan, the Green Book would increase the income tax rate for C corporations from 21% to 28%. The proposal would be effective for taxable years beginning after December 31, 2021. For taxable years beginning after January 1, 2021 and before January 1, 2022, only the portion of the taxable year in 2022 would be subject to the 28% rate. (However, as noted above, recent news reports suggest that President Biden may be willing to agree to maintain the corporate tax rate at 21%.)
Significant Changes to the International Tax Rules
GILTI
The “global intangible low-taxed income” (“GILTI”) regime generally imposes a 10.5% minimum tax on 10-percent U.S. corporate shareholders of “controlled foreign corporations” (“CFCs”) based on the CFC’s “active” income in excess of a threshold equal to 10% of the CFC’s tax basis in certain depreciable tangible property (this basis, “qualified business asset investment,” or “QBAI”).[2] GILTI is not determined on a country-by-country basis, and, therefore, under current law a U.S. multinational corporation may be able to avoid the GILTI tax with respect to its CFCs operating in low tax-rate countries by “blending” income earned in the low tax-rate countries with income from high tax-rate countries. In addition, income that is subject to a foreign effective tax rate in excess of 90% of the U.S. corporate income tax rate generally is excluded from GILTI.
Effective Tax Rate on GILTI
Under the Green Book (as under the prior Made in America Tax Plan), the effective tax rate on GILTI for corporate taxpayers would increase from 10.5% to 21%, which represents an increase in the effective tax rate on GILTI to 75% of the corporate tax rate (21%/28%) from 50% of the corporate tax rate under current law (10.5%/21%).
Country-by-Country Determination
Today, GILTI is applied on a global basis and U.S. multinationals can avoid the GILTI tax on investments in low-tax jurisdictions by “blending” the income earned by CFCs in low-tax jurisdictions with income earned in high-tax jurisdictions. The Green Book (as the prior Made in America Tax Plan) would require GILTI to be determined on a country-by-country basis that would prevent blending. Accordingly, income earned in low tax-rate countries would be subject to the minimum tax under the GILTI regime.
Elimination of 10% of QBAI exclusion
The Green Book (as the prior Made in America Tax Plan) proposes the elimination of the exclusion of 10% of QBAI from the GILTI calculation. Accordingly, the first dollar of CFC “active” income would be subject to the GILTI tax.
Repeal of the High-Tax Exception from GILTI
The Green Book (but not the prior Made in America Tax Plan) proposes to repeal the high-tax exception from GILTI.
FDII
The “foreign-derived intangible income” (“FDII”) regime provides a lower 13.5% effective tax rate for certain foreign sales and the provision of certain services to unrelated foreign parties in excess of 10% of the taxpayer’s domestic QBAI.
The Green Book (like the prior Made in America Tax Plan), would repeal FDII.[3]
BEAT
The “base erosion and anti-abuse tax” (“BEAT”) generally provides for an add-on minimum tax, currently at 10%, on certain deductible payments that are made by very large U.S. corporations to related foreign parties.
The Green Book (as the prior Made in America Tax Plan) would replace the BEAT regime with the “Stopping Harmful Inversions and Ending Low-tax Developments” or “SHIELD” regime. Similar to the BEAT, the SHIELD regime would also deny U.S. multinationals tax deductions for payments made to related parties, but only if the related parties receiving the payments are subject to a low effective rate of tax. The tax rate at which the SHIELD regime is triggered would initially be equal to the 21% proposed GILTI rate,[4] but would be replaced by an eventual global minimum tax rate established under OECD BEPS project’s Pillar Two.[5]
The SHIELD regime would only apply to financial reporting groups with greater than $500 million in global annual revenues, and would be effective for taxable years beginning after December 31, 2022.
Expansion of Anti-Inversion Rules
An inversion transaction is typically a transaction in which the shareholders of an existing U.S. corporation own that corporation as a subsidiary of a non-U.S. corporation. Statutory anti-inversion provisions under section 7874, together with additional guidance provided in the Treasury regulations, subject the foreign acquirer and/or the inverting U.S. corporation to a number of potentially adverse tax consequences. If the continuing ownership stake of the shareholders of the inverted U.S. corporation is 80% or more, the foreign acquirer is treated as a U.S. corporation for U.S. federal income tax purposes. If the continuing ownership stake of the shareholders of the inverted U.S. corporation is between 60% and 80%, certain rules designed to prevent “earnings stripping” – or deductible payments by the U.S. corporation to its foreign parent – apply.
The Green Book would expand the anti-inversion rules in many significant ways. These proposals were outlined in the Made in America Tax Plan, but the Green Book contains significantly more detail. First, the Green Book proposes to replace the 80% threshold with a 50% threshold, and to eliminate the separate regime that applies to inverted U.S. corporations with a continuing ownership level between 60% and 80%. Accordingly, under the Green Book, if a non-U.S. corporation acquires a U.S. corporation and 50% or more of the historic shareholders of the U.S. corporation own the non-U.S. corporation, the non-U.S. corporation would be taxable as a U.S. corporation.
Furthermore, the Green Book proposes an additional category of transactions that would be treated as inversion transactions that cause the acquiror to be treated as a U.S. corporation, without regard to the level of shareholder continuity: if a non-U.S. corporation acquires shares in a U.S. corporation and (1) immediately prior to the acquisition, the fair market value of the domestic target entity is greater than the fair market value of the foreign acquiring corporation, (2) after the acquisition, the “expanded affiliated group” (generally, a group of corporations related through at least 50% of ownership) is primarily managed and controlled in the United States, and (3) the expanded affiliated group does not conduct substantial business activities in the country in which the non-U.S. acquiring corporation is created or organized, then the non-U.S. acquiring corporation would be taxable as a U.S. corporation.
Finally, the Green Book would expand the scope of anti-inversion rules to cover acquisitions of substantially all of the assets constituting (i) a trade or business of a U.S. corporation or partnership, or (ii) a U.S. trade or business of a non-U.S. partnership and distributions of stock in a foreign corporation by a domestic corporation or a partnership that represent either substantially all of the assets or substantially all of the assets constituting a trade or business of the distributing entity.
15% Minimum Tax on Book Income for Certain Large Corporations
The Green Book (as the prior Made in America Tax Plan) proposes a 15% minimum tax on certain large corporations based on their book income. The Green Book clarifies certain aspects of this 15% minimum tax. The book income minimum tax would apply only to corporations with worldwide book income in excess of $2 billion, and would be reduced by general business credits (including R&D, clean energy and housing tax credits) and foreign tax credits. This tax is structured as a minimum tax, and therefore, would apply only if it exceeds the corporation’s regular income tax. The 15% minimum book income tax is effective for taxable years beginning after December 31, 2021.
Taxing Capital Gains at Ordinary Income Rates for High-Income Earners
The Green Book proposes (as did the earlier American Families Plan) taxing long-term capital gains and qualified dividends of taxpayers with adjusted gross income of more than $1 million (indexed for inflation after 2022) at the applicable ordinary income tax rates, which generally would be 39.6% (43.4% including the net investment income tax).
The Green Book proposes that this increase in the long-term capital gains and qualified dividend income tax rates be retroactive and be applied to income recognized after “the date of announcement”, which is April 28, 2021.
If the proposal to increase the tax rate of capital gains is enacted, we would expect taxpayers to defer sales of appreciated property and to use cashless collars and prepaid forward contracts to reduce economic exposure, and to monetize, liquid appreciated positions. We would also expect an increase in tax-free mergers and acquisitions.
Gift Transfer and Death as Realization Events
Under current law, transfer by gift or death is not taxable, and upon death, the decedent’s heirs get a “stepped up basis” to fair market value at the time of death. Under the proposal in the Green Book, death and gifts of appreciated property would be treated as realization events that require gain to be recognized as if the underlying property was sold, subject to a $1 million ($500,000 for married couples filing separately) lifetime exclusion, which would be indexed for inflation after 2022. Gains on gifts or bequests to charity would not be required to be recognized, and gains on gifts or bequests to a spouse would not be required to be recognized until the spouse dies or disposes of the asset. Basis would carry over in each case.
Payment of tax on the appreciation of certain family-owned and operated businesses would not be due until the interest in the business is sold or the business ceases to be family-owned and operated. The Green Book proposal would also allow a 15-year fixed-rate payment plan for the tax on appreciated assets transferred at death, other than (i) liquid assets, such as publicly traded financial assets, and (ii) businesses for which the deferral election is made.
The proposal would tax transfers of property into, and distributions in kind from, a trust, partnership or other non-corporate entity (other than a grantor trust that is deemed to be wholly owned and revocable by the donor). It is questionable whether the drafters intended as broad a result as the words of the proposal suggest because it would effectively prohibit the use of partnerships for many common business ventures.
Finally, the Green Book proposal would apparently impose tax without any realization event on the unrealized appreciation of assets of a trust, partnership or other non-corporate entity if there has not been a recognition event with respect to the applicable property within the prior 90 years, beginning on January 1, 1940. Accordingly, these entities would be subject to tax with respect to this property beginning on December 31, 2030.
The qualified small business stock (“QSBS”) rules of section 1202 would remain in effect.
The proposed rules would be effective after December 31, 2021.
3.8% Medicare Tax for All Trade or Business Income of High-Income Taxpayers
Under the current rules, a 3.8% NIIT is imposed on net investment income (generally, portfolio and passive income) of individuals above a certain income threshold, and a 3.8% Medicare tax under SECA is imposed on self-employment earning of certain high-income taxpayers. Limited partners and S corporation shareholders generally are not subject to the SECA Medicare tax on their distributive share of income from the partnership or the S corporation, respectively.
The Green Book proposes to impose a 3.8% tax (which will be used to fund Medicare), either through the NIIT or SECA Medicare tax, on all trade or business income of taxpayers with adjusted gross income in excess of $400,000.[6]
In addition, limited partners, LLC members and S corporation shareholders who traditionally have not been subject to SECA tax on their distributive share of income from the underlying entity would be subject to SECA tax if they provide services and/or materially participate in the underlying trade or business. Material participation standards appear to be similar to the same standards for purposes of passive activity rules under section 469, which require the person to work for the business for at least 500 hours per year.
The proposal would be effective for taxable years beginning after December 31, 2021.
Carried Interests Give Rise to Ordinary Income
Under current law, a “carried” or “profits” interest in a partnership received in exchange for services is generally not taxable when received and the recipient is taxed on their share of partnership income based on the character of the income at the partnership level. Section 1061 requires certain carried interest holders to satisfy a three-year holding period – rather than the normal one-year holding period – to be eligible for the long-term capital gain rate.[7]
Under the Green Book, a partner’s share of income on an “investment services partnership interest” (an “ISPI”) in an investment partnership would generally be taxable as ordinary income, and gain on the sale of an ISPI would be taxable as ordinary income if the partner’s taxable income (from all sources) exceeds $400,000.
The Green Book defines an ISPI as “a profits interest in an investment partnership that is held by a person who provides services to the partnership”. This definition is broader than section 1061, which applies to interests in partnerships in the business of “raising or returning capital” and investing or developing certain investment-type assets.[8]
Under the Green Book, a partnership will be considered an “investment partnership” if substantially all of its assets are investment-type assets (which are similar to the “specified assets” definition of section 1061), but only if more than 50% of the partnership’s contributed capital is from partners to whom the interests constitute property not held in connection with a trade or business.
The purpose and meaning of the exception provided by this 50% test is unclear. Assume that insurance companies contribute cash from their reserves to an investment partnership in exchange for partnership interests, and the general partner of that partnership receives a carried interest in exchange for managing the assets of the partnership. The partnership interests received by the insurance companies would appear to be reserves held in connection with their trade or business of providing insurance. It appears that the general partner would not be subject to the Green Book proposal or, as discussed below, section 1061, and therefore could receive allocations of long-term capital gain based upon a one-year holding period.
Under the Green Book, if a partner who holds an ISPI also contributes “invested capital” (generally money or other property, but not contributed capital attributable to the proceeds of any loan or advance made or guaranteed by any partner or the partnership or a related person) and holds a qualified capital interest in the partnership, income attributable to the invested capital, including the portion of gain recognized on the sale of an ISPI attributable to the invested capital, would not be subject to recharacterization. “Qualified capital interests” generally require that (a) the partnership allocations to the invested capital be made in the same manner as allocations to other capital interests held by partners who do not hold an ISPI and (b) the allocations to these non-ISPI holders are significant. The “same manner” requirement would be a return to the language used in the section 1061 proposed regulations, which was ultimately relaxed to a “similar manner” requirement in the final regulations.[9] The Green Book’s requirement that allocations to non-ISPI holders be “significant” is also a divergence from the final section 1061 regulations, which look to whether the capital contributed by “Unrelated Non-Service Partners” is significant.[10]
The Green Book would also require partners to pay self-employment tax on ISPI income.
In addition, under an anti-abuse rule of the proposal, any person above the income threshold who performs services for any entity (including entities other than partnerships) and holds a “disqualified interest” in the entity is subject to tax at “rates applicable to ordinary income” on any income or gain received with respect to the interest. A “disqualified interest” is defined as convertible or contingent debt, an option, or any derivative instrument with respect to the entity (but does not include a partnership interest, stock in certain taxable corporations, or stock in an S corporation). Thus, under this proposal if an employee received a note as compensation from a C corporation, any gain on the sale of the note would be taxable at ordinary income rates (but, apparently, would not be treated as ordinary income so the gain could be offset by capital losses). The anti-abuse rule provides that capital gain subject to it is taxable “at rates applicable to ordinary income,” but does not provide that the capital gain is ordinary income. It is unclear why this rule is different than the rule that applies to ISPIs, but it would allow capital losses of the taxpayer to offset the capital gains.
The proposal notes that it is not intended to adversely affect qualification of a REIT owning a profits interest in a real estate partnership.
The proposal would repeal section 1061 for taxpayers whose taxable income (from all sources) exceeds $400,000 and would be effective for taxable years beginning after December 31, 2021. Taxpayers whose taxable income is $400,000 or less would be subject only to section 1061. If the proposal were to become law, we expect that sponsors of funds will be more likely to receive their compensation in the form of deferred fees rather than as a carried interest.
The Green Book proposal appears to be based on the Carried Interest Fairness Act of 2021, the February 2021 House bill (the “House Bill”) introduced by Bill Pascrell (NJ) and co-sponsored by Andy Levin (Michigan) and Katie Porter (California).
Like the Green Book proposal, the House Bill contained provisions to treat the net capital gain with respect to an investment services partnership interest as ordinary income, with a carve out for gain attributable to a partner’s qualified capital interest.[11] The House Bill also subjects income from an investment services partnership interest to self-employment taxes.
The House Bill contains a narrower version of the exception from ISPI contained in the Green Book. Whereas the Green Book proposal exempts an ISPI if not more than 50% of the partnership’s contributed capital is from partners to whom the interests constitute property not held in connection with a trade or business, the House Bill would require 75% of a partnership’s capital to be attributable to qualified capital interests constituting property held in connection with a trade or business of its owner for the interest to be exempted.
The House Bill would also amend section 83 to currently tax partnership interests transferred in connection with the performance of services, would exempt income from investment services partnership interests from treatment as qualifying income of a publicly traded partnership,[12] would exempt certain family partnerships from the application of the bill, and would increase the penalty for tax underpayments resulting from failure to treat income from an investment services partnership interest as ordinary income. These provisions do not appear in the Green Book proposal.
If the Green Book proposal is enacted, we would expect fund managers increasingly to receive their compensation in the form of deferred fees rather than carry, and to subject the deferred fees to a “substantial risk of forfeiture” to avoid application of sections 409A and 457A.
Repeal of Section 1031 Like-Kind Exchanges
Under section 1031, taxpayers may defer gain on exchange of real property for other real property without any limitation on the amount of deferral.[13] The Green Book proposes to impose a $500,000 per person limit ($1 mm in the case of married individuals filing a joint return) on the aggregate amount gain deferral for each year, with any excess recognized in the year of the exchange.
The proposal would be effective in taxable years beginning after December 31, 2021.
If the proposal is enacted, we would expect an increased use of “UPREIT” structures for transfers of real property, whereby a taxpayer with appreciated property contributes that property to a partnership owned by a real estate investment trust (a “REIT”) in exchange for an interest in that partnership that may be converted into an interest in the REIT.
Excess Business Loss Limitation Made Permanent
Section 461(l) generally disallows non-corporate taxpayers from deducting “excess business losses.” Excess business losses are losses from business activities in excess of the sum of gains from business activities and specified threshold amount. These losses are carried forward to subsequent taxable years as net operating losses.
The Green Book proposes to make permanent the excess business loss limitation on non-corporate taxpayers, which otherwise would have sunset after December 31, 2026.
Comprehensive Financial Account Information Reporting Regime
The Green Book also proposes a comprehensive financial account information reporting by financial institutions and other similar institutions. This proposal calls for reporting of data on financial accounts, including gross inflows and outflows with a breakdown for cash, transactions with a foreign account and transfer to and from another account with the same owner. Payment settlement entities, custodians and crypto asset exchanges would be subject to similar reporting requirements. The proposal also provides for additional reporting requirements for purchase/transfer of crypto assets. The only exception specified in the proposal is for de minimis amounts at a $600 threshold.
This proposal is proposed to be in effect for tax years beginning after December 31, 2022.
Additional Funding To Be Provided for Enforcement and Tax Administration
The Green Book also proposes an increase in the budget for the IRS Enforcement and Operations Support accounts by $6.7 billion and to provide the IRS with $72.5 billion in mandatory funding, a portion of which would be used for IRS enforcement and compliance. The proposal would direct that these additional resources be used only for enforcement against taxpayers with income above $400,000.
No Repeal of the Cap on Social Security Taxes
Under current law, employers and employees are each subject to a 6.2% social security tax (for a total of 12.4%) and self-employed individuals are subject to a 12.4% social security tax on their first $142,800 (in 2021) of wages. It had been reported that the Biden Administration would lift the cap so that the social security tax applied to all wages and self-employment income. This proposal was not in the Green Book (or the American Families Plan).
No Change to the Gift and Estate Taxes
The Green Book (and the American Families Plan) does not propose any change to the gift and estate taxes.
No Repeal of the SALT Limitation
Currently, only a maximum of $10,000 annually of state and local taxes (“SALT”) are deductible from federal income. The Green Book (and the American Families Plan) does not propose to change the SALT limitation.
[1] Kristina Peterson, Andrew Restuccia and Richard Rubin. “Biden Signals Flexibility on Taxes for Infrastructure” Wall Street Journal, June 3, 2021. https://www.wsj.com/articles/bidens-latest-infrastructure-offer-1-trillion-11622725783?page=1
[2] Under section 250, the 10.5% rate is provided through a 50% deduction, which is generally not available for non-corporate taxpayers unless an election under section 962 is made. All section references are to the Internal Revenue Code of 1986, as amended.
[3] A proposal by the Senate Finance Committee would retain FDII, but make several significant changes to it.
[4] The 21% rate would notably treat the U.K. corporate income tax rate (currently at 19%) as being a low effective tax rate for purposes of the SHIELD regime.
[5] The Organisation for Economic Co-operation and Development’s (“OECD’s”) “Pillar Two Blueprint” is a set of rules that would require large multinationals to pay a minimum amount of tax, regardless of where they are organized or do business. On June 5, 2021, the Group of Seven (“G-7”) nations agreed that businesses should pay a minimum tax rate of at least 15% in each of the countries in which they operate. Paul Hannon, Richard Rubin and Sam Schechner. “G-7 Nations Agree on New Rules for Taxing Global Companies”. Wall Street Journal, June 5, 2021. https://www.wsj.com/articles/g-7-nations-agree-on-new-rules-for-taxing-global-companies-11622893415?page=1
[6] The Green Book does not include a proposal to remove the cap on Social Security tax on taxpayers with adjusted gross income in excess of $400,000, which is one of the proposals President Biden had made during his presidential campaign.
[7] Section 1061(a).
[8] Section 1061(c).
[9] Final Treas. Reg 1.1061-3(c)(3)(ii).
[10] Final Treas. Reg 1.1061-3(c)(3)(iv). Under the regulations, Unrelated Non-Service Partners will be treated as having made significant aggregate capital contributions if they possess 5% or more of the aggregate capital contributed to the partnership at the time the allocations are made.
[11] Carried Interest Fairness Act of 2021, H.R. 1068, 117th Cong. (2021).
[12] A “publicly traded partnership” with less than 90% passive “qualifying income” is taxable as a corporation for federal income tax purposes.
[13] Prior to the Tax Cuts and Jobs Act, section 1031 also applied to like-kind exchanges of personal property. The Tax Cuts and Jobs Act limited the scope of section 1031 to like-kind exchanges of real property.
Court of Appeal overturns High Court and holds that tax claim notice was valid
This was an appeal against the High Court decision in Dodika Ltd & Ors v United Luck Group Holdings Limited from August 2020 (see our Tax Blog on this). The case concerns the question of whether the notice given by the buyer to the sellers under a sale and purchase agreement (“SPA”) of a potential claim under a tax covenant complied with the requirements of the SPA.
As a reminder of the facts, the case related to a $1 billion sale of a group where, under the terms of the SPA, there was a $100 million escrow in respect of possible claims under the warranties and tax covenant given by the sellers. Before the final repayment of amounts from escrow, the buyer sent a notice of claim letter to the sellers referring to a transfer pricing investigation being undertaken by the Slovenian tax authority in respect of a group company. Prior to this letter being sent, the sellers and their representatives had been made aware of the investigation and were kept informed of its progress.
The terms of the SPA required the notice of claim to state “in reasonable detail the matter which gives rise to [the claim]”. The sellers argued that the notice of claim was invalid because it did not include sufficient detail about the matter giving rise to the claim and that the relevant matter was not the tax authority’s investigation itself (which was referenced in the letter) but the underlying facts, circumstances and events that were the subject of the transfer pricing investigation (which were not included in the letter other than stating that the Slovenian tax authority was enquiring into the relevant group companies’ historic pricing method).
The High Court had agreed with the sellers that the buyer was required to provide sufficient details relating to the facts, circumstances, and events that were the subject of the tax authority’s investigation and should not have relied on the sellers’ knowledge of the group’s historic activities.
Having reviewed the High Court’s decision, the Court of Appeal (“CA”) concluded that the buyer did provide sufficient details in the notice given to the sellers given the circumstances.
In reaching its conclusion, the CA noted the following:
• In the CA’s view, the “matter which gives rise to a claim” should include not only the fact that the tax authority had started to investigate one of the group company’s tax affairs but also the surrounding facts and circumstances of the company’s tax affairs. In this case, this was the adoption by the company of the disputed transfer pricing practices.
• The CA accepted that if a contract prescribes that certain information must be included in a notice, then a notice that fails to do so will be invalid, and the recipient’s knowledge of that specified information can be ignored.
• However, the CA noted that in this case, the SPA did not specify precisely what information the notice needs to contain, because the SPA simply required the notice to state things “in reasonable detail”. In the CA’s view, what is reasonable depends on all the circumstances and does not necessarily have to include what is already known to the recipient.
• Based on the facts, because the sellers already knew what the company’s transfer pricing practices were and so could surmise the general basis for the tax authority’s challenge, it was not reasonable to require the buyer to include this level of detail in the notice as it would not have conveyed any new or different information or identify anything the sellers could not establish for themselves.
• The CA concluded that the purpose of a notice of tax claim is to provide the recipient reasonable information to allow it to decide how it should approach the claim, what additional information it might request, what action it might require the claimant to take and similar. In this case, given the sellers’ intimate knowledge of the group’s prior transfer pricing practices, providing information that the tax authority was enquiring into the historic pricing methodology was sufficient to provide the sellers with this level of information.
As a result, the CA concluded that the notice provided by the buyer to the sellers complied with the terms of the SPA as it stated in reasonable detail the matter giving rise to the tax claim.
Although the decision is welcome in that it provides a more rational explanation on what a claims notice should include and the limits to sellers using highly technical arguments to seek to avoid the protections that they have agreed to give to a buyer, the case serves as a striking reminder to buyers and sellers just how much attention should be paid to claims notice provisions in the commercial documentation, where such provisions might not be considered as key terms.
In particular, when negotiating tax claim notice provisions, buyers would be well advised to carefully review the provisions with the view to establishing a clear framework of what information they are required to provide in relation to the underlying tax claim. While the sellers may wish to avoid limiting the notice requirements, it would be in the buyers’ interests to limit the scope of the requirements to the bare minimum so as to place the onus back onto the sellers to request further information as required.
If the buyers are in a position where they need to give a tax claim notice and the notice is required to include “reasonable detail” of the underlying tax matter, it would be prudent to provide to the sellers as many additional details as possible, including:
• the summary of the underlying tax claim,
• a detailed description of any facts and circumstances that gave rise to the claim, and
• all supporting information (including any documentation and correspondence from/to tax authority) relating to the claim.
In the event of doubt, the buyer should err on the side of caution and provide more information rather than less. The information and documentation should be provided irrespective of any assumed knowledge by the seller of the underlying facts and circumstances of the tax claim.
It would also be advisable for the claimants to avoid sending the claims notice to the sellers at the very end of the claims limitation period to ensure sufficient time to provide further information if necessary and have meaningful discussions with the sellers.
If the above considerations are taken into account, this could minimise the risk of any dispute arising as to the validity of a tax claim notice in the future.
In addition, if the contract provides for the final release of any escrow funds subject to the buyer submitting a valid claims notice, the buyer should consider including an appropriate dispute resolution mechanism. Such a mechanism could ensure that the escrow funds are not released to the sellers until any dispute relating to the claims notice has been resolved without a possibility of a further appeal.
Tax Provisions of the American Families Plan
On Wednesday, April 28th, the White House announced the American Families Plan, the “human capital” infrastructure proposal. The American Families Plan would spend $1.8 trillion, including $800 billion in tax cuts over ten years, offset by $1.5 billion in new taxes over the same period. This blog summarizes the tax provisions of the American Families Plan.
Tax Cuts
The American Families Plan proposes extending the expanded Affordable Care Act premium tax credits and the expanded Child Tax Credit enacted under the American Rescue Act, and making the Child Tax Credit, the Child and Dependent Care Tax Credit, and the Earned Income Tax Credit fully refundable on a permanent basis.
Increased Individual Ordinary and Capital Gains Top Rates
The American Families Plan would increase ordinary income rates from 37% to 39.6%, which when added to the 3.8% Medicare tax, would be 43.4% for the top ordinary income tax bracket. The capital gains tax rate for households over $1 million would be increased from 20% to 39.6%, which, including the 3.8% Medicare tax, would also be 43.4%. If this proposal is enacted, taxpayers will tend to hold their appreciated property rather than sell it and increasingly use financial products, such as prepaid forward contracts and costless collars, to reduce risk and monetize their appreciated publicly-traded positions.
Limiting Section 1014 Step-Up Basis at Death
Very generally, under section 1014, heirs acquire a decedent’s assets with a “stepped up” basis equal to fair market value so that the assets may be sold without income tax. The American Families Plan proposes to end “stepped up basis” under section 1014 for gains in excess of $1 million (or $2 million per couple).[1] Although the proposal is phrased as simply ending stepped up basis, it has been widely reported that the proposal would treat death as a realization event (i.e., upon death a decedent would be treated as if all of his or her assets were sold and the gain in excess of the $1 million/$2 million threshold would be subject to tax).[2] The American Families Plan also proposes that, for family-owned businesses and farms that are given to heirs who continue to run the business, tax on the appreciation would be due only upon a sale or when they are no longer family-owned and operated. It has been reported that a 15 year fixed-rate payment plan would be available for the taxes on certain illiquid assets.[3] No tax would be due for a gift to charity. Consequently, and as a result of the increased capital gains rates, gifts to charities would become much more attractive than under current law.
End Capital Gain Treatment for Carried Interests
Under current law, a partner who receives a share of future profits of (or a “carried interest in”) a partnership in exchange for services is not subject to income tax upon receipt and may be allocated capital gains from the partnership or realize capital gains upon a sale of the carried interest. Generally, under section 1061, certain holders of carried interests are entitled to long-term capital gains treatment only if they satisfy a three-year holding period (rather than the normal one-year period).
As mentioned above, the American Families Plan proposes to increase the highest marginal long-term capital gains rate so that it is equal to the highest marginal ordinary income rate. In addition, the American Families Plan proposes to “close the carried interest loophole so that hedge fund partners will pay ordinary income rates on their income just like every other worker.” It is, however, unclear whether the proposal will apply to all carried interest or only the carried interests currently subject to section 1061, and it is unclear what the mechanism for the change will be. If carried interests are taxable at ordinary income rates, we expect fund managers increasingly to receive their compensation in the form of deferred compensation. Finally, changes to the capital gains rate eliminate the benefits of issuing stock compensation, as capital gains would be taxable at the same rate as ordinary income.
End Section 1031 Like-Kind Exchanges
The American Families Plan proposes to end section 1031 tax-free like-kind exchanges for real estate gains in excess of $500,000. If this proposal is enacted, we expect real estate investors will use up-REIT structures and leveraged distributions to diversify and achieve liquidity for their appreciated real estate holdings.
3.8% Medicare Tax Reform
Under current law, limited partners and S shareholders can avoid paying the 3.8% Medicare tax on business income. The American Families Plan indicates that it would expand the 3.8% Medicare tax to apply to all those earning over $400,000.
Make Permanent the Section 461(l) Limitation on Excess Business Losses
Under section 461(l), business losses in excess of $250,000 (or $500,000 for a joint return, both indexed for inflation) that are not deductible become net operating losses. Section 461(l) will expire in 2026. The American Families Plan would make section 461(l) permanent.
No Repeal of the Cap on Social Security Taxes
Under current law, employers and employees are each subject to a 6.2% social security tax (for a total of 12.4%) and self-employed individuals are subject to a 12.4% social security tax on their first $142,800 (in 2021) of wages. It had been reported that the Biden Administration would lift the cap so that the social security tax applied to all wages and self-employment income. This proposal was not in the American Families Plan.
No Change to the Gift and Estate Taxes
The American Families Plan does not propose any change to the gift and estate taxes.
No Repeal of the SALT Limitation
Currently, only a maximum of $10,000 annually of state and local taxes (SALT) are deductible from federal income. The American Families Plan does not propose to change the SALT limitation.
Dramatic Increase in Tax Enforcement for High-Income Taxpayers
The American Families Plan proposes to dramatically increase IRS funding (by $80 billion, according to news reports[4]) and audit rates for taxpayers earning more than $400,000. The American Families Plan also proposes to give the IRS authority to regulate paid tax return preparers and require financial institutions to report financial account cash flow to the IRS.
[1] In addition, individuals would be able to exclude $250,000 (and couples $500,000) of gain from a principal residence, as is the case under current law.
[2] Biden’s Capital-Gains Tax Plan Would Upend Estate Planning by the Wealthy – WSJ
[3] Biden’s Capital-Gains Tax Plan Would Upend Estate Planning by the Wealthy – WSJ
[4] Biden Seeks $80 Billion to Beef Up I.R.S. Audits of High-Earners – NY Times.
Comparison of the Biden Administration and Senate Finance Committee International Tax Proposals
On March 31, 2021, the Biden administration released a factsheet for the “Made in America Tax Plan”. On April 5, 2021, Senate Finance Chair Ron Wyden (D-Ore.) and Senators Sherrod Brown (D-Ohio) and Mark Warner (D-Va.) released “Overhauling International Taxation: A framework to invest in the American people by ensuring multinational corporations pay their fair share” (the “Senate Finance Plan”), a parallel set of proposals to the Made in America Tax Plan. On April 7, 2021, the Treasury Department released a report on the Made in America Tax Plan that provides more detail on the Biden Administration’s tax proposals (the “Treasury Report”). Finally, on April 5, 2021, the Treasury Secretary, Janet Yellen, gave a speech to the Chicago Council on Global Affairs and, on April 8, 2021, wrote an op-ed in the Wall Street Journal advocating a global minimum tax, which is a chief component of the Made in America Tax Plan.
Together, while these proposals retain the basic international architecture of the Tax Cuts and Jobs Act, they effectively would flip the U.S. international tax system from a largely “territorial system”, with an effective U.S. tax rate of 10.5% on the foreign-source income of U.S. multinationals (50% of the domestic rate), to one that is largely “worldwide”, with a rate between 16.8% to 28% (representing between 60% and 100% of the domestic rate). This dramatic increase in the taxation of offshore income (both in absolute terms and as a percentage of the domestic corporate tax rate), which would increase the aggregate U.S. federal, state, and local tax rate to the highest of any OECD country, could affect U.S. competitiveness unless our trading partners enact corresponding increases to their own corporate tax rates. The threat of global tax competition – arising in part from the Administration’s proposed increase – led Secretary of the Treasury Janet Yellen to call for a global minimum tax.
The proposals do not address other elements of global tax competition, such as the OECD’s proposal that expands the ability of countries to tax internet and remote services, or transfer pricing, or a uniform corporate income tax. Although Treasury Secretary Janet Yellen has voiced support for some of these efforts, it is unclear exactly what measures the Biden administration would propose.
This blog describes the Biden Administration’s international tax proposals and compares them with the Senate Finance Plan.[1]
GILTI
The “global intangible low-taxed income” (“GILTI”) regime generally imposes a 10.5% minimum tax on 10-percent U.S. corporate shareholders of “controlled foreign corporations” (“CFCs”) based on the CFC’s “active” income in excess of a threshold equal to 10% of the CFC’s tax basis in certain depreciable tangible property (such basis, “qualified business asset investment”, or “QBAI”). GILTI is not determined on a country-by-country basis, and, therefore, under current law a U.S. multinational corporation may be able to avoid the GILTI tax with respect to its subsidiaries operating in low tax-rate countries by “blending” income earned in the low tax-rate countries with income from high tax-rate countries.
Effective Tax Rate on GILTI
Under the Made in America Tax Plan, the effective tax rate on GILTI for corporate taxpayers would increase from 10.5% to 21%, which represents an increase in the effective tax rate on GILTI to 75% of the corporate tax rate (21%/28%) from 50% of the corporate tax rate under current law (10.5%/21%).
While the Senate Finance Plan acknowledges that it is necessary to increase the effective tax rate on GILTI for U.S. corporate taxpayers, it does not propose a specific rate. Instead, it suggests that the rate could be anywhere between 60% and 100% of the domestic corporate tax rate.
Country-by-country determination
Today, GILTI is applied on a global basis and U.S. multinationals can avoid the GILTI tax on investments in low-tax jurisdictions by “blending” the income earned in low-tax jurisdictions with income earned in high-tax jurisdictions. The Made in America Tax Plan would require GILTI to be determined on a country-by-country basis that would prevent blending. Accordingly, income earned in low tax-rate countries would be subject to the minimum tax under the GILTI regime.
The Senate Finance Plan similarly addresses the “blending” issue, but provides for two alternatives to address the issue. The first option would be the same country-by-country determination proposed in the Made in America Tax Plan. The second option would be to exclude high-taxed income from GILTI altogether, effectively taxing only GILTI in low-taxed jurisdictions.
The Treasury Report asserts that this transition to a country-by-country determination would raise more than $500 billion in revenue over a decade.
Elimination of 10% of QBAI exclusion
Both the Made in America Tax Plan and the Senate Finance Plan propose the elimination of the exclusion of 10% of QBAI from the GILTI calculation. Accordingly, the first dollar of CFC “active” income would be subject to the GILTI tax.
Treating research and management expenses occurred in the U.S. as domestic expenses (provided only in the Senate Finance Plan)
Under current law, a portion of certain expenses are allocated to foreign source income for purposes of determining the effective foreign tax rate on that income, which may subject the foreign income to GILTI. To encourage research and certain types of management activities within the U.S., the Senate Finance Plan proposes to treat research and management expenses incurred in the United States as entirely “domestic expenses”, which would not cause U.S. multinationals that incur them to be subject to additional GILTI.
FDII
The “foreign-derived intangible income” (“FDII”) regime provides a lower 13.5% effective tax rate for certain foreign sales and the provision of certain services to unrelated foreign parties in excess of 10% of the taxpayer’s domestic QBAI.
Under the Made in America Tax Plan, FDII would be repealed in its entirety.
The Senate Finance Plan would retain FDII, but make a number of significant changes to the current regime:
- The exclusion of 10% of domestic QBAI would be removed.
- The effective tax rate on FDII would be made equal to the effective tax rate on GILTI.
- FDII would be redefined as “foreign deemed innovation income” (rather than “foreign deemed intangible income”), and would provide for a lower effective tax rate on “deemed innovation income”, which would be determined by reference to expenses for “innovation-spurring” activities that occur in the United States, such as research and development and worker training. No further details are given. It is unclear how the revised FDII regime would interact with existing incentives, such as deductions for research and development provided under section 174.
BEAT
The “base erosion and anti-abuse tax” (“BEAT”) generally provides for an add-on minimum tax, currently at 10%, on certain deductible payments that are made by very large U.S. corporations to related foreign parties.
The Made in America Tax Plan would replace the BEAT regime with the “Stopping Harmful Inversions and Ending Low-tax Developments” or “SHIELD” regime. Similar to the BEAT, the SHIELD regime would also deny U.S. multinationals tax deductions for payments made to related parties, but only if the related parties receiving the payments are subject to a low effective rate of tax. The tax rate at which the SHIELD regime is triggered would initially be equal to the 21% proposed GILTI rate, but would be replaced by an eventual global minimum tax rate established under a multilateral agreement.
The SHIELD regime would also expand the anti-inversion rules by treating any foreign corporation as a U.S. corporation for U.S. federal income tax purposes if (i) more than 50% (rather than 80% under current law) of the value or vote of the stock of the foreign corporation is owned by the former owners of the acquired U.S. company or (ii) any amount of the foreign corporation is owned by the former owners of the acquired U.S. company if the foreign corporation is “managed and controlled” in the United States.
The Senate Finance Plan would instead retain the BEAT regime, but would change the rules in a couple of ways:
- Under current law, taxpayers can apply 80% of their low-income house credits, renewable electricity production credits and certain energy credits to reduce their BEAT liability. In a pro-taxpayer change, the Senate Finance Plan would allow taxpayers to use 100% of these credits to reduce their BEAT liability. The Senate Proposal also notes that rules regarding foreign tax credits, which also generally increase the BEAT amount, may need to be addressed.
- The BEAT would be bifurcated into two minimum taxes. The first, at 10%, would operate as BEAT currently operates. A new higher rate would apply to “base erosion payments” that erode the tax base.
This table summarizes the Senate Finance Plan’s and the Made in America Tax Plan’s proposed changes to the international tax rules:
| The Made in America Tax Plan | The Senate Finance Plan |
| GILTI | |
|
– Effective tax rate: 75% of the corporate tax rate (21%/28%) – Eliminate exclusion for 10% of QBAI – Country-by-country determination |
– Effective tax rate: 60-100% of the corporate tax rate (e.g. 16.8% – 28%) – Eliminate exclusion for 10% of QBAI – Country-by-country determination OR mandatory high-tax exclusion – Treat expenses for research and management in the U.S. as domestic expenses for foreign tax credit purposes |
| FDII | |
| – Repeal |
– Eliminate exclusion for 10% of QBAI – Equalize tax rates on FDII and GILTI – Replace “deemed intangible income” with “deemed innovation income” |
| BEAT | |
|
– Replace with the SHIELD regime – Seek international cooperation in implementing global minimum corporate tax |
– Restore full value of certain credits under the BEAT regime – Create second, higher bracket for “base erosion payments” |
__________________
[1] Our prior blog post provided a summary of the changes in the Made in America Tax Plan.
The Made in America Tax Plan: The Biden Administration Outlines its Tax Reform Proposals
On March 31, 2021, the White House released a factsheet describing the “American Jobs Plan”, a $2.3 trillion proposal for infrastructure spending that also contains certain significant tax credits, and the “Made in America Tax Plan”, a tax proposal that would generate revenue to pay for the American Jobs Plan spending. The White House estimates that the Made in America Tax Plan will raise $2 trillion in tax revenue over the next 15 years.
The Made in America Tax Plan contains a number of proposals that apply principally to multinational corporate taxpayers, many of which are similar to those proposed by President Biden during his presidential campaign. The proposals include a significant increase to the U.S. federal corporate income tax rate (but still well below the pre-2017 rate), a “minimum” tax on the book income of large corporations, and significant changes to some of the international tax rules that were enacted as part of the Tax Cuts and Jobs Act in 2017.
The factsheet is not proposed legislation, and each element of the Made in America Tax Plan must be introduced and passed by Congress before it can become law. It is very possible that some or all of the proposals in the Made in America Tax Plan will be substantially modified before being enacted into law. Additionally, Senate Finance Chair Ron Wyden (D-Ore.) and Senators Sherrod Brown (D-Ohio) and Mark Warner (D-Va.) introduced a separate international tax proposal on April 5, 2021. The Senators’ plan is somewhat different than the Made in America Tax Plan.
The remainder of this post contains a short summary of the proposals under the Made in America Tax Plan and the tax credits in the American Jobs Plan:
Increase in corporate income tax rate
Under the Made in America Tax Plan, the U.S. federal corporate income tax rate would be increased from 21% to 28%. The Tax Foundation has estimated that, taking into account state and local taxes, the aggregate U.S. corporate tax rate would be 32.34%, which would be the highest in the OECD. (The Tax Foundation estimates that the United States is currently the 12th highest in the OECD, with a combined U.S federal, state and local rate of 25.76%.)[1]
Revised GILTI regime
The “global intangible low taxed income” (“GILTI”) regime was enacted as part of the Tax Cuts and Jobs Act. Very generally, GILTI imposes a 10.5% minimum tax on 10-percent U.S. corporate shareholders of “controlled foreign corporations,” based upon the controlled foreign corporation’s “active” income in excess of a threshold equal to 10% multiplied by the foreign corporation’s tax basis in certain depreciable tangible property.[2] (This basis is referred to as “qualified business asset investment”, or “QBAI”.) GILTI is not determined on a country-by-country basis, and, therefore, under current law a U.S. multinational corporation may be able to avoid the GILTI tax with respect to its subsidiaries operating in low tax-rate countries by “blending” the low rate with income from subsidiaries operating in high tax-rate countries.
The Made in America Tax Plan would make three changes to the GILTI regime.
- The effective tax rate on GILTI for corporate taxpayers would increase from 10.5% to 21%, which represents an increase in the effective tax rate on GILTI to 75% of the corporate tax rate (21%/28%, assuming the U.S. federal corporate tax rate is raised to 28%) from 50% of the corporate tax rate under current law (10.5%/21%).
- GILTI would be required to be determined on a country-by-country basis. Accordingly, income earned in low tax-rate countries would become subject to GILTI, whereas under current law, it might be blended with higher-taxed income and either reduce or eliminate GILTI entirely.
- The exclusion equal to 10% of QBAI would be removed.
Together, these proposals would change the GILTI regime in a manner that would generally tax foreign source income of U.S. multinational corporations at a significantly higher rate and make offshore investments by U.S. multinationals much less attractive than under current law.
Repeal of FDII regime; expansion of R&D investment incentives
The “foreign derived intangible income” (“FDII”) regime under current law is intended to provide a counterbalance to the GILTI regime by encouraging U.S. multinational groups to keep intellectual property in the United States by providing a lower 13.5% effective tax rate for certain foreign sales and the provision of certain services to unrelated foreign parties in excess of 10% multiplied by the taxpayer’s QBAI.[3]
The Made in America Tax Plan would repeal the FDII regime in its entirety. The factsheet states, without detail, that the revenue from the repeal of the FDII regime will be used to expand more effective research and development (“R&D”) investment incentives.
Multi-lateral global minimum tax agreement and replacement of BEAT
The factsheet indicates that the Biden Administration will seek a global agreement on a strong minimum tax through multilateral negotiations and will repeal and replace the “base erosion and anti-abuse tax” (“BEAT”) with a regime that denies deductions to U.S. multinationals that make payments to countries in jurisdictions that have not adopted the minimum tax. (The BEAT is a 10% minimum tax that applies to very large multinational corporations and limits deductions on certain transactions with related foreign persons.)[4]
Strengthening “anti-inversion” rules; imposing U.S. tax on foreign corporations with U.S. management and operations
The factsheet indicates that President Biden will seek to prevent U.S. corporations from merging with foreign corporations and reducing their U.S. federal income tax while retaining management and operations in the United States. It is unclear whether tax would be imposed on the merger, or whether such a resulting foreign corporation would be treated as a U.S. corporation. It is also unclear what effect this proposal might have on foreign corporations that previously inverted.
Elimination of deductions for expenses relating to “offshoring jobs” and new tax credits for “onshoring jobs”
The Made in America Tax Plan would eliminate deductions for expenses arising from offshoring jobs (i.e., moving a factory from the United States to a foreign jurisdictions) and provide tax credits for onshoring jobs. There is no detail on these proposals.
Minimum corporate tax on “book income”
The Made in America Tax Plan would impose a 15% minimum tax on “large, profitable corporations” based on “book income”, which appears to refer to GAAP income. This proposal is in line with President Biden’s presidential proposal of a minimum tax of 15% on book income for corporations with book income exceeding $100M. The proposal does not indicate how the minimum tax would be computed for companies that use IFRS or other non-GAAP methods of accounting.
Fossil fuels and environmental cleanup
The Made in America Tax Plan proposes to eliminate all subsidies, loopholes, and special foreign tax credits available to the fossil fuel industry. The factsheet also indicates that the Plan would restore payments from polluters into the Superfund Trust Fund to cover costs of environmental cleanups.
Strengthening enforcement against corporations
The Made in America Tax Plan also proposes strengthening enforcement against corporations by increasing funding and resources to the IRS, with a stated goal of raising audit rates.
Tax credits in the American Jobs Plan
Aside from the proposed tax law changes in the Made in American Tax Plan, the American Jobs Plan also proposes a series of tax credits. These tax credits include:
- Point of sale rebates and tax incentives to buy American-made electric vehicles;
- A business tax credit for low- and middle-income families and small businesses to invest in disaster resilience;
- A targeted investment tax credit for construction of high-voltage capacity power lines;
- An investment tax credit and production tax credit for clean energy generation and clean energy storage;
- Reform and expansion of the section 45Q tax credit, which provides a tax credit on a per-ton basis for CO2 that is sequestered by new equipment placed into service. The American Jobs Plan proposed to make the credit direct pay and easier to use for certain industrial applications, air recapture, and retrofits of existing power plants;
- Targeted tax credits to expand affordable housing rental opportunities in underserved communities;
- The Neighborhood Homes Investment Act tax credit (which is proposed to be $20 billion over five years) to build or rehabilitate 500,000 homes;
- Expanding the home and commercial efficiency tax credits under the Weatherization Assistance Program;
- A tax credit (50% of the first $1 million in construction costs per facility) to encourage the building of child care facilities at places of work; and
- An expansion of the section 48C tax credit program, which aims to build a robust U.S. manufacturing capacity to supply clean energy projects with American-made parts and equipment.
[1] See Biden Infrastructure Plan: American Jobs Plan | Tax Foundation.
[2] Under section 250, the 10.5% rate is provided through a 50% deduction, which is generally not available for non-corporate taxpayers unless an election under section 962 is made. All section references are to the Internal Revenue Code.
[3] The lower effective rate is achieved through a deduction. See section 250.
[4] Section 59A. Corporations subject to the BEAT are generally those with annual gross receipts exceeding $500M whose base erosion percentage is 3 percent or higher. A base erosion percentage generally is the base erosion tax benefits divided by the corporation’s total deductions.
