Global Tax Alert (News from Washington Council EY)| 27 February 2014
Highlights of Chairman Camp’s tax reform discussion draft
On 26 February 2014, House Ways and Means Committee Chairman Dave Camp, released a comprehensive tax reform discussion draft that would eliminate and modify a host of current corporate tax provisions to reduce the statutory corporate tax rate to 25%. The draft also would make major reforms to the individual tax provisions. The long-awaited plan, the product of three-plus years of work from Camp and his staff, illustrates the trade-offs necessary to significantly lower tax rates but also, through a macroeconomic analysis, achieve potential economic growth associated with tax reform: GDP would be projected to grow between 0.1% to 1.6% during the 10-year budget period, increasing revenues by $50 billion-$700 billion over the same period.
It is not clear that Camp’s plan will be brought up for consideration in the Ways and Means Committee or otherwise in Congress this year: Speaker John Boehner described the release of the draft as the beginning of a “public conversation” on tax reform, following comments from Senate Democratic and Republican leaders earlier indicating tax reform is a non-starter in that chamber this year. Attempting to cultivate some bipartisan support for the plan, Chairman Camp noted in a news conference the elements on which Ways and Means members of both parties have worked. The draft taps proposals that have had mostly Democratic support, including changing the tax treatment of carried interest, imposing a tax on large financial institutions and allocating a portion of one-time revenue from the deemed repatriation of foreign earnings to the Highway Trust Fund, which the White House found “encouraging.”
Other changes to achieve the reduction in the corporate rate include replacement of the modified accelerated cost recovery system (MACRS) with a system for longer recoveries approximating economic depreciation under the Alternative Depreciation System (ADS), repeal of the deduction for income attributable to domestic production activities and elimination/modification of a host of business tax credits, deductions and accounting methods.
This Alert outlines the key corporate, international, and financial services provisions of interest to multinational companies.
Corporate tax rate: The plan reduces the maximum corporate tax rate from 35% to 25%, phased in ratably over five years.
Corporate AMT repeal: The corporate alternative minimum tax would be repealed under the draft. Existing AMT credits would be refundable for any tax year beginning after 2015 and before 2020 in an amount equal to 50% (100% for tax years beginning in 2019) of the excess of the minimum tax credit for the tax year over the amount of the credit allowable for the year against regular tax liability. The full amount of the minimum tax credit will be allowed in tax years beginning before 2020.
Medical device excise tax repeal: The draft also calls for repeal of the medical device excise tax for sales after date of enactment.
The draft would repeal or modify many deductions and exclusions, including:
Accelerated depreciation: The modified MACRS rules would be repealed and replaced by rules substantially similar to the ADS. This would lengthen class lives and require the use of the straight-line method. Taxpayers would be able to adjust their basis in depreciable assets in accordance with the chained consumer price index rate at the end of each year. This provision is prospective and is effective for property placed in service after 2016.
Special depreciation provisions repealed: Bonus depreciation and special provisions for depreciation of qualified leasehold improvements, qualified restaurant property and qualified retail improvement property, among others, would be repealed.
Section 179 expensing: The draft would make Section 179 expensing permanent at the 2008-09 levels, allowing small businesses to expense up to $250,000 of investments in new depreciable property each year, with the deduction phased out for investments exceeding $800,000.
R & E expenditure: All research and experimentation expenses would be amortized over five years. This would be phased in over several years, during which more than 20% of R&E expenses would continue to be currently deductible. A credit for qualified research expenses would be available on a permanent basis (discussed later).
Advertising expenses: Advertising expenses would be 50% deductible currently and 50% amortizable ratably over 10 years. This would be phased in over four years. For taxpayers with less than $1.5 million of advertising expense, the first $1 million would be currently deductible; this benefit would phase out fully for taxpayers with more than $2 million of advertising expense. Advertising expenses would include wages paid to employees primarily engaged in activities related to advertising and the direct supervision of such employees.
Amortization of acquired intangibles: The amortization period for the cost of acquired intangibles under Section 197 would be lengthened to 20 years.
Section 199 domestic production activities: The draft would phase out the Section 199 deduction over two years, reducing the current 9% deduction to 6% for 2015 and 3% for 2016. At the same time, the draft would create a “qualified domestic manufacturing income” exclusion from the 10% surtax for high-income individuals.
Entertainment expenses: The current rules on deductibility of entertainment expenses would be tightened significantly.
Like-kind exchanges: The nonrecognition of gain or loss on exchanges of like-kind property would be repealed for transfers after 2014.
Net operating losses: The draft would limit the deduction of an NOL carryforward or carryback to 90% of a C corporation’s taxable income for the year, and would repeal certain special NOL carryback rules.
Percentage depletion: The percentage-depletion method of capital cost recovery for oil and gas companies would be repealed.
Reform of business credits
The draft would repeal many business credits and would reform the following:
Research credit: A modified research credit would be made permanent. The credit would equal 15% of qualified research expenses and basic research payments exceeding the average of those expenses and payments for the three preceding years. Amounts paid for supplies or computer software would no longer qualify as qualified research expenses.
Low-income housing tax credit: The housing credit would be one of just three current law business tax credits that would be preserved (along with the research credit and the credit for the cost of complying with American with Disabilities Act). The draft includes a number of proposed modifications to the housing credit program, including:
- • Elimination of the tax-exempt bond program for multifamily housing
- • Elimination of the 4% Housing Credit for acquisition of existing property
- • Extension of the credit period from 10 years to 15 years
- • Repeal of the 130% basis boost for “high-cost and difficult development areas”
- • Elimination of all special occupancy preferences except for individuals with special needs and veterans
- • Removal of the requirement that states include energy efficiency and the historic nature of the project as selection criteria
The draft would repeal many business credits, including credits for:
- • Electricity produced from certain renewable resources (10-year phase-out)
- • Employer Social Security taxes paid on employee cash tips
- • Clinical testing expenses for orphan drugs
- • Employee health insurance expenses of small employers
- • Rehabilitation for old and/or historic buildings
- • Employer-provided childcare
Many of the international tax proposals in the plan mirror those in Camp’s October 2011 international tax draft, with some significant changes.
95% exemption for foreign-source dividends: The draft would exempt 95% of the foreign-source portion of dividends received by a US corporation from a foreign corporation in which the US corporation owns at least a 10% stake. No exemption is provided for income of foreign branches. This proposal is simpler than Camp’s 2011 international tax reform discussion draft, which exempted 95% of dividends from controlled foreign corporations (CFCs), treated foreign branches of US corporations as CFCs and allowed the taxpayer to elect to treat non-controlled 10%-owned foreign corporations as CFCs.
Mandatory toll charge on tax-deferred foreign earnings: A one-time transitional tax would be imposed on a US 10%-shareholder’s pro rata share of the foreign corporation’s post-1986 tax-deferred earnings, at the rate of either 8.75% (in the case of accumulated earnings held in cash, cash equivalents or certain other short-term assets) or 3.5% (in the case of accumulated earnings invested in property, plant and equipment). An affected US shareholder with a 10%-or-greater stake in a foreign corporation with a post-1986 accumulated deficit would be able to offset the deficit ratably against tax-deferred earnings of other foreign corporations. The US shareholder could elect to pay the transitional tax over a period of up to eight years. Of the $170.4 billion raised over 10 years by this proposal, $126.5 billion would be paid into the Highway Trust Fund.
Anti-base-erosion provisions: The draft would impose current US tax (subject to foreign tax credits) on a CFC’s income exceeding 10% of the CFC’s adjusted basis in depreciable tangible property (excluding income and property related to commodities), if the effective foreign tax rate on such income was less than 15%. A US corporation would be able to deduct a percentage (55% for 2015, phasing down to 40% for 2019 and later years) of the foreign-sales portion of such CFC income and could also deduct the same percentage of the foreign-sales portion of the US corporation’s income exceeding its adjusted basis in depreciable tangible property. As a result, a 15% US tax rate would apply to foreign-sales income exceeding the normal return on investment in tangible business assets, whether the income was earned by a CFC or directly by a US corporation.
Other Subpart F changes: The temporary look-through rule of Section 954(c)(6) would be made permanent. Foreign base company sales income would not include any income of a CFC that was a qualified resident of a country with a comprehensive income tax treaty with the United States. The high-foreign-tax exception threshold, currently 90% of the US corporate tax rate, would be reduced to 50% of the US corporate rate (i.e., 12.5%) for foreign base company sales income. To the extent that income was subject to foreign tax at a rate of less than 12.5%, it would be taxed in the United States under Subpart F at the rate of only 12.5%, subject to foreign tax credits.
Active financing exception: The active financing exception would be extended for five years (through 2019), during which time active financial services income of CFCs would be tax-deferred (subject to dividend exemption upon repatriation) if it were subject to foreign tax at an effective rate of at least 12.5% (50% of the maximum US rate). If the foreign effective tax rate was less than 12.5%, the income would be taxed under Subpart F at the rate of 12.5%, subject to foreign tax credits.
Foreign tax credit changes: The indirect foreign tax credit (FTC) would be available only for Subpart F inclusions. In determining the FTC limitation, only expenses directly attributable to the production of foreign-source income would be allocated against such income. There would continue to be two baskets for FTC purposes, but the passive basket would be renamed the mobile income basket and expanded to include certain related-party sales income and foreign-sales income in excess of the normal return on investment in tangible business assets. The source of income from sales of inventory produced in the United States and sold abroad (or vice versa) would be based solely on the relevant production activities.
Thin-capitalization rules: The draft proposes essentially the same thin-capitalization rule that was in Camp’s 2011 discussion draft, applicable to US corporations that own foreign subsidiaries. Deductible net interest expense of the US corporate taxpayer would be reduced by the lower of: (1)the amount of such interest that is attributable to debt in excess of the global group’s debt level, or (2)the excess of such interest over 40% of the adjusted taxable income of the US group. In addition, the draft would amend Section 163(j), relating to inbound related-party loans, by reducing the threshold for excess interest expense from 50% to 40% of adjusted taxable income and by eliminating the ability to carry forward any excess interest incurred after 2014.
Affiliate reinsurance: The draft would deny deductions to US insurance companies for reinsurance premiums paid to an affiliate that was not subject to US taxation, unless the affiliate was subject to an effective rate of income tax imposed by a foreign country that is not less than 100% of the maximum US rate. If deductions were denied, related income (such as ceding commissions) from such affiliate reinsurance would not be subject to US taxation.
PFIC exception for active insurance business: The draft would amend the passive foreign investment company (PFIC) rules to provide that a foreign insurance company would be within the rules unless it met three conditions: (1) it would be taxed as an insurance company if it were a US corporation, (2) more than 50% of its gross receipts consist of premiums, and (3) its insurance liabilities amount to more than 35% of its total asset value.
Denial of treaty benefits on certain deductible FDAP income payments: The draft would deny the benefit of reduced withholding rates under a tax treaty if the payment was made to an affiliate and the common parent company is not resident in a country that has a tax treaty with the US that would give an equivalent reduction in the withholding rate if the payment had been made to the parent company.
Carried interest, pass-through entity changes
Carried interest: The Camp proposal would subject certain partnership interests held in connection with the performance of services to a rule that characterizes a portion of any capital gains as ordinary income. It would apply to partnership distributions and dispositions of partnership interests. Real property partnerships would be carved out of the rule. To the extent a service partner contributes capital, the result would be less recharacterization as ordinary income, determined under a recharacterization formula.
Partnerships: Other partnership changes, some of which were proposed in Chairman Camp’s small business discussion draft that was released in March of 2013, include:
- • Repeal of rules relating to guaranteed payments and liquidating distributions
- • Mandatory basis adjustments in case of transfers of partnership interests
- • Revisions related to unrealized receivables and inventory items
- • Repeal of time limitation on taxing pre-contribution gain
- • Publicly traded partnership exception restricted to mining and natural resources partnerships
S corporations: Similarly, some of the S corporation changes proposed in Chairman Camp’s small business discussion draft are included in the proposal. The S corporation changes include:
- • Reduced recognition period for built-in gains made permanent
- • Modifications to S corporation passive investment income rules
- • Expansion of qualifying beneficiaries of an electing small business trust
- • Extension of time for making S corporation elections
REITs and RICs: The proposal also makes a number of changes to the REIT and RIC rules, designed both to make the REIT structure a more attractive investment vehicle, and to discourage the use of the REIT structure to erode the corporate tax base by: a) making it more difficult for operating companies to convert into REITS, and b) limiting REIT eligible assets to those assets more closely related to real estate. The REIT changes include:
- • Prevention of tax-free spinoffs involving REITs
- • Limits on short-life property treatment as real property
- • Repeal of timber REITs by not permitting timber sales to count as real property
- • Limits on the use of rents tied to fixed percentage of sales
- • Repeal of the preferential dividend rule
- • Limits on the designation of dividends
- • Treatment of REIT dividends as real estate assets
- • Reduction of the taxable REIT subsidiary limit from 25% to 20% of assets.
Financial product reforms
On 24 January 2013, Chairman Camp released a discussion draft on financial products that notably would have required mark-to-market treatment for most derivatives. His comprehensive tax reform plan retains many of the proposed reforms in that earlier draft, but with significant modifications.
Mark-to-market treatment: The plan proposes that all taxpayers generally account for all derivatives on a mark-to-market basis, with any resulting gain or loss recognized annually as ordinary in character. Notably different from the earlier financial products draft are a number of exclusions from the definition of derivatives subject to the mark-to-market rule, though most of those exclusions would be left to regulations. To the extent provided by regulations, securities lending and sale-repurchasing and similar financing arrangements would be excluded. Insurance, annuity and endowment contracts would be excluded, as would American depositary receipts (ADRs) and other similar instruments. Certain commodity contracts are also made exempt, as are certain contracts with respect to stock issued by any member of the same affiliated worldwide group of companies. Unlike the earlier draft, the plan includes special rules for determining the fair market value of derivatives. In addition, a new effective date rule is included, so that the proposal would apply to tax years ending after 31 December 2014, for property acquired and positions established after that date, but would not apply until tax years after 31 December 2019, for all other property or positions.
Mark-to-market for straddles: Similar to the earlier Camp draft, the plan would treat the non-derivative portion of a straddle as a derivative for both timing and character purposes. Upon establishing the straddle, any built-in gain position would be treated as sold for its fair market value. A change from the earlier draft would exclude qualified covered calls from the straddle proposal.
Business hedging transactions: The plan includes new rules for transactions that are properly identified as hedging transactions, and exempts those transactions from mark-to-market treatment. Similar to the earlier draft, a hedging transaction would be treated as meeting the hedge identification requirement under Section 1221 if it is so identified for tax purposes, like under current law, or if it is treated as a hedging transaction within the meaning of GAAP for purposes of the taxpayer’s audited financial statements. A new proposal clarifies the hedging exception for insurance company indebtedness so that, for purposes of Section 1221 only, that indebtedness would be treated as ordinary in character and thus hedges of such indebtedness would qualify as good tax hedges. Another new proposal would broaden the exception from Subpart F for income arising out of commodity hedging transactions.
Determining cost basis of securities and repeal of the specific identification method: Like the earlier Camp draft, the proposal repeals the ability of taxpayers to specifically identify shares of stock they are selling when they are selling a portion, but not all, of the same security for purposes of determining basis in the security. The proposal requires that taxpayers utilize a first-in, first out (FIFO) method unless utilizing average cost for determining basis of the security is allowed (as in the case of a RIC), effective for securities sold, exchanged or otherwise disposed of on or after January 1, 2015. Camp’s prior proposal would have limited the cost basis computation to average basis only.
New derivatives proposal not in prior Camp draft: A new proposal would require a corporation to recognize gain or loss with respect to derivatives relating to a corporation’s own stock in certain transactions that involve the corporation acquiring its own stock and entering into a forward contract with respect to its own stock.
Other proposals in prior Camp draft: In addition, like the earlier Camp draft, the plan includes proposals relating to the treatment of market discount, exchanges of debt instruments, and the treatment of wash sales involving related parties.
Tax-exempt bonds: The draft would repeal the exclusion from gross income for interest on qualified private activity bonds and for interest on any bond issued to advance refund a tax-exempt bond, effective for bonds issued after 31 December 2014. In addition, the draft would repeal, prospectively, all the existing authority for issuing tax credit bonds and direct pay bonds.
Financial services companies
Imposition of new excise tax on systemically important financial institutions (SIFIs): The plan would apply a 0.035% excise tax on a quarterly basis to the consolidated total assets of any SIFI whose assets total more than $500 billion. The tax would apply to assets exceeding that amount and would apply to calendar quarters beginning after 31 December 2014. The $500 billion amount would be indexed to changes in gross domestic product after 2015.
Deductibility of FDIC premiums: No deduction would be allowed for a certain percentage of premiums paid by banks to the Federal Deposit Insurance Corporation for tax years after 2014. The deduction would be disallowed for taxpayers with consolidated assets of $50 billion or more, and limited for smaller financial institutions.
Corporate owned life insurance (COLI): The proposal would apply the pro-rata interest deduction limitation to COLI contracts, with the exception of those covering 20% owners in a company. The exceptions for contracts covering employees, officers and directors would be repealed for contracts issued after 31 December 2014.
Net operating losses of life insurance companies: The carryback and carryforward rules for life insurance companies would conform to the rules that apply to all other companies.
Computation of life insurance company reserves: The proposal, among other things, would make the Federal applicable interest rate, plus 3.5 percentage points, the interest rate for determining reserves. Any income or loss from the change in computing reserves would be taken into income ratably over eight years.
Life insurance company proration rules for dividends received deductions (DRD) and reserve deductions: The proposal would change the methodology for reducing the DRD and reserve deductions relating to untaxed income.
Modification of proration rules for P&C companies: In calculating the amount of reserves that can be deducted relating to losses, the 15% reduction that relates to tax-exempt interest would be replaced with a new formula. That formula would reduce the deduction for losses by the ratio of the average adjusted basis of tax-exempt assets to the average adjusted basis of all the assets of the company. The proposal would be effective for tax years beginning after 31 December 2014, but a transition rule would apply so that adjustments would be taken into account ratably over eight years.
Modifications of reserve discounting rules for P&C companies: The proposal would modify the manner in which reserves are discounted in several ways, including changing the prescribed interest rate, extending the period applicable under the loss payment pattern and repealing the election to use a taxpayer’s historical loss payment pattern.
Repeal of special rules for Blue Cross Blue Shield insurance companies: The plan repeals Section 833 in two stages, with “deemed insurance company” status being repealed for tax years beginning after 31 December 2016.
Capitalization of policy acquisition expenses for insurance companies: For purposes of capitalizing and amortizing specified insurance policy acquisition expenses, the plan would increase the amount of such expenses that have to be capitalized. The proposal would consolidate the three categories of insurance contracts utilized for this purpose under current law into two categories: group contracts and other specified insurance contracts: and increases the percentage of net premiums that may be treated as specified policy acquisition expenses for both categories of contracts.
Tax reporting of life insurance settlement transactions: The plan imposes reporting requirements for these transactions.
Under the Camp draft, virtually all tax incentives for renewable energy would be repealed, along with a handful of provisions relating to the tax treatment of fossil fuels. Specifically, the plan would:
- • Repeal the election to expense certain refineries (Section 179C)
- • Repeal the deduction for energy-efficient commercial buildings (Section 179D)
- • Repeal percentage depletion (Sections 613 and 613A)
- • Repeal the passive activity exception for working interests in oil and gas wells (Section 469)
- • Repeal special rules for gain or loss on timber, coal, and domestic iron ore (Section 631)
- • Repeal the credit for alcohol used as a fuel, etc. (Section 40)
- • Repeal the credit for biodiesel and renewable diesel used as fuel (Sections 40A, 6426 and 6427(e))
- • Repeal the enhanced oil recovery credit (Section 43)
- • Modify and repeal the credit for electricity produced from certain renewable resources; (i.e., eliminate the inflation adjustment and reduce the credit rate to 1.5 cents for electricity produced between 2015-2024); and modify the “beginning of construction” rule for the PTC (Section 45)
- • Repeal the credit for production of low sulfur diesel fuel (Section 45H)
- • Repeal the credit for producing oil and gas from marginal wells (Section 45I)
- • Repeal the credit for production from advanced nuclear power facilities (Section 45J)
- • Repeal the credit for producing fuel from a nonconventional source (Section 45K)
- • Repeal the energy-efficient new homes credit (Section 45L)
- • Repeal the energy-efficient appliance credit (Section 45M)
- • Repeal the credit for carbon dioxide sequestration (Section 45Q)
- • Repeal the energy investment tax credit (Section 48)
- • Repeal the qualifying advanced coal project credit (Section 48A)
- • Repeal the qualifying gasification project credit (Section 48B)
- • Repeal the qualifying advanced energy project credit (Section 48C)
Among the proposals relating to accounting methods, the draft includes the following:
LIFO, lower-of-cost-or-market methods: For tax years beginning after 2014, the last-in/first-out (LIFO) method of accounting and lower-of-cost-or-market method would both be repealed under the plan. Repeal is subject to a transition rule that LIFO reserves and any positive adjustment from LCM repeal be included in income over four years, starting in 2019.
Cash method: Businesses with average annual gross receipts of $10 million or less may use the cash method of accounting, while businesses with more than $10 million would be required to use accrual accounting. Farming businesses would continue to use current accounting methods, and sole proprietorships could use the cash method regardless of gross receipts. Any positive adjustments to income resulting from the change would be taken into income over four years starting in 2019.
UNICAP: The exception to the uniform capitalization (UNICAP) rules for businesses with average annual gross receipts of $10 million or less that acquire property for resale would be expanded to include all types of property.
For additional information with respect to this Alert, please contact the following:
Washington Council Ernst & Young
- • Any member of the group, at +1 202 293 7474