It’s rare that humble US tax professionals can expect much attention outside our small circle of clients and colleagues, but in the aftermath of the enactment of the Tax Cuts and Jobs Act 2017 (TCJA) in December, US tax remains a big issue.
Significant responses to the legislation have been quick to materialise.
Like a tsunami, enactment of the TCJA has created a huge mess which may take years to fix.
Validity of many of the new rules is under active challenge
Abolition of the Deduction for State and Local Income Tax (Salt)
The elimination of the Salt deduction (the adverse impact of which falls most heavily on residents of States that voted Democratic in the 2016 election) was hotly protested.
Some of the affected states, including New York, New Jersey, Connecticut and Maryland, have been quick to announce their intention to level a Constitutional challenge against the legislation in the courts.
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If it can be proven that the entirely Republican vote in favour of the new provision was motivated by an intention to punish the Democrats, there will be a respectable argument that the provision is a violation of the “equal protection” clause of the US constitution which guarantees to all citizens the equal protection of the laws.
Challenges requiring less of an evidentiary burden also could be envisaged.
As the sixteenth amendment to the constitution only allows Congress to levy an income tax, it could be asserted that if an individual receives payments that give rise to a mandatory money obligation to state or local government, then only what is left truly represents income.
Some states are also actively considering workarounds to mitigate the non-deductibility of Salt.
One of the more popular suggestions is that individuals could make deductible charitable contributions to specified state or local institutions (in California, the proposed new California Excellence Fund) which would give rise to a credit that could be offset on a dollar-for-dollar basis against state and local tax obligations.
Whether such an approach would be effective under Federal law seems doubtful. Assuming any state or city actually enacts a workaround, it is likely to require a quick response from an already overburdened Treasury department.
It remains to be seen how taxpayers will address the elimination of the Salt deduction on their 2018 income tax returns.
If large numbers of taxpayers refuse on constitutional or other grounds to accept the validity of the change and complete their returns accordingly, the IRS will be faced with an impossible administrative burden.
Introduction of a number of international taxing measures which appear to discriminate against overseas activities of multinationals was, once again, widely protested in the run-up to the adoption of the TCJA.
Most notable of these protests was a letter jointly written by the finance ministers of France, Germany, Italy, Spain and the UK to US Treasury Secretary Steven Mnuchin and chairmen of key House and Senate committees, warning that measures under consideration could contravene US income tax treaties and have “a major distortive impact on international trade”.
These protests went unheeded. The process of calling the US to account is under way.
The EU has referred some of the US provisions to the OECD’s Forum on Harmful Tax Practices for a fast-track determination of whether these provisions violate US income tax and trade treaty obligations.
It has been suggested, for example, that the base erosion alternative tax (Beat), which can result in an increased corporation tax liability for US companies or branches which make large deductible payments to overseas affiliates (which the finance ministers warned could “harmfully distort international financial markets”), violates the non-discrimination provision of the OECD Model Income Tax Treaty, replicated in all the US’s bilateral income tax conventions.
In the meantime, companies which consider that application of Beat or other new changes will violate US treaty obligations may consider not paying the relevant tax on the basis that it is overridden by treaty.
Excise tax on investment income of universities
Federal tax law exempts certain categories of institutions, including charities, from income tax.
However, charitable “private foundations” are generally subject to an excise tax of 2% on net investment income, whereas public charities, including those supporting churches, hospitals, colleges and universities, have always been exempt from this levy.
Spurred by a need to find revenue offsets for some of the tax cuts enacted by the TCJA, Congress imposed a 1.4% excise tax on the net investment income of colleges and universities, subject to a carve-out for certain smaller institutions.
Colleges and universities were somewhat slower than the States to mobilise their opposition to this measure, but have now been heard from.
Presidents of 50 of America’s most prestigious institutions of higher learning have written to House and Senate leaders on 7 March expressing their “deep objections” to the new excise tax, which they consider implements a “misguided policy”.
They urge that the provision be repealed or amended “to preserve resources that support students, teaching, and research”.
We are not aware that any Constitutional challenge to the excise tax has yet been mooted, but it is not outside the realm of possibility, particularly in view of the path being taken by blue States in attacking the repeal of the Salt deduction.
Impact of repeal of the individual health insurance mandate
While Congress failed twice during 2017 to repeal the Affordable Care Act (ACA), in the context of enacting tax reform it was able to repeal one of the measures that was adopted to help fund the ACA, the individual health insurance mandate, which was a tax on individuals not purchasing minimum levels of health insurance.
As part of the TCJA, Congress repealed the individual mandate, based on the understanding that it was severable from the other obligations imposed under the ACA.
However, on 26 February, 20 red states joined in filing an action in a Federal District Court in Texas seeking a declaratory judgement that repeal of the individual mandate invalidates the ACA in toto.
This is not specifically a tax problem, but rather potential collateral damage caused by the TCJA and apparently not anticipated by Congress.
Hasty drafting of the TCJA is now creating massive administrative difficulties
In their haste to enact tax legislation while they could still command a majority, Congressional Republicans drafted the TCJA in a very short time frame and it appeared mistakes would be inevitable.
A senior Treasury official recently asked a gathering of tax professionals the following rhetorical question:
Read the statute. Do you think it’s a model of sophistication?
The Treasury and IRS are being besieged on all fronts by tax professionals and taxpayer groups clamouring for clarifications.
Apparent loopholes are already being exploited. They may not show tax advisers in their best light, but we can only be as good as the laws we are given to interpret.
Avoiding new limitations on favourable taxation of carried interest
Investment managers in private equity funds are frequently rewarded for their services with, among other things, a share of gain realised on the disposal of an investee company.
If such a share is structured as a profits interest in a partnership formed to acquire the investment (commonly known as a carried interest), then what might be considered income from services that would usually be taxed as ordinary income will instead be taxed as capital gain, eligible for reduced long-term rates if the investment has been held for at least a year before disposal.
This was widely considered a loophole in the partnership taxation rules and the Obama administration proposed to significantly reduce the benefit of such structures.
The present administration, while talking tough about the taxation of carried interest, proposed a much more benign change to the previous rules, namely an increase in the holding period required to obtain long-term capital gains treatment of carried interests from one to three years.
This was enacted in the TCJA.
The new three-year holding period requirement has proven significant for managers of hedge funds, which frequently invest over shorter periods.
Lo and behold, a way out has been identified.
Carried interests covered by the new legislation do not include interests held by a corporation, presumably because a corporation which is subject to corporation tax (commonly referred to as a C corporation) does not have the benefit of a preferential rate of tax for long-term gain.
However, the term corporation as used in the new carried interest provision is not specifically limited to C corporations.
Individuals wishing to avoid the new three-year holding period requirement are therefore being advised to acquire their carried interests through S corporations, which despite being nontaxable pass-through entities nonetheless are clearly corporations as that term is defined in the Internal Revenue Code.
This is the type of error which in normal circumstances would be corrected through technical corrections legislation adopted subsequent to the enactment of the original legislation and made retroactive to the date of the original legislation.
However, there is significant doubt that Congress is sufficiently functional to enact such legislation in relation to the TCJA.
Perhaps for this reason the Treasury Department has stepped into the breach, publishing a Notice on 1 March in which it states its intention to promulgate regulations which will clarify that the term corporation as used in the new carried interest provision only refers to C corporations.
No authority has been cited by the Treasury department to support such an interpretation, and tax advisers are now stating that any regulations incorporating the provision promised in the notice may be invalid.
The rise of the cooperative
In connection with the reduction in corporation tax rates from 35% to 21%, some Congressional Republicans insisted on a reduction in the rate of tax applied to individuals carrying on business through non-corporate (pass-through) structures and succeeded in obtaining a 20% reduction in tax for such income.
The reduction is generally not available for income of professionals, such as accountants, lawyers and doctors, whose taxable income exceeds a threshold amount, which for 2018 is $315,000 for married filing joint and $157,500 in all other cases.
However, due to the way the new provision is drafted, the threshold does not operate in the case of dividends received from a cooperative, a worker-owned and run enterprise whose members share profits in the form of dividends.
The cooperative structure is typically used by farmers and collectives, but it apparently can be adapted for use by professional firms.
Such structures are reportedly being touted as a means of circumventing the income thresholds under the pass-through rules.
Again, the bet is that the Treasury department lacks the authority to plug this loophole and that Congress will be incapable of fixing it at least for some period of time.
There is a tremendous amount of money to be made even from the short-term availability of the 20% deduction, and it can be anticipated that simple country lawyers familiar with cooperative structures will now be in hot demand to form professional cooperatives.
Retroactivity of the repatriation tax creates more acute challenges
Typically, other than where enacted to curb an identified abuse, new tax legislation is made applicable not earlier than the first day of the next calendar year.
One benefit of this approach is that it gives advisers and the IRS more than a year to consider, and if necessary address, issues raised under the new legislation before the first tax returns reflecting the changes are required to be filed.
With limited exceptions, the TCJA changes follow this approach.
In particular, the new territorial approach to taxation of domestic corporations through the adoption of a “participation exemption” (100% deduction for dividends received from a 10% or greater foreign subsidiary) applies from 1 January 2018.
However, in conjunction with this change, the so-called repatriation tax (at a rate of up to 15.5% for corporations) has been imposed on pre-2018 accumulated profits of foreign subsidiary holdings, and this is a liability for 2017.
Furthermore, in order to qualify for interest-free deferral of the payment of most of this tax, the first instalment of 8% must be paid on the due date of the domestic shareholder’s 2017 US tax return without extensions, which in many cases will be 15 April 2018, little more than a month away.
The Treasury department has already issued two rounds of guidance on the repatriation tax but many more questions remain unanswered, some of them fundamental.
For example, in conjunction with the introduction of the territorial regime, a change was made to the rules for determining whether a corporation is a controlled foreign corporation (CFC), which not only affects the future application of those rules but also is crucial to the question of whether the repatriation tax applies in particular cases.
Strong representations have been made to the Treasury department that the changes would confer CFC status in cases that were not intended to be caught by Congress, and a Treasury department representative stated at a 22 February tax conference that Treasury were not averse to issuing regulations to restrict the application of the rule change provided they could be persuaded that they had the authority to make such regulations.
Pressure on the Treasury department to issue binding guidance in advance of 15 April will be intense.
The above is only a sampling of the significant problems that are emerging now that the provisions of the TCJA have become fully effective.
A number of provisions that are intended to raise revenue to partially offset the massive tax cuts delivered in the new legislation appear vulnerable either to direct challenge or to avoidance techniques that the Treasury department may lack the authority and Congress the will to redress.
This, together with the intense pressure on the Treasury department to deliver guidance on provisions that may not have been “a model of sophistication”, could create a “perfect storm” for those responsible for the administration of US tax law.