US president Donald Trump and the Republican Congress have managed to achieve what they promised.
Just 79 days after the administration and congressional Republican leaders published the so-called big six framework for major tax reform, Republicans in the House and Senate tax-writing committees published on Friday the agreed text of HR 1, the Tax Cuts and Jobs Act 2017.
In the process, they have put flesh onto the bones of the original framework.
The speed with which this legislation has been agreed by both Houses is unprecedented. It is unclear what assumptions have been used to cost all the measures and there was a notable absence of debate in either House.
Whether such a truncated process gives rise to the best law is something which remains to be seen.
Changes to the taxation of US corporations
The most comprehensive changes affect the taxation of US corporations, and would do so almost immediately, for taxable years beginning after 31 December 2017, for example.
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- Most eye catching is the reduction of the 35 percent rate of corporation tax to an internationally competitive 21 percent, coupled with the move to a so-called territorial system of taxation which would exempt foreign source income earned through foreign subsidiaries from US tax at the point of repatriation (the so-called participation exemption).
- An estimated $3trn of existing accumulated overseas profits in foreign subsidiaries which have been tax-deferred under the current rules would suffer an immediate tax of eight percent, to the extent invested in overseas business activity, and 15.5 percent to the extent held in liquid form (subject to credits for a pro rata portion of foreign taxes already paid on that income, and subject to the ability to pay the tax in instalments). This applies regardless whether the funds are repatriated to the US. This measure would both generate needed revenue to pay for some of the tax cuts and eliminate any obstacle to repatriation of the overseas accumulations.
- The existing controlled foreign corporation (CFC) rules, which are designed to prevent the shifting of portable profits overseas, will be augmented by a new category of so-called global intangible low-taxed income (GILTI), taxed directly to the US parent at 50 percent of the normal corporate rate. To further discourage outbound transfers of intangibles, the current “active business” exception allowing the tax-free transfer of overseas business activities to foreign subsidiary corporations is to be repealed.
- For very large US corporations, erosion of the tax base through payment of deductible expenses to foreign affiliates will be discouraged through the imposition of a so-called base erosion minimum tax equal to the amount by which 10 percent of the corporation’s income before deductions for offshore related-party payments exceeds the corporation’s liability to corporation tax after taking those deductions into account.
- On the other hand, to incentivize domestic companies that hold on to their intangibles, foreign derived intangible income of US companies, included embedded IP in exported goods, will be taxed at a reduced rate (72.5 percent of the normal rate).
- Also going into the mix are a limitation on the deductibility of interest expense by large corporations to 30 percent of taxable income before interest, and a 100 percent write-off for purchases of equipment.
The Republicans’ claim that these changes will prevent US jobs, headquarters, and research from moving overseas appears reasonable.
However, the provisions are very comprehensive and due to the very short time-frame not fully thought-through.
The Conference Committee Report accompanying the bill is very short on statements of legislative intent, which would normally be an aid to interpretation of the new rules.
US corporations and the IRS will both have a great deal to do in a short time, while the first order of business for Congress in January should be to draft and enact technical corrections legislation to retrospectively fix any problems with the bill as drafted.
We will have to wait and see whether that actually happens.
The US’s international partners in its tax treaties and trade agreements have warned, quite rightly, that some aspects of the new corporate provisions will conflict with those agreements.
As a matter of US Constitutional law, legislation ranks equally with treaty commitments, with the more recent provision taking precedence in the event of a conflict, so to the extent the bill is intended to override existing US treaty commitments it will do so.
The result may be eventual sanctions, but it is equally possible that, the US now having taken a lead in addressing the difficult issues presented by the growth of the global IP-based economy, could become a model for other nations to emulate.
Changes to the taxation of US individuals
Individual and entrepreneurial changes are more piecemeal.
- The top rate of income tax is to be reduced from 39.6 percent to 37 percent (on income in excess of $600,000 for married filing jointly), and tax rates on lower rate bands have also been reduced.
- Broadening of the tax base is to be achieved by eliminating a number of deductions. There is to be a $10,000 per annum limit on deductions for State and local property and income taxes, which is a slight improvement on the complete elimination of deduction for state and local income tax previously anticipated, but will do very little for high earners. This could have quite significant political implications for high income-tax States such as California and New York who also tend to vote Democrat.
- A 20 percent deduction for “qualified” business income earned through non-corporate structures would lessen the gap between the rate of taxation of corporate and non-corporate businesses (for individuals benefitting from the new deduction, an effective rate of 29.6 percent), although it appears likely there will still be plenty of room for arbitrage. An unexpected tweak in committee has resulted in the relief extending also to real property businesses which, unsurprisingly to some may provide some a tax benefits in respect to Trump’s own holdings.
- The one-time tax on existing accumulated overseas profits of CFC’s, which is part of the new corporate regime explained above, apparently also applies to individual 10 percent or greater US shareholders of CFC’s, notwithstanding that they will not benefit from the new participation exemption.
- Investors in the stock market who have bought shares of the same issuer at different prices would no longer be able to specify which tranche of shares is being sold so as to dispose of higher- basis shares first, and instead will have to apply a rule of first-in first-out. As this would not come into effect until 1 January 2018, year-end planning for 2017 may include selling high-basis shares while the current rules are still available.
- The repeal of the estate tax (referred to by Republicans as the so-called death tax) has been left for another day but the individual lifetime exemption of $5m plus indexation (currently $5.49m) is to be doubled. This is an out-and-out tax break for the very wealthy on which the Republican legislators have ladled generous amounts of spin such as “to reduce uncertainty and costs for many family-owned farms and businesses when they pass down their [sic] life’s work to the next generation”. On the other hand, there is no change to the current $60,000 exemption from the estate tax of non-resident non-citizens of the US, who are therefore much more likely to incur a liability on their US taxable estates.
- Changes which have less general impact include: limiting tax-deferred like-kind exchange treatment to exchanges of real estate, the elimination of the ability of divorcing spouses to shift income through deductible alimony payments (with a 12-month delayed effective date), and the confirmation of capital gains treatment for carried interests, subject to a three-year holding period requirement to obtain the reduced long-term rate.
It is worth noting that the so-called territorial approach for domestic corporations is not replicated for US citizens, who continue to be taxable on worldwide income irrespective of where they reside.
Changes to the taxation of foreign persons
There are few changes specifically targeted at foreigners’ US activities, but some of the broader changes, particularly the reduction in the corporation tax rates, will have a significant impact on planning for inward investment.
One provision will eliminate the present ability of foreign investors to realize without tax gains from the disposal of partnership interests that are attributable to an underlying US trade or business activity.
As noted, adoption of the bill will only be the beginning of a long process of making the new rules coherent and effective, and the impact of the bill on the US’s relations with its treaty partners will also take time to play out.
Overall, the changes are expected to add over $1trn to the US budget deficit over the next 10 years, and to prevent an even larger figure a number of the tax cuts have expiration dates (for example the individual rate cuts are set to end after 2025).
Whatever the composition of Congress going forward, revenue raising (possibly from new taxes rather than adjustments to the existing ones) and or reduction of government expenditure will be a priority.