Sen. Joe Manchin, D-W.V., and Senate Majority Leader Chuck Schumer, D-N.Y., on July 27 announced a breakthrough on a significant tax package that would raise approximately $450 billion in tax revenue to pay for a generous package of energy tax incentives.
The deal is a far cry from the massive tax bill originally envisioned by Democrats, but it would resurrect a few key pieces of an ambitious agenda that had appeared all but dead. Just days ago, Manchin allegedly walked away from negotiations on a broader bill, telling Schumer that he was prepared only to accept a narrow bill that would use money from drug pricing reform to extend Affordable Care Act (ACA) subsidies. The surprise agreement adds a new tax and spending title to the overall package — now dubbed the “Inflation Reduction Act of 2022” — though the legislation includes a only handful of major Democratic tax proposals:
- The 15% minimum tax on financial statement income
- Increased spending on IRS enforcement
- Increasing the holding period from three to five years for carried interest to qualify for long-term capital gains treatment
- A package of new, expanded and extended energy incentives with some changes from earlier versions
- An increased cap on R&D credits refundable against payroll taxes for qualified small businesses
The Joint Committee on Taxation has not yet provided an official score, but the entire reconciliation bill is projected to raise $739 billion, with $288 billion coming from drug pricing reform and the remaining $451 billion coming from new tax revenue. The bill would spend $433 billion on ACA extensions and energy and climate change proposals, with more than $300 billion going to deficit reduction. Schumer submitted the text to the Senate Parliamentarian for review on July 27 and said he plans to bring the bill to the Senate floor the week of August 1.
Enactment is not a foregone conclusion. Manchin’s support is key, but with only 50 Democrats in the Senate, any other Democratic senator could effectively block the bill. Earlier agreements ran into trouble even after Schumer stated they were locked down. Just weeks ago, Schumer submitted a net investment income tax proposal to the Parliamentarian claiming he had the support of all 50 Senate Democrats, but several quickly backtracked — including Manchin — and the provision was ultimately discarded.
Sen. Kyrsten Sinema, D-Ariz., may be the biggest Senate wild card, and she has yet to comment on the new agreement. She previously supported the 15% minimum tax but has reportedly been growing more averse to tax increases. She also has been reluctant to support changing the tax treatment of carried interest.
The bill also could run into problems in the House, where Democrats can only lose three votes and still pass legislation without Republican support. The omission of any relief from the $10,000 cap on state and local tax (SALT) deductions may be a major sticking point. Rep. Josh Gottheimer, D-N.J., and several other Democratic members have repeatedly insisted they will block any deal without SALT cap relief. Manchin, however, appears strongly opposed to such relief, characterizing the SALT deduction in a statement as a “loophole.”
President Joe Biden has issued a statement in support of the agreement, and his administration will be pushing the bill hard. Tweaks to the bill may be needed for the legislation to gain enough support for passage, but Manchin seems unlikely to renegotiate major pieces now that he has finally reached an agreement with Schumer.
The tax provisions in the bill are discussed in more detail below.
Corporate minimum tax
The bill would impose a 15% minimum “book” tax on corporations that report three-year average annual adjusted financial statement income exceeding $1 billion (with a $100 million threshold for certain foreign-parented corporations if the international reporting group has $1 billion in income). The tax would be imposed on both public and private C corporations, but not S corporations, real estate investment trusts, or regulated investment companies. Democrats claimed in summaries that only about 200 companies would meet this threshold.
The 15% rate would apply against “net income” from an applicable financial statement (AFSI), defined under Section 451(b)(3), with many significant adjustments, including:
- For foreign corporations, only U.S. effectively connected income would be considered
- Domestic corporations would add a pro rata share of financial statement income of each controlled foreign corporation where the domestic corporation is a U.S. shareholder
- Both foreign and domestic tax would be added back
- AFSI from disregarded entities owned by the taxpayer would be included
- Pension plan treatment would be aligned to tax principles rather than book principles
General business credits would be subject to the same limit applied under the old corporate alternative minimum tax. Newly defined “financial statement” net operating losses could offset up to 80% of AFSI. Any tax paid would be creditable against regular tax in future years. The proposal would be effective for tax years beginning after Dec. 31, 2022.
Grant Thornton Insight
This provision appears nearly identical to the proposal in the House-passed reconciliation bill from November, despite facing criticism since then. The tax came under some fire for potentially erasing the benefit of some Democratic-favored tax incentives like certain credits and accelerated depreciation. The tax also carries complex technical issues and adds tension to financial statement income determinations. It is similar in some ways, but narrower in scope, to the 15% qualified domestic minimum tax that is part of the Biden administration’s proposed undertaxed profits rules (UTPR). The UTPR is a component of Biden’s broader proposal to implement the global minimum tax agreement under Pillar 2 with the Organization for Economic Cooperation and Development. It is unclear how this tax would potentially interact with the UTPR, and future efforts could amend or replace this tax to align it with the UTPR. Manchin recently expressed major reservations with implementing Pillar 2 in the U.S., and if Republicans make election gains in November, Pillar 2 implementation will only prove more difficult.
The bill would amend Section 1061 to increase the holding period from three years to five years for taxpayers with adjusted gross income of $400,000 or more to receive long-term capital gains treatment on carried interests in certain partnerships. The new version also would slightly modify the definition of an “applicable partnership interest,” include Section 1231 gain, and give the IRS broader authority to write rules to prevent abuse. The legislation also would make a series of technical changes, including requiring gain to be recognized even in a nonrecognition transaction and requiring all of a partner’s gain to be recharacterized regardless of the partnership’s holding period. The new rules would be effective for tax years beginning after 2022.
Grant Thornton Insight
The inclusion of this provision is surprising. This provision was removed from the House after objections from Sinema. Schumer, too, has been a quiet supporter of preserving the current treatment of carried interest. His acquiescence is an indication of Manchin’s leverage and the deep desire among leaders for a deal. It is less clear whether Sinema is prepared to fold. Manchin offered some strong comments on retaining the provisions, claiming that he’s “not prepared to lose it.”
The agreement would increase IRS funding by $80 billion, which the Congressional Budget Office has previously estimated would raise $206 billion in revenue for a net increase of $124 billion.
ITC and PTC
The bill includes a substantial package of energy incentives as part of the climate change initiative, though there are significant differences from the House-passed bill. The new legislation generally would extend and enhance the Section 45 production tax credit (PTC) and Section 48 investment tax credit (ITC) before replacing them with similar credits that are meant to be technology-neutral. This transition is scheduled for 2025 (instead of 2027, as proposed under the House-passed bill).
The PTC generally would be extended at a rate of 2.5 cents per kilowatt hour if the project meets prevailing wage and apprenticeship requirements. The ITC generally would be extended at the full 30% rate (though solar property placed in service in 2021 would remain at the 26% rate). Like the Section 45 credit, the full credit would be available only if prevailing wage and apprenticeship requirements are met. Both credits would offer rate boosts based on using domestic suppliers, and the ITC would provide additional credits for projects in specific energy communities or low-income areas. Qualifying property would be expanded to include energy storage, but an expansion to cover transmission property was not included. Taxpayers could continue to elect the ITC in lieu of the PTC, but the bill would replace the House-passed direct pay mechanism with a transferability regime discussed in further detail below.
Additional important energy provisions would:
- Increase the Section 45Q carbon capture tax credit
- Create a new credit for clean hydrogen production
- Create a new credit for manufacturing solar, wind, battery and mineral components
- Reinstate the Section 48C advanced energy property credit
- Increase the cap on the alternative fuel refueling property credit, which includes charging stations, from $9,000 per location to $30,000 per location
- Extend fuel tax credits
- Increase the energy-efficient commercial buildings deduction under Section 179D
- Extend and increase the nonbusiness energy property credit under Section 25C
- Extend the residential energy-efficient credit under Section 25D
- Extend and enhance the new energy-efficient home credit
- Reinstate the Hazardous Substance Superfund excise tax on crude oil and imported petroleum products at an increased rate of 16.4 cents per gallon
The updated legislation omits provisions from the House-passed energy package that would have expanded the qualifying activities of publicly traded partnerships under Section 7704 to include a variety of alternative energy activities, create a credit for installing mechanical installation, modify the income exclusion for conservation subsidies, and reinstate fringe benefit for bicycle commuting.
The new legislation also would replace the extension and enhancement of the plug-in electric vehicle credit with new credits for new and used “clean vehicles,” as well as commercial vehicles.
The legislation limits the direct pay mechanism from the House-passed bill to tax-exempt entities. In its place, the bill creates a new transferability regime that would generally allow taxpayers to monetize the credits by transferring them to other taxpayers. The transfer would be required to be in exchange for cash from an unrelated party. The proceeds would be exempt from income but not deductible to the buyer. Nearly all of the energy credit would be eligible for this transferability treatment.
Grant Thornton Insight
Manchin appears to have compromised on two key objections: electric vehicle credits and direct pay refunds. The clean vehicle tax credit is broader than the plug-in electric vehicle credit, but many electric vehicles would still qualify. Manchin remained unwilling to allow Treasury to issue direct refundable payments for energy credits — but allowing taxpayers to essentially sell their credits to other taxpayers who can use them would make monetization much easier. The complex partnership planning and lease structures for assigning credits would likely not be necessary.
Hurdles to enactment remain, but lawmakers are rushing to try and finish the bill before Congress recesses in August. There is a Sept. 30 deadline for passing a reconciliation bill under the current budget agreement. Given the aggressive timeline, taxpayers who would be affected by the proposals should begin assessing the impact and their planning options and opportunities.
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