Democrats approach sweeping tax agreement
Democrats appear to be nearing a potential agreement on a transformative tax package that has evolved considerably under days of furious negotiations.
President Joe Biden released a framework of the potential $1.75 trillion reconciliation deal early on Oct. 28 in an effort to showcase an agreement before global climate talks kicked off on Oct. 31 and gubernatorial elections in Virginia and New Jersey on Nov. 2. Democratic leaders were also hoping the framework could convince progressive Democrats in the House to pass a bipartisan infrastructure package before transportation funding expired on Oct. 31.
Leaders raced to release nearly 2,000 pages of legislative language and a section-by-section summary of the potential reconciliation agreement after progressives demanded to see an actual bill. This full version offers important details beyond framework, but it does not appear to represent a final agreement. It was cobbled together very quickly from pieces that don’t appear fully refined. House Speaker Nancy Pelosi, D-Calif., acknowledged that progressives will need to fully review the text, and conceded that additions, clarifications, and subtractions may be necessary. Key moderate Sens. Joe Manchin, D-W.V., and Kyrsten Sinema, R-Ariz., also stopped short of fully endorsing the agreement, though they offered general support. Negotiations are likely to continue, and the bill should evolve further.
The House passed an extension of transportation funding through Dec. 3, setting a new potential deadline for a final deal and coinciding with the current deadline for government funding. Democratic leaders are clearly hoping to reach a final agreement more quickly, but getting full official revenue scores, cleaning up the text, and negotiating critical components could prolong the process.
The tax title has already undergone drastic changes from both the version outlined in Biden’s “Green Book” and the version passed by the House Ways and Means Committee on Sept. 15. The current agreement, for now, drops key proposals like a corporate rate increase and a mark-to-market tax on “billionaires,” but adds significant new provisions that would impose a surtax of up to 8% on high-income taxpayers and create a new 15% minimum tax on financial statement income of the largest corporations. Many of the effective dates have also been pushed back, particularly on the international provisions.
Specifically, the core revenue-raising provisions announced in Biden’s framework include:
- Imposing a 15% minimum book tax for corporations with more than $1 billion in net financial statement income
- Creating a 1% excise tax on stock buybacks by publicly traded companies
- Raising the rate on global intangible low-taxed (GILTI) income to 15%, imposing it on a country-by-country basis, and enhancing the base-erosion and anti-abuse tax (BEAT)
- Imposing a 5% surtax on adjusted gross income exceeding $10 million, with an additional 3% tax on AGI exceeding $25 million
- Expanding the 3.8% tax on net investment income (NII)
- Making the active loss limitation under Section 461(I) permanent and adjusting the carryforward
The full legislative text adds a number of other significant revenue raisers that were not mentioned in the high-level framework agreement, including:
- Reducing the deduction for foreign derived intangible income (FDII)
- Imposing a new interest limit based on share of a global group’s total interest
- Significant additional international reform
- Repealing the 100% and 75% exclusions for gain qualified small business (QSB) stock
- Expanding constructive sale rules to digital assets
- Expanding the wash sale rules to commodities, currencies, and digital assets
- Expanding common control rules to target private equity
- Requiring gain recognition on certain divisive reorganizations under Section 361
- Amending Section 165(g) so that losses with respect to securities are treated as realized on the day that the event establishing worthlessness occurs
The bill also includes more than $300 billion new, enhanced, and extended green incentives. It would also postpone for four years the five-year amortization of research and experimental (R&E) expenditures that is currently scheduled to become effective beginning in 2022.
On the individual side, there are extensions and enhancements for the child tax credit, the earned income tax credit, and Affordable Care Act premium credits.
Numerous significant revenue raisers proposed in earlier versions have been dropped due to opposition, including:
- A corporate rate increase
- Individual ordinary and capital gains rate increases (apart from the AGI surtax)
- A cap on pass-through deduction under Section 199A
- A proposal to require “billionaires” to mark-to-market tradeable assets
- Carried interest changes
- Estate and gift tax changes and the repeal of step-up in basis of inherited assets
- IRS bank and financial account reporting
- Restrictions on individual retirement accounts
- A carbon tax
- Repeal of like-kind exchanges
- Repeal of oil and gas tax incentives
The most significant development was the abandonment of corporate and individual rate increases due to Sinema’s objections. Lawmakers quickly scrambled to resurrect other revenue-raisers to fill the hole. The minimum book tax made a comeback and Wyden’s mark-to-market proposal was briefly considered. When the mark-to-market provision itself proved unpopular, it was replaced with the AGI surtax. The surtax would create effective top rates of 28% on capital gains and dividends (before the NII tax) and 45% ordinary income. These rates are actually higher than the respective 25% and 39.6% top rates initially opposed by Sinema, but they would also apply at a much higher income threshold.
It is possible that revenue raisers currently not part of the package, even a corporate rate increase, could resurface if the other revenue raisers prove controversial. There will also likely be a revenue crunch as scores roll in from the Joint Committee on Taxation (JCT), as the JCT is not expected to give lawmakers a substantial revenue score for the increases in IRS funding, for instance.
Democrats will also need to find a way to offset relief from the $10,000 cap on state and local tax (SALT) deductions. The SALT cap remains a contentious issue. A compromise will likely be needed for any bill to pass the House. Democrats have discussed raising the $10,000 cap, or temporarily repealing it for 2022 and 2023, possibly offset by extending past its currently scheduled expiration in 2026.
There are still many hurdles to enactment as Democrats can’t afford to lose a single vote in the Senate and can only lose three in the House. Failure remains possible, though Democrats appear to be narrowing their differences. If enacted, the tax title would affect nearly every type of business and investor. Taxpayers should assess the potential impact of the proposals and consider if pre-emptive planning can offer benefits.
The following provides more information on key proposals included in the most recent version of the bill.
Corporate minimum tax
The bill would impose a 15% minimum “book” tax on corporations that report over $1 billion with adjusted financial statement income in excess of $1 billion over any three-taxable-year period (with a $100 million threshold for certain foreign-parented corporations if the international reporting group has $1 billion in income). Lawmakers claim only about 200 companies would meet this threshold.
The 15% rate would apply against “net income” from an applicable financial statement (defined under Section 451(b)(3)) with adjustments for several items, including several international items. General business credits could offset up to 75% of tax and newly defined “financial statement” net operating losses could offset up to 80% of financial statement income. 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: Biden has long been a champion of this provision and was quickly willing to abandon the corporate rate increase in favor of it under pressure from Sinema. The proposal could prove controversial, however. A similar tax was created in 1986, but quickly abandoned because lawmakers believed companies were manipulating financial statements to avoid it. Lawmakers would also be ceding control over the definition of taxable income under this regime to the accounting industry, which generally sets financial statement income standards. It also comes with complex technical issues, and defers may issues to Treasury regulations. It would also curb the benefit of bonus depreciation, which is generally popular with Democrats.
Excise tax on corporate stock buybacks
The bill would impose a 1% excise tax on publicly traded U.S. corporations for the value of any of stock that is repurchased by the corporation during the taxable year. The term “repurchase” would mean a redemption within the meaning of Section 317(b) with regard to the stock of such corporation, and any other economically similar transaction as determined by Treasury. The tax would not apply to:
- Tax-free reorganizations
- Stock contributed to an employee pension plan, ESOP or similar plan
- Stock repurchases of less than $1 million in a year
- Stock purchased by a dealer in securities in the ordinary course of business
- Repurchases treated as a dividend
- Repurchases by a regulated investment company or real estate investment trust.
The tax would apply to repurchases of stock after Dec. 31, 2021.
The bill would expand the aggregation rules under Section 52(b) that treat groups of related entities as a single employer. The legislation would require the inclusion of any trade or business activity under Section 469(c)(5) or Section 469(c)(6). Section 469(c)(6) would incorporate the definition of “trade or business activities” under Section 212, which includes management, conservation, and maintenance of property held for the production of income. Section 469(c)(5) would include research and experimentation activities.
Grant Thornton Insight: The proposal appears to target the private equity structure, which often takes the position that portfolio companies are not part of a common control group because the partnership is not involved in a trade or business. The change could be meaningful, as aggregation rules under Section 52 are used to determine limits on many credits and other code provisions.
The bill would significantly reform the GILTI system. The Section 250 deduction related to GILTI would be reduced from 50% to 28.5% for tax years beginning after 2022, creating a GILTI tax rate of 15%. In addition, GILTI would generally be determined on a country-by-country basis with the ability for controlled foreign corporations (CFCs) with tested losses in a particular country to carry forward such losses to reduce future years’ test income.
The bill would preserve the exemption for the deemed rate of return on qualified business asset investment (QBAI), but would cut the deemed rate of return in half from 10% to 5%. The deemed paid credit for foreign taxes attributable to GILTI would increase from 80% to 95%, and deductions for interest expenses, stewardship expenses and research and experimental expenses would not affect the taxpayer’s foreign tax credit limitation with respect to GILTI.
Grant Thornton Insight: The bill largely retains the GILTI provisions included in the House Ways and Means proposal, other than the significant change in lowering the proposed GILTI tax rate from 16.5625% to 15%.
The FDII deduction would be reduced from 37.5% to 24.8% for years beginning after 2022, resulting in an effective 15.8% FDII rate. In addition, the Section 250 deduction (both GILTI and FDII portions) would no longer be limited to taxable income, and would be allowed as a deduction resulting in an increase in the net operating loss (NOL) for the taxable year.
Grant Thornton Insight: The retention of FDII, even at a reduced rate, is a favorable development for taxpayers though Democrats repeatedly criticized the provision and the Biden administration proposed repealing it altogether. While the reduction in the Section 250 deduction limits its benefit, the NOL treatment of the excess Section 250 deduction could provide potential benefits to a wide range of taxpayers that ordinarily would be limited or unable to benefit from the deduction.
The bill would expand the scope of BEAT and alter the calculation beginning in 2023 by adding costs of goods sold and other making other significant change. The BEAT rate would increase to 12.5% for tax years beginning in 2023, 15% in 2024 and 18% in 2025.
Grant Thornton Insight: The administration seems to have relented on its push to replace BEAT with its own Stopping Harmful Inversions and Ending Low-tax Developments (SHIELD) proposal. Several of the changes, however, address the administration’s concerns with BEAT or align BEAT more closely to SHIELD.
New interest deduction limit
The bill would create a new Section 163(n) limit on the interest deduction under for domestic corporations that are members of a multinational group that prepares consolidated financial statements and has average annual business interest expenses of more than $12 million over the past three years. The domestic corporation could only deduct up to its allowable percentage of 110% of the total net interest expense. The allowable percentage is based on the member’s allocable share of the groups interest expense, and the allocable share is the ratio of the domestic corporation’s financial statement earnings before interest expense, taxes, depreciation, depletion and amortization (EBITDA) and the group’s EBITDA.
In addition, disallowed interest expense under Section 163(j)(1) or the new Section 163(n)(1) could be carried forward for only up to five tax years. The bill also modifies Section 163(j) for S corporations and partnerships so that the limitation is no longer computed at the entity level, but rather is computed at the investor level only.
The proposal would be effective for tax years beginning after 2022—unlike the Ways and Means Committee proposal, which proposed an effective date beginning after 2021.
Portfolio interest exemption
The bill would narrow the portfolio interest exemption currently available for interest received by any corporate shareholder owning less than 10% of the combined voting power of all classes of such corporation.
The definition of a 10% shareholder of a corporation would be expanded to include 10% ownership of total stock value or combined voting power. This proposal would apply to obligations issued after the date of enactment of the bill.
Grant Thornton Insight: The bill would narrow the eligibility for the exemption by preventing taxpayers from availing themselves of the exemption simply by providing a class of stock without voting power. Debt issued prior to enactment of the bill would be grandfathered, so taxpayers should be careful when modifying any debt that could cause the debt to lose its grandfathered protection.
Other international changes
There are several other significant international tax provisions that would:
- Modify a number of foreign tax credit rules
- Limit the 100% deduction for dividends received to dividends from a CFC (currently available to CFCs and also foreign corporations that are owned from 10% up to 50% by domestic corporations)
- Repeal the election for a one-month deferral in the determination of taxable year of specified foreign corporations
- Limit foreign base company sales and services income to situations in which the relevant arrangement includes a related person that is a taxable unit that is a U.S. tax resident (i.e., U.S. residents, passthrough entities and branches in the U.S.)
The bill would impose a 5% surtax to the extent AGI exceeds $10 million ($200,000 for an estate or trust) and an additional 3% surtax to the extent AGI exceeds $25 million ($500,000 for an estate or trust). The change would be effective for tax years beginning after 2021.
Grant Thornton Insight: The surtax would bring the true top proposed rate to 45% on ordinary income before any Medicare or NII tax, and 28% on capital gains and dividends before NII tax. Coupled with the potential that the corporate rate will remain 21%, this surtax could spur pass-through entities whose owners are over the AGI thresholds to consider converting to a C corporation. In addition, unlike the proposed increase the capital gains rate in the original House proposal, which would have generally been effective for transaction after Sept. 13, 2021, these rate increases would generally not apply to any transactions occurring before the end of 2021. Taxpayers that would be affected could consider accelerating gain or other types of income to avoid the surtax.
Excess business losses under Section 461(l)
The bill would make permanent the limit on deducting excess business losses under Section 461(l). The provision was created by the TCJA, but was suspended from 2018 through 2020 and is scheduled to expire in 2026. The bill would also change the treatment of excess losses subject to the limit. Excess losses would no longer carry forward an NOL the following year, but would remain subject to the Section 461(l) limit in future years.
Grant Thornton Insight: The change in treatment of suspended losses in future years represents a significant and unfavorable change. The current provision acts more like a one-year delay, as suspended losses can generally be taken as an NOL the following year against other types of income.
Net investment income tax
The bill would expand the scope of the 3.8% Medicare tax on net investment income (NII) so that essentially all income not subject to employment or self-employment tax would be subject to NII tax. Most income that escapes both employment or self-employment tax on earned income is taxed as NII, but there can be exceptions, such as non-compensation income from an owner of an S corporation or a partner in a limited partnership who is not passive. This provision would close that gap by repealing the exception for income derived in the ordinary course of a trade or business for a nonpassive owner for taxpayers with income exceeding $400,000 (single) or $500,000 (joint).
Green energy package
The bill includes a robust $300 billion package of extensions and enhancements to existing renewable energy and energy efficiency incentives, and many new incentives. In addition, many of the credits would be eligible as refundable direct pay, even at the pass-through entity level.
Taxpayers now have updated legislative language to assess the true potential impact of the reconciliation bill on tax and business planning decisions. The current bill, however, is likely not a finished product. Taxpayers should continue to monitor the legislative process to see how the proposals evolve. Some taxpayers may also benefit from pre-emptive tax planning.
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