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Tax News & Views
The comprehensive tax reform discussion draft that House Ways and Means Committee Chairman Dave Camp, R-Mich., released February 26 achieves, at least nominally, the goals he set in 2011 of reducing the top income tax rate for corporations and individuals to 25 percent and moving the United States toward a territorial system for taxing domestic multinational corporations. But to accomplish those objectives – plus keep the legislation revenue neutral and ensure that the reformed tax code would retain the levels of progressivity in place under current law – the draft proposal includes an array of base broadening provisions that would have a significant impact on corporations, passthrough entities, individual taxpayers, and tax-exempt organizations. It also includes a 10 percent surtax on certain higher-income individuals, making their top statutory rate 35 percent.
Like the previous discussion drafts Camp unveiled in 2011 and 2013, this latest draft is not an introduced bill, but it does contain legislative language. Significantly, Camp released two revenue estimates from the Joint Committee on Taxation (JCT) staff in conjunction with the draft: the first, a traditional “static” score, shows that the proposal would be revenue neutral over 10 years; the second, a so-called “dynamic” score, which includes estimates about the macroeconomic impact of the proposal, projects that Camp’s plan would boost the size of the economy and therefore also boost federal receipts by between $50 billion and $700 billion over 10 years, depending on which assumptions and models are used to make the calculations.
A detailed summary prepared by Ways and Means Committee staff and a technical explanation and distribution tables prepared by the JCT staff were also released as part of this draft.
Statutory language and all supporting materials related to the proposal are available on the Ways and Means Committee Web site.
The draft’s massive scope can be measured by page count. The statutory text itself is just under 1,000 pages and the technical explanations from the Joint Committee on Taxation totals almost 700. Even the shorter summary prepared by the Ways and Means Committee staff clocks in at 182 pages.
This report is not intended to be a complete summary of the bill; instead, it offers an overview of the package, makes observations on key provisions, and provides commentary on some of the political and policy challenges that stand in the way of Chairman Camp and his allies working to overhaul the U.S. tax code.
Business tax reform
The draft delivers on Camp’s call for lowering the top statutory corporate tax rate from 35 percent to 25 percent. However, the reduction would be phased down by 2 percentage points a year until the top rate reaches 25 percent beginning in 2019. As discussed below, this may give pause to many advocates of lowering the corporate income tax rate.
Net operating loss deduction – The draft would limit the net operating loss (NOL) deduction to 90 percent of taxable income. The draft also repeals a number of special carryback provisions including specified liability losses, bad debt losses of commercial banks, and excess interest losses relating to corporate equity reduction transactions, among others. The proposal is generally effective for taxable years beginning after 2014 and losses arising after 2014 and carried back to prior years.
Contributions to capital – The draft provides that a contribution to the capital of a corporation (by a shareholder or nonshareholder), other than a contribution of money or property made in exchange for stock of the corporation or any interest in an entity, is included in gross income of the corporation. The draft repeals section 108(e)(6), so contributions of debt to capital will generally be taxable to the debtor corporation unless stock equal to the value of the debt is issued in the exchange. It should be noted that cancellation of debt (COD) income may still be recognized to the extent that the value of the debt is less than the adjusted issue price of the debt.
R&E expenditures – Research and experimentation (R&E) expenditures under section 174 would be capitalized and amortized over a five-year period rather than currently deducted, though as noted elsewhere in this report, a modified version of the R&E credit, which lapsed at the end of 2013, would be extended and made permanent.
Advertising costs – The draft would allow the current deduction for 50 percent of specified advertising costs, but require the remaining 50 percent to be amortized and capitalized ratably over a 10-year period beginning in 2018. A transition rule would phase out the deduction with 20 percent amortizable in 2015; 30 percent in 2016; and 40 percent in 2017. The proposal would allow full expensing on the first $1 million of advertising, but that would phase out once advertising costs exceeded $2 million.
There are a number of proposals in the draft that would dramatically affect the tax treatment of costs incurred by media including newspapers, magazines, or other periodicals. Among them, the draft would require the amortization of circulation expenditures over 36 months, phased in to allow a deduction of 75 percent of the expenditures in 2016, 50 percent in 2017, and 25 percent in 2018 before becoming fully amortizable beginning in 2019.
Nothing on interest deductions – While the provisions requiring amortization of some R&E and advertising costs were widely expected, the draft did not include a general limitation on the deductibility of business interest. That is something many thought might be included in the chairman’s draft.
Goodwill and intangibles amortization – The amortization period for acquired intangible assets would be extended from 15 to 20 years. Mortgage servicing rights would also be amortized over 20 years. The chairman’s draft did not include a repeal of the anti-churning rules as had been expected.
Domestic production activities – The section 199 domestic production activities deduction would be phased out. The current-law 9 percent deduction would be reduced to 6 percent in 2015 and 3 percent in 2016 and would be fully repealed beginning in 2017.
Medical device excise tax repeal – The current-law 2.3 percent medical device excise tax was enacted in the Patient Protection and Affordable Care Act. Generally, a manufacturer, producer, or importer of any taxable medical device (excluding certain devices purchased by the general public at retail for individual use) must pay a 2.3 percent excise tax on the sales prices of such device. Camp’s draft would repeal the medical device excise tax effective for sales after the date of enactment.
Like-kind exchanges – The draft would repeal the special rule allowing for a nonrecognition of gain in the case of like-kind exchanges effective for transfers after 2014. However, a like-kind exchange would be permitted in cases where a binding contract is entered into prior to 2015 and the exchange is completed before 2017.
Production tax credit – Opponents of the production tax credit (PTC) claim that the tax incentives provided for the production of energy from wind, biomass, geothermal, solar, and other sources is unnecessary and distorting. Supporters of the PTC counter that government support is needed in order to build the energy infrastructure necessary to sustain the industry as an alternative to traditional fossil fuels. The draft would move the tax code in the direction of offering less support for these energy sources by eliminating the rate inflation adjustments for renewable electricity and refined coal production under the PTC effective beginning in 2015. For renewable electricity, the full credit rate would be 1.5 cents per kilowatt-hour (down from 2.3 cents per kilowatt-hour in 2013); for refined coal production tax credits, the rate would revert to $4.375 per ton (down from $6.59 per ton in 2013). The draft also revises the placed-in-service date rules for new renewable energy projects where the construction began before the end of 2013. That provision, combined with the full termination of any further PTC benefits after 2024, represents a sharply more limited vision of this provision than Congress embraced in the American Taxpayer Relief Act, which was enacted early last year.
Other deductions and exclusions repealed – The draft would repeal a number of business-related deductions and exclusions including, among others, the:
Unified deduction for start-up and organizational expenditures – The draft would combine the various existing provisions for start-up and organizational expenses into a single provision allowing a taxpayer to deduct up to $10,000 in start-up and organizational costs phasing out beginning at $60,000.
Cost recovery system
The draft would repeal the Modified Accelerated Cost Recovery System (MACRS) and replace it with rules similar to the Alternative Depreciation System. Class lives would generally be extended, which Chairman Camp said more accurately reflects the economic life of assets, and depreciation deductions would be determined under the straight-line method. Taxpayers would be allowed to elect an additional depreciation deduction to account for inflation on depreciable personal property.
Special depreciation provisions such as bonus depreciation; depreciation of leasehold improvement property, qualified restaurant property, and qualified retail improvement property; special recovery periods for Indian reservation property; and special allowances for second generation biofuel plant property, certain reuse and recycling property, and qualified disaster assistance property would all be repealed. The draft would require Treasury, with input from the Bureau of Economic Analysis, to develop a new schedule of economic depreciation and submit a report to Congress by the end of 2017.
The new depreciation rules would be effective for property placed in service after 2016.
The draft would make significant changes to tax accounting, limiting the cash method and eliminating some methods entirely. Most of these changes would be effective for tax years beginning after 2014, but in some cases taxpayers could defer taking adjustments into income for several years.
Cash method – As Camp proposed in the discussion draft on small-business and passthrough issues he released last year, this draft would limit the cash method of accounting to businesses with average annual gross receipts of $10 million or less. Businesses with average annual receipts above that threshold would be required to use the accrual method. This limitation on the cash method would not apply to farming businesses (a change from the earlier proposal) or sole proprietorships, regardless of receipts. While effective after 2014, resulting adjustments to income would not have to be taken into account until the first tax year beginning after 2018 following an inclusion schedule of 10 percent in 2019, 15 percent in 2020, 25 percent in 2021, and 50 percent in 2022. A taxpayer could elect to begin the inclusion before 2019, however.
Year of inclusion – The draft would modify the section 451 rules for recognition of income by accrual method taxpayers, requiring a taxpayers to recognize income no later than the taxable year in which that income is taken into account as income on a financial statement. The draft would also coordinate the application of the original issue discount rules with this provision, specifying that taxpayers apply the recognition rules of section 451 before applying the original issue discount rules of section 1272.
The chairman’s draft would also codify the deferral method of accounting for advance payments for goods and services under Rev. Proc. 2004-34 and would repeal special rules for crop insurance proceeds or disaster payments; proceeds from livestock sold on account of drought, flood, or other weather-related conditions; and sales or dispositions to implement FERC or state electric restructuring policy. Application of these rules would be a change of accounting method for purposes of section 481.
LIFO and LCM – The draft would repeal the last-in, first-out (LIFO) and lower of cost or market (LCM) methods of accounting. According to the Ways and Means explanation, taxpayers currently using LIFO could switch to the first-in, first-out (FIFO) method or another method that conforms to best accounting practices in the industry and clearly reflects income. Like the cash method change, repeal of these provisions would be effective after 2014, but income inclusion from the change could be deferred until 2019 and then taken into account using a schedule similar to the one described above.
Installment sales – The draft would modify the installment sale rules to apply the interest charge rules to any installment sale in excess of $150,000 if the obligation remains outstanding at the end of the tax year.
Long-term contracts – The draft would limit the use of the completed-contract method to contracts estimated to be completed within two years for taxpayers with average gross receipts of $10 million or less over a three-year period. The draft would also repeal special exceptions to the percentage-of-completion method for multi-unit housing and shipbuilding contracts.
Income forecast method – Current law provides for the cost of motion pictures, sound recordings, copyrights, books, and patents to be recovered using the income forecast method (ICM). The draft would modify the ICM, extending the forecast period to 20 years, with required income-earned computations before the close of the fifth, tenth, fifteenth, and twentieth years.
Additional method provisions – Other accounting method provisions in the chairman’s draft bill would modify rules for determining whether a taxpayer has adopted a method of accounting, certain UNICAP rules for small businesses, and the treatment of patent or trademark infringement awards. The draft would repeal special tax rates for nuclear decommissioning reserve funds, the farm-income averaging method, certain rules for carrying charges, and the recurring item exception for spudding of oil and gas wells. Qualified environmental remediation expenses would be capitalized and recovered ratably over 40 years.
Other business tax changes
Low-income housing tax credit changes – Owners of certain residential rental property may claim a low-income housing tax credit (LIHTC) over a 10-year period for the cost of rental housing occupied by qualifying low-income tenants. Rental housing must remain qualified low-income housing for a 15-year compliance period, or else there is a recapture of the accelerated portion of the credit, with interest, for all prior years. Depending on whether the present value of the total qualified basis of each low-income building is 70 percent or 30 percent, there is a 9 percent credit or 4 percent credit, respectively.
Owners of qualified buildings receive a housing credit allocation from the state or local housing credit agency. Among other components, a state’s available credit allocation depends on its share of the national pool of unused credits from other states.
Camp’s draft would make several changes to the LIHTC, including: (1) requiring states and local housing authorities to allocate qualified basis (generally equal to $31.20 multiplied by the state’s population), rather than credit amounts; (2) eliminating the component of a national pool of unused credits; (3) extending the credit period to 15 years (from 10 years) to match the 15-year compliance period, and thus eliminating the recapture rules; and (4) repealing the 4 percent credit.
The provision would be effective for state basis amounts and allocations of such amounts determined for calendar years after 2014. A transition rule would translate credit allocations prior to 2015 into equivalent amounts of eligible basis for purposes of determining new allocations of basis after 2014.
Taxation of passenger cruise ship income – The draft would create a category of income for foreign flagged cruise ship companies called “passenger cruise gross income” and provides rules on when this income would be effectively connected with the conduct of a trade or business in the United States, therefore subjecting it to U.S. tax. The tax would apply whether or not the cruise company’s home jurisdiction grants a reciprocal exemption for U.S. carriers. The provision would be effective for taxable years beginning after December 31, 2014.
Repeal of employer credit for Social Security taxes paid on employee cash tips – Under current law, an employer may claim an income tax credit equal to its share of FICA taxes attributable to cash tips received from customers in connection with the provision of food or beverages, if tipping is customary. Camp’s draft would repeal the employer tip credit effective for tips received for services performed after 2014.
Determination of worker classification – For tax purposes, classifying a worker as an employee or independent contractor is generally made under a common-law facts and circumstances test that seeks to determine whether the worker is subject to the control of the service recipient. A safe harbor (section 530 of the Revenue Act of 1978) provides for a service recipient to treat a worker as an independent contractor for tax purposes if the service recipient has a reasonable basis for doing so and other requirements are met.
Camp’s draft would permit workers qualifying for a safe harbor to not be treated as an employee and the service recipient to not be treated as the employer for any federal tax purpose. In order to fall within the safe harbor, the worker must satisfy certain sales and service criteria and the worker and service recipient must enter into a written agreement meeting certain requirements. Significantly, the service recipient would also be required to withhold tax at a rate of 5 percent on the first $10,000 of payments made to the worker. To the extent that the IRS determines that the safe harbor requirements are not met, the draft would generally allow the IRS to reclassify a worker as an employee on a prospective basis only. The provision would be effective for services performed and payments made after 2014.
International provisions: Outbound
The draft generally follows the proposal that Chairman Camp released in October 2011, but with significant changes. These provisions would be effective generally for taxable years beginning after December 31, 2014.
Participation exemption for foreign dividends – The draft would change the way U.S. law prevents double taxation of U.S. corporations’ foreign income, by adopting a participation exemption for certain foreign dividends. The draft would introduce a 95 percent dividends received deduction (DRD) for the foreign-source portion of dividends received by a domestic corporation from a foreign corporation the voting stock of which is at least 10 percent owned by the domestic corporation for a six-month holding period. Neither credits nor deductions would be allowed for any foreign taxes paid with respect to dividends eligible for the new DRD. Unlike the 2011 proposal, the participation exemption extends beyond dividends from controlled foreign corporations (CFCs) and corporations electing to be treated as CFCs, and does not extend to gains on sales of stock of foreign corporations, except insofar as the gains are deemed to be dividends under present-law rules. Also unlike the 2011 proposal, the draft would not change the present-law treatment of income of foreign branches of domestic corporations, and would add a new branch-loss recapture rule to the code for cases in which the new DRD is claimed for dividends from a foreign corporation that acquired substantially all the assets of a branch that had previously generated losses.
Transition rule – As part of the transition to the proposed participation exemption (or “territorial”) regime, the draft would generally require any 10 percent U.S. shareholder (whether or not corporate) of a CFC or other 10 percent owned foreign corporation to include in income the shareholder’s pro rata share of the undistributed and nonpreviously-taxed post-1986 foreign earnings of the corporation. This inclusion would occur in the last taxable year before the exemption system begins and would be taxed at present-law rates, reduced by the deductions described below. (Shareholders of S corporations that own such foreign stock would generally have the ability to defer the tax on such inclusions.) Pre-1987 earnings would generally be excluded from this deemed repatriation, but would still be eligible for the new DRD upon actual repatriation after the participation exemption system takes effect.
Responding to concerns that the 2011 proposal (a 5.25 percent rate on all deemed repatriations) would have been burdensome on U.S. shareholders of foreign corporations that had reinvested their profits in bricks and mortar, the draft released Wednesday would impose multiple tax rates on the deemed repatriation depending on the types of assets that the deferred earnings had funded. The U.S. shareholder would be entitled to a 90 percent deduction for the portion of the deferred earnings that are held in noncash assets, and 75 percent for cash or liquid assets. This would result in a 3.5 percent U.S. tax rate for noncash assets and 8.75 percent U.S. tax rate for cash and cash equivalents, less deemed-paid foreign tax credits, if any. The draft would also respond to comments on the 2011 proposal by permitting a U.S. shareholder owning stock in a foreign corporation with accumulated earnings to offset the deemed repatriation by a share of the deficits in the earnings of other foreign corporations also owned by the shareholder.
The shareholder could elect to pay the tax under this transition provision in eight installments: 8 percent of the liability in each of years 1 to 5; then 15 percent in year 6; 20 percent in year 7; and 25 percent in year 8. By contrast to the 2011 proposal, the shareholder would owe no interest on the deferred payments if the payments are timely.
Revenues from this provision would be earmarked for the Highway Trust Fund, and would not be dedicated to offsetting the proposed lower corporate tax rate, another difference from the chairman’s original international tax proposal released in 2011.
Foreign tax credits – Unlike the 2011 proposal, the new proposal retains the separate basket for passive income, renaming it “mobile” income, and adds to that basket foreign base company sales income (as modified for subpart F purposes, discussed below), present-law “financial services income,” and the new category of “foreign base company intangible income” (described below). Similar to the 2011 proposal, foreign dividends would no longer bring up deemed-paid credits, and taxes deemed paid with subpart F inclusions would no longer be determined on a multi-year corporate-wide (within baskets) “pooled” basis. Unlike the 2011 proposal, the new proposal would source income from the production and sale of inventory property solely by reference to the location of production activities (e.g., not in any part based on the “title passage rule”), and would retain the code’s “anti-splitter” provision enacted in 2010.
Subpart F/Base erosion – In large part, the subpart F provisions of the 2014 draft vary, in greater or lesser degrees, from those in the 2011 draft.
CFC lookthrough – The new draft would make the temporary “CFC lookthrough” rule permanent, with no break from the expiration date of its last extension.
High tax exception – The high-tax exception from foreign base company income would become mandatory rather than elective, and where the newly proposed minimum worldwide rate approach (described below) does not apply, the threshold for the exception would be 100 percent of the U.S. rate, rather than 90 percent.
Foreign base company intangible income and deduction for foreign intangible income – The draft would create a new residual category of foreign base company income called “foreign base company intangible income” (FBCII) and an accompanying deduction for “foreign intangible income.” These provisions are similar to “Option C” in the 2011 proposal. The draft would afford FBCII, as well as foreign base company sales income (FBCSI) and income excluded from foreign personal holding company income (FPHCI) under the active financing exception, a new “minimum worldwide tax rate” approach similar to Option Y in former Senate Finance Committee Chairman Baucus’s staff discussion draft of November 2013. In the case of FBCII, the draft is intended to have the effect of causing a CFC’s FBCII to bear, in effect, a minimum worldwide tax rate of 15 percent. The rate of worldwide tax rate on such income would be greater than 15 percent only if a foreign government imposed a greater-than-15 percent rate.
Foreign base company intangible income – FBCII would generally be defined by reference to the excess of the CFC’s “adjusted gross income” over 10 percent of its “qualified business asset investment” (generally the adjusted basis in certain tangible property). The “adjustment” in “adjusted gross income” backs out gross income from (and investment in) the production or extraction of commodities.
This profit component of the CFC’s entire gross income (other than commodities gross income) – perhaps in the drafters’ minds a supranormal level of profit – would be apportioned among all of the types of the CFC’s income (other than commodities gross income), and only the portion not apportioned to (other) types of foreign base company income would be treated as “FBCII.” Note that this definition of FBCII is free of any reference to separately identified or valued intangible property (if any) that the CFC could be said to “own” for U.S. federal tax purposes.
To the extent that a CFC’s income to which its FBCII is attributable is “foreign-derived” (i.e., is derived in connection with property sold for use, consumption, or disposition outside the United States, or services provided with respect to persons or property located outside the United States) the draft would subject a corporate U.S. shareholder’s subpart F inclusion of the CFC’s FBCII to a reduced rate of U.S. tax: not the proposal’s fully phased-in 25 percent rate, but a reduced rate of 15 percent. (During the overall rate’s five-year phase-in period, the effective rate of U.S. tax on a subpart F inclusion of FBCII would approximate 15 percent).
This is achieved by (1) the draft’s modified “high tax exception” specifically for FBCII – a “high” foreign tax rate under this modification would be 15 percent or more – and (2) the draft’s proposed allowance to domestic corporations of a deduction for “foreign intangible income.”
Deduction for foreign intangible income – The deduction would be equal to the “applicable percentage” of the lesser of (1) the domestic corporation’s taxable income or (2) the sum of:
The “applicable percentage” would ultimately equal 40 percent starting in 2019 (resulting in an effective U.S. tax rate of 15 percent on the domestic corporation’s net imputed intangible income), and would phase in for four years, such that the effective U.S. tax rate on a domestic corporation’s net imputed intangible income and subpart F inclusions of FBCII such income would approximate 15 percent as the U.S. corporate tax rate phases down from 35 percent to 25 percent.
“Net imputed intangible income” would be based on the profit component described above that defines FBCII (i.e., adjusted gross income less 10 percent of qualified business asset investment), and each corporation’s “foreign percentage” would be based on the “foreign-derived” portion of its total adjusted gross income for the taxable year.
Foreign base company sales income – The 2014 draft would modify the definition of FBCSI so as to exclude income of a CFC that is eligible for treaty benefits as a qualified resident of a country that has a “comprehensive income tax treaty” in force with the United States. The JCT explanation says that the exclusion is intended to be limited to those CFCs that are subject to “the robust limitation on benefits provisions of income tax treaties.”
The draft would also apply a modified high tax exception to FBCSI, under which a “high” foreign tax would be 12.5 percent or more. Finally, the draft would limit a U.S. shareholder’s subpart F inclusion of FBCSI to 50 percent of the CFC’s net FBCSI. Notwithstanding the reduced subpart F inclusion, 100 percent of the taxes paid or accrued by the CFC on the CFC’s (unreduced) FBCSI would be deemed paid by a corporate U.S. shareholder on the shareholder’s (reduced) subpart F inclusion of FBCSI. Therefore, similar to the draft’s treatment of FBCII, the draft is intended to have the effect of causing a CFC’s FBCSI to bear a minimum worldwide tax rate of 12.5 percent.
Active financing exception from foreign personal holding company income – The draft would generally extend for five years the temporary exception from FPHCI for certain income derived in the active conduct of a banking, financing, insurance, or similar business, with a significant change. The extension would only apply to income that is subject to a foreign effective tax rate of 12.5 percent or more. Active financing income subject to an effective foreign tax rate less than 12.5 percent would not be excluded from FPHCI but, like FBCSI, would be subject to a U.S. tax rate of only 12.5 percent before the application of foreign tax credits.
Interest expense deductions – The draft includes, with minor modifications, the proposed 2011 denial of interest expense deductions for corporate U.S. shareholders of worldwide affiliated groups that have “excess domestic indebtedness.” Thus, if the U.S. shareholders (as a group) fail both a relative leverage test and a percentage-of-adjusted-taxable-income test, their interest expense deductions would be reduced. The relative leverage test asks whether the U.S. group members’ debt exceeds the debt they would owe if their aggregate debt-to-equity ratio were 110 percent of the worldwide group’s ratio. (In the 2011 proposal, the corresponding benchmark was 100 percent, rather than 110 percent, of the worldwide group’s debt-to-equity ratio.) Net interest expense associated with this excess leverage could potentially be disallowed. However, such disallowance would be limited to the amount by which the net interest expense of the U.S. group exceeds 40 percent of its “adjusted taxable income,” as defined in present law’s “earnings stripping” rules (see below). (In the 2011 proposal, the relevant percentage number was left unspecified.) Interest deductions disallowed under this provision could be carried forward indefinitely.
International: Inbound provisions
Unlike the 2011 proposal, the 2014 draft contains several provisions that primarily affect foreign-based multinational enterprises with investments in the United States.
Earnings stripping – The draft would amend the section 163(j) “earnings stripping” rule that defers or denies a corporate U.S. taxpayer deductions for its “disqualified interest” expense (interest that bears no U.S. tax in the hands of the recipient or that is owed with respect to debt that is guaranteed by a foreign or tax-exempt person) to the extent of the taxpayer’s “excess interest expense.” Generally, the provision would lower, from 50 percent to 40 percent, the percentage of the taxpayer’s adjusted taxable income that serves as the general benchmark for determining whether its net interest expense is “excess interest expense”; the draft would also eliminate recourse to the taxpayer’s prior three years’ “excess limitation” to increase this threshold.
Statutory limitation on treaty benefits – Lifting a proposal (H.R. 1556) from Ways and Means Committee member Lloyd Doggett, D-Texas, the draft would deny treaty benefits for certain payments that are treaty-protected under present law. Under internal U.S. law, the receipt of U.S.-source fixed or determinable, annual or periodical (FDAP) gross income by a foreign corporation (or a nonresident alien individual) is subject to a 30 percent tax, but if the beneficial owner of the income is a resident of a country with a U.S. tax treaty in force, the tax may be reduced or eliminated by the treaty. The 2014 draft would statutorily override treaty protection in the case of “deductible related-party payments” between members of a foreign controlled group of entities, unless the tax would have been reduced by treaty if the payment had been made directly to the common foreign parent corporation of the payer and payee.
This provision, which was not in the chairman’s 2011 draft, was previously criticized by the Treasury Department in light of the fact that it would violate existing U.S. treaties.
Other transactions – Other inbound proposals related to reinsurance transactions, the Foreign Investment in Real Property Tax Act, and the taxation of passenger cruise ship income are discussed elsewhere in this report.
Treatment of passthrough entities
Camp’s discussion draft proposes a number of administrative fixes and makes some far-reaching recommendations related to S corporations, partnerships, real estate investment trusts (REITs) and regulated investment companies (RICs). Significant proposals include recharacterizing the treatment of carried interest, significantly restricting exceptions allowing certain publicly traded partnerships to avoid taxation as corporations, removing exceptions for REITs and RICs in regards to the Foreign Investment in Real Property Tax Act (FIRPTA), and the requiring immediate taxation of unrealized gain upon the conversion of a C corporation to a REIT or the contribution of property by a C corporation to a REIT.
Carried Interest – To the surprise of many, Camp’s discussion draft provides for ordinary income tax treatment of a portion of the carried interest of partners providing services to certain investment partnerships (generally, private equity funds). While similar in thrust to past proposals from Democrats including President Obama and Ways and Means ranking member Sander Levin of Michigan, the proposal unveiled by Chairman Camp contains important structural differences.
The chairman’s discussion draft adopts a formulary approach to the taxation of carried interests. Under the formula, a portion of the gain recognized by partners providing services to certain investment partnerships would be recharacterized as ordinary income.
Unlike the prior offerings from his Democratic colleagues, Camp’s carried interest proposal is limited in scope. For instance, it would not apply to partners engaged in a real property trade or business. Although relatively clear in concept, the proposed legislative text contains ambiguities that could significantly impact the reach of the chairman’s proposal.
The provision would apply to taxable years beginning after December 31, 2014.
New publicly traded partnership restrictions – The chairman’s discussion draft proposes to significantly limit the ability of publicly traded partnerships (PTPs) to avoid taxation as corporations. In essence, only mining and natural resource PTPs would continue to be taxed on a flow-through basis.
Under current law, a PTP generally is treated as a corporation for federal tax purposes unless 90 percent or more of the partnership’s gross income is “qualifying income.” The chairman’s proposal would limit the definition of “qualifying income” to (1) certain income or gains derived from the exploration, development, mining or production, processing, refining, transportation (including pipelines transporting gas, oil, or products thereof), or the marketing of any mineral or natural resource (including geothermal energy and excluding fertilizer and timber) or industrial-source carbon dioxide, and (2) gain from the sale or disposition of a capital asset held for the production of income described in item (1).
The provision would be effective for taxable years beginning after December 31, 2016. If enacted, nonqualifying PTPs would have a short window in which to take themselves private before becoming taxable as a corporation.
TEFRA partnership audit rules – Under current law, three different regimes exist for auditing partnerships: those with 10 or few partners, those with more than 10 partners (large partnerships), and those who elect to be treated as Electing Large Partnerships (ELP). Under the TEFRA partnership procedures (so-called TEFRA rules adopted as part of the Tax Equity and Fiscal Responsibility Act of 1982) which apply to large partnerships, the IRS determines the tax treatment of partnership items in a single administrative proceeding at the partnership level. Determinations at the partnership level are binding upon the partners of the partnership. After completion of the administrative proceeding, the tax liability of each partner is recalculated to reflect determinations with respect to the particular audit year.
As under the TEFRA partnership audit rules, ELPs and their partners are subject to unified audit rules. Thus, the tax treatment of partnership items is determined at the partnership level rather than the partner level. Unlike TEFRA, adjustments to the ELP’s tax return flow through to the partners for the year in which the adjustment takes effect, rather than the audit year.
The proposal would repeal the current TEFRA and ELP rules. Under the proposed system, the audit and adjustments of all items would be determined at the partnership level. Any IRS adjustments would be taken into account by the partnership in the year that the audit or any judicial review is completed (rather than the year examined by the IRS). Any underpayment of tax determined as a result of an audit would be assessed against and collected from the partnership. The proposal allows partnerships with fewer than 100 partners, subject to certain conditions, to opt out of this proposed audit procedure, in which case the partnership and partners would be audited under the general rules applicable to individual taxpayers.
The provision would be generally be effective for partnership tax years ending after 2014.
Other passthrough provisions – Camp’s proposal generally incorporates a number of proposals related to S corporations and partnerships that were included in Option 1 of the Ways and Means Committee’s discussion draft on small business and passthrough issues that was released in March of last year. Also, the employment tax rules for partners and S corporation shareholders would change as described below in the “Employee tax provisions” section.
Some of the significant S corporation proposals adopted from the 2013 discussion draft include:
Some of the significant partnership proposals include:
REITs and RICs
The Ways and Means staff summary states that the REIT rules were intended to provide a “tax efficient vehicle for average investors to acquire diversified and passive interests in real estate” and were not “intended to facilitate erosion of the corporate tax base.” A number of changes listed in the Camp proposal are meant to address the panel’s concerns, while other provisions move in the opposite direction and make REITs a more attractive investment vehicle.
Prevention of tax-free spinoffs – Under current law, a corporation is permitted under section 355 to distribute (spin off) to shareholders stock of a controlled corporation on a tax-free basis if the transaction satisfies certain requirements, including that both the distributing corporation and the controlled corporation are engaged immediately after the distribution in the active conduct of a trade or business. A recent IRS ruling allows a REIT to satisfy the active trade or business requirements, even though the gain on the sale of property that is stock in trade of a REIT, or property includable in inventory of a REIT, does not satisfy the REIT income tests.
This proposal would make a REIT ineligible to participate in a tax-free spin-off as either a distributing or controlled corporation under section 355. The proposal generally would apply to distributions on or after February 26, 2014. However, the proposal shall not apply to any distribution made pursuant to an agreement that was binding on February 26, 2014 and at all times thereafter.
Certain short-life property not treated as real property – Under current law, a REIT must meet certain income and asset tests, including one providing that at least 75 percent of the assets of a REIT must be comprised of real estate assets. Those assets include, among other items, real property and interests in real property. Under the proposal, the term real property would not include tangible property with a class life of 27.5 years for purposes of the REIT income and asset tests. The proposal would be effective for tax years beginning after 2016.
Repeal of special rules for timber – Under current law, a number of provisions have been enacted allowing timber to qualify under the REIT rules, including allowing capital gains from the sale of standing timber to satisfy the REIT income tests and providing a safe harbor under prohibited transaction income. Effective for tax years beginning after 2016, the term “real property” would not include timber for all purposes of the REIT provisions. The proposal also would repeal each of the special rules applicable to REITs that hold or dispose of timber or timberland.
Limit on fixed percentage rent and interest exceptions for REIT income tests – Under current law, in order to satisfy the 95 and 75 percent REIT income tests, rents from real property and interest do not include amounts that are contingent on the income or profits of the tenant or debtor, but do include amounts based on a fixed percentage of receipts or sales of the tenant or debtor. Effective for tax years ending after 2014, rents from real property and interest would not include amounts based on a fixed percentage of receipts or sales to the extent that such amounts are received or accrued from a single tenant that is a C corporation and the amounts received or accrued from such tenant constitute more than 25 percent of the total amount received or accrued by the REIT that is based on a fixed percentage of receipts or sales.
Non-REIT E&P required to be distributed in cash – Under current law, REITs that accumulate earnings and profits (E&P) prior to becoming a REIT are required to distribute such E&P by the end of the first tax year after electing to become a REIT in cash, property, or stock. The proposal, effective for distributions after February 26, 2014, would require REITs to distribute their pre-REIT E&P in cash.
Reduction in TRS percentage of the total assets of a REIT – Under current law, a REIT may own a taxable REIT subsidiary (TRS), provided that the securities of one or more TRSs do not represent more than 25 percent of the value of the total assets of the REIT. Under the proposal, effective for tax years beginning after 2016, the TRS stock limitation would be reduced to 20 percent.
Recognizing built-in gains when a C corp converts to REIT or RIC – Under current law, a REIT or RIC that previously operated as a C corporation is subject to an entity-level tax at the highest corporate tax rate on certain built-in gains of property that it held while operating as a C corporation. The tax generally applies to gain recognized within 10 years from the date that the C corporation elected to be a REIT or RIC. Most recently, a temporary reduction of the period to five years expired for transactions occurring in taxable years beginning after December 31, 2013.
The proposal, effective for elections and transfers on or after February 26, 2014, would require the current-law entity-level tax on built-in gains to be imposed at the time the C corporation elects to become a REIT or RIC or transfers assets to the REIT or RIC in a carryover basis transaction, without regard to when the gain otherwise would be recognized by the REIT or RIC. The change would not apply if a net loss would be recognized. This provision, in particular, appears targeted at slowing, if not stopping, the increasingly frequent practice of corporations becoming REITs, something the staff summary cites as a potential source of concern.
FIRPTA – Under current law, FIRPTA generally imposes a tax on the dispositions by foreign persons of U.S. real property interest (USRPI). However, an interest in U.S. real property does not include an interest in a U.S. corporation that does not hold any interests in U.S. real property at the time of disposition and, during the five-year period preceding the disposition of an interest in the U.S. corporation by a foreign person, disposed of its interests in U.S. real property in transactions in which the full amount of any gain was recognized for tax purposes.
Previous legislative proposals have aimed at increasing foreign equity investment in the U.S. commercial real estate market by providing relief. However, those are not included in the Camp proposal.
Key expired tax provisions
The draft includes proposals to address – though often not favorably – the status of many of the 55 temporary business and individual tax provisions that expired at the end of 2013. Camp has long called for reviewing each of the temporary tax provisions – the so-called “extenders” – and determining which ones should be made permanent and which should be repealed outright as part of a comprehensive tax code overhaul. That approach puts Camp at odds with Senate Finance Committee Chairman Ron Wyden, D-Ore., who argues that Congress should act in the short term to renew the extenders and use that legislation as a “bridge to a broader reform.”
The R&E tax credit – The R&E tax credit would be made permanent and modified effective for tax years beginning after 2013. Going forward, the draft would make the alternative simplified credit permanent and equal to 15 percent of qualified research expenses that exceed 50 percent of the average qualified research expenses in the three preceding tax years. The draft also would make permanent the basic research credit but reduce the credit rate to 15 percent. The draft would eliminate the energy research credit and the credit for research related to computer software. (Supporters of the R&E credit should also note that the draft makes other important changes to the tax treatment of research expenses, notably by requiring noncredit eligible costs to be amortized over five years.)
Enhanced small business expensing – Beginning in 2014, the draft would make permanent an expensing limit of $250,000 and an investment phase-out of $800,000. Rules allowing computer software and certain investments in real property to qualify as section 179 expensing also would be made permanent.
Active financing exception and CFC lookthrough – As noted in the discussion of international provisions, the draft makes permanent the now-expired CFC lookthrough provision (section 954(c)(6)) and modifies the exception from subpart F for active financing income, which is extended for five years in the draft.
Provisions facing permanent expiration – The draft calls for a number of the extenders to be removed from the tax code and, in effect, stay expired.
Among the notable general business credits that would not be renewed are the:
Some of the individual provisions that would face elimination include the:
Several energy provisions are also slated for extinction including, among others, the:
Fate uncertain – Interestingly, there is also a group of now lapsed provisions that are neither extended nor specifically repealed, and it is not clear how they should be differentiated from those lapsed provisions the chairman explicitly repeals. Included on this “neither here nor there” list are such items as the:
Financial institutions and products
The Camp draft includes several proposals that are identical or substantially similar to proposals that he first unveiled in the financial products discussion draft in January 2013. New provisions in this area would significantly alter the tax treatment of derivatives, repeal several types of tax-favored bonds, make substantial changes in the insurance area, and impose an excise tax on large financial institutions.
Tax on financial institutions – The draft’s proposed fee on financial institutions is conceptually similar to one that President Obama has included in past budget submissions to Congress. Specifically, it would apply a 0.035 percent tax on the excess total consolidated assets of a “systemically important financial institution” (SIFI) at the close of each quarter beginning in 2015. A SIFI is defined as an entity subject to section 165 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Excess consolidated assets would be those assets in excess of $500 billion (using definitions from Dodd-Frank to determine consolidated assets), and that amount would be indexed to changes in gross domestic product.
Derivatives – Similar to the 2013 financial products discussion draft, the plan unveiled by the chairman this week would generally require all taxpayers to mark derivative contracts to market and recognize gain or loss as if they were sold for fair market value on the last day of the taxable year. The resulting gain or loss would be treated as ordinary. The Joint Tax Committee technical explanation indicates that taxpayers and the IRS are expected to use general tax principles to determine fair market value, but it gives a list of nontax reports and statements, such as reports filed with the Securities and Exchange Commission and prepared in accordance with generally accepted accounting principles (GAAP), that can evidence fair market value.
A derivative would be defined broadly as any contract the value of which (or any payment or transfer with respect to which) is directly or indirectly determined by reference to one or more items including stocks, bonds, debentures, evidence of indebtedness, certain real property, commodities, or currency. The proposal would apply regardless of whether the derivative or the subject matter is publicly traded.
Under the chairman’s draft, if a taxpayer enters a straddle with offsetting derivative and nonderivative positions, then both the derivative and nonderivative components must be marked to market, even if the nonderivative component, such as stock, would not ordinarily be marked to market. The chairman’s draft does exclude some derivatives from mark-to-market treatment, including certain contracts with respect to a tract of real property, hedging transactions, securities loans, compensatory stock options, insurance company contracts or annuities, and some contracts providing for physical delivery of commodities.
The proposal would be effective for taxable years ending after December 31, 2014 for property acquired and positions established after that date (as well as for straddles established after that date). It would be effective for taxable years ending after December 31, 2019 for all other property or positions.
Hedges – As in the earlier proposal, the draft would treat a hedging transaction as meeting the section 1221 identification requirement if the transaction is identified as a hedging transaction for tax purposes, or if it is treated as such under GAAP for purposes of the taxpayer’s financial statements. Additionally, the proposal would provide hedging treatment for hedges entered into by insurance companies with respect to their bond portfolios. The proposal would apply to transactions entered into after December 31, 2014.
Market discount income – For bonds acquired at a discount in the secondary market, the draft would require the holder to currently include in income, as interest, the market discount as it accrues, calculated on the basis of a constant interest rate. These accruals would be limited by the greater of the bond’s original yield plus 5 percentage points or the applicable federal rate plus 10 percentage points. If the bond is later sold or retired at a loss, the loss would be treated as ordinary to the extent of market discount that the taxpayer previously recognized into income. The proposal would be effective for market discount bonds acquired after December 31, 2014.
Debt restructuring – The current draft retains most of the previous proposal to effectively change the COD income rules for certain debt restructurings. In the case of the exchange of a new debt instrument for an existing one from the same issuer after 2014, the issue price of the new instrument would be the lesser of the adjusted issue price of the existing instrument, the stated principal amount of the new instrument, or the imputed principal amount of the new instrument. As a result, an issuer generally would not have any COD income on a debt restructuring. The current draft also addresses the holder’s tax treatment. The holder would generally not recognize gain or loss unless receiving boot in the transaction. Thus, the current draft addresses the situation in which a holder has “phantom income” on a debt restructuring.
Basis in securities – The draft would prevent taxpayers from using the “specific identification” method for determining basis in a covered security. For securities sold, exchanged, or disposed of beginning in 2015, the draft would require taxpayers to use a first-in, first-out method to determine basis, except where an average basis method is allowed (such as with RIC stock). This is a change from the earlier Camp draft, which would have required taxpayers to use average cost basis.
Wash sales – As in the earlier proposal, this draft would extend the wash sale rules to apply to closely related parties, such as the taxpayer’s spouse, dependents, or an entity the taxpayer controls. The provision would apply to sales and dispositions after December 31, 2014.
Tax-favored bonds – The draft would repeal the exclusion from gross income for interest on private activity bonds and advance refunding bonds as of the end of 2014. The draft would also disallow the tax credit provided by mortgage credit certificates for any certificates issued after December 31, 2014. Tax-credit bonds, such as clean renewable energy bonds, qualified energy conservation bonds, and qualified zone academy bonds, would be repealed as of date of enactment. Current law would remain in place for bonds outstanding on that date.
Insurance companies and products
The draft would make several changes to the taxation of insurance companies and their products. Most of these provisions would be effective for taxable years beginning after December 31, 2014.
Reinsurance – The draft would generally not allow an insurance company to deduct reinsurance premiums paid to a related company that is not subject to U.S. tax on the premiums, unless the related company elects to treat the premium income as effectively connected to a U.S. trade or business. Deductions for reinsurance premiums would also be allowed if the U.S. insurer demonstrates to the IRS that the foreign jurisdiction taxes premiums at a rate as high or higher than the U.S. corporate rate. This proposal is similar to one that has been introduced by Ways and Means member Richard Neal, D-Mass.
COLI – Current law provides an exception to the pro rata interest deduction disallowance rules for corporate owned life insurance (COLI) contracts that cover the life of a single employee, officer, or director. The draft adopts an Obama administration budget proposal that would repeal this exception but would leave the exception for 20 percent owners in place. The amendment will apply to contracts issued after December 31, 2014 as well as to any existing contracts where there is a material increase in the death benefits or other material change after that date.
Policy acquisition expenses – The draft would replace the three categories of life contracts under section 848 for determining the capitalization of policy acquisition expenses with two categories: group contracts and all other specified insurance contracts. The percentage of net premiums that may be treated as acquisition expenses would be 5 percent for the group contracts and 12 percent for the others.
Life reserves – The draft would make significant changes to the calculation of life insurance company reserves. One provision would require the interest rate used in determining reserves to be the applicable federal rate plus 3.5 percentage points. Any income or loss from the change in reserves would then be taken into account ratably over eight years. The draft would also amend section 807 to provide that a change in the method for determining life reserves must be taken ratably over four years (rather than 10 years under current law), beginning with the year of such change, as changes in methods of accounting under section 481.
Proration – The draft would modify life insurance company proration rules for reducing dividends received and reserve deductions with respect to untaxed income. The company share of untaxed income would be determined on an account-by-account basis – the share would be determined separately for the general account and each separate account. The formula would also be modified to compare mean reserves to mean assets of each account, rather than by computing the company and policyholders’ respective shares of net investment income.
On the property and casualty side, the draft would modify the proration formula, eliminating the fixed 15 percent reserve reduction and replacing it with a formula matching the ratio of the company’s tax-exempt assets to its total assets.
Property and casualty discounting rules – Current law allows property and casualty companies to deduct unpaid losses that are discounted using the applicable federal mid-term rate and a loss payment pattern. The draft would change the interest rate to one based on the corporate bond yield curve, extend application of the payment pattern period for long-tail lines of business to all lines of business, together with elimination of the five-year limit on the extension period, and repeal the election to use a historical loss payment pattern.
Blue Cross and Blue Shield and certain other health insurance organizations – The draft would repeal the special 25 percent deduction for claims and expenses incurred on cost-plus contracts that exceed the adjusted surplus of Blue Cross and Blue Shield and certain other health insurance organizations. It would also repeal the exception permitted these companies to the 20 percent haircut to the deduction for increases in unearned premiums.
Basis of life insurance contracts – This provision clarifies that the tax basis of a life insurance contract is not reduced for mortality, expense, or other reasonable charges incurred. This provision would be effective with respect to transactions entered into after August 25, 2009.
Other provisions – The draft also includes provisions that would:
Individual standard deduction and personal exemptions
To determine taxable income under current law, a taxpayer can reduce adjusted gross income (AGI) by personal exemption deductions, and either the standard deduction or itemized deductions. Currently, there is a basic standard deduction that varies depending on the taxpayer’s filing status and an additional standard deduction for any individual who is elderly or blind.
Camp’s draft would consolidate the current-law basic and additional standard deductions into a single standard deduction of $22,000 for joint filers and surviving spouses ($11,000 for all others). These amounts would be adjusted annually from tax year 2013 based on chained CPI, which is expected to cause these amounts to grow more slowly than they would if current inflation calculation methods were retained.
However, the standard deduction, or an equivalent amount of itemized deductions if the taxpayer itemizes, would phase out by 20 percent of every dollar that the taxpayer’s modified AGI (MAGI, described below) exceeds $513,600 for joint filers ($356,800 for single filers). These amounts would be indexed for inflation based on 2013 dollars.
The proposal would be effective for taxable years beginning after December 31, 2014.
Personal exemptions – Under current law, taxpayers may deduct $3,900 for each personal exemption, but the personal exemption phase-out (PEP) reduces a taxpayer’s personal exemptions by 2 percent for each $2,500 by which the taxpayer’s AGI exceeds $300,000 for joint filers ($250,000 for single filers).
Camp’s proposal would repeal the deduction for personal exemptions, because the personal exemption would be consolidated into the single standard deduction under the proposal. The change would be effective for taxable years beginning after December 31, 2014.
Other changes – Camp’s plan would increase the child credit to $1,500 (from $1,000) and provide it for qualifying children under the age of 18. Notably, a taxpayer would be required to provide his or her Social Security number to claim the refundable portion of the credit. (A Social Security number is not required for the child or dependent).
With respect to the Earned Income Tax Credit (EITC), Camp proposes to refund employment-related taxes (e.g., payroll taxes and self-employment taxes) paid by or with respect to the individual. The employee’s share of payroll taxes would be offset by a credit against the taxes, while the employer’s share would be rebated through a refundable income tax credit. The EITC would phase out as AGI exceeds certain thresholds.
Both changes would be effective for taxable years beginning after December 31, 2014.
Individual income tax brackets
According to the Ways and Means Committee staff summary, Camp’s draft would consolidate the current-law seven tax brackets (10, 15, 25, 28, 33, 35, and 39.6 percent) into three new brackets: 10 percent, 25 percent, and 35 percent. The new 35 percent bracket is composed of the 25 percent rate and an additional 10 percent surtax on MAGI in excess of $450,000 for joint filers ($400,000 for all others). Beginning in 2015, these income levels would be indexed for inflation using chained CPI.
The 10 percent bracket would apply to taxable income below $71,200 for joint filers ($35,600 for single filers), while the 25 percent bracket would apply to taxable income in excess of these amounts.
The 10 percent bracket is phased out at a 5 percent rate if an individual’s MAGI exceed $300,000 for joint filers ($250,000 single filers). Thus, the benefit is fully phased out at MAGI of $513,600 for joint filers ($356,800 for single filers). These thresholds are also adjusted for chained CPI in taxable years after 2013.
For purposes of both the 10 percent surtax on upper-income individuals and the phase-out of the original 10 percent bracket, MAGI is defined as AGI increased by:
The resulting amount is then reduced by:
The net of those amounts is MAGI for purposes of calculating the surtax and the phase-out of the original 10 percent bracket and the expanded standard deduction.
Qualified domestic manufacturing income defined – Qualified domestic manufacturing income is generally net income attributable to domestic manufacturing gross receipts, including: (1) any lease, rental, license, sale, exchange, or other disposition of tangible personal property that is manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the United States, or (2) construction of real property in the United States as part of the active conduct of a construction trade or business.
For any taxable year beginning in 2015, 33 percent of a taxpayer’s QDMI would reduce AGI, and for any taxable year beginning in 2016, 67 percent of a taxpayer’s QDMI would reduce AGI. Thereafter, all of a taxpayer’s QDMI would reduce AGI.
Partners of a partnership and shareholders of an S corporation will generally take into account their allocable share of QDMI components from the partnership or S corporation. However, QDMI from publicly traded partnerships will not be taken into account. According to the Ways and Means Committee staff summary, excluding QDMI from the 35 percent bracket “would ensure that small businesses and passthrough entities (such as S corporations and partnerships) engaged in such activity are taxed at a rate no higher than 25 percent, achieving parity with C corporations.”
Generally, these changes would be effective for taxable years beginning after December 31, 2014.
Capital gains and dividends
The proposal would repeal current-law top rates for capital gain and dividends, and instead provide an above-the-line deduction equal to 40 percent of adjusted net capital gain. Adjusted net capital gain would equal the sum of net capital gain reduced by net collectibles gain and increased by the qualified dividend income. As a result, capital gain and dividend income would be taxed at 60 percent of the taxpayer’s marginal ordinary income rate.
Notably, Camp’s plan also retains the 3.8 percent tax on net investment income that was enacted under the Patient Protection and Affordable Care Act.
The proposal would be effective for taxable years beginning after December 31, 2014.
Individual and corporate alternative minimum tax repealed
Significantly, Camp’s draft would repeal the individual and corporate alternative minimum tax (AMT) and permit a taxpayer with an AMT credit carryforward to claim a refund of 50 percent of the remaining credits (to the extent the credits exceed regular tax for the year) in taxable years beginning in 2016, 2017, and 2018. (Taxpayers would be permitted to claim a refund of all remaining credits in taxable years beginning in 2019.)
The American Taxpayer Relief Act of 2012 permanently increased and indexed the exemption amounts under the individual AMT annually for inflation, thus ending what had become an almost annual ritual in Congress of adopting temporary “patches” to the AMT. Camp’s plan goes a step farther and repeals it outright.
Changes to significant deductions, exclusions, and other provisions
Camp’s proposal makes changes to several significant individual income tax provisions, including the mortgage interest deduction, the deduction for charitable contributions, the deduction for expenses attributable to a trade or business of an employee, and the 2 percent floor on miscellaneous itemized deductions, among others.
Mortgage interest deduction – Under current law, a taxpayer may claim an itemized deduction for mortgage interest paid with respect to a principal residence and one other residence belonging to the taxpayer. Deductions may be claimed on interest payments on up to $1 million of indebtedness incurred in acquiring, constructing, or substantially improving the residence, and up to $100,000 in home equity indebtedness.
Effective for interest paid on debt incurred after 2014 (meaning the provision does not apply to existing mortgages or the refinancing of those mortgages), Camp’s draft would reduce the $1 million limit to $500,000 over four years. The limitation would drop to $875,000 in 2015, $750,000 in 2016, $625,000 in 2017, and $500,000 thereafter. Interest on home equity indebtedness incurred after 2014 would not be deductible.
Exclusion of gain from sale of principal residence – Under current law, a taxpayer may exclude from gross income up to $500,000 (for joint filers) of gain on the sale or exchange of a principal residence as long as the taxpayer owned and used the residence for at least two of the previous five years.
Camp’s draft would require the taxpayer to own and use the home as the principal residence for five out of previous eight years to qualify for the exclusion. Moreover, Camp would permit the taxpayer to only use the exclusion once every five years. The provision would be effective for sales and exchanges after 2014. Moreover, the exclusion would now be subject to an income phase-out; the amount of gain excludable from income would decline, dollar for dollar, as a taxpayer’s MAGI exceeds $500,000 ($250,000 for single filers).
Deduction for state, local, and foreign taxes – Under current law, individual income taxpayers are allowed to take state, local, and foreign income taxes as an itemized deduction. In prior years, taxpayers were allowed to take state and local sales tax as an itemized deduction in lieu of the deduction for state and local income tax. Under the proposal, no deduction for state and local income or sales taxes will be allowed. Foreign income taxes related to a trade or business will still be allowed as a deduction.
Additionally, taxpayers are currently allowed to deduct state, local, and foreign property taxes on property not held in a trade or business or as an investment asset as an itemized deduction. Under the proposal, only state, local, and foreign property taxes paid in conjunction with a trade or business or on an investment asset will be allowed.
Charitable contributions – Under current law, a taxpayer may claim an itemized deduction for qualifying charitable contributions. For a calendar year taxpayer, the charitable contributions must be made on or before December 31 to be included on a tax return for that tax year. Generally, the deduction for charitable contributions is limited to a certain percentage of the individual’s AGI depending on the type of property contributed and the type of exempt organization receiving the property.
Camp’s draft would make numerous changes to the charitable contribution deduction, such as:
Trade or business expenses – Under current law, a taxpayer may claim a deduction for certain trade or business expenses. However, only if taxpayers itemize deductions may they claim expenses relating to being an employee of a trade or business.
Camp’s draft does not allow business expenses incurred by an employee to be deductible as an itemized deduction. Above-the-line deductions of employee business expenses (i.e. expenses of members of a reserve component of the Armed Forces) would still be deductible. The provision would be effective for tax years beginning after 2014.
Other provisions – Camp’s discussion draft proposes numerous other changes, including repealing the:
The draft also would set the qualified transportation fringe excludable qualified parking amount at $250 per month, and the excludable transit pass amount at $130 per month. Significantly, these amounts would no longer be adjusted for inflation.
Estate and tax regime generally untouched
Camp’s discussion draft makes few changes to the current-law estate and gift tax rules. In early 2013, Congress passed the American Taxpayer Relief Act of 2012, which permanently extended the unified estate and gift tax regime, generally providing for an estate and gift tax exemption that, with inflation adjustment now stands at $5.34 million and a top estate and gift tax rate of 40 percent.
Consistent basis reporting between estate and person acquiring property from decedent – Under current law, the basis of property acquired by a beneficiary from a decedent and the property included in a decedent’s gross estate for estate tax purposes generally is the fair market value of the property on the date of the decedent’s death. However, there is no requirement that the valuations be the same.
Camp’s proposed new subsection 1014(f) would eliminate differences in the valuation of the basis of property included in a decedent’s gross estate and the basis of property acquired from a decedent. This new subsection provides that the basis of property acquired from a decedent may not exceed the fair market value of property as reported for estate for tax purposes.
The provision would be effective for transfers for which an estate tax return is filed after the date of enactment.
Under current law, there are four higher education tax benefits – American Opportunity Tax Credit (AOTC), Hope Scholarship Credit, Lifetime Learning Credit, and qualified tuition deduction. Camp’s proposal would consolidate these into a permanent, but reformed, AOTC.
The new AOTC would provide a 100 percent tax credit for the first $2,000 of certain higher education expenses and a 25 percent tax credit for the next $2,000 of such expenses. (Eligible expenses include tuition, fees, and course materials.) The credit would phase out for taxpayers with combined AGI and income excluded under sections 911, 931, and 933 between $86,000 and $126,000 for joint filers ($43,000 and $63,000 for single filers). The credit amounts and phase-out ranges would be indexed for inflation starting in 2018.
The provision would be effective for taxable years beginning after 2014.
The plan also makes changes to a host of other education-related changes including repealing the: (1) exclusion for education assistance programs; (2) deduction for interest paid on education loans; (3) deduction for qualified tuition and related expenses; (4) exclusion for discharge of student loan indebtedness; and (5) exception to the additional 10 percent tax for early distributions from retirement plans and Individual Retirement Accounts used to pay for higher education expenses.
Individual income tax credits
Camp’s draft would repeal the dependent care credit and the adoption credit. It also would explicitly repeal several temporary individual credits and incentives that expired at the end of last year (see separate discussion of the extenders in this report).
Employee tax provisions
Deduction for Social Security taxes in computing net earnings from self-employment – Under current law, self-employed individuals may deduct one-half of self-employment taxes for income tax purposes, because a similar tax is imposed on an employee’s wages under the Federal Insurance Contributions Act (FICA), with the liability to pay the tax divided evenly between employer and employee. The deduction is intended to provide parity between FICA and Self Employment Contribution Act (SECA) taxes, but the Ways and Means Committee asserts that the SECA deduction is larger than the amount needed to make SECA taxes the economic equivalent of FICA taxes.
Camp’s draft, therefore, would make SECA taxes economically equivalent to FICA taxes by limiting the deduction of net earnings from self-employment. The provision would be effective for taxable years beginning after 2014.
Net earnings from self-employment – Camp’s draft would clarify that the SECA tax applies to general and limited partners of a partnership as well as to shareholders of an S corporation to the extent of their distributive share of the entity’s income or loss. A new deduction would be allowed for partners and S corporation shareholders in determining net earnings from self-employment.
Individual retirement plans – Camp’s draft would make several changes to the area of individual retirement plans, including: (1) eliminating income eligibility limits for contributing to Roth IRAs, (2) prohibiting new contributions to traditional IRAs and nondeductible traditional IRAs (meaning these contributions would have to be made to Roth-style plans); and (3) repealing the rule allowing recharacterization of Roth IRA contributions or conversions.
Finally, Camp’s draft would suspend the inflation indexing of the limit on the maximum annual IRA contribution. The limit, currently $5,500 for 2014, would remain unadjusted for the next 10 years. Inflation adjustments would resume in 2024. Taxpayers who are age 50 or over may continue to contribute an additional $1,000 catch up contribution (which is not indexed for inflation).
Employer-provided plans – Camp’s draft would make numerous changes to employer-provided retirement plans. These include the following:
Under current law, compensation is taxable to an employee and deductible by an employer in the year actually or constructively received. However, an employee does not take nonqualified deferred compensation into income until the year received, with the employer’s deduction is postponed until that time.
Under Camp’s draft, any nonqualified deferred compensation is includible in gross income of the service provider when there is no substantial risk of forfeiture of the service provider’s rights to such compensation, without regard to continuing risks of forfeiture related to performance or other conditions on receipt of the compensation. The provision would be effective for amounts attributable to services performed after 2014, but current-law rules would continue to apply to existing nonqualified deferred compensation arrangements with respect to previously deferred compensation until the last taxable year beginning before 2023.
Limitation on excessive employee remuneration – Under current law, a corporation may deduct compensation paid or accrued with respect to a covered employee of a publicly traded corporation up to $1 million per year. The deduction limitation applies to all remuneration paid to a covered employee for services with several exceptions, including commissions, performance-based remuneration, payments to a tax-qualified retirement plan, and amounts excluded from the executive’s gross income.
The IRS has interpreted “covered employee” to mean the principal executive officer and the three highest compensated officers as of the close of the taxable year.
Camp’s proposal would repeal the exceptions to the deduction limitation for commissions and performance-based compensation. It would also revise the definition of a covered employee to include the CEO, CFO, and the three other highest paid employees. Thus, under the bill, a company could deduct only the first $1 million in compensation paid to these individuals. The provision would be effective for taxable years beginning after 2014.
Excise tax on excess tax-exempt organization executive compensation – Beginning in 2015, the Camp proposal would subject a tax-exempt organization to a 25 percent excise tax on compensation in excess of $1 million paid to any of its five highest paid employees for the tax year.
Unrelated Business Income Tax (UBIT) issues
Under current law, income derived from a trade or business regularly carried on by an organization exempt from tax under section 501(a) that is not substantially related to the performance of the organization’s tax-exempt functions is subject to UBIT. Certain activities are per se unrelated trades or businesses for UBIT purposes, such as advertising activities and debt management plan services. Where a tax-exempt organization conducts two or more unrelated trades or businesses, the unrelated business taxable income is the aggregate gross income of all the unrelated trades or businesses less the aggregate deductions allowed with respect to all such unrelated trades or businesses. Income derived from a research trade or business is exempt from UBIT in certain circumstances.
The top corporate tax rate is applied to UBIT.
Camp’s draft would subject all 501(a) tax-exempt entities, notwithstanding the entity’s exemption under any other code provision, to UBIT rules. The draft would also treat as a per se unrelated trade or business any sale or licensing by a tax-exempt organization of its name or logo. (Royalties paid with respect to such licenses would be subject to UBIT.) Moreover, a tax-exempt organization would be required to calculate separately, rather than in the aggregate, the net unrelated taxable income of each unrelated trade or business and any loss derived from one trade or business could only be used to offset income from that trade or business.
These provisions would be generally effective for tax years beginning after 2014.
Requirements for tax-exempt organizations – Under current law, certain organizations that provide support to another public charity may also be classified as public charities rather than private foundations. To qualify as a supporting organization, three tests must be met, including a “relationship test.” Under the relationship test, a supporting organization must hold one of three relationships with the supported public charity: Type I (operated, supervised, or controlled by a publicly supported organization); Type II (supervised or controlled in connection with a publicly supported organization); or Type III (operated in connection with a publicly supported organization).
Camp’s draft would repeal Types II and III supporting organizations. If an organization does not meet the Type I relationship test, then it would be treated as a private foundation.
The provision generally would be effective for entities organized after the date of enactment, but Type II and III supporting organizations existing on the date of enactment would have until the end of 2015 to qualify as a public charity or a supporting organization, or be treated as a private foundation.
Professional sports leagues – A professional football league is specifically granted 501(c)(6) tax-exempt status. Camp’s draft would deny eligibility for 501(c)(6) tax-exempt status to professional sports leagues effective for tax years beginning after 2014.
The draft proposes reforms related to IRS investigations, taxpayer protection and services, due dates of filings, and compliance matters.
Filing deadlines – The draft contains provisions to modify due dates, along with corresponding extensions, for various filings including:
These provisions are generally applicable for returns for tax years beginning after December 31, 2014.
JCT threshold – This draft would raise the Joint Committee on Taxation threshold for review of refund and credit claims from the current level of $2 million to $5 million for C corporations. This provision would generally be effective as of the date of enactment, except in the case of refund or credit for which a report was made prior to enactment.
Compliance reforms – Provisions in this area include, among others:
Under U.S. GAAP, the effects of new legislation are recognized upon enactment. More specifically, the effect of a change in tax laws or rates on a deferred tax liability or asset is recognized as a discrete item in the interim period that includes the enactment date. The tax effects of a change in tax laws or rates on taxes currently payable or refundable for the current year are reflected in the computation of the annual effective tax rate after the effective dates prescribed in the statutes, beginning no earlier than the first interim period that includes the enactment date of the new legislation. However, any effect of tax law or rate changes on taxes payable or refundable for a prior year, such as when the change has retroactive effects, is recognized upon enactment as a discrete item of tax expense or benefit for the current year. Before enactment, financial statement preparers should consider whether potential changes represent an uncertainty that management reasonably expects will have a material effect on the results of operations, liquidity or capital resources. If so, financial statement preparers should consider disclosing information about the scope and nature of any potential material effects of the changes.
State corporate income tax considerations
Many state corporate income tax regimes are affected by federal tax law changes because they “piggy-back” off of the Internal Revenue Code by either incorporating the code in whole or in part, or by using federal taxable income as the starting point. States with automatic or “rolling” conformity generally will adopt such changes unless there is specific state legislation enacted to decouple from federal law. Other states either adopt the code as of a specific date, do not adopt the code provisions in totality, or provide modifications or exceptions to certain adopted provisions.
Because the state tax base and the code are often heavily intertwined, fundamental shifts in federal tax policy may cause states to reevaluate their own tax policy. If adopted, two particular items in the Camp draft – transition to a territorial system of taxation and changes to the federal cost recovery system – may be of sufficient magnitude to warrant such a reevaluation by the states.
Regardless of how and to what extent a state conforms to the code, further analysis is needed to determine how federal tax reform would affect the state tax regime in a particular state.
Outlook for action in 2014
Release of Camp’s draft is a significant marker in the tax reform debate, but there are several reasons why it may be premature to view it as a sign that Congress will act on a tax code rewrite this year. Notably, signals from the House Republican leadership thus far suggest that while there is a great deal of interest in the idea of tax reform – indeed, it was a frequently discussed topic among House GOP members at a retreat last month to consider this year’s legislative agenda – there is little appetite to actually add tax reform to the party’s 2014 “to do” list.
Rather, it appears the House Republican leadership is comfortable making the 2014 election a referendum on the rollout and implementation of the Patient Protection and Affordable Care Act and, to a lesser extent, the 2009 stimulus, which Republicans contend failed in its mission of strengthening the economy or boosting employment. Unless Republican leaders conclude that tax reform is the key to electoral victories in November, they are unlikely to act on it this year to avoid exposing their members to criticism for supporting changes to popular tax expenditures that are necessary to offset the cost of lowering marginal tax rates – especially considering the uncertain prospects for such a bill in the Democratic-controlled Senate, where Finance Committee Chairman Ron Wyden, has his own tax reform agenda and has stated that his top priority for 2014 is renewing the temporary tax provisions that expired at the end of last year. That pessimism from the Senate was echoed by comments earlier this week by both Senate Majority Leader Harry Reid, D-Nev., and Minority Leader Mitch McConnell, R-Ky., that the chamber is unlikely to consider tax reform in 2014.
For his part, Camp has devoted much of his time and energy to tax reform since he became the top Republican at Ways and Means in January of 2009, so he is going to do everything he can to see tax reform enacted. House Republican rules impose term limits on committee chairmen, however, and Camp’s term as the head of the Ways and Means Committee expires at the end of this year. So even though some may think the environment for reform might be more hospitable after the upcoming elections, waiting until 2015 to unveil his bill is a luxury Camp cannot afford. (Camp could receive a waiver from the rule and serve another term as the panel’s top Republican, but that seems unlikely for a variety of reasons.)
Time will tell whether the release of Camp’s draft will mark the last substantive action on tax reform in 2014, serve as a milepost on the road to passage later this year, or become the high-water mark for tax reform in another Congress and under a different presidential administration, as the difficult choices that must be made come into sharper focus and Congress retreats from the topic for several years.
That said, it appears that tax reform is inevitable, although its timing is uncertain. At some point, policymakers are likely to decide that the current system – with its narrow base, high statutory rates compared to many of our major trading partners, and patchwork international tax rules – is no longer sustainable.
Even if no further action is taken on it in 2014, Chairman Camp’s draft is likely, at the very least, to greatly influence the content of future tax reform legislation. With that in mind, prudent taxpayers will take the opportunity to examine Camp’s proposal, begin assessing the potential impact of tax reform, and consider how best to position themselves to thrive in a post-reform environment.
— Jon Almeras, Michael DeHoff, Joel Deuth, Victoria Glover, Jeff Kummer