The Tax Cuts and Jobs Act (the Act): Corporate tax considerations
The good, the bad and the ugly of corporate tax reform under the Act
TAX ALERT |
Congress passed the Tax Cuts and Jobs Act (the Act), and the President has signed it. The Act will make sweeping changes to the tax law. From a corporate taxpayer’s perspective, the Act reads like a spaghetti western – with the good, the bad and the ugly.
The good, a lower corporate rate, elimination of AMT and move toward a territorial system; the bad, to offset the lower rate the Act significant limitations on interest deductibility and net operating loss utilization; and the ugly, a more complex corporate tax system adding additional compliance burdens for corporations. This Alert summarizes those changes as well as a few of the Act’s other changes impacting corporations as follows:
1. Reduction to the corporate tax rate;
2. Limitations on business interest deductions;
3. Changes to the net operating loss deduction rules;
4. Elimination of the corporation alternative minimum tax (AMT);
5. Capital contributions from non-shareholders such as state and local governments included in taxable income;
6. Stricter limits on executive compensation deductibility; and
7. Multiple changes applicable to foreign earnings and income of foreign affiliates.
Reduced 21 percent corporate tax rate
The Act will reduce the corporate income tax rate to 21 percent, a significant decrease from the prior graduated rate structure with a 35 percent maximum rate. The new 21 percent rate generally will apply beginning on Jan. 1, 2018.
Fiscal-year corporations with a tax year straddling the 21 percent rate’s Jan. 1, 2018 effective date will apply a blended rate to that year. The effect of this blended rate will be as if the income for the entire fiscal year is prorated between the portions of the fiscal year subject to the old and new rates (and not as if there is a December 31 closing of the books for tax rate purposes).
To maintain the after tax benefit supplied by the dividends received deduction (DRD) at roughly the same level as supplied under prior law, the Act will reduce allowed DRD amounts. The 80 percent DRD deduction (for dividends from 20 percent owned corporations) will go down to 65 percent of the dividend, and the 70 percent DRD (for dividends from less than 20 percent owned corporations) will go down to 50 percent of the dividend. The DRD reductions will be effective for tax years beginning after 2017.
Limitation on interest deductions
While not limited to corporations, the business interest limitations of amended section 163(j) will impact many corporate taxpayers. Please see our separate Alert discussing the new business interest deduction limitation.
Net operating losses (NOLs)
The Act’s changes to the NOL rules will result in significant decreases to the value of NOLs for many companies. The Act limits NOL deductions to 80 percent of taxable income for losses arising in tax years beginning after Dec. 31, 2017. On a positive note, the Act permits carrying forward NOLs indefinitely, to the extent they arise in tax years ending after Dec. 31, 2017.
The Act also generally eliminates NOL carrybacks for NOLs arising in tax years ending after Dec. 31, 2017. There are limited exceptions where some NOL carrybacks remain permitted, applicable to certain farming losses and to property and casualty insurance companies.
The Act repeals the corporate AMT, effective for tax years beginning after Dec. 31, 2017.
AMT credit carryovers to post-2017 tax years generally could be utilized to the extent of the taxpayer’s regular tax liability (as reduced by other credits), with a portion of the credit carryovers refundable each year. Any remaining AMT credits would be fully refundable in 2021.
Contributions to capital from non-shareholders
Prior to the Act, corporations could exclude from taxable income contributions to capital received by state and local governments and civic groups under section 118 of the Tax Code. Application of section 118 has been a contentious issue between the IRS and taxpayers for a long time. States and cities often utilize state grants and other incentives when competing for business headquarters and capital expenditures bringing with it local employment. Corporations would often exclude these incentives from income and instead reduce the basis of the acquired property. Under the Act, this type of capital contribution will be included in taxable income if a corporation receives it from a non-shareholder.
Executive compensation deduction limitation broadened
The Act broadens the executive compensation deduction limitation of Tax Code section 162(m), making it more widely applicable while providing a transition rule for existing plans. The limitation generally applies to covered employees of publicly held corporations. The Act expands the definitions of both ‘publicly held corporation’ and ‘covered employee.’ The Act also repeals the exception for commissions and performance-based compensation, which represents a significant change.
Repeal of the commission and performance-based exclusions will likely have a significant impact on corporate taxpayers, as publicly traded corporations often utilize performance-based compensation such as stock options to compensate executives for a well performing corporation.
Taxation of foreign income
a) Territorial taxation aspect
The Act establishes a partial ‘territorial’ system of taxation, for the first time in U.S. history, under which U.S. corporations (but not other taxpayers) may deduct dividends received from a ‘specified’ foreign corporation held for one year.
The Act’s territorial approach to the taxation of foreign earnings is limited. Certain earnings of foreign corporations continue to give rise to taxable Subpart F income to their US shareholders, as under prior law.
b) Previously untaxed foreign earnings
Prior to the Act, U.S. shareholders generally could defer U.S. taxation on their ‘foreign subsidiaries’ earnings (with many exceptions to this general deferral rule). Under the Act, these U.S. shareholders generally must include in their 2017 taxable income their pro rata share of the untaxed earnings of the corporation.
The newly-added section 965 imposes a tax on this income at a 15.5 percent rate to the extent the income is attributable to the shareholder’s aggregate foreign cash position, and at an 8 percent rate otherwise. Taxpayers may elect to defer payment of the resulting additional taxes over an eight-year period, generally beginning when the taxpayer’s final tax payment for 2017 is due.
c) Tax on foreign intangible income
The Act provides special tax rates for foreign intangible income earned either directly or indirectly through a controlled foreign corporation. The effective tax rates generally are 13.125 percent for intangible income earned directly and 10.5 percent rate for intangible income earned through a foreign corporation. These rates result from interaction of new provisions taxing global intangible low-taxed income (GILTI) of controlled foreign corporations and allowing a deduction for foreign-derived intangible income (FDII).
d) The excise tax
The Act also provides a new base erosion and anti-abuse tax (BEAT) – a 10 percent tax (5 percent for 2018) on U.S. corporations that make certain tax-deductible payments to related foreign persons. The BEAT rules are complex, and apply only to corporate taxpayers with average annual gross receipts of at least $500 million, and only if they have a “base erosion percentage” of 3 percent or higher. Companies making significant tax-deductible payments to related persons should carefully consider the impact of this provision.
As stated above, there is certainly good news in the Act for corporate taxpayers with a welcomed decrease to the U.S. corporate tax rate and elimination of the corporate AMT. However, there is also bad news for corporations with debt and NOLs that had provided a significant tax shield under the old law. And of course the ugly, like seemingly all recent tax changes, the Act adds complexity and additional compliance burdens to an already complex and burdensome system.
We also need to remember that this is just the start. Like many areas of the Internal Revenue Code, these amendments are sure to leave many questions only partially answered, provide broad rules as opposed to detailed rules for application, and create potential contradictions with rules in other areas. As a result, we should all expect a very active Treasury Department in the coming months and years providing additional guidance such as proposed, temporary and final regulations, notices, revenue rulings, and revenue procedures.