06 November 2017 House Tax Cuts and Jobs Act contains M&A provisions On November 2, 2017, House Republicans unveiled their comprehensive tax reform bill called the "Tax Cuts and Jobs Act." (For an overview of the entire bill, see Tax Alert 2017-1831; for discussion of the bill's international provisions, see Tax Alert 2017-1845; for discussion of the bill's pass-through provisions, see Tax Alert 2017-1847.) The bill contains a number provisions relevant to mergers and acquisitions (M&A). Taxpayers should evaluate the proposed legislation and assess/model the impact of the provisions to enable timely action in case they are enacted. Current law taxes a corporation's regular income tax liability by applying this rate schedule to its taxable income: — $0-$50,000 — taxed at 15% The 15% and 25% rates are phased out for entities with taxable income between $100,000 and $335,000, meaning that a corporation with taxable income between $335,000 and $10 million is effectively taxed at a 34% rate. Similarly, the 34% rate is phased out for corporations with taxable income between $15 million and $18.33 million, so that corporations with taxable income above this amount are effectively subject to a 35% flat rate. Personal service corporations (e.g., health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting) may not use the graduated corporate rates below 35%. The bill would tax corporate income tax at a flat 20% rate and impose a flat 25% rate on the income of personal services corporations. The reduction in the corporate tax rate to 20% would reduce the value of a corporation's existing losses (including built-in losses) and credits. Corporations should consider opportunities for accelerating the use of losses and credits in 2017, to maximize the benefit of such attributes. Current law allows taxpayers to claim additional depreciation (i.e., bonus depreciation) under Section 168(k) in the year in which qualified property (as described later) is placed in service through 2019 (with an additional year for qualified property with a longer production period, as well as certain aircraft). The bonus depreciation generally equals 50% of the cost of the property placed in service in 2017 and phases down to 40% in 2018 and 30% in 2019. Qualified property is defined as tangible property with a recovery period of 20 years or less under the modified accelerated cost recovery system (MACRS), certain off-the-shelf computer software, water utility property or qualified improvement property. Certain trees, vines, and fruit-bearing plants also are eligible for additional depreciation when planted or grafted. To be eligible for bonus depreciation, the original use of the property must begin with the taxpayer. Under current law, taxpayers have the option of making an annual election to not claim bonus depreciation with respect to qualified property under Section 168(k)(7). Alternatively, taxpayers may elect under Section 168(k)(4) to accelerate AMT credits (as refundable credits) in lieu of claiming bonus depreciation with respect to qualified property. Such election comes with the added requirement to depreciate that qualified property using a straight-line recovery method. The provision would allow taxpayers to immediately expense 100% of the cost of qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023 (January 1, 2024, for certain qualified property with a longer production period, as well as certain aircraft). The provision also would expand the property eligible for immediate expensing by repealing the requirement that the original use of the property begin with the taxpayer; instead, property would generally be eligible for immediate expensing if it were the taxpayer's first use of that property. Qualified property would not include property used by a regulated public utility company or any property used in a real property trade or business (as defined in Section 469(c)(7)(C)). Additionally, the provision would repeal Section 168(k)(4) (i.e., the election to accelerate AMT credits in lieu of claiming bonus depreciation) for tax years beginning after December 31, 2017. However, the provision would retain the annual election to not claim bonus depreciation with respect to qualified property under Section 168(k)(7). Generally, the provision would apply to property that is acquired and placed in service after September 27, 2017. Similar to prior bonus depreciation transition rules, property would not be treated as acquired after September 27, 2017, if a written binding contract for its acquisition was entered before September 27, 2017. The provision would apply to specified plants planted or grafted after September 27, 2017. The provision would allow taxpayers to elect to apply Section 168 of the Internal Revenue Code of 1986, without regard to the amendments made by the provision (i.e., the current law), to a taxpayer's first tax year ending after September 27, 2017. For taxpayers that instead choose to apply the provision to its first tax year ending after September 27, 2017, the provision would place limitations on the ability to carry back any losses attributable to the 100% expensing rules (by only allowing those taxpayers to carry back the portion of the loss that would have been generated under the current law). — Extending expensing to taxpayers that buy existing qualified property is likely to increase the tax benefit to acquirers of structuring transactions as asset acquisitions for tax purposes. Accordingly, acquisitions of subsidiary members of a consolidated group likely will continue to be structured as asset acquisitions (or stock acquisitions with Section 338(h)(10) elections). — Increased expensing is likely to turn many companies into loss corporations, broadening the relevance of loss limitation provisions of Section 382 and Section 384. — Extending expensing to taxpayers that buy existing qualified property would provide a potentially significant benefit to corporations with losses whose use is limited under Section 382. As mentioned, one of the requirements for 50% bonus depreciation under current-law Section 168(k) is that the "original use" of the property must commence with the taxpayer. Therefore, bonus depreciation is not available in the case of a deemed acquisition of depreciable property pursuant to a Section 338 election. Accordingly, under current law, we do not believe bonus depreciation is taken into account in determining hypothetical cost recovery and recognized built-in gain under the 338 approach of Notice 2003-65. However, with the removal of the "original use" requirement, it appears that the 100% depreciation deduction claimed under amended Section 168(k) would appear to be available for computing hypothetical cost recovery of qualified property under the 338 approach. This could significantly increase recognized built-in gain (RBIG) for some loss corporations. Current law allows business interest as a deduction in the tax year in which the interest is paid or accrued, subject to limitation rules, as applicable. Section 163(j) limits a corporation's ability to deduct disqualified interest (i.e., interest paid or accrued to a related party when no federal income tax is imposed on the interest) paid or accrued in a tax year if: (1) the payor's debt-to-equity ratio exceeds 1.5 to 1.0 (safe harbor ratio); and (2) the payor's net interest expense exceeds 50% of its adjusted taxable income. In general, adjusted taxable income is the corporation's taxable income calculated without taking into account deductions for net interest expense, NOLs, domestic production activities under Section 199, depreciation, amortization and depletion. Disallowed interest amounts may be carried forward indefinitely and any excess limitation may be carried forward for three years. The provision would limit the net interest expense deduction for every business, regardless of form, to 30% of adjusted taxable income. The provision would require the interest expense disallowance to be determined at the tax filer level. Adjustable taxable income for purposes of this provision would be a business's taxable income calculated without taking into account business interest expense, business interest income and NOLs, as well as depreciation, amortization and depletion. The provision would allow businesses to carry forward interest amounts disallowed under the provision to the succeeding five tax years and those interest amounts would be attributable to the business. The provision would include special rules to allow a pass-through entity's owners to use the unused interest limitation for the tax year and to ensure that net income from pass-through entities would not be double-counted at the partner level. The provision would exempt businesses with average gross receipts of $25 million or less from these rules. The provision also would not apply to certain regulated public utilities and real property trades or businesses; these businesses would be ineligible for full expensing. Additionally, the provision would repeal Section 163(j). For discussion of the additional limitation on deductibility of net interest expense in addition to this general limitation, see Tax Alert 2017-1845. — As currently drafted, the proposal does not include a grandfather rule for existing debt obligations. Therefore, it appears that the limitation on interest deductibility would apply to such debts. Companies with significant leverage should assess the potential impact of this proposal on their cost of capital. — The proposal would reduce the advantage of financing M&A transactions with debt in certain circumstances. To the extent the acquirer cannot deduct interest on acquisition debt, the proposal would increase the economic cost of debt-financed stock acquisitions compared to current law. However, the proposals effect on debt-financed asset acquisitions would depend on the cost of the loss of interest deductions compared to the benefits of increased expensing (as compared to depreciation and amortization). — Companies facing deferral or disallowance of interest deductions would have incentives to: (i) decrease their interest expense by converting non-deductible interest expense into deductible non-interest expense; and (ii) increase their interest income by converting taxable non-interest income into interest income. Strategies for realizing these incentives could involve the use of financial products as well as changes to a variety of ordinary course business arrangements. — The treatment of disallowed interest carryovers as pre-change losses significantly broadens the relevance of Section 382. It is likely that highly leveraged companies will be subject to Section 382 solely as a result of having disallowed interest. Furthermore, because the Section 163(o) carryforward is only five years, it will be critical to maximize the Section 382 limitation during that five-year period to realize the full benefit the disallowed interest carryovers. Under current law, Section 172 allows taxpayers to carry back a net operation loss (NOL) arising in a tax year for two years and carry forward the NOL for 20 years to offset taxable income. Generally, an NOL is the excess of the taxpayer's business deductions over its gross income. Section 172 also provides special provisions modifying the carryback period for specific types of losses or losses arising in particular years. Included in these special provisions is Section 172(f), which allows a 10-year carry back of losses arising from specified liabilities. The AMT rules do not allow a taxpayer's NOL deduction to reduce the taxpayer's alternative minimum taxable income by more than 90%. The provision, Section 3302 of the bill, would allow indefinite carry forward of NOLs arising in tax years beginning after December 31, 2017. The provision also would repeal all carrybacks, but would provide a special one-year carryback for small businesses and farms for certain casualty and disaster losses. The provision would define an eligible disaster loss in Section 172(b) as an NOL attributable to federally declared disasters. The provision would limit the amount of an NOL that a taxpayer could use to offset taxable income to 90% of the taxpayer's taxable income (computed without taking into account the NOL deduction). In addition, the provision would permit NOLs arising in tax years beginning after 2017 and carried forward to be increased by an interest factor to preserve the NOL value. As part of the repeal of NOL carrybacks, the provision would repeal Section 172(f), the special rule allowing a 10-year carryback of specified liability losses. The indefinite carry forward and general repeal of carrybacks (including the repeal of Section 172(f)), and the special one-year carryback rule for casualty and disaster losses would be effective for losses arising in tax years beginning after December 31, 2017. The 90% limitation rule would be effective for tax years beginning after December 31, 2017. The annual increase of carry forward amounts would apply to amounts carried to tax years beginning after December 31, 2017. Under current law, contributions to capital are generally excluded from a corporation's gross income (whether or not the contribution is made by a shareholder). In addition, Section 108(e)(6) generally provides that, when a shareholder-creditor forgives a debt obligation of the debtor corporation as a contribution to capital, the debtor corporation realizes cancellation of indebtedness (COD) income as if it had satisfied the obligation with an amount of money equal to the shareholder-creditor's adjusted basis in the debt (i.e., the debtor corporation realizes income only to the extent the adjusted issue price of the debt obligation exceeds the shareholder-creditor's adjusted basis therein). Under the provision, contributions to capital would generally be included in a corporation's gross income. For a contribution to a corporation in exchange for the corporation's stock, however, the corporation would not realize gross income to the extent that the fair market value of the money or other property contributed does not exceed the fair market value of the stock. In addition, the current rules governing the contribution of debt obligations by a shareholder-creditor to a debtor corporation in Section 108(e)(6) would be eliminated. Finally, similar rules would apply to capital contributions to non-corporate entities. The provision would be effective for contributions made, and transactions entered into, after the date of enactment. — The "Section-by-Section Summary" of the Tax Cuts and Jobs Act provided by the House Ways & Means Committee indicates that lawmakers were focused on addressing a fairly narrow set of circumstances. Specifically, the summary document twice references a concern with situations in which state and municipal governments transfer money or other property to a corporation as an incentive for the corporation to locate business operations in their jurisdiction. However, as currently drafted, the provision would have a much broader impact. In a significant departure from current law, the provision suggests that, when a shareholder contributes cash or other property to a wholly owned corporation, the contribution will result in taxable income to the corporation unless the shareholder receives stock of equal value in the exchange. Thus, the shareholder's receipt of additional stock could control material tax consequences, even though such receipt would be economically meaningless. — The elimination of Section 108(e)(6) likewise would mark a significant change from current law. Under the proposal, it appears that the contribution of a debt obligation by a shareholder-creditor to a debtor corporation would result in COD income to the debtor corporation equal to the fair market value of the obligation. In the case of a debt restructuring of a financially troubled company, the fair market value of the debtor's obligation is less than its adjusted issue price. Thus, many debt restructurings that can be accomplished tax-free under Section 108(e)(6) would result in COD income. Companies should consider undertaking intercompany debt clean-up transactions in 2017 to avail themselves of the benefits of Section 108(e)(6) while it still exists. Section 1221 treats a self-created patent, invention, model or design, or secret formula or process as a capital asset. Copyrights, literary, musical or artistic compositions and letters or memoranda are not capital assets and any gain or loss recognized as a result of the sale, exchange or other disposition of the property is ordinary in character. Current law, however, allows the creator of musical compositions or copyrights in musical works to elect to treat that property as a capital asset. The provision would no longer treat a self-created patent, invention, model or design, or secret formula or process as a capital asset. As such, gain or loss from the disposition of the property would be ordinary in character. Those items of property also would be excluded from the definition of property used in the trade or business under Section 1231. Additionally, the provision would repeal the election to treat musical compositions and copyrights in musical works as a capital asset. The provision would be effective for dispositions of a self-created patent, invention, model or design, or secret formula after December 31, 2017. — The Ways and Means Committee Summary indicates this change is relevant to patents and other identified intellectual property (IP) that is self-created, but the amendments to Section 1221 and 1231 would preclude capital gain treatment to taxpayers that purchase these types of IP and then resell them at a gain in excess of the amount of Section 1245 recapture. Admittedly, however, the most profound impact of this provision would be on the creators of these items of IP, on their original sale. — Although the character of gain or income for this IP would be ordinary irrespective of whether the transfer of these items constitutes a sale or a license (i.e., whether the transfer consists of "all substantial rights"), the sale-versus-license determination would continue to be relevant to sellers of this IP for other reasons, including basis offset and availability of installment reporting. — The disparate treatment of these types of IP from other categories of self-created intangibles surely would lead to valuation issues and purchase price allocation disputes. First, it is not clear that the listed items of IP describe all types of know-how. For example, would self-created computer software still be eligible for capital gain treatment, or would it be considered an "invention," "model" or "process"? Second, other types of intangibles would clearly fall out of the listed items of IP, including self-created customer- and supplier-based intangibles, workforce, trademarks, trade names, and franchises, as well as residual goodwill and going-concern value. So taxpayers for which capital gain treatment is beneficial (including C corporations with expiring capital loss) would want to allocate amounts realized to these intangibles rather than to the ordinary income items of IP. For example, if a franchisee sold all of its interest in an existing franchise to an unrelated person, and the franchise agreement included a license to use the franchisor's patents, would the seller have to allocate its amount realized between the distribution rights under the franchise and the interest in the patents, contrary to the Syncsort doctrine, which treats all the elements of a franchise agreement as a single asset? Likewise, if a pharmaceutical company sold all rights to a patented product in the US, might the lion's share of the gain be allocated not to the underlying patent, but rather to the brand name and the FDA-granted marketing right, which should give rise to capital gain? Document ID: 2017-1849 |
