07 November 2017 House tax reform bill would affect banking and capital markets The House tax reform bill (the Bill), released November 2nd by House Ways and Means Committee Chairman Kevin Brady (R-TX), contains a number of tax reform provisions that would affect the Banking and Capital Markets sector. A House "mark-up" of the Bill commences this week. Also this week, the Senate Finance Committee is expected to release its own tax reform bill. The two bills will need to pass in their respective houses and be reconciled before they reach the President's desk. Very few changes were targeted specifically at banks or capital market participants. Nonetheless, there will be significant issues for taxpayers to adjust in their modeling assumptions based on the details included in the Bill. This Alert discusses key provisions of the Bill that could have the most significant impact on banks and their businesses. For a general discussion of the Bill's provisions, see Tax Alert 2017-1831. The lower corporate tax rate is generally favorable for the industry, because the lower effective tax rate would result in increased earnings and capital going forward. Banks would also be required to adjust deferred taxes upon enactment, which could result in an unfavorable, one-time charge to earnings and capital depending on facts and circumstances. Taxpayers must compute their income for purposes of both the regular income tax and the alternative minimum tax (AMT), with their tax liability based on whichever is higher. Repeal would reduce compliance burdens and taxes. Existing AMT credit carry forwards would continue to be utilizable against future tax liability. 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 for losses generated in tax years beginning after December 31, 2017, 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 all NOLs 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) for tax years beginning after December 31, 2017. 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. NOLs generated in 2018 or later would no longer be eligible for carry back, which would preclude the ability to obtain tax refunds by amending a corporate tax return. The impact on Comprehensive Capital Analysis and Review (CCAR) calculations could be significant, particularly for those institutions relying on the carryback in their CCAR calculations. NOLs are treated as tax attribute deferred tax assets (DTAs). The elimination of NOL carry backs would therefore result in an increase in tax attribute DTAs, which are disallowed for regulatory capital purposes. The research and development (R&D) credit and Low-Income Housing Tax Credit (LIHTC) are retained, but many other business credits would be altered or eliminated, including certain energy-related credits. Careful review of the energy credit provisions will be required, dependent upon the nature of the credit, as various transition rules apply and not all energy credits appear to have been repealed. Although LIHTCs are preserved, the value of an investment may be reduced from the impact that lower corporate tax rates have on: (a) the value of the depreciation deduction component, and (b) the slower utilization of any credit carry forwards. Insured depository institutions paying an assessment by the Federal Deposit Insurance Corporation (FDIC) to support the Deposit Insurance Fund (DIF) may deduct the amount paid as a trade or business expense. The provision would make a percentage of such assessments non-deductible for institutions with total consolidated assets in excess of $10 billion. The percentage of nondeductible assessments would be equal to the ratio that total consolidated assets in excess of $10 billion bears to $40 billion. Assessments would be completely non-deductible for institutions with total consolidated assets in excess of $50 billion. Limitation or elimination of this deduction would increase effective tax rates for those larger banks that are subject to the provision. Repeal of rollover of publicly traded securities gain into specialized small business investment companies While gain or loss generally is recognized on any sale, exchange or other disposition of property, a special rule permits an individual or corporation to roll over without recognition of income any capital gain realized on the sale of publicly traded securities when the proceeds are used to purchase common stock or a partnership interest in a specialized small business investment corporation (SSBIC) within 60 days of the sale of the securities. The provision would repeal the special rule permitting gains on publicly traded securities to be rolled over to an SSBIC. Under Section 118 and its regulations, a corporation's gross income does not include contributions to its capital (e.g., transfers of money or property to the corporation by a shareholder or non-shareholder). Instead, the taxpayer excludes that amount from income and the basis in property contributed (or acquired with contributed money) is modified in accordance with Section 362(c) and its regulations. The provision would replace Section 118 with Section 76. Under new Section 76, gross income includes contributions to the capital of any entity (both those operating in corporate form as well as non-corporate entities). In addition, Section 76 provides that transfers of money or other property to a corporation solely in exchange for stock in the corporation is not a contribution to the corporation's capital and, thus, is not required to be recognized as income to the corporation but only to the extent that the amount of money and fair market value of property contributed to the corporation does not exceed the fair market value of any stock issued in exchange for the money or property. Further, Section 362(c) would be modified to provide that, if property (other than money) is provided as a contribution to capital (and thus is recognized as income) to a taxpayer, then the basis of that property in the hands of the taxpayer would equal the greater of: (1) the basis in the hands of the transferor plus the gain recognized by the transferor on the transfer, or (2) the amount included as income by the taxpayer as a result of Section 76. The provision would be effective for contributions made, and transactions entered, after the date of enactment. Banks sometimes obtain financial incentives from state and local governments, as do other large employers. These incentives would be taxable going forward. 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). Banks may experience increased demand for leasing solutions if many business customers lack the tax capacity to utilize 100% expensing. 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. Banks generally have net interest income and are, therefore, not directly impacted by a disallowance of net interest expense deductions. However, many bank customers may be adversely impacted and, accordingly, banks may wish to develop their product offerings, to provide for alternative funding arrangements for their customers — such as leasing, preferred equity funding and certain asset-based financings. Under current law, no gain or loss is generally recognized to the extent that property held for productive use in the taxpayer's trade or business or for investment purposes is exchanged for property of a like-kind that is also held for productive use in a trade or business or for investment. The taxpayer then utilizes a carryover basis in the property acquired in the exchange equal to the basis of the property exchanged, decreased by the amount of any money received by the taxpayer and increased in the amount of gain or decreased in the amount of loss to the taxpayer that was recognized on such exchange, if any. The like-kind exchange rules under Section 1031 generally apply to tangible property (both real and personal), as well as certain intangible property. The provision would modify Section 1031 so that its provisions would only apply to like-kind exchanges of real property. The provision would be effective for like-kind exchanges completed after December 31, 2017, although the provision would not apply to any like-kind exchange if the taxpayer has either: (1) disposed of the relinquished property; or (2) acquired the replacement property on or before December 31, 2017. Banks with leasing businesses, including automobile leasing, would no longer be permitted to use like-kind exchanges to defer lease termination gains. Although the Bill does not directly change the taxation of debt instruments or other financial products (other than the limitation on the deductibility of interest expense), the sweeping nature of the changes made by the Bill would require many taxpayers to carefully consider their current structures and practices regarding financial products to determine whether modifications are appropriate. International Provisions — there are sweeping changes that could impact both US headquartered and non-US headquartered banks. The proposed Bill would move the US to a territorial system with a participation exemption regime. Dividends to a US corporation from a 10% or greater owned foreign subsidiary would be exempt from tax. Accumulated earnings and profits of foreign subsidiaries with at least 10% US ownership would be subject to a one-time tax of 12% (for assets held in cash or cash-equivalents) or five percent (for illiquid assets). Cash, cash equivalents, nonfunctional currency, and government securities are treated as cash for purposes of this rule. No relief is given to such items, even though they may be held as part of regulatory capital or active trading assets. The E&P measurement date is effectively as of November 2, 2017, unless measurement as of December 31, 2017, would give a higher "E&P" for the taxpayer. Deficits of affiliates may reduce the amount of the deemed inclusion (subject to the measurement dates, above). E&P earned after December 31, 1986, is subject to the deemed repatriation, regardless of whether earned during the taxpayer's holding period and regardless of whether earned when the foreign entity was owned by foreign persons. Deemed paid credits that accompany the deemed repatriation are reduced to the same degree that income is exempt from the deemed repatriation. Fifty percent of the "foreign high return amounts" of a CFC would be subject to current US taxation by effectively treating returns that are deemed "high" as Subpart F income. The amount deemed a high return is based on a comparison of the CFC's income to a deemed, net return on its tangible assets. The deemed net return is the short-term AFR plus 7%, less interest expense associated with the US shareholder's net CFC tested income. Certain income is excluded from this test, such as income that qualifies for the active financing exception applicable to banks and certain broker dealers. However, as written, income of many broker dealers would not qualify for the carve-out from foreign high return amounts. In addition, financial assets are not tangible assets and consequently would not be beneficial in the calculation of income exempt from deemed repatriation. As part of a new, sweeping anti-base erosion measure, a 20% excise tax would be imposed on certain payments (other than interest) made by a US corporation to an affiliated foreign corporation, unless the foreign corporation receiving the payments make an election to treat the amounts as ECI and subject itself to net US taxation. These provisions would not permit a treaty to reduce US taxation on the ECI or excise tax. This will cause significant issues for banks if financial transactions are not included as an exception. Banks routinely use related party transactions to mitigate risks, with one entity (typically a US entity in the case of a US based multinational) facing the market. Payments to foreign related parties for this type of common business transaction would be subject to the excise tax. Further, a bank with dealer activity that acquires [foreign] securities from a related party may face an excise tax on the payment for acquiring this inventory. In other words, it may face an excise on what effectively is the dealer's "cost of goods sold." While the excise tax can be avoided by the ECI exception, this could cause additional cases of double taxation as well as increased compliance burdens. Investments in US property would be repealed for domestic corporations. Thus, for example cash of CFCs can be loaned to US affiliates and assets / stock of CFCs could be pledged to support US borrowing by domestic corporate affiliates. The Bill would repeal the exclusion from gross income for interest on qualified private activity bonds and for interest on any bond issued to advance refund a tax-exempt bond, effective for bonds issued after December 31, 2017. The Bill would also repeal, prospectively, all the existing authority for issuing tax credit bonds. In addition, the federal tax exemption for interest on bonds issued to finance the construction of, or capital expenditures for, a professional sports stadium would be repealed, effective for bonds issued after November 2, 2017. The Bill retains 401(k) and Individual Retirement Accounts, and it does not decrease pretax contribution limits to 401(k)s. The proposed legislation will be marked up in the House this week. Ultimately the full House will vote on the Bill, which could happen the week of November 12. At the same time, the Senate will prepare its own Chairman's mark of a tax bill, which could be materially different than the House bill. The Senate Finance Committee mark-up and Senate floor process could take some time, and ultimately a House and Senate conference committee would be necessary to reconcile any differences between the House and Senate bills. Document ID: 2017-1859 |
