On November 2, 2017, House Ways and Means Committee Chairman Kevin Brady (R-TX) released a comprehensive tax reform bill called the "Tax Cuts and Jobs Act." (For an overview of the entire bill, see Tax Alert 2017-1831.)

The bill will be the subject of Committee consideration, kicking off formal tax committee action on the first such overhaul of the US tax system in over 30 years. Senate Finance Committee Chairman Orrin Hatch (R-UT) announced that he plans to release a Senate Republican version of a tax reform bill after the Ways and Means Committee completes its work.

Brady's plan would immediately and permanently reduce the statutory corporate tax rate to 20% while eliminating many current business tax benefits, and move to a territorial system of taxing foreign earnings with anti-base erosion provisions targeting both US-based and foreign-based multinational companies.

Significantly, the bill would include a new excise tax on otherwise deductible payments from US companies to related foreign companies that acts similar to the border adjustment in the House Republican Blueprint, but only for outbound payments. The adoption of a territorial tax system would include a one-time transitional tax on accumulated foreign earnings, determined as of November 2, 2017, or December 31, 2017 (whichever is greater), at 12% for cash and cash equivalents and 5% for illiquid assets, and payable over up to eight years.

The effect from several proposed provisions — from those addressing the taxation of foreign earnings to the loss of certain deductions — could have important implications for the media and entertainment (M&E) industry. While effects will vary within the diverse M&E subsectors (including film and television, publishing, cable operators, advertising, music and sports), this Alert highlights some of the proposals with the broadest reach within the industry. Taxpayers should evaluate the proposed legislation and model the effects of the provisions to enable timely action in case they are enacted.

International trade and the digital economy

Effect of general international tax provisions

From a US international tax perspective, the combination of a 20% corporate tax rate, coupled with a territorial tax system that provides a 100% exemption for foreign-source dividends is a favorable starting point for US outbound and inbound M&E companies. However, a number of the specific international tax proposals that are intended to raise revenue — namely the transition tax on foreign earnings, base erosion/minimum tax proposal, and proposed excise tax on related-party payments out of the United States — are expected to affect M&E companies across the different subsectors (e.g., film, TV/cable, publishing, advertising, digital media/internet, sports and entertainment) with specific fact patterns.

Transition tax on deferred foreign earnings

Similar to other industries, the mandatory, one-time transition tax on deferred foreign earnings would have the greatest effect on the larger, more established M&E companies that have accumulated significant cash over the years, or that have generated substantial E&P that is relatively low-taxed from organic operations or through acquisitions.

The bill would require a mandatory inclusion of the accumulated foreign earnings of a controlled foreign corporation (CFC) and other foreign corporations with a 10% domestic corporate shareholder (a 10/50 company), collectively referred to as specified foreign corporations, or "SFCs." The mandatory inclusion would be implemented by increasing the subpart F income of the specified foreign corporation (treating a 10/50 company as a CFC solely for this purpose) in its last tax year beginning before January 1, 2018, by its "accumulated post-1986 deferred foreign income" determined as of November 2, 2017, or December 31, 2017, whichever amount is greater. Because the mandatory inclusion for transition tax purposes would be determined as of November 2 or December 31, 2017, M&E companies should review their E&P calculations and projected E&P to determine the potential inclusion amount if the provision is enacted. The incremental transition tax impact of any foreign acquisitions completed before the end of the year should be factored into deal discussions as appropriate.

The 12% transition rate would apply to an amount of the mandatory inclusion equal to a US shareholder's aggregate foreign cash position, which means one-third of the US shareholder's pro rata share of the cash position of its specified foreign corporations determined on: (1) November 2, 2017, (2) the last tax year of each specified foreign corporation that ended before November 2, 2017, and (3) at the end of the tax year preceding the last year of each specified foreign corporation that ended before November 2, 2017. As a result of this provision, M&E companies should prepare a more detailed review of their historic cash balances and accounts receivable balances, and should determine the proper fair market value of cash equivalents (e.g., certain securities or investment in short-term obligations) during the relevant dates.

Due to the proposed rules on the transition year, M&E companies with year-ends other than December 31 should review their potential inclusion amounts, because counterintuitive results could arise based on 2017 calendar-year transactions undertaken.

Excise tax on payments to foreign affiliates

New Section 4491 would impose on each "specified amount" paid or incurred by a domestic corporation to a foreign corporation that is a member of the same international financial reporting group (IFRG) a tax equal to the highest rate of tax imposed under Section 11 for the tax year in which the specified amount is paid. This new "excise tax" would be imposed on the domestic corporation and would not be deductible for US federal tax purposes. For this purpose, a specified amount paid, incurred or received by a partnership that is a member of an IFRG would be treated as paid, incurred or received by its partners, and a specified amount paid, incurred or received by a foreign corporation in connection with a US trade or business would be treated as paid, incurred or received by a domestic corporation.

A specified amount for this purpose means any amount that is, with respect to the payor, deductible or includible in cost of goods sold (COGS), inventory or the basis of a depreciable or amortizable asset for the payor. However, a specified amount does not include interest, amounts paid or incurred for the acquisition of certain commodities, fixed or determinable annual or periodical (FDAP) payments subject to withholding tax under Section 881, or service fees not subject to a markup to the extent the payor elects the services cost method for Section 482 purposes. For FDAP amounts, however, the provision would only exclude the portion of such amount in proportion to the actual rate of tax imposed under Section 881(a) to 30%. Thus, for example, it would appear that, if $100 of a FDAP royalty payment were subject to a treaty-reduced withholding tax rate of 10% under Section 881(a), only 1/3 of that amount would be excluded from treatment as a specified amount.

An IFRG for this purpose is any group of entities, with respect to any specified amount, if the specified amount is paid or incurred during a reporting year of such group with respect to which it prepares consolidated financial statements (within the meaning of Section 163(n)(4)) and the average annual aggregate payment of specified amounts of such group for the three-reporting-year period ending with such reporting year exceeds $100 million.

Election to treat specified amounts as ECI

In lieu of the domestic corporation incurring an excise tax on a specified amount, the foreign corporation receiving the payment could elect to take the specified amount into account as if it were engaged in a USTB and had a US permanent establishment (PE) during the tax year in which the amount was received, and as if such amount were ECI and attributable to the US PE (the ECI election). Once made, the ECI election could be revoked only with IRS consent. For any underpayment, penalties, additions to tax or additional amounts, the provision would place joint and several liability on each domestic corporation that is a member of the IFRG.

If the ECI election were made, the foreign corporation would be allowed a deduction against the specified amount for a "deemed expenses" amount. The deemed expenses with respect to a specified amount received by the foreign corporation during a reporting year is the amount of expenses required so that the foreign corporation's net income ratio (i.e., the ratio of the net income determined without regard to interest income, interest expense, and income taxes, divided by revenues) with respect to the specified amount equals the IFRG's net income ratio with respect to the product line to which the specified amount relates. The amounts required to determine the net income ratio would be determined on the basis of the IFRG's consolidated financial statements and the books and records of the IFRG members used to prepare those statements.

Implications

This provision could have significant adverse effects on large M&E companies in a number of instances on an ongoing basis, and could substantially increase the US taxation of their global supply chains. As an example, payments made by media content companies for television, publishing, advertising or digital rights that are developed abroad and paid to foreign affiliates for use in the United States would be subject to the excise tax, where they were not taxed before. This would hamper the ability of M&E companies to enjoy the benefits of using internationally developed or acquired content rights in the United States, despite the fact that the US media market may actually have an appetite for such rights. In addition, while the proposal is intended to apply equally to inbound and outbound companies, in reality, in the M&E industry, it is likely to have a disparate effect and make US-based M&E multinationals less competitive, because they historically have had larger, more global legal entity and operating structures, and are more likely to have payment flows that could be subject to the excise tax.

The excise tax could also apply negatively to other situations, such as when primarily US-based M&E companies make acquisitions of foreign targets and integrate IP from those supply chains with their existing US customer base, or when they invest in foreign hubs in countries such as the UK or Singapore, and seek to integrate IP rights developed from or acquired by those related businesses for the US market.

In addition, while it may be possible for an M&E business in certain situations to restructure its operations to minimize the effects of the excise tax, there may be commercial and regulatory restrictions, unlike in some other industry sectors, that impede its ability to do so. Also, as previously mentioned, cross-border payments made by M&E companies often arise for different reasons, i.e., consumer desires rather than cost-cutting efforts. The option to be taxed on a net ECI basis may be beneficial to many M&E companies that would otherwise be caught by the provision. Depending on the foreign tax treatment of the proposed excise tax or US tax on ECI if the election were made, however, the risk of double taxation would increase on the M&E business models to which the provision applies.

Anti-base erosion provision

The bill would add new Section 951A, which would require a US person that is a US shareholder of any CFC for any tax year to include in gross income 50% of its "foreign high return amount" determined for that tax year. A US shareholder's foreign high return amount is the excess, if any, of the US shareholder's "net CFC tested income" for that tax year over the excess, if any, of: (1) the US shareholder's "applicable percentage" of its aggregate pro rata share of the "qualified business asset investment" of each CFC with respect to which it is a US shareholder in that tax year, over (2) any interest expense taken into account in determining the US shareholder's net CFC tested income for that tax year. Effectively, the bill is identifying an amount of income earned by the US shareholder's CFCs that it considers "excessive."

First, it should be noted that the M&E industry invests heavily in (and its success depends on investment in) intangible rights, such as content and brand rights, as well as marketing and other related know how, and this is even more the case in light of today's digital economy and converged world. As a result, because M&E companies have less investment in tangible assets, they are more likely to be hurt by this proposal (i.e., other industries may be able to realize a lower ETR on their foreign earnings).

For the US-based M&E companies that are currently claiming deferral benefits through licensing, cost sharing or offshore IP ownership structures and operating models, a more detailed review of the proposed foreign high return calculation and the mechanics to calculate the associated foreign tax credits under Section 960 is required to assess the exact potential impact to M&E companies on their international entities and profits in the aggregate. In many instances, payments of licensed media content is subject to local country withholding taxes on royalties and, therefore, the foreign effective tax rates for those businesses may be sufficiently high so that the particular calculated minimum tax would not apply. Digital M&E businesses that characterize their income as services, sales of licensed property, or that are otherwise based on software as a service (SaaS) may be subject to less withholding taxes globally, so the likelihood of the provision applying is greater.

In any event, outbound M&E companies would be more likely to suffer from the anti-base erosion proposal than inbound companies, given that they are more likely to own low-taxed CFCs that would be subject to the proposal. Note that this provision would be an addition to the existing Subpart F rules that M&E companies already have to satisfy with regard to their deferral structures for US federal tax purposes.

If the anti-base erosion proposal were enacted, there would still be some benefit to considering opportunities to earn international and other new revenue streams in CFCs of US parent entities. In light of other wide-sweeping tax developments globally (e.g., the OECD BEPS initiative, EU Anti-Tax Avoidance Directive, EU state aid developments and passage by many countries of the Multilateral Instrument (MLI)), it is even more important to plan structures and operating backed with appropriate substance and commercial reality, in order to be able to yield low effective rates over a sustainable period. Nonetheless, given the arbitrage in the calculated minimum tax rate compared to the 20% federal rate and applicable state tax rate that could otherwise apply to such income, opportunities continue to exist for M&E companies looking to set up international hubs at the same time that their business models grow globally. Cost sharing and other mechanisms for the transfer of existing IP rights would continue to apply and, in the future, profits from IP rights could be exempt from additional taxation due to territoriality, provided that they are appropriately taxed abroad based on this anti-base erosion proposal and existing anti-deferral rules.

Foreign branches or disregarded entities

Because the House bill would not change the treatment of the US tax rules with regard to foreign branches or disregarded entities of US persons, the income of those operations would continue to be taxed in the US at the proposed 20% corporate tax rate with an offsetting foreign tax credit.

For M&E companies with material disregarded foreign operations, it would be best to model the net effect of the proposed tax reform provisions (e.g., lower corporate rate, loss of Section 199 deduction, continued availability of research credit, immediate expensing of qualified property) on the US tax position of those businesses under their particular facts. Depending on the tax profile and existing tax attributes of those businesses, consideration may be given to incorporating part or all of those foreign operations from a US tax perspective, in order to benefit from territoriality with respect to those profits in the future. M&E companies that own foreign disregarded entities or branches held by a partnership or other flow-through entity should consider similar structuring options for their foreign disregarded operations, while still benefitting from the 25% single level, reduced rate of tax on qualifying flow-through income and gains.

Corporate provisions

Immediate expensing

The bill would allow taxpayers to immediately expense 100% of the cost of qualified property, in general, acquired and placed in service after September 27, 2017, and before January 1, 2023. Current Section 168(k)(3) generally defines the term "qualified property" as property that is tangible property with a recovery period of 20 years or less under the modified accelerated cost recovery system (MACRS) and the original use of which commences with the taxpayer. This includes property such as film and television equipment, theme and amusement park assets subject to a seven-year recovery period, qualified improvement property, computers and peripherals, and office furniture. It does not include non-residential real property, such as building property that is not qualified improvement property and sports stadiums. Therefore, if large infrastructure projects are being undertaken, it will be important to segregate qualified property eligible for immediate expensing.

The bill 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 such property. This expansion on the concept of original use would be a substantial benefit to taxpayers and could affect how taxpayers value and structure future transactions (as taxpayers would be able to immediately expense a significant portion of the consideration paid for assets acquired in applicable asset acquisitions, as defined in Section 1060(c)).

In contrast to the expanded deduction for qualified tangible property that would be eligible for 100% expensing, there were no provisions that increased deductions for the costs to create intangible assets, such as films and television programming. Similarly, for publishing companies, pre-publication costs would not be eligible for immediate expensing. Further, the bill does not address Section 181 (immediate expensing for film and TV production costs), which technically expired on December 31, 2016. There are many intangible cost categories not expressly addressed by the bill; the legislative intent in this context is unclear and further developments should be anticipated.

In terms of the effective date, the expensing provisions would apply to property acquired and placed in service after September 27, 2017. Given the proposed effective date of the 20% maximum corporate income tax rate (applicable to tax years beginning after December 31, 2017), companies that may benefit from the 100% expensing provision have a single, time-limited opportunity to acquire and expense qualified property in the current tax year before the lower rate takes effect (the maximum corporate tax rate is currently 35%). As discussed, qualified property includes tangible property such as computers, office furniture and equipment and does not include non-residential real estate. In addition, there are many categories of intangible costs categories, such as film assets, not expressly addressed by this bill.

Effect on other deductions

The bill would eliminate or significantly limit specific business deductions in favor of the lower overall tax rate. Several provisions that specifically affect the M&E industry are discussed next.

The bill would eliminate the domestic production deduction (Section 199), which allows, in some cases, a several-point tax rate reduction for many M&E companies, such as TV networks and film producers, among many others. The repeal would be effective for tax years beginning after December 31, 2017.

As M&E companies are aware, Section 199 has been an ongoing focus of IRS examination activity, which has resulted in several cases pending in a variety of federal courts. Because the bill would eliminate Section 199 for tax years beginning after December 31, 2017, it is unclear how the IRS will examine and litigate Section 199 claims for tax years beginning before 2018.

The bill also 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.

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. Careful analysis and modeling of these provisions will be necessary for highly leveraged M&E companies. The provision would be effective for tax years beginning after December 31, 2017.

In addition, the bill would affect the deductibility of entertainment expenses. It states that no deduction would be permitted for entertainment, amusement, or recreation expenses. Examples of such expenses would include, but would not be limited to, sporting event tickets, theatre tickets, golf green fees, etc. This would be a significant departure from current law, which allows a 50% deduction for qualified client entertainment and recreation; further, taxpayers are currently entitled to a 100% deduction for qualified employee recreation expenses. Meals and entertainment expenses can be significant for M&E companies.

The provision would further disallow a deduction for reimbursed expenses, transportation fringe benefits, on-premises gyms and other athletic facilities, or any other amenities provided to an employee that are not directly related to the employer's trade or business, unless the benefit were treated as taxable compensation to the employee. Any amounts for goods, services or facilities that were treated as compensation to an employee or includible as income to a non-employee would remain deductible. The provision would still permit a 50% deduction for food or beverage expenses that qualify as a business expense (or a 100% deduction for certain Section 119 expenses and certain Section 132(d) expenses). M&E companies will need to reevaluate their current approach for calculating the overall limitation or non-deductibility of these types of expenses, which could significantly affect the overall deductibility of entertainment expenses. From an overall industry perspective, it appears that the tax treatment of these types of expenses potentially could influence the aggregate amount spent on entertainment activities, such as sporting events. This provision would be effective for tax years beginning after December 31, 2017.

Limitation on gain deferral

The bill would substantially modify like-kind exchanges by limiting them only to real property. Going forward, gain deferral under Section 1031 would not be available to M&E companies related to the exchange of intangible assets. For example, this could affect the tax treatment of television or radio station license "swaps" after the effective date of this provision.

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 disposed of the relinquished property or acquired the replacement property on or before December 31, 2017.

Modification to net operating loss deduction

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 carryforward amounts would apply to amounts carried to tax years beginning after December 31, 2017.

The provision would reduce some of the incentives under current law to accelerate the utilization of NOLs. The 90% limitation on the utilization of NOL carryforwards would effectively impose a minimum tax for corporate taxpayers, even though the provision proposed to eliminate the corporate AMT (see Section 2001). The elimination of the ability to carry back NOLs to prior years, other than in relation to small businesses and farms for certain casualty and disaster losses, would eliminate opportunities for immediate cash refunds. By allowing for the indefinite carryforward of NOLs with interest, the proposal has the effect of confirming that the net present value of the NOL deduction remains constant over time.

The effective date language for the 90% limitation for the use of NOLs implies that the limitation would not only apply to losses arising in tax years beginning after December 31, 2017, but to losses arising in tax years before January 1, 2018, and carried forward to tax years beginning after December 31, 2017.

Effects on the M&E industry

This bill and the previously released House "Blueprint" portray the significant limitation placed on the net interest expense deduction as a "fair" trade-off in light of its additional proposal to allow for the immediate expensing of business investments. For many in the M&E industry, however, the trade-off might not be favorable. More specifically, such companies could lose the value of a significant deduction, while gaining little from the expanded immediate expensing of business investments relative to more capital-intensive industries. There are many intangible cost categories not expressly addressed by the bill; the legislative intent in this context is unclear and further developments should be anticipated. In addition, companies in the TV network and film industry should closely monitor the prospective applicability of Section 181 (immediate expensing for film and TV production costs). This bill does NOT address Section 181, which technically expired on December 31, 2016. It is not clear if Congress will consider "extenders" legislation in light of the ongoing tax reform process.

In addition to this potentially unfavorable trade-off, most M&E companies would also be affected by the repeal of the domestic production deduction (Section 199) and the limitation on tax-free Section 1031 exchanges.

In essence, M&E companies are "paying" for the lower tax rate by giving up several valuable tax deductions. The ultimate impact on the effective tax rate for M&E companies will require careful modeling of the provisions contained in this bill.

Provisions not addressed

The bill would preserve the research credit because the incentive has proven to be effective in promoting policy goals important in the American economy. The bill's policy highlights released by the House Ways and Means Committee asserts that preserving the credit under Section 41 "encourages our businesses and workers to develop cutting-edge 'Made in America' products and services."

Many companies in the M&E industry currently claim the research credit. These companies provide various digital products and services. To provide these digital products and services, M&E companies incur significant technology and software development costs to design the necessary core platform technology, front-end applications and the underlying technology infrastructure.

The preservation of this permanent incentive should entice M&E companies to carefully evaluate all activities and costs that could be included in the research credit calculation.

Proactive accounting methods considerations

There are certain tax-planning actions M&E companies may consider taking now regarding the timing of deductions and income recognition. Such planning could create permanent tax savings given the bill would permanently reduce the statutory corporate tax rate to 20% for tax years beginning after December 31, 2017. While the bill provides no effective date, the section-by-section summary provides that the rate would be effective for tax years beginning after 2017.

M&E-specific considerations

Expense acceleration/methods analysis:

Although Section 181 was not addressed in the House Bill, and technically expired on December 31, 2016, it has been extended several times in the past. M&E companies should plan ahead as follows for Section 181 being enacted or not being extended:

— If Section 181 is extended, M&E companies should make sure it is optimally applied. For example, is it being used to include development costs? Or creative property acquisition costs?

— If Section 181 is not extended, this will result in more cost recovery deductions for the taxpayer's depreciation methods for films and programming. M&E companies should evaluate their depreciation methods. Are they using permitted methods? Have these methods been tested to determine if they clearly reflect income? Consider using the income forecast method for 2017 assets.

— A detailed analysis of underperforming content should be undertaken. Are loss deductions available for worthlessness, permanent retirement, or content that has become valueless? Could licensed content be returned to the licensor?

M&E companies also could:

— Change to an optimal method for recovering creative property costs, as applicable. Revenue Procedure 2004-36, for example, provides a 15-year safe harbor amortization period for eligible creative property costs.

— Analyze accrual of various expenditures, such as circulation expenses, agent commission expenses and publisher rebates under Section 461, also to ensure optimal methods.

— Consider funding Section 468B trusts to deduct contested liabilities. These trusts apply to certain payment liabilities under the economic performance rules, such as breach of contract, torts, or violation of law. A Section 468B trust permits a deduction upon funding instead of deferring the deduction until the claim is paid. Examples of qualifying liabilities include copyright / intellectual property infringement, talent disputes, or contract litigation with a distributor or producer. The matter does not need to be in litigation, only a qualifying claim is needed, and company stock can even be used to fund the trust. The value of a Section 468B trust is that it allows taxpayers with a contested payment liability to lock in their deduction at higher pre-tax reform marginal rates.

Revenue deferral/methods analysis:

— Analyze accrual of subscription revenue under Section 451 to ensure optimal methods

— Analyze accrual of revenue in other specific industry contexts (e.g., licensing and royalties) to ensure optimal methods

— Analyze disputed revenue to ensure amounts are not accrued prematurely (e.g., cable company revenue and associated billing procedures)

— Consider whether Section 1031 can be used before it is limited to real property

General method considerations

Expense acceleration/methods analysis:

— Deduct eligible repair expenditures that presently may be capitalized (e.g., repair expenditures that have not been analyzed fully)

— Accelerate depreciation deductions through a fixed asset or cost segregation study to identify assets eligible for shorter recovery periods and/or recovery of missed bonus depreciation (a similar recovery period analysis can be undertaken for intangibles (e.g., software))

— Deduct prepaid assets using the 12-month rule, if applicable, as opposed to ratably (e.g., over the term of coverage or contract)

— Deduct expenditures in accordance with the "all events" test, including economic performance and favorable recurring item exception, as applicable

— Analyze Section 263A uniform capitalization rules to identify optimal methodologies

Revenue deferral/methods analysis:

— Defer eligible advance payment income

— Defer income that is not fixed (e.g., subject to milestone events or other conditions precedent)

Changing the timing of deductions or income typically would necessitate an application for change in accounting method (i.e., Form 3115). Non-automatic accounting method changes must be filed on or before December 31, 2017, to be effective for the 2017 tax year for calendar-year taxpayers. Automatic accounting method changes must be filed on or before the extended due date of the tax return (e.g., to be effective for the 2017 calendar tax year).

Pass-through provisions

The proposal includes the addition of a new maximum income tax rate of 25% for individuals on certain net income from pass-through entities, which include partnerships and S corporations. The proposal generally provides a 25% tax rate for an individual who has pass-through taxable income otherwise subject to a rate higher than 25%. The 25% tax rate would apply to qualified business income (QBI), after the exclusion of net capital gain. QBI generally is 100% of "net business income" derived from a "passive business activity" and 30% (or the capital percentage) of any "net business income" derived from an "active business activity."

In determining net business income, an individual would have to identify each business activity and then net the income, gain, deduction and loss from the activity, taking into account only items includible or allowable in determining taxable income. The House Bill excludes certain items from being allocated to the business activity, including: capital gains and losses, dividends and dividend equivalents, interest income unless properly allocable to a trade or business, certain foreign currency and commodity hedging gains and losses, and annuities not connected with the trade or business, as well as any deduction or loss on these items.

A passive business activity is a trade or business for which the individual's involvement is treated as passive under the Section 469 rules (for example, the individual does not materially participate in the business activity). An active business activity is a trade or business for which the individual's involvement is not passive under the Section 469 rules. As stated, 100% of net passive business income is eligible for the 25% rate, and generally 30% of net active business income is eligible for the 25% rate.

Subject to an exception for capital-intensive activities (further discussed later), active business income from "specified service activities" would generally be ineligible for the 25% rate. Activities treated as specified service activities would be determined by cross-reference to Section 1202(e)(3)(A), which include health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business in which the principal asset of that trade or business is the reputation or skill of one or more of its employees or owners. In addition to the Section 1202(e)(3)(A) list, the House Bill also would treat investing, trading or dealing in securities, partnership interests or commodities as a specified service activity.

For the specified service activities, generally none of the net active business income would be eligible for the 25% rate by reason of the House Bill treating such activities as having a zero capital percentage. The capital percentage is zero unless an individual partner can establish an "applicable percentage" (discussed later) that is at least 10%. In effect, active business income attributable to a specified service activity could be eligible for the 25% rate only if the individual can establish an applicable percentage of at least 10% for such activity. For all business activities other than those involving specified service activities, the capital percentage would be 30% unless an individual taxpayer elects to use the applicable percentage. Individual taxpayers who elect to apply the applicable percentage must use the applicable percentage (as calculated each year) for the current tax year and the four succeeding tax years and the election may not be revoked during such period.

The applicable percentage would equal an individual partner's "specified return on capital" from the activity for the tax year, divided by the partner's net business income from the activity for that tax year. An individual partner's specified return on capital is the taxpayer's share of the active business activity's "asset balance," multiplied by a deemed rate of return (the federal short-term rate, plus 7%), reduced by deductible interest attributable to the activity. The asset balance is the owner's distributive or pro rata share of the partnership or S corporation's adjusted basis of any property described in Section 1221(a)(2) that is used in connection with the active business activity as of the end of the tax year (money is not included in the asset balance). For this purpose, Sections 168(k) (concerning bonus depreciation) and 179 (concerning accelerated depreciation) would be disregarded.

As discussed, active business income from "specified service activities" would generally be ineligible for the 25% rate. Specified service activities include, among others, performing arts, athletics, or any trade or business for which the principal asset is the reputation or skill of one or more of its employees or owners. Based on this definition, many pass-through entities in the M&E industry (e.g., sports teams, film production companies, etc.) could be subject to the restrictions of this provision. For example, for the sports industry, the language of Section 1202(e)(3)(A) is unclear whether just the players or the players and the teams would fall into the performing arts and/or athletics bucket. If this provision applies, then the only way for the 25% rate to apply to active income is to have a significant amount of tax basis in property used in the business (not counting cash and, when determining basis, not taking into account expensing under 168(k) or 179)).

Other provisions

Interest on bonds to finance professional sports stadium

Under the provisions in this bill, interest on bonds issued to finance the construction of, or capital expenditures for, a professional sports stadium would be subject to federal income tax. A professional sports stadium is defined as any facility that is used as a stadium or arena for professional sports exhibitions, games or training for at least five days in any calendar year. The provision would be effective for bonds issued after 2017.

Clearly, this provision could materially affect the financing costs for the construction of new professional sports stadiums. In a simple example, taxpayers in the highest 39.6% tax bracket that purchase a bond with a 3% federal income tax-free return would need to receive at least 5% interest in a taxable bond in order to be in the same net federal cash income tax position.

Estate tax

The bill would increase the federal estate and gift tax unified credit applicable exclusion amount to $10 million, effective for decedents dying and gifts made after 2017. In addition, the bill would repeal the federal estate tax, effective for estates of decedents dying after 2023. The bill would lower the federal gift tax rate from 40% to 35%, effective for gifts made after 2023. Given there are many family businesses in the M&E industry, adding this additional exclusion will allow for more family wealth transfer before 2023.

WOTC

The bill would repeal the work opportunity credit, which is a nonrefundable tax credit for a portion (40%) of wages paid to certain employees who qualify as members of disadvantaged groups. Many M&E companies enjoy this current benefit and need to consider the effect of elimination.

State and local tax implications

Yet to be fully considered in the tax reform debate are the state and local tax implications to M&E companies. Nearly all states tie their business tax system to determinations of federal taxable income. Depending upon how the states conform to the federal tax base, federal tax law changes could be felt at the state level as well. More importantly, while most states tie to the federal tax base, they do not automatically tie to federal tax rate reductions. Thus, as the federal tax base expands under tax reform, taxpayers could experience increased state tax burdens unless states that conform to that expanded federal tax base respond with reductions to their tax rates.

As each state's taxing system varies in its approach and conformity to federal tax law changes, M&E companies should address the effect the proposed federal tax law changes will have not only on their federal tax liabilities but also on their state business tax liabilities. Doing so will put such businesses in the best position to identify and execute planning strategies to minimize the state and local tax impact of the proposals while enabling them to utilize relevant attributes efficiently. In addition, such businesses will be in a better position to engage state and local lawmakers as they too begin to prepare to respond to forthcoming federal tax reform measures.

Conclusions

The first step in preparing for any changes likely to stem from any tax reform legislation is carefully modeling the impact the changes would have on a business's federal and state tax liabilities. A clearer idea of the effects on a particular M&E company's sub-sector and individual business will inform planning discussions around particular issues.

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