November 14, 2017 Senate tax reform plan contains M&A provisions On November 9, 2017, Senate Republicans unveiled a description of their version of the "Tax Cuts and Jobs Act" (the Senate Plan). The Senate Plan contains a number provisions relevant to merger and acquisition (M&A) transactions and internal restructurings of corporate groups. This Tax Alert discusses those provisions. Other provisions impacting corporate taxpayers are discussed in other Tax Alerts. (For an overview of the entire Senate Plan, see Tax Alert 2017-1907. For a discussion of the international provisions, see Tax Alert 2017-1917). Taxpayers should evaluate the Senate Plan and assess the impact of the provisions to enable timely action in case they are enacted. Reduction in corporate tax rate Current law Under current law, a corporation's regular income tax liability is determined by applying the following rate schedule to its taxable income: — $0-$50,000 — taxed at 15% — $50,001-$75,000 — taxed at 25% — $75,001-$10 million — taxed at 34% — Over $10 million — taxed at 35% 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%. Provision The provision would tax corporate income at a flat 20% rate and eliminate the special tax rate for personal services corporations. Effective date The provision would be effective for tax years beginning after December 31, 2018 — one year later than under the Ways and Means version. Implications 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 and 2018, to maximize the benefit of such attributes. Reduction of dividends received deductions Current law Current law allows a corporation to deduct certain amounts with respect to dividends received from other taxable domestic corporations.The amount of the deduction generally equals 70% of the dividend received.Such dividends are thus taxed at a maximum rate of 10.5% (i.e., 30% of the top corporate tax rate of 35%). Where a dividend is received from a 20%-owned corporation (i.e., where the taxpayer owns stock representing at least 20% of the voting power and value of the distributing corporation), the amount of the deduction equals 80% of the dividend received.Such dividends are thus taxed at a maximum rate of 7% (i.e., 20% of the top corporate tax rate of 35%). Where a dividend is received from a subsidiary member of the same affiliated group, the amount of the deduction equals 100% of the dividend received. Provision The Senate Plan would reduce the 70% dividends received deduction to 50% and the 80% dividends received deduction to 65% in order to reflect the lower corporate tax rate.Such dividends would be taxed at a maximum rate of 10% (i.e., 50% of the top corporate tax rate of 20%) and 7% (i.e., 35% of the top corporate rate of 20%), respectively. Increased expensing Current law 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. Provision The provision would allow taxpayers to immediately expense 100% of the cost of qualified property acquired and placed in service (as well as specified plants planted or grafted) 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). Qualified property would not include certain public utility property. 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. Effective date Generally, the provision would apply to property that is acquired and placed in service after September 27, 2017. The provision would include a transition rule that allows taxpayers to elect to apply a 50% allowance for a taxpayer's first tax year ending after September 27, 2017. Implications — The House Ways and Means Committee (Ways and Means) version of this provision 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. In contrast, the Senate Plan would retain the "original use" requirement as a condition to expensing. Thus, unlike under the Ways and Means version, taxpayers that buy existing qualified property (e.g., in an M&A transaction structured as a taxable asset acquisition) would not be able to avail themselves of the benefits of increased expensing. — The interaction of the delayed reduction in the corporate income tax rate (discussed above) and the increased expensing provisions creates significant planning opportunities for taxpayers. For example, a taxpayer may fully expense an investment in qualified property made in 2018 (at the 35% rate) and sell the property in 2019, with gains taxed at the reduced 20% rate. Similarly, the opportunity to deduct the cost of an investment at the 35% rate, and realize income from that investment at the reduced 20% rate, may convert unprofitable investments (on a pre-tax basis) into profitable investments (on an after-tax basis). Interest Current law 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. Provision 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. Adjusted taxable income for purposes of this provision would be a business's taxable income calculated without taking into account (i) any item of income, gain, deduction, or loss which is not properly allocable to a trade or business, (ii), business interest expense, (iii) business interest income, (iv) the 17.4% deduction for certain pass-through income, and (iv) NOLs. The provision would allow businesses to carry forward interest amounts disallowed under the provision to succeeding tax years indefinitely. Any carryforward of disallowed interest is an item taken into account in the case of certain corporate acquisitions described in Section 381 and is treated as a "pre-change loss" subject to limitation under Section 382. The provision would include special rules to allow a pass-through entity's owners to use 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 $15 million or less from these rules. The provision also would not apply to certain regulated public utilities and, at the taxpayer's election, any real property trades or businesses. Effective date The provision would be effective for tax years beginning after December 31, 2017. Implications — The Ways and Means and Senate versions of this provision differ in certain key respects. First, although both versions of the provision would limit the deduction for net business interest expense to 30% of a taxpayer's adjusted taxable income for the tax year, they define adjusted taxable income differently. The Ways and Means version defines adjusted taxable income computed without regard to (i) business interest expense, (ii) business interest income, (iii) NOLs, and (iv) depreciation, amortization, and depletion. In contrast, the Senate version defines adjusted taxable income as taxable income computed without regard to (i) any item of income, gain, deduction, or loss which is not properly allocable to a trade or business, (ii) business interest expense, (iii) business interest income, (iii) the proposed 17.4% deduction for certain pass-through income, and (iv) NOLs. Notably, by not accounting for depreciation, amortization, and depletion, the Senate version's definition of adjusted taxable income is less generous than the definitions under current law and the Ways and Means version. Second, whereas under the Ways and Means version, disallowed interest amounts may be carried forward five years, under the Senate version, such amounts may be carried forward indefinitely. — 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. To the extent the acquirer cannot deduct interest on acquisition debt, the economic cost of a debt-financed acquisition would be greater than under current law. Moreover, because increased expensing does not extend to taxpayers that buy preexisting qualified property, the loss of interest deductions would not be offset by the benefits of increased expensing (as compared to depreciation and amortization). Finally, the book cost of debt-financed acquisitions would also go up compared to current law. — 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. Modification of net operating loss deduction Current law Under current law, Section 172 allows taxpayers to carry back an 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%. Provision The provision would make two significant changes to the rules governing NOL deductions. First, NOLs arising in tax years beginning after December 31, 2017, may be carried forward indefinitely but may not be carried back. Second, for losses arising in tax years beginning after December 31, 2017, the amount of an NOL that a taxpayer could use to offset taxable income would be limited to 90% of taxable income. Effective date The indefinite carry forward and modification of carrybacks would be effective for losses arising in tax years beginning after December 31, 2017. The 90% limitation rule would apply to losses arising in tax years beginning after December 31, 2017. Implications Under the Ways and Means version of this proposal, the 90% limitation rule would apply for losses carried to tax years beginning after December 31, 2017. Thus, an NOL arising in 2016 and carried forward to 2018 would be subject to the limitation. In contrast, under the Senate version, the 90% limitation rule would not apply to losses arising in tax years beginning on or before December 31, 2017. Accordingly, taxpayers should be able to continue deducting 100% of such NOLs. ———————————————
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