November 20, 2017 An engineering and construction industry perspective on tax reform Tax reform is heating up after the House of Representatives and Senate Finance Committee passed their respective versions of the Tax Cuts and Jobs Act on November 16, 2017. While a compromise on tax reform is still developing, there are significant items of particular interest to the engineering and construction industry that taxpayers should begin considering now. The House bill that passed is the same as the version passed by the House Ways and Means Committee on November 2, 2017, after the House markup. It includes provisions that lower the corporate tax rate to 20% and individual tax rates generally, while eliminating many current tax benefits. The House bill would also move the US to a territorial system of taxing foreign earnings with an anti-base erosion provision and one-time transitional tax on accumulated foreign earnings. For an overview of the House bill and its potential application to accounting methods and other sector implications, please see Tax Alert 2017-1831. For an overview of the House markup, finished November 9, 2017, see Tax Alert 2017-1892. The Senate Finance Committee passed an amended version of the Senate Finance Committee Chairman's Mark (the Chairman's Mark), released on November 9, 2017. It also would lower the corporate tax rate to 20%, but would delay the reduction until 2019. Likewise, it would move to a territorial tax system for foreign earnings, but would take a different approach to preventing base erosion. In addition, the Chairman's Mark would make numerous changes to business and partnership provisions currently in effect that do not have a counterpart in the House bill. For an overview of the Chairman's Mark, see Tax Alert 2017-1907. The House bill and the Chairman's Mark will need to be reconciled before a tax reform bill can be enacted. Tax reform highlights specific to the engineering and construction industry — Changes to the treatment of interest on municipal and qualified private activity bonds (PABs) issued to finance professional sport stadiums, arenas, and infrastructure Details on proposals for tax reform Bond reforms Current law Section 103 excludes from gross income the interest on any state or local bond. This includes private activity bonds, which are qualified bonds within the meaning of Section 141. The exclusion presently includes interest on certain bonds used for professional stadiums. Sections 54, 54A-54F and 54AA allow holders of certain bonds (tax credit bonds) a credit against income taxes. House bill provision The House bill would repeal, for bonds issued after December 31, 2017, the exclusion from gross income for interest on qualified private activity bonds and for interest on any bond issued as an advance refund on a tax-exempt bond. In addition, the provision would repeal, prospectively, all the existing authority for issuing tax credit bonds. The provision would also repeal the federal tax exemption for interest on bonds issued to finance the construction of, and capital expenditures for, a professional sports stadium or arena used for sports exhibitions, games or training. Chairman's Mark provision The Chairman's Mark would retain the exclusion from gross income for interest on qualified private activity municipal bonds for certain infrastructure projects. Implications By closing down a commonly used financing technique, new stadium construction projects will find it more difficult to get funding and move projects forward. Passthrough income House bill provision The House bill would add a new maximum income tax rate of 25% on certain net income from passthrough entities, which include partnerships and S corporations. The proposal generally would provide a 25% tax rate on qualified business income (QBI) after the exclusion of net capital gain for an individual who has passthrough taxable income otherwise subject to a rate higher than 25%. Specified service activities that are not capital intensive would not be eligible for the reduced rate. Service activities are determined by cross-reference to Section 1202(e)(3)(A), and include health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners. Chairman's Mark provision The Chairman's Mark would provide individuals with a 17.4 % deduction on certain pass-through income. In determining a taxpayer's qualified items of income, gain, deduction and loss items would be taken into account only to the extent included or allowed in the determination of taxable income for the year. REIT non-capital gain dividends and certain cooperative dividends would be considered qualified items of income for this purpose. QBI would not include reasonable compensation of an S corporation shareholder, amounts for the performance of services allocated or distributed to a partner who is acting other than in his/her capacity as such, and guaranteed payments in the nature of remuneration for services. It also does not include certain investment-related items, and is limited to 50% of the W-2 wages of the taxpayer. If the computation of QBI results in a loss for a tax year, the amount of the loss is carried forward and treated as a loss from a qualified business in the next tax year. The deduction would not apply to "specified service businesses," except for taxpayers whose taxable income does not exceed $150,000 (if married filing jointly) or $75,000 (for other individuals). The benefit of the deduction would also be phased out for these taxpayers over a $50,000 range for taxable income exceeding the aforementioned thresholds. A "specified service business" would be defined as any trade or business activity involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business whose principal asset is the reputation or skill of one or more of its employees. Implications Design firms seemingly would not qualify for the lower rate. It is unclear whether firms with mixed activities, such as design and construction, could qualify. Interest expense deduction Current law Businesses may generally deduct interest expense in the tax year in which the interest is paid or accrued. Disallowed interest expense may be carried forward indefinitely, while any excess limitation may be carried forward for three years. House bill provision Effective for tax years beginning after December 31, 2017, the House bill would limit the net interest expense deduction for every business, regardless of form, to 30% of adjusted taxable income (ATI). The provision would require the interest expense disallowance to be determined at the tax filer level. ATI for purposes of this provision would be a business's taxable income calculated without taking into account business interest expense, business interest income, NOLs, depreciation, amortization and depletion. Disallowed interest (which would be considered attributable to the business) could be carried forward five years. The provision 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 create a new Section 163(n) that would limit the deduction for net interest expense of domestic corporations that are part of a worldwide group. The limitation would be based on a comparison of the domestic corporation's earnings before interest, taxes, depreciation, and amortization (EBITDA) to the worldwide EBITDA of the group (referred to as an international financial reporting group). The interest expense of the domestic corporation would be grossed up by 110% but then limited to a percentage (referred to as the allowable percentage) that takes into account the domestic corporation's share of worldwide EBITDA. Chairman's Mark provision Section 163(j) would be repealed and replaced with a provision that would disallow net business interest expense deductions that exceed 30% of ATI. For partnerships, the limitation would apply at the partnership 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. Both bills also would exclude similar activities from the definition of a trade or business (e.g., performing services as an employee, a real property trade or business, and certain activities of regulated utilities). Activity related to floor plan financing, however, is only in the House bill. Small businesses that meet a $15 million gross receipts test would not be subject to the limitation. A worldwide limitation on interest deductibility would be targeted at US interest deductions that are seen as eroding the US tax base. The limitation would be based on a comparison of the debt that could be incurred if the US group had a debt-equity ratio in proportion to the worldwide group's debt-equity ratio. The resulting amount of debt that "should" be in the United States (based on the proportionate ratios) would be grossed-up by 110% to determine the amount of the US debt exceeding the "proper" amount — this excess would be the "excess domestic indebtedness." The excess domestic indebtedness would be divided by all actual domestic debt and multiplied by the net interest expense. Thus, the more the actual US leverage exceeds the leverage that "should" be in the US group, the more the numerator increases and the allowable percentage of interest deductions decreases. As with the House bill, in cases in which the Section 163(j) and worldwide interest limitations both apply, the one that results in the lower limitation on interest deductions — and therefore the greatest amount of interest to be carried forward — would govern. Any disallowed interest would be carried forward indefinitely (as opposed to the five years proposed in the House bill). Implications The broad language of Section 469(c)(7)(C) offers the architecture, engineering and construction industry a potential opportunity to shape tax reform to make it clear that architecture, engineering, and construction enterprises that are regularly engaged in a trade or business involving the development, construction, substantial renovation, management and oversight of real property should not be subject to the interest expense limitation, without regard to whether they have an outright ownership in real property. A key challenge may be isolating projects or activities that are related to real property. Increased expensing Current law Taxpayers may claim additional depreciation (i.e., bonus depreciation) under Section 168(k) in the year in which qualified property 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. To be eligible for bonus depreciation, the original use of the property must begin with the taxpayer. House bill provision The House bill 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 and certain aircraft). 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 expand eligible property 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. 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). Chairman's Mark provision For qualified property placed in service in tax years beginning after 2017, Section 179 expensing would increase to $1 million with a phase-out beginning at $2.5 million. Further, qualified property would be expanded to include certain depreciable personal property used to furnish lodging and improvements to nonresidential real property (such as roofs, heating and property protection systems). Bonus depreciation would be increased from 50% to 100% for qualified property placed in service after September 27, 2017 (the date the Unified Framework was released). The increased allowance would remain until 2022. Qualified property would be defined to exclude (as with the Section 163(j) interest limitation) certain public utility property. A transition rule would allow for an election to apply 50% expensing for one year. Implications An open question is whether the wording differences between the House and Senate provisions denying capital expensing for certain property of regulated utilities and real property businesses will deny capital expensing treatment where taxpayers are exempt from the 30% interest expense limitations. Taxpayers in the architecture, engineering, and construction industry may have the opportunity to shape the bill to allow capital expensing, and also be exempt from the interest expense rules. Excise tax on payments to foreign affiliates House bill provision Under the House bill, all deductible payments except interest paid to a related foreign company would be subject to a 20% excise tax unless the related foreign company elected to treat those payments as effectively connected income (ECI) and, thus, taxable in the United States. If the ECI election were made to treat the payments as taxable in the United States, the income would be taxed on a net basis. The deduction allowed to offset the income would be determined by reference to the profit margins reported on the group's consolidated financial statements for the relevant product line. No foreign tax credits would be allowed to reduce the US tax on that income. If no election were made to treat the payments as taxable income, the excise tax would not be a deductible payment. The provision would apply to covered amounts paid by domestic corporations after December 31, 2018. Chairman's Mark provision A one-time transition tax would apply to a 10% US shareholder's pro rata share of the foreign corporation's post-1986 tax-deferred earnings at the rate of either 10% (for accumulated earnings held in cash, cash equivalents, or certain other short-term assets) or 5% (for accumulated earnings invested in illiquid assets (e.g., property, plant and equipment)). The House bill applies rates of 14% and 7%, respectively. A foreign corporation's post-1986 tax-deferred earnings would be the earnings as of November 9, 2017, limited to the earnings accumulated after the shareholder's acquisition of the foreign corporation from a foreign shareholder. Similar to the House bill, the Chairman's Mark would allow an affected US shareholder with a 10%-or-greater stake in a foreign corporation with a post-1986 accumulated deficit to offset the deficit against tax-deferred earnings of other foreign corporations. The US shareholder could elect to pay the transitional tax over eight years or less. The Chairman's Mark also has a new anti-inversion provision, requiring a US corporation to pay the full 35% rate on deferred foreign earnings (less the taxes it already paid) if it inverts within 10 years after enactment. No foreign tax credits would be available to offset the tax. Anti-base-erosion provisions House bill provision The House bill would impose current US tax on 50% of a US shareholder's aggregate net CFC income (excluding income from commodities, subpart F income, active finance income qualifying under Section 954(h) and 954(i), insurance income and certain related-party payments) in excess of extraordinary returns from tangible assets. The extraordinary return base would equal 7%, plus the federal short-term rate of the CFCs' aggregate adjusted basis in depreciable tangible property less interest expense. Only 80% of the foreign taxes paid on the income would be allowed as a foreign tax credit. Chairman's Mark provision The Chairman's Mark would impose tax on income from the sale of goods and services abroad at only 12.5%, and presumably would tax a US shareholder's aggregate net CFC income at a similar rate. Net CFC income would be gross income in excess of extraordinary returns from tangible assets excluding effectively connected income (ECI), subpart F income, high-taxed income, dividends from related parties and foreign oil and gas extraction income. The carve-outs are similar, but not identical to those in the House bill. Most notably, the carve-outs do not include AFE-qualifying income or commodities income. The extraordinary return base would equal 10% of the CFC's aggregate adjusted basis in depreciable tangible property. Only 80% of the foreign taxes paid on the income would be allowed as a foreign tax credit. As with the provision in the House bill, all CFCs would be aggregated. Fringe benefits Current law Taxpayers may deduct the cost of certain fringe benefits provided to employees (e.g., employee discounts, transportation fringe benefits, qualified moving expenses), even though the benefits are excluded from the employee's income under Section 132. House bill provision The House bill 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 such benefit were treated as taxable compensation to the employee. Chairman's Mark provision The current rules on deductibility of entertainment expenses would be tightened for fringe benefits provided to employees. Repeal of rehabilitation credit Current law Section 47(a) allows a rehabilitation credit of 20% of the qualified rehabilitation expenditures for any certified historic structure and 10% of expenditures for qualified buildings. This credit is taken into account in the year the rehabilitated building is placed in service. House bill provision The House Bill would repeal the rehabilitation credit effective immediately. Transitional relief would allow a credit for qualified expenditures incurred through the end of a 24-month period beginning no later than 180 days after enactment provided the building was in the taxpayer's control by December 31, 2017. Chairman's Mark provision The credit for pre-1936 buildings would be repealed. The provision includes (1) a 20% credit for qualified rehabilitation expenditures with respect to a certified historic structure; and (2) that the 20% credit be claimed ratably over a five-year period beginning in the tax year in which a qualified rehabilitated structure is placed in service. Section 174 research and experimental expenditures Current law Certain expenditures associated with the development or creation of an asset having a useful life extending beyond the current year generally must be capitalized and depreciated over that useful life under Sections 167 and 263(a). Under current law, Section 174 provides that a taxpayer may treat research or experimental expenditures that are paid or incurred during the tax year in connection with a trade or business as deductible expenses under Section 174(a), or the taxpayer may elect to capitalize and amortize these expenditures ratably under Section 174(b) over a period of not less than 60 months. Alternatively, taxpayers may elect to amortize their research expenditures over a period of 10 years. Section 174 applies only to the extent that the expenditure is reasonable under the facts and circumstances. House bill provision The House bill would require taxpayers to treat research or experimental expenditures as chargeable to a capital account and amortized over five years (15 years in the case of foreign research). The provision would also modify Section 174 to require that all software development costs be treated as research or experimental expenditures. Any capitalized research or experimental expenditures relating to property that is disposed of, retired, or abandoned during the amortization period would be amortized over the remainder of the period. Further, Section 174 would continue to be inapplicable to expenditures (1) for the acquisition or improvement of land; (2) for the acquisition or improvement of property to be used in connection with research and development that is subject to the allowance for depreciation under Sections 167 or 616; and (3) for exploration expenditures to ascertain the existence, location, extent, or quality of any deposit of ore or other minerals (including oil and gas). Implications For architecture, engineering, and construction firms, these rules may offer planning opportunities under Section 460, and also could result in additional complexity when performing look-back calculations — regardless of the current treatment as direct or indirect contract expenses. State income tax implications Many of the proposed changes by the House and Senate Finance Committee would have a direct effect on state income taxes primarily through the expansion of the federal tax base. In general, states use federal taxable income as the starting point in state income tax computations. Unless states react to the expanding federal tax base by lowering their own tax rates or by decoupling from the changes, it is likely that state income tax revenues would rise significantly. Although many states automatically conform to changes to the federal tax code, some states adopt federal tax provisions as of a particular date (and would need to legislatively conform to the current proposed changes), while others selectively conform. Because of these varying conformity dates, taxpayers should consider the impact of any legislation that is ultimately enacted on a state-by-state basis. Interest expense limitations Conformity questions aside, there could be a significant additional burden placed on taxpayers with complex domestic structures due to the way the proposed interest expense limitations would be computed for state income tax purposes. Differences arising from the inclusion of different affiliated members in a particular state tax filing could necessitate multiple discrete state-limitation computations, whereas only a single computation would be required for federal tax purposes. Increased expensing Historically, many states have been unwilling to grant taxpayers the accelerated benefit of bonus depreciation — especially in the current era of falling state tax revenues. States may manage the potential tax revenue windfall by conforming to federal bonus depreciation provisions, but many, especially those facing budgetary shortfalls, may continue to decouple. Anti-base erosion provisions The state income tax impact of repatriated foreign earnings could have a significant impact on a company's state income tax liability. Provisions regarding dividend received deductions for foreign dividends or subpart F income taxation can vary significantly among states. Sourcing laws and the treatment of dividends and subpart F inclusions in the apportionment calculation can be complex and nuanced. Additionally, foreign tax credits against foreign taxes imposed on these repatriated earnings ease some of the burden of repatriation; however, state income tax systems have no similar mechanism. ———————————————
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