December 19, 2017 Tax reform conference committee report contains M&A provisions On December 15, 2017, House and Senate members of the tax reform conference committee released an agreement (the Conference Agreement) to be considered by the full House and Senate. The Conference Agreement contains a number of 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 Tax Alerts 2017-2131 and 2017-2134. Taxpayers should evaluate the Conference Agreement and assess the impact of the provisions. 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 21% rate (as opposed to 20% under the Senate bill) and repeal the maximum corporate tax rate on net capital gain as obsolete. As in the Senate bill, the provision does not provide a special rate for personal service corporations. Effective date The provision would be effective for tax years beginning after December 31, 2017 — consistent with the House bill and one year earlier than under the Senate bill. Implications The reduction in the corporate tax rate to 21% would reduce the value of a corporation's existing losses (including built-in losses) and credits. Corporations should consider opportunities for accelerating the use of losses and credits in 2017, to maximize the benefit of such attributes. 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 provision, which follows the Senate bill, 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 extend the additional first year depreciation deduction through 2026 (2027 for longer production period property and certain aircraft). The provision would allow taxpayers to claim 100% bonus depreciation with respect to 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 would phase down bonus depreciation to 80% for qualified property placed in service before January 1, 2024; 60% for qualified property placed in service before January 1, 2025; 40% for qualified property placed in service before January 1, 2026; and 20% for qualified property placed in service before January 1, 2027 (with an additional year to place in service available for long production period property and certain aircraft associated with each phase-down percentage). The provision also would apply to certain plants planted or grafted after September 27, 2017, and before January 1, 2027, with similar bonus percentages in place. The provision would also expand the current law definition of qualified property by repealing the requirement that the original use of the property begin with the taxpayer; instead, property would generally be eligible for 100% bonus depreciation if it is the taxpayer's first use of such property (provided that such "used" property is not acquired from a related party or in a carryover basis transaction). The provision would further expand the current law definition of qualified property to include certain qualified film and television productions, as well as certain qualified theatrical productions. While the provision would generally expand the definition of qualified property, it specifically states that qualified property would not include property used by a regulated public utility company in the trade or business of the furnishing or sale of: (1) electrical energy, water or sewage disposal services; (2) gas or steam through a local distribution system; or (3) transportation of gas or steam pipeline, if the rates for the furnishing or sale of such services have been established or approved by a state or political subdivision thereof, by an agency or instrumentality of the United States or by a public service or utility commission or other similar body of any state or political subdivision thereof. Additionally, the provision states that qualified property would not include any property used in a trade or business that has had floor plan financing indebtedness (as defined in paragraph (9) of Section 163(j)), if the floor plan financing interest related to such indebtedness was taken into account in computing the interest limitation under Section 163(j). Further, a real property trade or business that elects not to be subject to certain interest provisions of Section 163(j) would have to depreciate qualified improvement property under the alternative depreciation system (and thus, such property would not be eligible for bonus depreciation). Lastly, a farming business that elects not to be subject to certain interest provisions of Section 163(j) would have to depreciate its property with a recovery period of 10 years or more under the alternative depreciation system (and thus, such property would not be eligible for bonus depreciation). The provision also would repeal the election to accelerate AMT credits in lieu of bonus depreciation under Section 168(k)(4). Effective date The provision would apply to property acquired and placed in service after September 27, 2017, as well as specified plants planted or grafted after that date. Property would not be treated as acquired after the date on which a written binding contract is entered into for its acquisition. For property acquired prior to September 27, 2017, (e.g., property for which a binding written contract was entered into prior to September 27, 2017, to purchase the property), such property would be subject to the bonus depreciation rules in place prior to the enactment of the provision (as described under the "Current Law" section above). A transition rule would allow a taxpayer to elect to utilize 50% bonus depreciation, instead of 100%, for qualified property placed in service during the first tax year ending after September 27, 2017. Implications The Conference Agreement follows the House bill 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. 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 is modified from the Senate bill and 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) any business interest or business interest income; (iii) NOLs; (iv) the amount of any deduction allowed under Section 199A; (v) in the case of tax years beginning before January 1, 2022, any deduction allowable for depreciation, amortization or depletion; and (vi) such other adjustments as provided by the Secretary. Adjusted taxable income also would not include the Section 199 deduction, as it would be repealed. 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 from these rules businesses with average annual gross receipts of $25 million or less for the three-tax-year period ending with the prior tax year. 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 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 Net operating loss deduction Under current law, Section 172 allows taxpayers to carry back a net operating loss (NOL) arising in a tax year for two years and carry forward the NOL for 20 years to offset taxable income. Generally, a 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 carryback of losses arising from specified liabilities. The alternative minimum tax rules do not allow a taxpayer's NOL deduction to reduce the taxpayer's alternative minimum taxable income by more than 90%. Loss limitation Under current law, Sections 469 and 461(j) limit trade or business losses for certain types of activities. Section 469 limits passive activity losses of some taxpayers such that deductions attributable to passive activities, to the extent they exceed the income from passive activities, may not be deducted against other income. The excess losses from passive activities in a tax year can be carried forward to offset income from passive activities in future years, or can be recovered upon the taxpayer's disposition of its entire interest in the passive activity. Similarly, Section 461(j) limits excess farming trade or business losses of non-C corporation taxpayers. Excess farming losses are the excess of deductions attributable to farming businesses over the sum of gross income or gain from farming businesses and a "threshold amount." The threshold amount is the greater of $300,000 ($150,000 in the case of married individuals filing separately), or the excess of the aggregate amount of farming trade or business income or gain over the aggregate amount of farming trade or business deductions for the five tax years preceding the tax year. Provision Net operating loss deduction The provision would allow indefinite carry forward of NOLs arising in tax years ending after December 31, 2017. The provision also would repeal all carrybacks for losses generated in tax years ending after December 31, 2017, but would provide a special two-year carryback for certain losses incurred in the trade or business of farming. For losses arising in tax years beginning after December 31, 2017, the provision would limit the amount of NOLs that a taxpayer could use to offset taxable income to 80% of the taxpayer's taxable income. Net operating losses that are farming losses for any tax year would be treated as a separate net operating loss to be taken into account after the remaining portion of the net operating loss for such tax year. 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. Non-corporate loss limitation The provision would limit excess business losses for non-corporate taxpayers for tax years beginning after December 31, 2017 and before January 1, 2026. Excess business losses are defined as the excess of the taxpayer's aggregate deductions attributable to trades or businesses of the taxpayer over the excess of aggregate gross income or gain of such taxpayer for the tax year that is attributable to such trades or businesses, plus $250,000 (200% of such amount in the case of a joint return). Disallowed excess business losses would be treated as a net operating loss carryforward to the next year under Section 172. The provision also provides that the farming loss limitation of Section 461(j) would not apply for tax years beginning after December 31, 2017 and before January 1, 2026. For partnerships and S-corporations, the provision would be applied at the partner or S-corporation owner level. The provision would be applied after the application of Section 469 (the passive loss limitation rules). The provision would require the Treasury Department to prescribe reporting requirements, as necessary, to carry out the purposes of the provision. The provision would apply to tax years beginning after December 31, 2017. Effective dates The indefinite NOL carry forward, general repeal of NOL carrybacks (including the repeal of Section 172(f)), and the special NOL carryback rule for certain farming losses would be effective for losses arising in tax years ending after December 31, 2017. The 80% NOL limitation rule would be effective for losses arising in tax years beginning after December 31, 2017. The loss limitation provision would apply to tax years beginning after December 31, 2017. Implications The 80% 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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