December 20, 2017 A tax credits and incentives perspective on the tax reform bill Conference Agreement On December 19, 2017, the House and Senate voted to approve the Conference Agreement for the "Tax Cuts and Jobs Act" (H.R. 1), clearing the way for enactment with the President's signature (after a re-vote by the House on December 20, 2017 to resolve technical issues). The final Conference Agreement reflects compromises by the conferees in a host of areas. However, with the exception of the rehabilitation tax credit, most tax credits and incentives escape unscathed. This Alert discusses those items and other items of interest to taxpayers. For a general discussion of the provisions included in the Conference Agreement, see Tax Alert 2017-2130. Modification of rehabilitation tax credit 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. The Conference Agreement would eliminate the 10% credit for buildings placed in service before 1936 and retain the 20% tax credit for certified historic structures, but would require that the credit be taken over five years rather than one. The bill as originally passed by the House (the House Bill) would have repealed both the 10% and 20% Section 47 credits. The Senate Finance Committee Chairman's Mark of the bill (the Senate Bill) would also have eliminated the 10% credit for buildings placed in service before 1936, but would have retained the 20% tax credit for certified historic structures at a lower rate of 10%. Effective date The repeal would be effective immediately, but transitional relief would allow the credit for qualified expenditures incurred through the end of a 24-month (or 60-month, if elected) period beginning no later than 180 days after enactment, provided that the building was in control of the taxpayer by January 1, 2018. Implications Those taxpayers that are currently undertaking or are planning to undertake the rehabilitation of a certified historic structure should evaluate their time line to best take advantage of the transitional relief. Taxpayers who invest in or utilize these tax credits will want to review contracts to understand what protections are available to them in the event that project construction continues outside of the transition period. Employer credit for paid family and medical leave The Conference Agreement would create, under a new Section 45S, an employer credit equal to 12.5% of wages paid to qualifying employees on family and medical leave if the rate of payment is at least 50% of the wages normally paid to the employee. The credit would increase by 0.25% (but not above 25%) for each percentage point by which the rate of payment exceeds 50%. The credit would be capped at 12 weeks per employee. Effective date The credit would apply only to wages paid in 2018 and 2019. Implications Eligible employers should evaluate whether they have the systems in place to track and claim this new credit beginning in 2018. While the credit is only currently available for two years, the expiration would line up with a number of so called extenders programs, thus leaving open the potential for future extensions. Retained credits The House Bill would have modified or eliminated several current credits, but those provisions were not included in the Conference Agreement. For detailed coverage of those items, please see Tax Alert 2017-1970. Accordingly, the following credits will continue unchanged: New Markets Tax Credit (NMTC) The House Bill did not allow for any additional new rounds of credit allocation. Work Opportunity Tax Credit (WOTC) The House Bill would have repealed the WOTC. Deduction for certain unused business credits The House Bill would have repealed the deduction for unused business credits. Nonrefundable credits The House Bill would have ended these nonrefundable credits. Production Tax Credit (PTC) The House Bill would have repealed the PTC inflation adjustment factor for electricity and refined coal, reverting the credit to 1.5 cents per kilowatt hour, and would have altered the current rules for when construction begins on a qualified facility. Investment Tax Credit (ITC) The House Bill contained various revisions to the ITC program. Employer-provided child care credit The House Bill would have repealed the credit. Other provisions of interest Taxable income inclusion Current law A cash basis taxpayer includes an amount in income when the amount is actually or constructively received. A taxpayer generally is in constructive receipt of an amount if the taxpayer has an unrestricted right to demand payment. An accrual basis taxpayer includes an amount in income when all the events have occurred that fix the right to receive the income and the amount can be determined with reasonable accuracy, unless an exception allows deferral or exclusion. For example, several exceptions allow tax deferral for advance payments of income. Provision The provision, which originated solely in the Senate bill, would modify the recognition of income rules by requiring a taxpayer to recognize income no later than the tax year in which the income is taken into account as income on an applicable financial statement or another financial statement under rules provided by the Secretary. An exception for special methods of accounting, including but not limited to, long-term contract income to which Section 460 applies as well as installment sales under Section 453, would apply. Also, in the case of a contract that has multiple performance obligations, the provision would require the taxpayer to allocate the transaction price in accordance with the allocation made in the taxpayer's applicable financial statement. Additionally, the provision would codify the deferral method of accounting for advance payments for goods and services contained in Revenue Procedure 2004-34. Under that method, taxpayers would be permitted to defer the inclusion of income associated with certain advance payments to the end of the tax year following the tax year of receipt if the income is deferred for financial statement purposes. The provision also would require taxpayers to apply the revenue recognition rules under Section 451 before applying the special rules under part V of subchapter P, which in addition to the original issue discount rules, also includes rules regarding the treatment of market discounts on bonds, discounts on short-term obligations, OID on tax-exempt bonds, and stripped bonds and stripped coupons. The provision would provide an exception for any item of gross income in connection with a mortgage servicing contract. Effective date The provision generally would apply to tax years beginning after December 31, 2017. In the case of income from a debt instrument having OID, the provision would apply to tax years beginning after December 31, 2018. Application of these rules would be a change in the taxpayer's accounting method for Section 481 purposes. Implications Should the Conference Agreement be enacted, income recognition for certain types of contracts, notably prepaid power purchase agreements, may be accelerated resulting in an earlier than expected recognition of taxable income. It does not appear that this provision would apply to lease accounting. Maximum tax rate for individual's business income Under current law, businesses organized as sole proprietorships, partnerships, limited liability companies, and S corporations are generally treated as "pass-through" entities subject to tax at the individual owner or shareholder level. Net income earned by owners of these entities is reported on their individual income tax returns subject to ordinary income tax rates. The Conference Agreement would allow individuals a 20% deduction on certain pass-through income. Special limitations would apply to "specified service businesses" based on the income of their owners. The House Bill would have created a new passthrough rate of 25%, while the Senate Bill would have allowed individuals a 23% deduction on certain pass-through income. Repeal of individual deduction for other taxes paid The Conference Agreement would generally allow individuals to deduct state, local, and foreign property taxes and state and local sales taxes only when paid or accrued in carrying on a trade or business, or an activity described in Section 212 (relating to expenses for the production of income). However, the Conference Agreement also contains an exception to the above-stated rule. Under the exception, a taxpayer would be able to claim an itemized deduction of up to $10,000 ($5,000 for a married taxpayer filing a separate return) for the aggregate of (i) state and local property taxes not paid or accrued in carrying on a trade or business, or an activity described in Section 212, and (ii) state and local income, war profits, and excess profits taxes (or sales taxes in lieu of income, etc. taxes) paid or accrued in the tax year. Foreign real property taxes would not be deductible under this exception. The House Bill would have repealed the deduction for state and local taxes, other than taxes on trade or business income, and $10,000 of real estate taxes. The Senate Bill followed the House Bill in this respect, but provided that the suspension of the deduction expired beginning in 2026. Repeal of the Alternative Minimum Tax (AMT) The Conference Agreement would repeal the corporate AMT, but allow taxpayers with an AMT credit to use the credit to offset regular tax liability. Taxpayers would be able to claim a refund of 50% (100% for years beginning in 2021) of the remaining credits (to the extent the credits exceed regular tax for the year) in tax years beginning before 2022. The provision would apply to tax years beginning after 2017. The Conference Agreement would increase the exemption limits and phase out thresholds for the individual AMT. The House Bill would have repealed the corporate and individual AMT, allowing any AMT credit carryforwards to be claimed in future years. The Senate Bill would not have changed the corporate AMT, but would have increased the exemption limits and phase out thresholds for the individual AMT. Reduction in corporate tax rate The Conference Agreement would lower the corporate tax rate to 21% for years beginning after December 31, 2017 and would include special rules for those subject to the normalization method of accounting (e.g., regulated public utilities). Increased expensing Under the Conference Agreement, 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) and before 2023. The increased expensing would phase-down starting in 2023 by 20% for each of the five following years. Qualified property would be defined to exclude certain public utility property and floor plan financing property. A transition rule would allow for an election to apply 50% expensing for the first tax year ending after September 27, 2017. The Conference Agreement would also remove the requirement that the original use of the property must commence with the taxpayer, as was also in the House Bill. The Conference Agreement would also modify Section 179 expensing to include up to $1 million for "qualified property" (i.e., tangible personal property used in a trade or business) placed in service in tax years beginning after 2017, with a phase-out beginning at $2.5 million; additionally, the term "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). Changes to accounting methods for small businesses The Conference Agreement would make the following changes: — Increase the annual gross receipts threshold for the use of the cash method of accounting for corporations (and partnerships with a corporate partner) to $25 million (up from $5 million), indexed to inflation — Repeal the requirement that such businesses satisfy the requirement for all prior years and extend the increased threshold to farms — Apply the cash method of accounting for these businesses, even if the business has inventories, and these businesses would be completely exempt from the uniform capitalization (UNICAP) rules and the percentage-of-completion accounting method for long-term contracts — Permit these businesses to use the percentage-of-completion accounting method for contracts that are expected to be completed within two years Interest limitation The Conference Agreement would limit the deduction for net interest expense of all businesses by amending Section 163(j). Unlike the House and Senate bills, however, the Conference Agreement drops the additional interest expense limitation that would have been imposed through a worldwide debt cap under what would have been Section 163(n). The revised Section 163(j) limitation would be on net interest expense that exceeds 30% of adjusted taxable income (ATI). For the first four years, ATI would be computed without regard to depreciation, amortization, or depletion. Thereafter (beginning in 2022), ATI would be decreased by those items, thus making the computation 30% of net interest expense exceeding EBIT. ATI would otherwise be defined similar to current Section 163(j). Interest expense would need to be related to a "business," which means the interest is properly allocable to a trade or business. Certain activities would be excluded from being a trade or business — e.g., performing services as an employee, a real property trade or business, and certain activities of regulated utilities. A small business exception would be keyed to businesses satisfying a gross receipts test of $25 million. The provision is effective for tax years after 2017. Revision of treatment of contributions to capital The Conference Agreement would retain Section 118 and it would continue to apply only to corporations. Thus, contributions to capital would be excluded from the corporation's gross income but new rules would clarify that such contributions do not include any contribution in aid of construction, any other contribution made by non-shareholders (such as a customer or potential customer), and any contribution made by any governmental entity or civic group. The clarification would generally apply to contributions made after the date of enactment. Repeal of partnership technical terminations Under Section 708(b)(1)(B) of current law, a sale or exchange of 50% or more of interests in partnership capital and profits within 12 months causes a "technical termination" of the partnership. The Conference Agreement would repeal Section 708(b)(1)(B) for partnership tax years beginning after December 31, 2017 (as in the House Bill). Tax-exempt bonds The Conference Agreement would make no change to the exclusion from gross income for interest on qualified private activity bonds and for interest on any bond issued to advance refund a tax-exempt bond. The House Bill would have repealed this tax treatment. Base Erosion Anti-Abuse Tax The Conference Agreement would adopt the Senate Bill's new base erosion anti-abuse tax (BEAT) provision. The BEAT would apply to corporations (other than RICs, REITs, or S-corporations) that are subject to US net income tax with average annual gross receipts of at least $500 million and that have made related party deductible payments totaling 3% (2% in the case of banks and certain security dealers) or more of the corporation's total deductions for the year. A corporation subject to the tax would generally determine the amount of tax owed under the provision (if any) by adding back to its adjusted taxable income for the year all deductible payments made to a foreign affiliate (base erosion payments) for the year (the modified taxable income). Base erosion payments do not include cost of goods sold, certain amounts paid with respect to services, and certain qualified derivative payments. The excess of 10% (5% in the case of one tax year for base erosion payments paid or accrued in tax years beginning after December 31, 2017) of the corporation's modified taxable income over its regular tax liability for the year (net of an adjusted amount of tax credits allowed) is the base erosion minimum tax amount that is owed. For tax years beginning after December 31, 2025, the rate would increase from 10% to 12.5%. Additional considerations: — The rate for certain banks and security dealers would be 1% higher. — Premiums related to reinsurance of life and property and casualty contracts would be specifically included as base erosion payments. — The exception for costs of goods sold would not apply to base erosion payments made to a surrogate foreign corporation that first became a surrogate foreign corporation after November 9, 2017. — The Conference Agreement would mostly eliminate the penalty in the BEAT calculation for companies that take advantage of certain business tax credits, including the low income housing tax credit and certain renewable electricity production tax credits (a modification from the Senate Bill). Final thoughts The Conference Agreement, with respect to Section 38 general business credits, generally adheres more closely to the Senate Bill in that most of the programs remain unmodified. While this is very good news for those taxpayers that utilize such credits (either to reduce their tax liability or as a way to finance projects), it is still important that taxpayers understand how the other proposals in the bill affect their overall liability. Items, such as the lower corporate tax rate, immediate expensing, and the BEAT must be considered to get a complete understanding as to how the Conference Agreement would affect their particular facts and circumstances in regards to tax credits. Additionally, there may be a number of smaller effects to programs contained in the Conference Agreement regarding transactions within individual tax credit programs. Please look out for further information on these impacts as time passes. ———————————————
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