July 2, 2021
Revenue proposals detailed in Treasury Green Book would significantly affect international private companies and families
In its FY2022 budget and explanation of revenue proposals (Treasury Green Book), the Biden Administration proposed numerous tax changes that would increase taxes on international private companies and their owners. The proposed changes would affect both global and domestic businesses, whether in corporate or pass-through form.
This Alert addresses the proposals, focusing on the proposed rules affecting individuals and private business, including cross-border private investments in passive assets and active global corporate groups. For a general discussion of the Administration's tax proposals affecting individuals, see Tax Alert 2021-1129; for a general discussion of the Administration's international tax proposals, see Tax Alert 2021-9011.
PROPOSALS GENERALLY AFFECTING US TAX RESIDENT INDIVIDUALS AND THE PRIVATE BUSINESSES THEY HOLD
Rate increases on ordinary income, capital gains and qualified dividends
For individuals, the top federal marginal tax rate would increase from 37% to 39.6% on ordinary income. For taxpayers with adjusted gross income (AGI) of more than $1m, ordinary income tax rates would apply to long-term capital gains and qualified dividends, rather than the current preferential rate of 20%. The increased rates would apply, however, only to the extent that the taxpayer's income exceeds $1m ($500,000 for married filing separately), indexed for inflation, after 2022. Capital gains recognized during the year would be included in determining the $1m threshold.
Ordinary rates would also apply to dividends that individuals receive from qualified foreign corporations (i.e., foreign corporations that are eligible for benefits under a US income tax treaty).
Implications: Considering that the Administration proposes to increase the top ordinary individual income tax rate to 39.6% (43.4% including the net investment income tax (NIIT)), taxing capital gains and dividends at ordinary income rates would be a significant change, particularly given the proposed effective date. According to the Green Book, the proposal would be effective for gains required to be recognized after the "date of announcement." The meaning of "date of announcement," however, is unclear. It could mean April 28, the date President Biden formally announced this proposal as part of his speech to a joint session of Congress; it could also mean May 28, the date the Green Book was released; or the date the proposal is formally introduced in Congress as part of a bill. As the proposed effective date does not mention whether it applies to qualified dividend income (QDI), it could be retroactive to the first day of the year in which the provision is announced.
Taxing carried (profits) interest as ordinary income
The proposal would generally tax as ordinary income a partner's share of income on an "investment services partnership interest" (ISPI) in an investment partnership, regardless of the character of the income at the partnership level, if the partner's taxable income (from all sources) exceeds $400k. Accordingly, such income would not be eligible for the reduced rates that apply to long-term capital gains (LTCG). In addition, the proposal would require partners in these investment partnerships to pay self-employment taxes on that income. The proposal would repeal IRC Section 1061 for taxpayers with taxable income (from all sources) over $400,000 and would be effective for tax years beginning after December 31, 2021.
Implications: This change is consistent with the Administration's overall approach to treat income from labor and capital equally. Compared to current law, this proposal would (1) apply irrespective of holding period, whereas IRC Section 1061 applies when the holding period is less than three years; (2) recharacterize carried interest as ordinary income, instead of short-term capital gain, which could affect other tax benefits; and (3) subject the income to Self-Employed Contributions Act (SECA).
Expanding application of NIIT and SECA taxes
This proposal would:
The proposal would ensure that all trade or business income of high-income taxpayers is subject to the 3.8-percent Medicare tax, either through the NIIT or SECA tax. For taxpayers with AGI over $400,000, the definition of net investment income (NII) would be amended to include gross income and gain from any trades or businesses that are not otherwise subject to employment taxes.
Implications: Directing all the revenue from the NIIT (both under current law and from the proposed expansion) to the Hospital Insurance Trust Fund, like revenue from the 3.8% tax under FICA and SECA, would benefit cross-border taxpayers. For US citizens or residents living outside the US, the NIIT would presumably be covered by totalization agreements if it is determined to be a social insurance-type tax. Presumably, this change would also come with language similar to that in the self-employment tax regime found in IRC Section 1401(c).
Limiting IRC Section 1031 exchanges
The proposal would allow the deferral of gain, up to an aggregate amount of $500,000, for each taxpayer ($1m for married individuals filing a joint return) each year for like-kind exchanges of real property. Taxpayers would recognize gains from like-kind exchanges exceeding $500,000 during a tax year (or $1m for married individuals filing a joint return) in the year they transfer the real property subject to the exchange. The proposal would be effective for exchanges completed in tax years beginning after December 31, 2021.
Implications: US nonresidents who invest in US real estate should be aware that the proposal would significantly impede their ability to defer gain in an IRC Section 1031 exchange, just like for US tax residents.
Making limitation on excess business loss permanent
The proposal would bring the tax treatment of losses from nonpassive pass-through business activities closer in line with the tax treatment of losses from corporations and passive pass-through business activities.
Implications: By constraining individuals' abilities to offset income sources such as wages with nonpassive pass-through business losses, IRC Section 461(l) creates a more uniform tax regime for business losses across different forms of business organization and types of business activity.
Treating transfers of appreciated property by gift or on death as realization events
Under the proposal, the donor or deceased owner of an appreciated asset would realize a capital gain at the time of the transfer. For a donor, the amount of the gain realized would be the excess of the asset's fair market value on the date of the gift over the donor's basis in the asset. For a decedent, the amount of gain would be the excess of the asset's fair market value on the date of death over the decedent's basis in the asset. That gain would be taxable income to the decedent on the federal gift or estate tax return or on a separate capital gains return (to be determined). Capital losses and carryforwards from transfers at death could offset capital gains income and up to $3,000 of ordinary income on the decedent's final income tax return. The tax imposed on gains deemed realized at death would be deductible on the estate tax return of the decedent's estate (if any).
A trust, partnership or other non-corporate entity that owns property would recognize gains on unrealized appreciation if that property has not been the subject of a recognition event within the prior 90 years, with the testing period beginning on January 1, 1940. According to the Green Book, the first possible recognition event for any taxpayer under this provision would be December 31, 2030.
Payment of tax on the appreciation of certain family-owned-and-operated businesses would not be due until the interest in the business is sold, or the business ceases to be family-owned-and-operated. Further, the proposal would allow a 15-year fixed-rate payment plan for the tax on appreciated nonliquid assets transferred at death, except for businesses for which the deferral election is made. The IRS would be authorized to require security any time there is a reasonable need for security to continue this deferral. That security may be provided from any person, and in any form, deemed acceptable by the IRS.
The proposal would be effective for gains on property transferred by gift, on property owned at death by decedents dying after December 31, 2021, and on certain property owned by trusts, partnerships and other noncorporate entities on January 1, 2022.
Implications: For multijurisdictional families in which US persons will be inheriting from non-US citizens/non-domiciliaries, this deemed sale provision might not apply to the US nondomiciliary decedent, which might allow a US heir to receive a basis step-up. If the assets are US situs, however, this deemed sale provision might still apply. Either way, the proposal underscores the need to review the tax implications of cross-border estate and gift planning.
As applied to trusts, partnerships and other non-corporate entities, the proposal aims to ensure taxpayers cannot prevent the deemed-sale rule from ever applying to the assets transferred to these entities. While relatively easy to apply to transfers in trust, this aspect of the proposal would be very complicated to apply to partnerships and noncorporate entities — especially those carrying on a trade or business. Presumably, S corporations, as corporate entities, are not subject to this provision. For trusts, this provision is similar to a Canadian tax provision that subjects a trust's assets to a deemed-sale rule every 21 years.
The deferral of tax on family-owned-and-operated businesses until the sale of the property or until it is no longer family-owned is a carve-out, perhaps intended to counter arguments that the tax would detrimentally affect family businesses (e.g., family farms), similar to the arguments made over the last 20 years in favor of eliminating the gift, estate and generation-skipping tax regimes. The definition of "family-owned-and-operated" will be key in applying this provision. Presumably, this would apply to transfers by gift as well as transfers by bequest. The provision regarding the 15-year payment seems to indicate that the deferral is elective.
PROPOSALS AFFECTING CROSS-BORDER INVESTMENTS AND GLOBAL PRIVATE BUSINESSES
Passive foreign investment companies (PFICs)
US investors who make minority investments in foreign corporations are subject to the passive foreign investment company (PFIC) rules when the foreign company's passive assets or activities meet certain thresholds. The PFIC regime limits the ability of US persons to avoid current US federal income tax on earnings accumulated in foreign corporations and is therefore aimed at discouraging US taxpayers from investing in foreign corporations that primarily earn passive income and hold passive assets.
Although US residents have historically enjoyed preferential long-term capital gains rates on dispositions of stock of a foreign corporation, the PFIC rules alter that outcome in three ways:
To mitigate these consequences, US shareholders can make a qualified electing fund (QEF) election for a PFIC. If a US shareholder makes a QEF election, US tax is no longer deferred on the PFIC's current earnings; instead the PFIC's income is currently included in the US shareholder's taxable income.
One advantage of the QEF election is that the PFIC's income that is passed through to the US shareholder retains its character, allowing lower capital gains tax rates to apply to income that was characterized as capital when earned by the foreign corporation. Despite the pass-through of annual earnings, non-corporate US shareholders cannot claim credit for foreign taxes paid by a QEF.
Implications: The proposed equalization of long-term capital gains rates and ordinary income tax rates would decrease the advantage of the QEF election, as the flow-through of the character of the currently included income would preclude capital gains rates from applying. With no differential between the long-term capital gains rate and the ordinary income tax rate for high net-worth individuals, the primary disadvantage of owning PFIC stock without a QEF election in place would be the statutory interest charge when the PFC distributes a dividend or a liquidity event occurs with respect to the PFIC stock. Investors may be willing to pay the interest charges if they believe the after-tax economic return from investing the deferred tax amount will exceed the statutory interest charged on an eventual distribution or stock disposal with respect to the PFIC.
Controlled foreign corporations
Like the PFIC rules, the rules for subpart F income and global intangible low-taxed income (GILTI) aim to include undistributed foreign corporate income in the current taxable income of US shareholders, specifically shareholders owning at least 10% of a controlled foreign corporation (CFC).
Currently, a domestic corporation's effective US federal income tax rate on GILTI is 10.5%, after applying a 50% deduction. The corporation may claim a foreign tax credit equal to 80% of the foreign taxes imposed on a CFC's GILTI income (subject to limitations on foreign tax credits). Conversely, ordinary income tax rates apply to any subpart F income or GILTI recognized by an individual or US non-grantor trust that is a US shareholder of a CFC. The 50% GILTI deduction or the foreign tax credit will apply to an individual or trust if the individual or trust makes an IRC Section 962 election.
i. Impact of rate changes and GILTI reforms on IRC Section 962 elections
According to the Green Book, the corporate income tax rate would increase to 28%; conversely, the IRC Section 250 deduction would decrease and the allowance for qualified business asset investments (QBAI) in the context of GILTI and the related foreign-derived intangible income (FDII) regime would be eliminated. For IRC Section 962 elections, these changes would increase an individual's potential minimum current effective tax rate on GILTI income from 10.5%, before foreign tax credits, to at least 21%, which is the Administration's targeted rate for GILTI income. Because individuals making IRC Section 962 elections also are subject to tax on a CFC's dividend of previously included amounts, eliminating the preferential rate on qualified dividend income would substantially increase the overall effective rate of a CFC's US tax on distributed earnings.
Implications: If the proposed changes to GILTI and the previously mentioned tax rates are enacted, individuals and trusts may want to consider whether IRC Section 962 elections will continue to be an effective strategy for mitigating the current US tax impact of subpart F and GILTI. Individuals who have historically made IRC Section 962 elections should recompute the benefit of doing so under the proposed changes and consider their current tax mitigation and cash repatriation strategies.
ii. Repeal of CFC high-taxed exceptions
Currently, taxpayers may elect to exclude high-taxed subpart F and GILTI income when the effective rate of foreign corporate income tax exceeds 90% of the US corporate income tax rate. As the current US corporate income tax rate is 21%, an 18.9% rate of non-US corporate income tax on CFC earnings is sufficient to exclude the CFC's subpart F or GILTI income from current inclusion by its US shareholders. According to the Green Book, both the subpart F and GILTI high-taxed exceptions would be repealed.
Implications: Today, the high-taxed exclusion elections effectively mitigate the US tax costs of operating businesses in foreign jurisdictions. Historically, the US has permitted deferral when local operations are subject to a relatively high rate of tax. This is particularly true for CFC income.
Country-by-country foreign tax credits
Under current law, US taxpayers may claim credit for foreign taxes paid, or that they are deemed to pay, on foreign-source income. The foreign tax credit is the primary US mechanism for alleviating the double taxation that can arise from US taxation of residents' worldwide income. US taxpayers can only claim credit for foreign tax to the extent of the US tax imposed on foreign-source income. To claim a foreign tax credit, the taxpayer segregates foreign-source income into the following categories: 1) GILTI; 2) passive income; 3) general category income; 4) foreign branch income; and 5) income resourced by treaty. After segregating their income, taxpayers allocate foreign tax paid to the appropriate basket and are limited to claiming a credit based on the amount of US tax imposed on the income in each basket.
In addition to the current limitation based on the character of a taxpayer's foreign-source income, a "per country" limitation would apply to a taxpayer's ability to claim foreign tax credits in the GILTI basket and the foreign branch basket. Within these baskets, the proposal would eliminate a taxpayer's ability to "cross-credit" or reduce its US tax burden on income earned through low-taxed jurisdictions by claiming credit for taxes paid to a high-tax jurisdiction.
Implications: These proposals would dramatically increase the cost of complying with US information reporting rules, as well as the complexity of the foreign tax credit rules. They would also increase the effective tax rate on many taxpayer's multinational business investments. By imposing a per-country limitation on the foreign tax credit, the Green Book proposals would eliminate a taxpayer's ability to blend credits for taxes paid in high and low tax rate jurisdictions, whether income is earned directly or through CFCs.
The proposals have varying effective dates; some would be retroactively effective, while others would be effective upon enactment or beginning 1 January 2022. Some of the more complex proposals will require significantly more time for guidance and implementation.
Although the tax proposals are still expected to change through the legislative process, their consistent appearance in prior proposals and the Administration's budget/Green Book suggests that they are not going to disappear entirely. Rather than waiting for their enactment, taxpayers may want to consider: