United States: The Largest Tax Reform In 30 Years

master limited partnerships or REITs. For example, dividends from a REIT with no W-2 wages will still be eligible for the Pass-through deduction regardless of the income of the taxpayer. One can expect that this treatment may create an additional incentive to organize investments in the form of a REIT or a publicly traded partnership.

Withholding Tax on Dispositions by Foreign Partners

The Tax Reform Act effectively codifies the holding of the controversial Revenue Ruling 91-32. In that ruling the IRS stated that a foreign partner's gain from the sale or disposition of an interest in a partnership is treated as effectively connected income (usually subject to U.S. taxation) to the extent that the gain is attributable to partnership assets that would have generated effectively connected income if sold by the partnership. The Tax Reform Act adds a new provision in Section 864(c)(8) which effectively restates and codifies the position of the Revenue Ruling 91-32.

The U.S. tax on the foreign partner's disposition of partnership interest is enforced by a new withholding requirement imposed by the new Section 1446(f). The transferee of a partnership interest is now required to withhold 10% of the amount realized on the disposition if the gain on such disposition would be treated as effectively connected under the new Section 864(c). Moreover, if the transferee fails to withhold, the partnership itself is required to withhold the required withholding amount (plus applicable interest) from distributions to the transferee partner.

As a result of these provisions, transferees of partnership interests should request an affidavit of non-foreign status from the transferor. The partnership agreements should include provisions to protect the partnership and the other partners from the risk that some partners may inadvertently fail to comply with their new withholding responsibility.

Partnership Technical Termination

The Tax Reform Act repeals the "technical termination" rule which previously treated partnerships as terminating if within a 12-month period there is a sale or exchange of 50% or more of the total interest in the partnership's capital and profits.

Treatment of Carried Interests

The Tax Reform Act does not change the general treatment of carried interests under current law, but imposes a longer three-year holding period for capital gain treatment. This provision is expected to have a lesser impact on real estate and private equity funds, than on hedge or short-term hold funds. A separate Stroock bulletin will discuss certain issues relating to carried interests after the Tax Reform Act.

Excess Business Losses

Under the Tax Reform Act, for taxable years starting after December 31, 2017 and before January 1, 2026, excess business losses (i.e., the excess of (i) aggregate deductions, over (ii) gross income and gain from trades or businesses of a taxpayer plus $250,000 for single taxpayers or $500,000 for married taxpayers who file jointly) are not deductible or available to offset non-business income, including passive activity income. Excess business losses may instead be carried forward as an NOL.

Corporate Taxation – 21% in 2018

The Tax Reform Act reduces the top marginal corporate rate from 35% to 21% for tax years beginning after December 31, 2017. The corporate AMT is repealed and the AMT credit will offset regular tax liability for any tax year. For taxable years beginning after 2017 but before 2022, the AMT credit is refundable in an amount equal to 50% of the excess of the minimum tax credit for the taxable year over the amount of credit allowed for the year against regular tax liability. In the case of a taxable year beginning in 2021 the AMT credit is refundable in an amount equal to 100%.

International Taxation

Participation Exemption and Repatriation Tax for Existing E&P

The Tax Reform Act shifts the U.S. corporate tax system closer to a territorial system by providing a participation exemption for foreign-sourced dividends paid by a foreign shareholder to a 10% U.S. shareholder which held the foreign corporation's stock for at least 365 days. This exemption, however, is unavailable for hybrid dividends (dividends that are deductible in the country of the paying company) and requires a stock holding period of at least 365 days during the 731-day period beginning on the date that is 365 days before the date on which the share becomes ex-dividend with respect to the dividend.

In order to transition to the "participation exemption" system of taxation, the Tax Reform Act provides for a one-time tax on all unrepatriated and previously untaxed earnings and profits of specified foreign corporations at the rate of approximately 15.5% for cash and other liquid assets and approximately 8% for reinvested earnings. For this purpose, the term "specified foreign corporation" includes (i) any controlled foreign corporation ("CFC") that is not also a passive foreign investment company ("PFIC") and (ii) any foreign corporation with respect to which one or more domestic corporations owns, directly, indirectly, or by certain attribution rules, at least 10% of the vote. The tax on unrepatriated income may be paid in installments of 8% of the amount of tax for the first 5 years, 15% in the sixth year, 20% in the seventh year, and the remaining 25% in the eighth year.

Foreign Tax Credits

The Tax Reform Act repeals the indirect foreign tax credit for dividends received from a foreign corporation, retains the indirect foreign tax credit for Subpart F inclusions, and sources income from the sale of inventory based on where production of the inventory occurs.

Modifications of CFC and Subpart F Provisions

Notwithstanding the general territoriality rule, the Tax Reform Act will tax a U.S. shareholder's share of a CFC's "global intangible low-taxed income," or "GILTI," at a 10.5% rate. GILTI is active income in excess of an implied return of 10% of the CFC's adjusted basis in tangible depreciable property used to generate the active income. In addition, a special deduction applies to the intangible income of a U.S. corporation derived in connection with foreign sales or foreign use (effectively a "patent box"), which reduces the effective U.S. federal corporate income tax rate on such income to approximately 13.125%. The Act also exempts a CFC from recognizing gain on the distribution of intangible property to a U.S. shareholder that is a corporation if made by the CFC before the last day of the third tax year of the CFC beginning after December 31, 2017.

The Tax Reform Act also makes a very slight, but very important change to the definition of "U.S. Shareholder" for purposes of the application of Subpart F provisions. Under the new definition, "U.S. Shareholder" is a person who owns at least 10% of the vote or value of the foreign corporation, as opposed to the previous rule that required at least 10% of the vote. Another significant change is that certain stock owned by foreign persons may now be attributed to a U.S. person for purposes of making the U.S. person a "U.S. Shareholder" for CFC purposes. Many existing corporate structures will have to be reexamined and modified in light of these changes.

Base Erosion

A new Base Erosion and Anti-Abuse Tax ("BEAT") tax imposes a "base erosion minimum tax." For purposes of this minimum tax, taxpayers are required to (i) calculate 10% (5% for tax years starting in 2018, and 12.5% for tax years starting after 2025) of their taxable income after adding back deductions for deductible payments to foreign affiliates and a portion of any net operating loss carryforwards and (ii) calculate the taxpayer's tax liability reduced by any tax credits claimed by the taxpayer (other than the R&D credit and certain provisions of the business tax credit, including 80% of the investment tax credit and production tax credit for renewable energy). If (i) is greater than (ii), the taxpayer must pay the difference as a tax. The base erosion minimum tax applies to domestic corporations that have annual gross receipts in excess of $500 million (for the three prior tax years) and that have a "base erosion percentage" of at least 3% or higher (2% for financial group member) for the taxable year.

Insurance Provisions

The Act has special rules relating to the computation of life insurance reserves for tax purposes, the apportionment of the dividends received deduction ("DRD") between life insurance companies and their policyholders, and the amortization of specified policy acquisition expenses (the so-called DAC tax). It generally follows the Senate version of the bill, with very slight numerical adjustments. Under the Act, the life reserves generally would be 92.81% of the statutory reserves (with a special rule for the interest rate used to discount them) and the difference for old contracts between the new reserve and the old reserve would be taken into income (or deducted) ratably over 8 years; the portion of the DRD allocated to life companies would be 70% of the total; and the DAC tax would be increased by lengthening the amortization period from 10 to 15 years and by increasing the amount subject to amortization from 1.75% of annuity premiums to 2.09% and from 7.7% to 9.2% in the case of life contracts (with a different rate for group life contracts). The BEAT provisions also affect reinsurance with foreign affiliates, though a Senate colloquy indicates that at least with "modco" and "funds withheld" arrangements, the minimum tax addback is computed on a net basis.

Taxation of Energy Projects

The Act does not directly change any tax credits or other incentives for the energy industry. However, it makes subtle changes that will indirectly and significantly affect the energy industry. The "base erosion minimum tax" described above may adversely affect the renewable energy industry. For taxpayers such as large multi-national banks, which historically have claimed a significant amount of the renewable energy tax credits, the inability to use tax credits to fully offset the tax liability under the base erosion minimum tax will make the tax credits significantly less valuable for such taxpayers. In effect, this could operate as a partial clawback of the tax savings associated with the investment and production tax credits, including for tax credits for already completed projects. Moreover, the ability to use these tax credits to offset tax liability under the BEAT tax sunsets after 2025.

Under the Tax Reform Act, owners of master limited partnerships ("MLPs") that are publicly traded partnerships (not treated as corporations) will benefit from reduced tax rates with respect to their share of the MLP's income because of the Pass-through deduction described above. The final version of the Act allows this deduction without regard to the W-2 wages limitation, ensuring that the passive investors in MLPs gain the full benefit of the reduced Pass-through deduction.

Tax Exempt Organizations

The final version of The Tax Reform Act does not include the previous proposals to subject state and local entities (including state pensions plans) to the rules governing Unrelated Business Taxable Income ("UBTI"), which would have subjected such entities to a tax on income derived from a trade or business that is not substantially related to such entity's tax exempt purpose.

Previously, private universities were not subject to the tax that private foundations paid on their investment income. The Tax Reform Act imposes a 1.4% excise tax on the "net investment income" of a private institution of higher education if the institution has at least 500 students more than 50% of which are located in the United States and  the aggregate fair market value of the institution's assets (other than assets used directly in carrying out its educational purpose) is at least $500,000 per student.

Previously, tax-exempt organizations could net their losses from one UBTI generating trade or business against gains from another unrelated trade or business and pay tax only on the net gains. The Tax Reform Act requires a tax-exempt organization to calculate UBTI separately for each trade or business in which it has an interest and does not allow such netting. However, losses generated before January 1, 2018 will be grandfathered and may reduce gains in subsequent years.

Other Significant Business Taxation Changes

• The deduction for net business interest expense is limited to 30% of the taxable income (subject to certain adjustments).
• Corporate net operating losses carryforwards incurred after 2017 cannot be used to offset more than 80% of the taxable income for the year.
• There are new accelerated depreciation rules for businesses.
• The timing of tax income recognition for certain accrual method taxpayers is accelerated.

Conclusion

Stroock tax attorneys have been closely monitoring the development of the Tax Reform Act, which is the single most significant change to the federal tax laws since 1986. Most individuals, pass-through businesses, and corporations will need to take these changes into account, but the Tax Reform Act creates many unresolved issues that will need to be addressed by subsequent legislation or by administrative regulations. We are available to discuss any questions you may have regarding this Tax Reform Act and its effect on your tax planning.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.