US Tax Reform: The Fight Begins
On November 2, 2017, the House Ways and Means Committee released the Tax Cuts and Jobs Act (TCJA), which provides details on how the House Republicans have interpreted the Big Six’s Tax Framework that we discussed last month. For how the proposed new US tax reform bill might impact US expats abroad or foreign investors, please see the commentary at the end.
“Highlights” from the Act include the following:
Individual Income Taxes
- TCJA consolidates the current seven tax brackets into four, with a bottom rate of 12 percent and a top rate of 39.6 percent (which is the top rate currently). On the plus side, the lower rate of 12 percent extends into the current 25 percent bracket, providing some tax relief to the middle class. However, those currently in the 33 percent bracket could see some of their taxable income being taxed in the higher 35 percent bracket, thereby raising some taxes on the middle class. Although the act retains the top marginal rate of 39.6 percent, it would apply to taxpayers with over $1 million in income.
- The standard deduction will be raised to $12,000 for single filers (up from $6,350), $18,000 for heads of household (up from $9,350), and $24,000 for married filing joint filers (up from $12,700). The additional standard deduction currently available to taxpayers aged 65 or older is eliminated.
- The Act eliminates all personal exemptions. So taxpayers with large families could potentially see their taxes increase.
- To help make up for this loss of personal exemptions, the Act increases the current child tax credit from $1,000 to $1,600 and increases the threshold at which this phases out (up from the current $110,000 to $230,000 for married couples). The first $1,000 would be refundable and there will be a new $300 non-refundable credit for parents and non-child dependents in the home (although this new credit will expire after five years).
- The Act retains the home mortgage interest and charitable deductions as well as the property tax deduction (which will be capped at $10,000). However, the Act would further limit the deduction of home mortgage interest. For mortgage debt incurred after November 2, 2017, the current loan limit of $1 million for deductible interest is reduced to $500,000. The Act would eliminate the deduction for interest on home equity loans incurred after November 2, 2017. The Act would also only allow interest to be deductible on a mortgage of a principal residence, rather than a principal residence and one other residence as permitted under existing law.
- The Act generally eliminates the deduction for state and local taxes, except for a limited deduction for property taxes of $10,000. The less significant medical expense and casualty loss deductions would be eliminated as well
- The Act retains retirement incentives such as the 401(k) and IRA provisions as well as the tax exclusion for employer-provided health care.
- Finally, the Act eliminates the individual Alternative Minimum Tax (AMT).
- The Act makes good on the promise to lower the US corporate tax rate from the current rate of 35% to 20%.
- In addition, US corporate taxation will move away from a system of worldwide taxation to a more “territorial system”, whereby foreign-source dividends and profits of US companies are not subject to US tax upon repatriation. That said, 50 percent of excess returns (those greater than a routine return, defined as AFR plus 7 percent) earned by controlled foreign corporations (CFC) are included in the US shareholder’s gross income.
- Further, payments made from a US corporation to a related foreign corporation will be subject to a 20 percent excise tax unless the foreign corporation elects to treat the payments as effectively connected income (ECI).
- With respect to cash that is currently held offshore by a US multinational corporation, there will be a deemed repatriation of currently deferred foreign profits at a rate of 12 percent for cash (and cash-equivalent profits) and 5 percent for reinvested foreign earnings.
- Under the Act, corporations will be allowed to immediately expense all investments rather than having to depreciate them over time, although it should be noted that this benefit expires after 5 years.
- The Act limits the deductibility of net interest expense on future loans to 30 percent of earnings before interest, taxes, depreciation and amortization (EBITDA), which is a significant change for highly-leveraged companies. However, real estate firms would be exempt from this limitation. The Act also has an overall limitation on interest deductions for an “International Reporting Group”.
- A corporation would be allowed to carry forward indefinitely its Net Operating Losses (NOLs) but such NOLs would be restricted to a 90 percent limitation on current year taxable income. NOL carry backs, except for one-year carry backs for certain disaster losses, would be eliminated.
- The Research and Development (R&D) tax credit and the low-income housing credit will be retained but the deduction for domestic manufacturing will be eliminated.
- Finally, the Act eliminates the corporate Alternative Minimum Tax (AMT).
Other Provisions on US tax reform
- With respect to pass-through entities such as LLCs, partnerships and S corporations, taxes on pass-through income would be capped at the 25 percent bracket rather than the top individual rate. Pass-through companies would still be able to deduct interest on loans in full, unlike US corporations (see above).
- To counter the perception that this might create a “loophole” for wealthy individuals to lower their income taxes by using a pass-through entity, the Act assumes that 100 percent of earnings from personal services firms (such as law firms and accounting firms) is wages and not pass-through income. Furthermore, for other business, there is a rebuttable presumption that 70 percent of income derived from a pass-through is compensation subject to ordinary rates and the remaining 30 percent is business income subject to the 25 percent rate. Businesses can rebut the 70/30 presumption by demonstrating a return on business capital at the short-term applicable federal rate (AFR) plus 7 percent.
- The Act increases the estate tax exemption to $10 million (which will be adjusted for inflation), but it only allows for full repeal of the estate tax after six years.
Obviously, this is a first draft and there will likely be several changes before the Act becomes law. Some industries, such as realtors, mortgage lenders and home builders will lobby hard against the various limitations and, it is expected that “Blue-State” Republicans from high income tax jurisdictions will fight to keep the state and local tax deduction. The bill will also have to fight any perceptions that it is a tax giveaway for wealthy individuals
The next step in the process is for the House to pass TCJA and the Act is expected to be debated on the House Floor during the week of November 6th. If it passes the House, the Act will go over to the Senate side and it is possible that the Senate will have changes. As Congress wants to have the bill finalized by Thanksgiving (November 23th), we can expect updates and changes to come fast and furious.
- Many of the individual tax changes may not actually benefit those taxpayers living overseas in jurisdictions such as the UK, where the local tax rates are higher than the current or proposed tax rate.
- The same can be said of the corporate and flow-through rates for those clients running their business outside of the US, where local tax rates will still apply.
- The elimination of the individual and corporate Alternative Minimum Tax should be welcome by all.
- Because of a combination of the “gives” and “takes” in the proposal, the impact on any one individual or entity will be hard to judge until the actual adjustments are put into place.
- The elimination of the Estate Tax after 2023 will obviously be welcome by those taxpayers in with substantial wealth, but planning for what “may” happen will still involve looking into the crystal ball of the future. Having said that, the increase in the lifetime exemption amount to $10 million should have an immediate impact, and with a combined exemption amount for US families of $20 million should all be eliminate the issue for almost all US taxpayers. The proposal also left in place the carry over basis rules for inherited property.
- What the US tax reform proposal did not do is:
- Alter the “global tax” treatment applicable to US individuals
- Eliminate the Net Investment Tax
- Eliminate any provision of FATCA