07 December 2018 - Article
2017 has seen a veritable geyser full of hot air emanating from the White House, the Senate and the House advocating the benefits of comprehensive tax reform but only describing it in the briefest way possible. Then last week the House released a draft bill with quite extensive reform proposals. This is just the beginning of a process and this article will be out of date by the time that you read it. Look on our website for our focus area on this issue.
Below we discuss some of the proposals. However, before readers think that this provides anything like an accurate guide to what might emerge at the end of the legislative sausage machine please bear in mind that some of these proposals have been passed by the House before only to go nowhere.
Senate and House Bills: and the winner will be?
Later this week Kevin Brady plans to release the Chairman's mark, which will reflect comments from members. At the end of this week the Senate expects to release its draft tax legislation and that will be different. For example, it seems clear that there is no majority in the Senate for estate tax abolition, which is contained in the House bill. Most importantly, the House bill has not been costed or scored, and until that happens it is not possible to gauge whether it will even meet the conditions of the reconciliation process.
It is clear that the House and the Senate will use the budget reconciliation process (passed by both sides) to enact tax legislation. While the reconciliation procedure should make the legislative proposals filibuster-proof and only require a 51 vote majority in the Senate, at the same time it requires fiscal neutrality over a 10 year window under the Byrd amendment so it forecloses permanent tax cuts without revenue raisers. This was the procedure used to pass the 2001 tax legislation which essentially adjusted tax rates but many of the provisions then expired. Readers may recall the one year abolition of estate tax in 2010 which was the result of using this parliamentary procedure. Given that the final legislation needs to be introduced in November to meet the budget timetable it is beginning to look more likely that a temporary rate adjustment will be passed rather than permanent tax reform.
Nevertheless the House has released a very detailed set of proposals and there is every likelihood that some of these will make it through the reconciliation process. So, with a somewhat sceptical eye there follows a summary of the proposals and how they may affect our readers, but with no predictions as to the likelihood of enactment.
The House budget reconciliation bill: HR1
Kevin Brady, as chairman of the House Ways and Means Committee published HR1, a budget reconciliation bill, with no catchy title on 2nd November. This differs somewhat from the “United Framework For Fixing Our Broken Tax Code” (no acronym seems possible with this title) which was released on 27th September by the “Big Six”, namely, Chief Economic Adviser Gary Cohn, Treasury Secretary Steven Mnuchin, House Speaker Paul Ryan, Senate Majority Leader Mitch McConnell, House Ways and Means Committee chair Kevin Brady and Senate Finance Committee chair Orrin Hatch.
Stephen Nerland highlights the proposed individual changes for house owners in the newsletter, and there could be significant changes in a range of areas if this bill is enacted. Other key proposals are:
Individual Income Tax Changes:
- Both HR1 and the Administration would reduce income tax rates to three with a top rate of 35% (though the Ways and Means Committee previously said it would add a further higher rate).
- HR1 would exempt the first $24,000 of household income. The Administration would increase the standard deduction to $12,000 for single filers and $24,000 for married couples filing jointly.
- HR1 would limit the deduction for state and local tax to $10,000. The Administration would eliminate itemised deductions except for home mortgage interest and charitable contributions (so the state and local tax deduction is limited or goes, but that typically does not much affect non US resident taxpayers).
Individual Transfer Tax Changes:
- HR1 would phase out estate tax over six years. The Administration eliminates estate tax and generation skipping transfer tax. Neither proposal mentions gift tax so that remains in force to protect the income tax base (otherwise high rate taxpayers would transfer income to lower rate family members). In 2010 the estate tax was replaced with a capital gains tax at death but the tax free basis step up at death continues under both proposals.
Business Income Tax Changes:
- Under both proposals the corporate income tax rate is reduced from 35% to 20% and the alternative minimum tax is abolished.
- Under both proposals a new low 25% tax is introduced on income from “pass through” business entities such as partnerships, LLCs, and LLPs. However, this will not be permitted to be used for compensation income which prevents unpopular rate cuts for lawyers and accountants, but should be available for those using capital assets such as real estate developers.
- Under both proposals an immediate write off is offered for equipment and technology investment for a five year window.
- Under both proposals the interest expense for corporations and businesses will be restricted but under HR1 small businesses can still deduct interest expenses.
- Both proposals would retain the research and experimentation credit and the low income housing credit but others may be eliminated.
International Business Income Tax Changes:
- HR1 would essentially contain a territorial system for corporates, but not individuals. The Administration proposed to eliminate the controlled foreign corporation so that foreign source business income will not be taxed under either proposal.
- The Administration would tax income when repatriated or deemed and presumably under either proposal there will be fewer barriers to the use of foreign corporations to shelter non business income.
- A new minimum tax on foreign earnings to stop profit shifting and tax base erosion in some fashion to be determined.
- The deficit – both proposals are expected to increase the deficit (the Administration's by $2.2 trillion over 10 years), so we expect even with the most dynamic scoring that items will be dropped.
- Carried interests seem to be safe for the present as they are not mentioned in either proposal but could be a potential revenue raiser – indeed we are hearing that the House may change this.
- The 3.8% net investment income tax remains as that was part of the healthcare legislation.
- It seems unlikely that the framework could be enacted without significant changes because the deficit hawks in the Republican majority are likely to insist on fewer cuts or more revenue raisers.
Winners and losers
Lots of Americans will benefit from this proposal, particularly elderly billionaire real estate investors, but it is quite a rate cut for all investors both in the US and internationally. The cut in the corporate tax rate should boost dividends or otherwise increase the value of corporate investments, particularly coupled with the retention of the qualified dividend and long term capital gain maximum tax rate of 23.8%. Potentially the cut in the rate for pass through entities could lead to the lowest combined rate on business income in living memory. If it applies to real estate and investment funds it seems to be a real boon for investors.
Foreign investors will benefit from a combination of the lower corporate tax rates and the elimination of transfer taxes. That means that the need to balance higher income tax rates against the potential for estate tax is also eliminated. Foreign investors can invest in US corporates and pass throughs without the need for any offshore corporate or trust structure designed to avoid estate tax. The focus will be on qualifying for income tax treaty benefits to reduce the potential for a 30% dividend withholding tax, which seems disproportionately high in light of the other rate cuts. Tax cuts for foreign investors can signify a need to finance a ballooning deficit so maybe that is the key to the unfunded tax cuts.
Americans resident in high tax European countries will not benefit from the rate cuts directly if their income is otherwise subject to, for example, 45% UK income tax. For those who can claim UK foreign domicile status, however, it increases the benefit for those with foreign source income. Interestingly it is going to incentivise the use of both US and foreign corporations to shelter income at 20% rates rather than 35% personal income tax rates. If there is a dividends received deduction then the American corporate income tax is going to start to look more like the UK corporation tax. Indeed it may be time to dust off those little used parts of the Code that penalise the use of corporations to shelter income such as the accumulated earnings tax (Code section 531).
Action before the end of the year?
As the turkeys get fatter and the year-end nears taxpayers wonder what steps they should take in light of the confusing tax position. It seems clear that even if only some rate adjustment is achieved it is likely that income tax rates may be lower in 2018 and deductions may be more limited. So that suggests that taxpayers should accelerate deductible expenditure such as charitable contributions into 2017, and postpone income until 2018 where possible. For non-domiciled UK residents a charitable lead or remainder trust might be useful for enhancing a charitable deduction. Any losses should be used to the greatest extent possible in 2017.