HOW WILL IT IMPACT YOUR ORGANIZATION?
On November 2, 2017 the House Ways and Means Committee Chairman introduced bill HR 1, the Tax Cuts and Jobs Act (“TCJA”), which proposes to make significant changes to how corporations and individuals are taxed. The proposed legislation largely follows the objectives and framework issued by the “Big Six” team of congressional Republicans in late September. The legislation, if passed, will generally be effective for tax years beginning after 2017; however, there are provisions in the legislation that have other effective dates, such as tax years starting after 2016 or after the date of introduction (November 2, 2017). The Committee also issued a section-by-section summary in connection with the bill.
For Corporations that issue US GAAP financial statements, any enacted legislation could have significant impacts on their US tax provision recorded under ASC 740. Companies will be required to recognize the tax effects, both current and deferred, in the period in which the law is enacted. Any changes will be recognized as part of the tax provision for continuing operations (regardless of the source of income). US tax law changes are generally considered enacted after the president signs it into law, or upon successful override of a presidential by both the Senate and House of Representatives.
The following summarizes of some of the key proposed changes for businesses, following the format of the section-by-section summary issued by the Committee, along with a discussion of some of the potential tax accounting implications of the changes.
PROPOSED TAX CHANGES TO BUSINESSES
Statutory Tax Rates
Under current law, a corporation’s regular income tax liability generally is determined by applying the following tax rate schedule to its taxable income:
A corporation with taxable income between $335,000 and $10,000,000 effectively is subject to a flat tax rate of 34 percent. The 34-percent rate is gradually phased out for corporations with taxable income between $15,000,000 and $18,333,333, such that a corporation with taxable income of $18,333,333 or more effectively is subject to a flat rate of 35 percent.
Under the proposed changes, the corporate tax rate would be a flat 20-percent rate beginning in 2018. Personal services corporations would be subject to a flat 25-percent corporate tax rate. The provision would be effective for tax years beginning after 2017.
- Potential ASC 740 Implications:
- Most companies currently value their US federal deferred tax assets (DTAs) and liabilities (DTLs) at 34% or 35%. In the period of enactment, companies will have to revalue their US federal DTAs and DTLs to 20% (or 25%, if applicable). The Federal benefit for state DTAs and DTLs will also have to be updated. All changes will be recorded as part of the continuing operations tax provision.
- If in the final legislation the rate reduction is phased in over a number of years, companies will need to schedule the reversal of existing DTAs/DTLs to determine the impact of the statutory rate changes.
- Companies should consider disclosing the impact separately on their effective tax rate (“ETR”) reconciliation in their tax footnote, depending on materiality of the changes.
- For interim reporting, companies should consider whether the impact should be part of their forecasted ETR or if it should be recorded as a discrete item. Generally, impacts related to current year ordinary income would be factored into the forecasted ETR, while adjustments to the beginning of year deferred balances would be reflected as a discrete item in the period of enactment.
Alternative Minimum Tax
Under current law, taxpayers must compute their income for purposes of both the regular income tax and the alternative minimum tax (AMT), and their tax liability is equal to the greater of their regular income tax liability or AMT liability. Corporations and, in some cases, non-corporate taxpayers receive a credit for AMT paid, which they may carry forward and claim against regular tax liability in future tax years (to the extent such liability exceeds AMT in a particular year), and which never expire.
Under the proposed changes, the AMT would be repealed. If a taxpayer has AMT credit carryforwards, the taxpayer would be able to claim a refund of 50 percent of the remaining credits (to the extent the credits exceed regular tax for the year) in tax years beginning in 2019, 2020, and 2021. Taxpayers would be able to claim a refund of all remaining credits in the tax year beginning in 2022. The provision would generally be effective for tax years beginning after 2017.
- Potential ASC 740 Implications:
- Companies that have DTAs currently recorded for AMT credits will need to reassess their valuation allowance positions for those credits. Any changes will be need to be recorded in the period the tax law is enacted.
Fixed Asset Cost Recovery
Under current law, taxpayers may take additional depreciation in the year in which it places certain “qualified property” in service through 2019 (with an additional year for certain qualified property with a longer production period). The amount of this additional depreciation is 50 percent of the cost of such property placed in service during 2017 and phases down to 40 percent in 2018 and 30 percent in 2019.
Under the proposed changes, taxpayers would be able to fully and immediately expense 100 percent of the cost of qualified property acquired and placed in service after September 27, 2017 and before January 1, 2023 (with an additional year for certain qualified property with a longer production period). The provision would expand the property that is eligible for this immediate expensing by repealing the requirement that the original use of the property begin with the taxpayer. Instead, the property would be eligible for the additional depreciation if it is the taxpayer’s first use. Under the provision, qualified property would not include any property used by a regulated public utility company or any property used in a real property trade or business. Under the provision, the taxpayer’s election to use AMT in lieu of the additional depreciation would be repealed.
The repeal of this election would be effective for tax years beginning after 2017.
- Potential ASC 740 Implications:
- This would be a timing item for purposes of ASC 740, and would be an annual election for a taxpayer to make, with the effect of increasing a Company’s DTL (or decreasing a DTA) if they elect to expense 100% of the costs of fixed assets placed in service during the applicable years. Companies with an increasing DTL should be aware of potential changes to valuation allowances, if applicable, that may be needed.
Deductibility of Interest Expense
Under current law, business interest generally is allowed as a deduction in the taxable year in which the interest is paid or accrued, subject to a number of limitations. For example, limitations on interest expense exist for certain amounts paid in connection with insurance and annuity contracts, while other disallowances exist with respect to interest payments between related taxpayers. Other limitations on the deductibility of interest expense, in general, exist to disallow certain amounts of interest paid in connection with tax-exempt interest, passive interest, investment interest, and qualified residence interest.
Under current law, Code section 163(j) may also limit the ability of a corporation to deduct disqualified interest (generally, interest paid or accrued to a related party when no Federal income tax is imposed with respect to the interest) paid or accrued in a taxable year. Interest amounts disallowed under these rules can be carried forward indefinitely. In addition, any excess limitation can be carried forward three years.
Under the proposed changes, every business, regardless of its form, would be subject to a disallowance of a deduction for net interest expense in excess of 30 percent of the business’s adjusted taxable income. The net interest expense disallowance would be determined at the tax filer level—for example, at the partnership level instead of the partner level. Adjusted taxable income is a business’s taxable income computed without regard to business interest expense, business interest income, net operating losses, and depreciation, amortization, and depletion. Any interest amounts disallowed under the provision would be carried forward to the succeeding five taxable years and would be an attribute of the business (as opposed to its owners). Special rules would apply to allow a pass-through entity’s unused interest limitation for the taxable year to be used by the pass-through entity’s owners and to ensure that net income from pass-through entities would not be double counted at the partner level.
The provision, would provide an exemption from these rules for businesses with average gross receipts of $25 million or less. Additionally, the provision would not apply to certain regulated public utilities and real property trades or businesses. In exchange, these businesses would be ineligible for full expensing of fixed assets noted above.
The provision would also repeal current law Code section 163(j). The provision would be effective for tax years beginning after 2017.
- Potential ASC 740 Implications:
- Because of the five-year carryforward of disallowed interest expense, this would be a timing item for purposes of ASC 740 that would create a tax attribute (i.e. creating a DTA). Companies will need to consider whether or not that DTA could be used within the five-year carryforward period. If the Company believes that it is more likely than not that they will not be able to use the DTA, then they will have to consider recording a valuation allowance against the DTA for the portion that will not be able to be used.
Net Operating Losses
Under current law, NOLs may be carried back two years and carried forward 20 years to offset taxable income in such years. The alternative minimum tax (AMT) rules provide that a taxpayer’s NOL deduction may not reduce the taxpayer’s alternative minimum taxable income by more than 90 percent.
Under the proposed changes, taxpayers would be able to deduct an NOL carryover or carryback only to the extent of 90 percent of the taxpayer’s taxable income (determined without regard to the NOL deduction) – conforming to the current-law AMT rule. The provision also would generally repeal all carrybacks but provide a special one-year carryback for small businesses and farms in the case of certain casualty and disaster losses; however, the carryforward period would be indefinite.
The provision generally would be effective for losses arising in tax years beginning after 2017. In the case of any net operating loss, specified liability loss, excess interest loss or eligible loss, carrybacks would be permitted in a taxable year beginning in 2017, as long as the NOL is not attributable to the increased fixed asset expensing noted above. Additionally, the provision would allow NOLs arising in tax years beginning after 2017 and that are carried forward to be increased by an interest factor to preserve its value.
- Potential ASC 740 Implications:
- Considering both the 90% limitation and new indefinite carryforward periods, companies will need to re-assess their valuation allowance positions for the NOL carryforwards. The presence of an unlimited or indefinite carryforward does not negate the requirements needed to meet realization; however, if a Company is able to support future projections of taxable income that are objectively verifiable and absent any sufficient negative evidence, companies should consider recognizing the full DTA even if realization is expected to occur over a long period of time or in the distant future.
- The indexing of NOLs based on an interest factor will be a new concept under US tax law. ASC 740-10-25-20(g) states that when tax basis is indexed for inflation, temporary differences arise as a result of the change in tax basis, which will increase the Company’s DTA. The increase in the DTA will likely impact the Company’s effective tax rate.
Domestic Production Activities Deduction (Sec. 199 Deduction)
Under current law, taxpayers may claim a deduction equal to 9 percent of the lesser of the taxpayer’s qualified production activities income or the taxpayer’s taxable income for the tax year.
Under the proposed changes, the deduction for domestic production activities would be repealed for tax years beginning after 2017.
- Potential ASC 740 Implications
- Companies who previously claimed the deduction under Sec. 199 recorded the impact as permanent book/tax difference, which has the effect of reducing a company’s effective tax rate in the financials. If enacted, companies will no longer have a tax benefit for this in their financials starting in 2018.
Establishment of Participation Exemption System for Taxation of Foreign Income
Under current law, domestic corporations generally are taxed on all income, whether earned in the United States or abroad. Foreign income earned by a foreign subsidiary of a U.S. corporation generally is not subject to U.S. tax until the income is distributed as a dividend to the U.S. corporation. To mitigate the double taxation on earnings of the foreign corporation, the United States allows a credit for foreign income taxes paid. The foreign tax credit generally is available to offset, in whole or in part, the U.S. tax owed on foreign income. A U.S. taxpayer may elect to deduct foreign income taxes paid rather than claim the credit.
Under the proposed changes, the current system of taxing U.S. corporations on the foreign earnings of their foreign subsidiaries when these earnings are distributed would be replaced with a dividend-exemption system. Under the exemption system, 100 percent of the foreign-source portion of dividends paid by a foreign corporation to a U.S. corporate shareholder that owns 10 percent or more of the foreign corporation would be exempt from U.S. taxation. No foreign tax credit or deduction would be allowed for any foreign taxes (including withholding taxes) paid or accrued with respect to any exempt dividend, and no deductions for expenses properly allocable to an exempt dividend (or stock that gives rise to exempt dividends) would be taken into account for purposes of determining the U.S. corporate shareholder’s foreign-source income. The provision would be effective for distributions made after 2017.
As part of the transition to a participation exemption system, U.S. shareholders owning at least 10 percent of a foreign subsidiary, generally, would include in income for the subsidiary’s last tax year beginning before 2018 the shareholder’s pro rata share of the net post-1986 historical earnings and profits (E&P) of the foreign subsidiary to the extent such E&P has not been previously subject to U.S. tax, determined as of November 2, 2017, or December 31, 2017 (whichever is higher). The net E&P would be determined by taking into account the U.S. shareholder’s proportionate share of any E&P deficits of foreign subsidiaries of the U.S. shareholder or members of the U.S. shareholder’s affiliated group.
The E&P would be classified as either E&P that has been retained in the form of cash or cash equivalents, or E&P that has been reinvested in the foreign subsidiary’s business (e.g. property, plant, and equipment). The portion of the E&P comprising cash or cash equivalents would be taxed at a reduced rate of 12 percent, while any remaining E&P would be taxed at a reduced rate of 5 percent. Foreign tax credit carryforwards would be fully available, and foreign tax credits triggered by the deemed repatriation would be partially available, to offset the U.S. tax.
At the election of the U.S. shareholder, the tax liability would be payable over a period of up to 8 years, in equal annual installments of 12.5 percent of the total tax liability due.
- Potential ASC 740 Implications:
- Due to the deemed repatriation that US companies will have to pay tax on as part of the transition rules to a participation exemption system, companies will have to reassess and determine the applicability of any indefinite reinvestment assertions that they currently maintain.
- As part of the transition rules, companies will have to calculate the tax that would be due on the deemed repatriation of historical E&P including impact of foreign tax credits, and either adjust their current DTL recorded or record the entire DTL (or potentially a non-current tax payable) if they previously claimed indefinite reinvestment with their foreign subsidiaries. The tax liability would need to be recorded in the period the tax law is enacted.
- For existing foreign tax credit carryforwards, companies will need to reassess their current valuation allowance position based on whether they will be able to realize the benefit under the new system.
NEXT STEPS
Significant political hurdles still must be overcome before this proposed legislation becomes law. HR 1 was passed, with some modifications to the original proposals, on November 16, 2017.
The Senate’s Finance Committee approved the Senate version of a tax reform bill on November 16, 2017, which differs in certain areas from the version passed by the House. The Senate is expected to consider amendments to their tax reform bill during the week of November 27 after the Thanksgiving holiday break. If a bill passes the Senate, the two chambers must then reconcile differences between the two bills and then each chamber must then vote on a final identical bill before it can be signed into law by the President.