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Congress on December 20 gave final approval to the House and Senate conference committee agreement on tax reform legislation (HR 1 or the Act). The Act will affect mergers, acquisitions and other deals and includes several areas of interest to businesses (click the link to go directly to the topic):
Here’s a look at each of the areas under the Act and what dealmakers need to do to prepare for the upcoming change in law.
The reduction of the top corporate tax rate to 21%, effective for tax years beginning after 2017, could significantly impact valuation and purchase price adjustments for deals now in the pipeline. While slightly higher than the 20% rate that was initially proposed, this is a significant reduction for corporate taxpayers that brings the US corporate tax rate more in line with the rest of the industrialized world. Unlike the Senate bill that would have delayed implementation until tax years beginning after 2018, the rate reduction would take effect starting next year. The proposed repeal of certain special tax credits and deductions could partially offset the rate reduction, with some companies being affected more than others.
To avoid benefiting corporate taxpayers disproportionately, a new 20% deduction would apply to certain “pass-through” business income of US individuals from businesses operated as sole proprietorships, partnerships, LLCs and S corporations. Coupled with the reduction of the top individual tax rate to 37%, this deduction would effectively yield a top 29.6% rate.
The availability of this deduction is limited for certain service businesses, although this exclusion would not apply to taxpayers with taxable income below $157,500 (or $315,000 in the case of a joint return), with the benefit phasing out above these threshold amounts. Also, this new deduction generally cannot exceed the greater of the pass-through owner’s share of (1) 50% of W-2 wages paid with respect to the pass-through business or (2) the sum of 25% of such W-2 wages plus 2.5% of the original tax basis of the business’s tangible depreciable assets. This cap also does not apply for taxpayers whose taxable income is below the threshold amounts discussed above.
Overall, given the new 21% corporate tax rate, the “double tax” disadvantage of operating a US business as a corporation and paying out dividends will shrink compared to the current spread, especially for business income ineligible for the pass-through deduction.
The Act generally caps net business interest expense deductions at 30% of adjusted taxable income (ATI). (ATI is roughly equivalent to tax basis EBITDA, but decreases to EBIT for tax years beginning after Dec. 31, 2021, which will make this limitation more severe.) The cap doesn’t apply to businesses with average gross receipts of $25 million or less, certain regulated public utilities and real property businesses.
Businesses would be able to immediately deduct the cost of certain property, other than structures, that is acquired and used between Sept. 27, 2017, and Jan. 1, 2023. (Jan. 1, 2024, for longer production period property and aircraft.) For property placed in service between Dec. 31, 2022, and Jan. 1, 2027, the percentage that can be immediately deducted is phased down by 20% per year. (Again, this is extended one year for longer production period property and aircraft.)
This is a timing benefit of accelerated deductions that wouldn’t help all companies; those with significant tax attributes likely would see little benefit. But PE buyers focused on after-tax cash flows in the early years may find it valuable. The provision also may increase demand for equipment and boost valuations of manufacturing companies.
Net operating loss (NOL) deductions arising in tax years beginning after 2017 would be limited to 80% of taxable income. This limitation is more punitive than the original House bill, which had proposed a 90% limitation.
Most NOL carrybacks would be repealed, which could reduce the tax value of transaction expenses, such as investment banker fees, compensatory payments and debt payoff costs. This is because they wouldn’t be recovered until there’s sufficient post-closing taxable income to monetize the taxable income benefit. NOLs generated in tax years beginning after 2017 would be carried forward indefinitely.
The 80% limit would slow the ability to use the NOL carryforward in post-closing years. This limit, along with the interest limitation noted above, also may lead highly leveraged companies that generate significant interest expense to become taxpayers more quickly after debt is paid off or revenues increase.
Starting next year, a 100% tax exemption for certain dividends received by US corporations from foreign subsidiaries would convert our worldwide tax system into a territorial system. There would be a one-time “deemed repatriation” tax on previously untaxed post-1986 earnings and profits (E&P) of foreign subsidiaries of US corporations. E&P held in cash and cash equivalents would be taxed at 15.5%, and any remaining E&P at 8%. This tax essentially is a debt-like item that could be paid in installments over eight years. Installment payments are back-loaded: payments for each of the first 5 years equal 8% of the tax liability, the sixth installment equals 15% of the liability, increasing to 20% for the seventh installment and the remaining balance of 25% in the eighth year.
Having incurred this one-time tax, US multinationals would have no further incentive to keep their historical E&P offshore. However, the timing of cash repatriation should be considered carefully, since it is not currently clear if the basis increase associated with the income inclusion would happen immediately or at year-end. This may be important, since an actual distribution of cash in excess of basis could trigger US taxable gain.
To discourage shifting future profits offshore, the Act requires current-year inclusion of certain “global intangible low-taxed income” (GILTI) of US companies’ foreign subsidiaries. This effectively subjects US multinationals to tax at a reduced rate on their foreign subsidiaries’ income that exceeds a routine annual return (10%) on their tangible depreciable assets. An 80% foreign tax credit would be permitted. This income would be taxed at an effective rate of 10.5% (rising to 13.125% for taxable years beginning after Dec. 31, 2025), before reduction for the 80% foreign tax credit, as applicable.
Further, US taxpayers would be entitled to a 37.5% deduction (reduced to 21.875% for taxable years beginning after Dec. 31, 2025) applied to their “foreign derived intangible income” (FDII), which in general terms, is certain income of the US taxpayer attributable to the sale of goods and services to foreign persons. After the deduction, the US taxpayer would be taxed on FDII at an effective rate of 13.125% (rising to 16.406% after 2025).
Together, the GILTI and FDII regimes would significantly decrease the advantage of holding intellectual property offshore. However, the GILTI regime would also tax successful offshore operations that generate high returns from tangible assets.
Finally, certain payments for goods and services from US companies or US branches of foreign companies to related foreign persons would generally trigger a 5% base erosion minimum tax (rising to 10% in taxable years beginning after Dec. 31, 2018, and 12.5% for taxable years beginning after Dec. 31, 2025), imposed on “modified taxable income” computed without deductions for such related party payments. This tax essentially prevents US taxpayers from zeroing out their taxable income with deductible payments to foreign affiliates. The final provision mirrors the Senate bill and is less onerous than the 20% excise tax that was proposed in the House bill. However, it does not include an option to avoid the regime by having the foreign recipient of the payment elect to pay US taxes, which was included in the House bill and may have been advantageous in many cases.
While some investors may see tax benefits, multiple provisions could challenge real estate businesses. The Act limits the interest deduction for new home mortgages to mortgage amounts of $750,000, down from $1 million, and it caps the individual property tax deductions (together with other deductions for state and local taxes) at $10,000. Insurance companies would be adversely affected by several provisions. Dealmakers looking at targets in the insurance and real estate businesses need to review their valuation models.
The Act would expand restrictions on certain public companies’ ability to deduct compensation above $1 million paid to the principal executive or financial officer and three other top executives, adding stock options and other performance-based compensation. The restrictions also would cover more corporations and include issuers of public debt, even if company stock is privately held. Dealmakers need to review projected tax modeling for their incentives for management and consider the use of partnership profits interests instead of stock options, where possible.