KPMG’s analysis on House tax reform bill (H.R. 1) | KPMG | GLOBAL

KPMG’s analysis on House tax reform bill (H.R. 1)

KPMG’s analysis on House tax reform bill (H.R. 1)

The U.S. House of Representatives today, November 16, passed H.R. 1, the “Tax Cuts and Jobs Act.” The bill was approved by a vote of 227 to 205. [13 Republicans opposed the bill and no Democrats voted for the bill].

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The bill passed is identical to the bill approved by the Ways and Means Committee on November 9.

 

Read KPMG’s report [PDF 1.8 MB] providing observations and analysis on H.R. 1, as approved by the House.

Highlights

Business provisions

Perhaps the centerpiece of the bill is the permanent reduction in the corporate income tax rate from 35% to 20%. The 20% rate would be effective beginning in 2018. But the full list of proposed changes for businesses is extensive, including additional tax benefits and offsetting tax increases.

Notably, the bill would introduce “expensing” on a temporary basis as the principal capital cost recovery regime, allowing most taxpayers to write off the costs of depreciable property acquisitions as made. This rule generally would apply to both new and used property (but not to property used in a real property trade or business, by a regulated public utility company, or in some businesses that have floor plan indebtedness).

The bill would also implement a permanent new tax rate on business income earned by passthrough businesses, such as partnerships, S corporations, and sole proprietorships. The bill proposes several rules that define and limit the income that is eligible for this lower rate, including special rules for owners of certain personal services businesses.  

To offset the costs of these tax benefits, the bill would repeal or modify dozens of existing items in the tax law. For example, the bill generally proposes to:

  • Repeal the section 199 domestic manufacturing deduction
  • Require capitalization of section 174 research and experimentation expenditures
  • Impose a limit on interest deductibility (a limit based on a percentage of an alternate version of taxable income and with an exception for interest incurred with respect to a public utility, a real property trade or business, and certain floor plan indebtedness)
  • Limit the use of, and generally repeal the carryback of, net operating losses
  • Repeal tax credits, including the work opportunity tax credit, new markets tax credit, orphan drug credit, and several others
  • Revise several rules governing the taxation of private activity, refunding, tax credit, and tax-exempt bonds
  • Provide significant revenue-raising changes for taxation of the insurance industry 

The bill also would impose a three-year “holding period” requirement for long-term capital gain treatment in the case of certain partnership interests received in connection with the performance of services (i.e. carried interests).

The bill does not address the pending expiration of the moratorium with respect to the medical device excise tax, and does not modify or repeal any other tax provisions of the Affordable Care Act. 

The bill would retain the research credit and the low income housing tax credit, but would require capitalization and amortization of research or experimentation expenditures. Extensive changes to provisions in the areas of real estate, tax-exempt entities, executive compensation, and excise taxes are also included in the bill as well as the repeal of dozens of special business credits and deductions.

With respect to natural resources, oil and gas would remain subject to the higher of cost or percentage depletion under section 613A while minerals other than oil and gas would remain subject to the rules under section 613(a). 

Multinational entity taxation

The bill proposes significant changes to the taxation of business income earned outside the United States. It would move from the current system, which permits deferral of the U.S. tax on foreign active business earnings until those earnings are repatriated, to a “territorial” system. 

U.S. corporate shareholders that own 10% or more of a foreign corporation would receive a 100% exemption on the foreign-sourced portion of dividends paid by the foreign corporation to the U.S. shareholder.

As a transition to this new system, the bill would deem a repatriation of previously deferred foreign earnings. This repatriation would impose a 14% tax rate on cash and cash equivalents and a 7% rate on illiquid assets. (These rates were modified during the Ways and Means Committee's markup of the bill.) The resulting tax could be paid in installments over eight years.

As expected, the bill would also implement what is effectively a new 10% minimum tax on “high return” foreign earnings of multinational businesses. 

The Chairman’s “mark” (described below) proposed a 20% excise tax on certain payments made by a domestic company to a foreign affiliate. This proposal, which was narrowed by two amendments during the Ways and Means Committee's markup, also would allow, alternatively, an election for the foreign affiliate to be taxed on net profits earned in the United States.The bill also includes a number of other measures, including provisions to avoid erosion of the U.S. tax base through, for example, the excessive placement of debt in the United States relative to worldwide group debt.

Individual provisions

The bill would permanently reduce the seven current tax brackets to four: 12%, 25%, 35%, and 39.6%. The top rate would apply to single filers with income of $500,000 and married joint filers with income of $1 million—a substantial increase from the current income levels to which that rate applies. 

The standard deduction would be increased to $24,400 for joint filers and $12,200 for individual filers, with these deductions indexed annually. At the same time, the deduction for personal exemptions would be repealed, while the child tax credit would be enhanced and a new family tax credit created.

The revenue cost of these changes would be offset by modifying or eliminating a number of tax preferences, many of them significant and long-standing. These include new limits on (and other changes to) deductions for home mortgage interest, state and local taxes, personal casualty losses, and medical expenses. The exclusion of gain from the sale of a principal residence would be phased out for taxpayers with adjusted gross income exceeding $500,000 ($250,000 for single filers) and modified. The “Pease” limitation on itemized deductions would be repealed.

The individual AMT, like the corporate AMT, would be repealed. There would be no changes to the capital gains and dividends tax rate. The bill also does not include repeal of the net investment income tax.

Changes would be made to a large number of other individual tax items including modifications to education savings benefits, the treatment of discharge of student loan debt, and the deductibility of student loan interest expenses. A large number of other special credits and deductions would be repealed.

The estate tax exclusion would immediately be doubled to $10 million (indexed for inflation). The estate and generation-skipping taxes would be repealed after 2024, while maintaining a beneficiary’s stepped-up basis in estate property. The gift tax would be lowered to a top rate of 35%, retaining a basic exclusion of $10 million and annual exclusion of $14,000 (indexed for inflation).

Exempt organization provisions

In addition to a number of generally applicable provisions that may affect exempt organizations (e.g., reduced corporate income tax rates, changes to the deductibility of various fringe benefits, modifications to the exclusion for employer-provided housing, tax-exempt bond reform), the bill proposes a number of changes that specifically address exempt organizations. For example, the bill would:

  • Impose an excise tax on compensation in excess of $1 million and on “excess parachute payments” paid to certain employees of exempt organizations
  • Impose a 1.4% excise tax on the investment income earned by private colleges and universities with large endowments
  • Subject state pension plans to the unrelated business income tax 
  • Simplify the private foundation excise tax on net investment income by setting a uniform rate of 1.4% (as opposed to the current 1% or 2%)
  • Permit all organizations described in section 501(c)(3) to engage in a de minimis amount of political campaign activity in the ordinary course of their activities

Legislative background

On November 2, Ways and Means Chairman Kevin Brady (R-TX) released H.R. 1, the “Tax Cuts and Jobs Act,” as well as a section-by-section summary (the “summary”) of the proposed tax reform legislation. 

On November 3, Brady released amended legislative text of H.R. 1, which revised the text released on November 2, and constituted the so-called Chairman’s mark. The Chairman’s mark served as the starting point for consideration of the legislation by the Ways and Means Committee.

On November 6, Chairman Brady offered an amendment in the nature of a substitute, which was approved by the Committee by a party line vote.

On November 9, Chairman Brady offered a “manager’s amendment,” which was approved by the Committee on a party line vote shortly before the Committee voted to approve H.R. 1, as amended, and to order it to be reported to the House floor.

On November 16, the House of Representatives passed the bill and ordered it to be transmitted to the Senate for further consideration.

KPMG observation

On the Senate side of Capitol Hill, the Senate Finance Committee is in the process of marking up its own version of tax reform this week. Although the Finance Committee’s approach is similar to the House approach in some respects, it is quite different in others. 

For example, while the House bill would permanently reduce the tax rates applicable to both individuals (including individuals who own passthrough businesses) and corporations, the legislation being considered by the Senate Finance Committee would sunset the individual tax cuts and a proposed deduction for passthrough owners. Further, although the legislation the Finance Committee is considering would, like the House, reduce the corporate rate to 20%, it would delay the reduction until 2019.  The Finance Committee also is considering reducing to zero the Affordable Care Act penalty for individuals who do not have health insurance (the “individual mandate”); this provision is not in the House bill.  

There are also numerous other differences.  All these differences ultimately would need to be resolved for tax reform to become law.

 

What is next?

Now that the House has passed H.R. 1, the bill proceeds to the Senate. 

Typically, the Senate Finance Committee would wait to receive the House bill before beginning its own markup. Article I of the Constitution requires that “all bills for raising revenue shall originate in the House of Representatives.” However, in an effort to save time, the Finance Committee began its markup this week on tax reform legislation unveiled by Chairman Hatch. 

Assuming the Finance Committee approves its own tax reform bill, that bill would be processed through the Senate Budget Committee as required by reconciliation rules and then would be referred to the full Senate for consideration. 

As a result, once the House bill is received in the Senate, H.R. 1 would likely be “held at the desk” at the Senate. This procedural maneuver would allow the bill to be called up for consideration by the full Senate more quickly by avoiding referral of the bill to a Senate committee. Assuming the successful completion of required procedural votes, the Senate can, under budget reconciliation procedures, begin 20 hours of debate on H.R. 1, evenly divided between Republicans and Democrats, which could take one or more days to complete.

The first amendment to the House-approved bill would likely be a procedural amendment designed to move the Senate Finance bill back into compliance with Article I of the Constitution. The Senate-Finance-approved legislation is expected to be presented as a “strip-and-replace” amendment to H.R. 1 –  i.e., that amendment would “strip” out the House-passed language in its entirety and replace it with the text of the bill approved by the Finance Committee.

During consideration by the full Senate, it is possible that amendments would be offered and adopted. It is not yet certain when Senate floor action would commence or when a vote on final passage would take place. 

Based on the Senate’s approach to tax reform thus far, it appears likely that, if the Senate approves a bill, it will be different from the House bill. Some of the differences will likely be dictated by the Senate rules governing budget reconciliation under which the legislation is proceeding.  (See below for more information on budget reconciliation.)

For a bill to become law, the House and the Senate ultimately would have to pass identical legislation.  It is possible that a conference committee might be convened to work out the differences between the two bills (as was done in the case of the 1986 Act). It is also quite possible, however, that House and Senate policymakers might negotiate behind the scenes before final Senate passage in an effort to produce a final Senate floor amendment that would result in a bill that could pass the Senate and then pass the House. Regardless of the mechanism used, finalizing a bill that could pass both the House and the Senate could be challenging and time-consuming.  

The often stated goal of Republican congressional leadership is to pass a bill and send it the president for his signature prior to the end of 2017. The aggressive schedule outlined by House and Senate leaders is aimed at meeting this deadline. Significant hiccups at any of the many junctures along the path to enactment could derail this tight timeline and push the process over into 2018 or lead to the demise of the bill.

Impact of reconciliation rules

H.R. 1 or any subsequent version of a tax reform bill in the current legislative effort will be at least partially shaped by budget reconciliation requirements.   

Budget reconciliation is a process by which spending and revenue legislation (including tax measures) can avoid a potential Senate filibuster and be passed by simple majority vote. The ability to use these rules was “unlocked” when the House and Senate agreed to a budget resolution for FY 2018. The budget resolution permits the tax bill produced pursuant to its instructions to increase the deficit by up to $1.5 trillion over the 10-year budget window. 

The budget reconciliation requirements can be expected to be particularly significant when the Senate considers tax reform legislation. To retain the protection from a Senate filibuster that the reconciliation rules provide, the legislation must meet a number of complex requirements. Any senator could raise a point of order against any provision that does not meet these requirements.

One of the most relevant reconciliation rule for tax legislation is one intended to prevent an increase in the long-term deficit of the United States. Even though a tax bill considered pursuant to the budget resolution could provide up to a $1.5 trillion net tax cut within the 10-year window, no title of the bill can result in a net tax cut in any year beyond the 10-year budget window unless offset by an equivalent reduction in spending. Tax cuts enacted in 2001 and 2003 under budget reconciliation, for example, were "sunsetted" at the end of the 10-year period in order to comply with this requirement.

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