President Obama’s budget submission contains numerous tax proposals, many of them quite “hostile” towards business in general and “high-income” taxpayers in particular. Many of the proposals are aimed at eliminating, or at least curtailing, tax preferences enjoyed by the oil and gas industry. In fact, those changes are designed to add some $39 billion to the government’s coffers over the 10-year projection period.
What follows is a breakdown of proposed tax-rule changes found in the President’s plan.
Domestic Tax Issues
• An extension to the rules for qualifying property placed in service in a taxable year beginning in 2010. A qualifying property is defined as depreciable tangible personal property and certain depreciable real property that is purchased for use in the active conduct of a trade or business. Currently, the rules, which are found in Section 179 of the Internal Revenue Code, are in effect for years beginning in 2008 and 2009. Under the extension, the maximum amount of qualifying property a taxpayer may deduct, rather than capitalize and depreciate, would be $250,000, and the “phase-out” would begin at $800,000. In other words, the deduction is reduced by the amount by which the cost of qualifying property exceeds $800,000.
• An additional first-year depreciation deduction for one year with respect to property both acquired and placed in service during 2010. The first-year deduction equals 50% of the cost of qualifying property, which is tangible property with a “recovery period” of 20 years or less.
• The “Financial Crisis Responsibility Fee” that the President proposed last month has been “memorialized.” The fee would apply to banks, thrifts, bank and thrift holding companies, brokers, and securities dealers. Firms with consolidated assets of less than $50 billion would not be subject to the fee. The assessable base of the fee would include the worldwide consolidated liabilities of financial firms. For this purpose, liabilities would exclude FDIC-assessed deposits and, in the case of insurance companies, certain policy-related liabilities. The fee would be levied at the rate of 15 basis points of the assessable base.
“The one thing that is certain is these proposals will be changed, eliminated, embellished, etc., as they wend their way through Congress.” — Robert Willens
• A ban on the use of the LIFO (last-in, first-out) accounting method. The LIFO method can provide a tax benefit for a taxpayer facing rising inventory costs since, in those cases, the cost of goods sold amount is based on more recent, higher inventory values, resulting in lower taxable income. To be eligible for the LIFO method, a taxpayer must use this method for financial-accounting purposes. Under the proposal, taxpayers that employ the LIFO method would be constrained to “write up” their beginning LIFO inventory to its FIFO (first-in, first-out) value in the first taxable year beginning after December 31, 2011. The onetime increase in gross income, resulting from this write up, would be taken into account, ratably, over 10 years.
• Repeal of the “boot within gain” limitation that is part of current law (see Section 356(a)(1)). The limitation relates to any reorganization in which both stock and “boot” is received by an exchanging target shareholder, but only if the exchange “has the effect of the distribution of a dividend” within the meaning of the tax code (specifically, Section 356(a)(2)). The boot refers to nonqualifying consideration received by the shareholder, such as cash in exchange for stock. Under current law, an exchanging shareholder, in a case in which both stock and boot are received, will recognize the lesser of (1) the realized gain or (2) the boot. Under the proposal, such a shareholder will record the boot as dividend income, even if the boot is in excess of the realized gain. Fortunately, this proposal should have very little impact because it is exceedingly rare that an exchange will have the effect of the distribution of a dividend (see Revenue Ruling 93-61, 1993-2 C.B. 118).
International Tax Provisions
• Deferral of the interest expense deduction that is properly allocated and apportioned to foreign-source income that is not currently subject to U.S. tax. The deferred interest expense would be deductible in a subsequent taxable year in proportion to the amount of the previously deferred income, that is subject to tax during that year.
• A requirement for a U.S. taxpayer to determine its “deemed-paid” foreign tax credits on a consolidated basis based on the aggregate foreign taxes and earnings and profits of all of its foreign subsidiaries.
• A “matching” rule would be adopted to prevent the unwarranted separation of creditable foreign taxes from the associated foreign income.
• A new trigger related to the tax code’s Subpart F. Subpart F is the tax code chapter containing the complex “antideferral” rules that force companies to pay tax on certain foreign-source income in the year it was earned, rather than when the U.S. parent repatriates the profits. The proposal states that if a U.S. person transfers an intangible asset from the United States to a related controlled foreign corporation (CFC) that is subject to a “low foreign effective tax rate,” and there is evidence that the transfer results in “excessive income shifting,” then an amount equal to the “excessive return” would be treated as a category of Subpart F income. As a result, the return would be includable in the gross income of the CFC’s “U.S. shareholders.”
• A provision to “clarify” that intangible property includes “workforce in place,” as well as goodwill and going concern value, in the case of transfers of intangible property to a foreign corporation. For instance, if a U.S. person transfers intangible property to a foreign corporation in certain nonrecognition transactions, the U.S. person is treated as selling the intangible property for a series of payments contingent on the productivity, use, or disposition of the transferred intangible.
• A tightening of the limitation on the deductibility of interest paid by an “expatriated entity” (for example, Tyco and Ingersoll-Rand) to related parties under Section 163(j) of the tax code. In this case, the debt/equity safe harbor would be eliminated, the 50% “adjusted taxable income” threshold would be reduced to 25%, the carryforward for disallowed interest expense would be limited to 10 years, and the carryforward of “excess limitation” would be eliminated.
• New treatment for income earned by foreign persons with respect to equity swaps. Under the proposal, the income would be treated as U.S. source income, and therefore subject to withholding tax to the extent that the income is attributable to, or is calculated by reference to, dividends paid by a domestic corporation. Under current law, this income escapes withholding taxes because income from a “notional principal contract” is sourced based upon the residence of the investor.
• A partner’s share of income with respect to a “Services Partnership Interest” (SPI) would be subject to tax as ordinary income, regardless of the character of the income at the partnership level. Moreover, gain recognized on the sale of an SPI would be treated as ordinary income. For this purpose, an SPI is defined as a carried interest held by a person who provides services to the partnership.
• “Black liquor” would be excluded from the definition of cellulosic biofuel. As a result, black liquor would not be eligible for the $1.01 per gallon cellulosic biofuel credit.
• No deduction would be allowed for punitive damages paid or incurred by the taxpayer. This is true even though the activities that gave rise to the lawsuit were performed in the ordinary conduct of the taxpayer’s trade or business (see Revenue Ruling 80-211, 1980-2 C.B. 57).
• A provision to “clarify” that a transaction satisfies the economic substance doctrine. Under the proposal, the doctrine would be satisfied only if the transaction changes, in a “meaningful way” (apart from federal tax effects), the taxpayer’s economic position and the taxpayer has a substantial purpose (other than a federal tax purpose) for entering into the transaction. A transaction would not be treated as having economic substance by reason of its profit potential unless the present value of the “reasonably expected” pretax profit is substantial in relation to the present value of the net federal tax benefits arising from the transaction.
Personal Tax Provisions
• Beginning in 2011, the highest income tax rate would, once again, be 39.6%, and the second-highest rate would be 36%.
• A 20% rate on long-term capital gains and qualified dividend income would apply for married taxpayers with income in excess of $250,000 and for single taxpayers with income exceeding $200,000.
• Itemized deductions would be reduced by 3% of the amount by which one’s adjusted gross income exceeds certain indexed statutory floors ($250,000 for married taxpayers; $200,000 for single taxpayers).
• A limit on the value of all itemized deductions — after they are reduced as described above — by limiting the “tax value” of these deductions to 28% whenever they would otherwise reduce taxable income in the 36% or 39.6% tax bracket.
The vast majority of the revenue the President’s proposals would raise would arise from the application of the personal tax changes described above. The one thing that is certain is these proposals will be changed, eliminated, embellished, etc., as they wend their way through Congress. What emerges in the fall from this legislative process no doubt will be heavily influenced by the fact that the midterm elections are imminent. We will keep you abreast of all relevant budgetary developments.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.