Tax Reform Redux: What’s Old is New Again, Except When It’s Not

On Monday, March 28th, the Biden Administration transmitted its fiscal year 2023 budget recommendations to Congress, which lay out the Administration’s discretionary spending plan for the fiscal year beginning October 1, 2022, along with its long-term infrastructure and social spending plans. In addition, Treasury released its General Explanations of the Administration’s Fiscal Year 2023 Revenue Proposals (the “Green Book”), most of the content of which was outlined in the Administration’s FY 2022 budget recommendations discussed in our alert last year.

When considering the new Green Book, it is important to keep in mind that the Administration has assumed, to some extent, that the House passed a version of the Build Back Better Act (BBBA) will be enacted, which means the FY 2023 revenue proposals are on top of the BBBA provisions discussed in our prior alert. With the uncertainty surrounding the BBBA, it is unclear whether any of these “new” proposals will be enacted by Congress, or if they are more akin to talking points in advance of the midterm elections. Nonetheless, we thought it would be helpful to highlight some of the proposals renewed from last year and what has changed, along with details on some new proposals.

Specifically, the following topics are covered in this alert:

• Corporate Provisions
• International Provisions
• Individual, Estate, and Trust Provisions
• Other Targeted Provisions
• Select Tax Administration and Compliance Provisions

Corporate Provisions

• Increase the corporate income tax rate from 21% to 28%, as proposed last year and presumably on top of the BBBA’s 15% alternative minimum income tax based on financial statement income and the 1% excise tax on certain stock redemptions.
• Change the definition of “control” to include a test based on value as well as voting power for certain corporate transactions, such as capital formations, spin-offs, and reorganizations.
  • Under current law, control is defined as (i) at least 80% of the total combined voting power of all classes of stock entitled to vote and (ii) at least 80% of the total number shares of all other classes of stock of the corporation.
  • The Green Book resurrects a proposal introduced by past Democratic administrations, which would modify the definition of control by replacing the second requirement with a requirement that includes at least 80% of the total value of the stock of the corporation, like the requirement under the consolidated group rules.
  • This change is potentially on top of the BBBA’s restrictions on using certain property in some divisive D reorganizations.

A&M Insight: The proposal is the Administration’s attempt to address a perceived abuse regarding taxpayers’ use of high vote/low vote stock in structuring transactions to achieve either a tax-free or a taxable transaction. However, conforming the control test for purposes of certain corporate transactions and reorganizations with the test for affiliated companies raises the specter of valuation disputes as companies will need to determine the value of their different classes of stock to determine whether certain transactions are eligible for tax-free treatment. Also, because the affected transactions would involve individuals, rather than only affiliated corporations that generally wholly own their subsidiaries, taxpayers would have to address numerous complexities in determining value, such as applicable discounts and premiums. Further, it is unclear whether certain types of stock would be excluded from this determination, similar to the rules governing affiliated group determination, which would seem to provide a mechanism to circumvent the proposal.

International Provisions

• Replace the base erosion anti-abuse tax (BEAT) with an undertaxed profits rule (UTPR), which is consistent with the UTPR described in the OECD’s Pillar 2 model rules. While the global intangible low-taxed income (GILTI) regime in the BBBA baseline will ensure income earned through controlled foreign corporations is taxed at a minimum rate on a jurisdictional basis, the proposed UTPR will apply primarily to foreign-parented multinationals operating in low-tax jurisdictions. The UTPR would generally apply, subject to some de minimis exceptions, to financial reporting groups with global annual revenue of $850 million or more in at least two of the last four years if a low-taxed member is not subject to the top-up tax under the income inclusion rule (such that its income is subject to at least a 15% tax rate). If it applies, the UTPR would:
  • Disallow U.S. tax deductions so that the group would have a worldwide effective tax rate of at least 15% on income earned in each foreign jurisdiction in which the group has profits.
  • Impose a domestic minimum top-up tax which would apply to increase the U.S. company’s effective tax rate to 15%, if it would otherwise be subject to another jurisdiction’s UPTR.
  • Allow taxpayers to continue to benefit from U.S. tax credits and other tax incentives that promote U.S. jobs and investment, although no details on the mechanics were provided.

A&M Insight: If the BBBA’s proposed changes to the GILTI regime and the UTPR are adopted, the U.S. would arguably be compliant with the OECD Pillar 2 model rules. However, that may be in doubt if the adopted UTPR preserves the benefits of U.S. tax credits and other tax incentives to allow an effective tax rate below 15%. Also, it is unclear what the effect would be on U.S. companies if other countries do not adopt Pillar 2. It appears that if most countries adopt Pillar 2, it may be beneficial for all countries to adopt the rules. But if several countries lag in adoption, or decline to adopt Pillar 2, companies in jurisdictions that have adopted the rules might be subject to higher worldwide effective tax rates than companies in jurisdictions that have not. Multinational groups with in-scope companies should actively monitor the Pillar 2 positions and plans for those jurisdictions in which they operate or derive revenue. It may become desirable to reposition activities or modify the group structure to minimize the impact of Pillar 2 taxes on the group’s ongoing worldwide effective tax rate.

It is also worth noting that, unlike last year’s Green Book, this year’s Green Book does not include a proposal to expand the scope of the inversion rules. While it is unclear why the Administration choose not to repropose the changes, as they are also not included in the BBBA, it is possible that it is due to the proposed implementation of the UTPR.

• Retain the foreign-derived intangible income (FDII) regime (unlike last year’s Green Book) but increase the effective tax rate for FDII to 21.1%. The proposal also raises the effective tax rate for GILTI inclusions to 20%, reflecting the proposed increase in the corporate tax rate (coupled with the BBBA’s decrease in the GILTI deduction to 37.5%) and therefore, a higher rate than the 15% minimum tax under Pillar 2.
• Like last year’s Green Book, create a new 10% credit for eligible expenses paid or incurred in onshoring a foreign trade or business and disallow deductions associated with offshoring a U.S. trade or business.

A&M Insight: While the proposal is intended to incentivize taxpayers to bring their businesses back to the U.S., the fact that this has been proposed could have the opposite effect until it is adopted. This is because companies that are currently considering bringing their businesses back to the U.S. are incentivized to wait because they will not be eligible for the credit unless they incur the expenses after enactment. Companies may also be incentivized to offshore their trades or businesses prior to enactment.

• Under the passive foreign investment company (PFIC) rules, expand access to retroactive qualified electing fund (QEF) elections, which allow U.S. persons to avoid additional tax on excess distributions if they include in income their pro-rata shares of ordinary income and long-term capital gain of the PFIC on an annual basis.
  • In certain situations, allow retroactive QEF elections without IRS consent and permit taxpayers to amend previously filed returns for open years.
  • For closed tax years, the proposal could allow taxpayers to make the election with IRS consent if they pay the taxes that would have been due for closed years if a timely QEF election had been made.

A&M Insight: The Green Book proposal would be a welcome relief for taxpayers who inadvertently failed to file a timely QEF election and cannot satisfy the existing requirements to obtain IRS consent. The proposed changes would also eliminate the need for a private letter ruling, reducing the burden and costs for taxpayers and the IRS. However, to permit taxpayers to make QEF elections affecting closed years raises some interesting questions that might need clarification to existing statutes of limitations. For example, would taxpayers be allowed a refund for a closed year to recover taxes paid on PFIC excess distributions.

Individual, Estate, and Trust Provisions

Individuals

• Like last year’s Green Book, tax certain long-term capital gains and qualified dividends at ordinary income tax rates and tax carried interest as ordinary income.
• Also, like last year’s Green Book, increase the top marginal income tax rate for individuals to 39.6% but lower the thresholds for application of that rate. The new top rate in 2023 would apply to taxable income over:
  • $450,000 for married individuals filing a joint return,
  • $400,000 for unmarried individuals (other than surviving spouses),
  • $425,000 for head of household filers, and
  • $225,000 for married individuals filing a separate return.

A&M Insight: The inclusion of the increase to the top individual tax rate, as well as the corporate tax rate discussed above, in this year’s Green Book is interesting as Senator Sinema has been adamant that she would not support tax rate changes. However, it appears that Senator Sinema supports the BBBA’s individual surcharge. If the BBBA’s surcharge and net investment income tax (NIIT) changes are adopted, in addition to the two proposals discussed above, then tax liabilities for high-net-worth individuals will presumably increase significantly.

• For taxpayers with a net worth greater than $100 million, impose a new 20% minimum income tax on income earned and unrealized capital gains and allow taxpayers the option to pay the minimum tax liability over a specified number of years.

A&M Insight: The minimum income tax proposal, which is estimated to raise approximately $361 billion over 10 years — nearly 15% of the total estimated net receipts of $2.5 trillion — has already been nixed by Senator Manchin, at least regarding the taxing of unrealized gains, making it unlikely that it will advance. Taxing unrealized gains has been floated before without success, such as in Senate Finance Committee Chairman Ron Wyden’s 2021 proposed Billionaire’s Income Tax, although Biden’s proposal differs from Wyden’s in some respects.

Estates, Trusts, and Gifts

• Similar to last year’s Green Book, this year’s Green Book proposes to treat transfers of property by gift or death as a realization event, and therefore taxed. Therefore, a gift of appreciated property can be subject to both income tax and gift tax. However, last year’s proposed “$1 million per-person exclusion” from gain recognition has been revised in this year’s proposal to a “$5 million per-donor exclusion.”
• Reduce incentives for tax planning techniques, such as funding a grantor retained annuity trust (GRAT) with assets expected to appreciate and selling an appreciating asset to a grantor trust by the deemed owner of the trust.
• Require consistent valuation of promissory notes for gift and estate tax purposes to address certain tax planning strategies involving below-market interest rates on loans between individuals.
• For trusts subject to the generation-skipping transfer (GST) tax rules, limit the duration of the exemption to the life of any trust beneficiary who is either no younger than the transferor’s grandchild or is a member of a younger generation but was alive when the trust was created.

A&M Insight: Because the BBBA would not have made broad changes to the taxation of estates, trusts, and gifts, many individuals took comfort that existing planning strategies remained useful and that no rush to implement any planned changes was needed. As noted in our analysis of last year’s Green Book, with these proposed changes, taxpayers will want to consider the implications of the proposals, while also noting the proposed effective dates to timely implement any changes to new or existing strategies.

Other Targeted Provisions

• Prevent basis shifting when partnership distributions result in a step-up in the basis of the partnership’s non-distributed property by prohibiting related partners from benefiting from the stepped-up basis until the partner receiving the property disposes of it in a fully taxable transaction.

A&M Insight: It is unclear to what extent abusive basis-shifting transactions occur, but the proposal is estimated to raise nearly $62 billion in revenue over 10 years. The approach seems analogous to the BBBA proposal in the corporate context regarding Granite Trust transactions and would have similar tracing concerns, as well as raise questions regarding related-party rules and tiered partnerships. Moreover, the anti-basis shifting proposed would likely sweep in legitimate transactions between related parties in a partnership that are not motivated by tax avoidance.

• Like last year’s Green Book, limit the annual deferral of gain for like-kind exchanges of real property to $500,000 for each taxpayer ($1 million for married individuals filing a joint return).
• Require 100% recapture of cumulative depreciation deductions as ordinary income for certain depreciable real property (referred to as “section 1250 property,” which includes buildings and structural components) for noncorporate taxpayers with adjusted taxable income of $400,000 or more ($200,000 for married individuals filing separate returns).

A&M Insight: The depreciation recapture proposal would have significant financial and administrative implications for certain real estate businesses, likely drawing the ire of industry advocates. Nevertheless, real estate businesses and their investors should keep an eye on potential changes to the depreciation recapture and like-kind exchange rules and be prepared to model scenarios and potential effects.

• For actively traded digital assets, apply the securities loan nonrecognition rules and allow dealers and traders to mark the assets to market. The proposal also specifies new reporting requirements for brokers regarding digital assets held by substantial foreign owners of passive entities and for taxpayers regarding their foreign digital asset accounts.

A&M Insight: For the most part, the Green Book’s proposals regarding digital assets, including cryptocurrency, are welcome news. In the meantime, as the use of cryptocurrency and other digital assets (e.g., non-fungible tokens (NFTs)) continues to increase, taxpayers are left wondering how to properly characterize their transactions. It is essential to receive proper tax advice regarding their treatment and A&M is happy to assist.

Select Tax Administration and Compliance Provisions

• Modify the centralized partnership audit rules to treat net negative changes in tax that exceed a partner’s income tax liability in the reporting year as an overpayment that can be refunded and to include items related to self-employment income tax and investment income tax as partnership-related items.
• Impose an affirmative obligation for taxpayers to disclose positions taken on a return that are contrary to a regulation with the penalties for failure to disclose equal to 75% of the reduction in taxes on the return because of the position taken, up to $200,000.
• Extend the statute of limitations to six years for returns reporting benefits from certain listed transactions and in situations in which a taxpayer omits more than $100 million from gross income on a return, as well as provide additional assessment time for certain qualified opportunity fund investors that fail to include or reflect the inclusion of the deferred gains.
• Increase the IRS’s total budget to $14.1 billion, which is 18% above the 2021 enacted level, to fund additional oversight of high-income individual taxpayer and corporate tax returns, improvements of the taxpayer experience and expanded customer service outreach, and acceleration of systems modernization projects.

A&M Tax Says

With all eyes on the Senate as to the potential passage of any tax reform proposals, many officials have stated that they are anticipating that any tax reform proposals that are adopted would generally be within the scope of the BBBA. In other words, proposals that were not passed by the House are unlikely to be included in a final bill. This casts a long shadow on the Administration’s hopes of including the proposals in the Green Book, as it has assumed that BBBA, at least to some extent, will be adopted. With that said, Congress has an unpredictable nature about adopting proposals and so corporations, partnerships, and individuals should consider “what-if” scenarios to understand the potential impact in the event a proposal starts to gain traction in Congress. The changes most likely to advance seem to be those that align with the OECD’s Pillar 2 rules, recognizing that even those proposals face some resistance, perhaps even more so if the effective tax rates on GILTI and FDII exceed the global minimum tax of 15%. A&M will continue to monitor the BBBA provisions and other tax reform legislation, if any, that could be enacted before the end of the year. As always, we are available to discuss the proposals and your specific business and tax challenges in managing through unprecedented times characterized in part by the Ukraine-Russia situation, lingering COVID-19 concerns, supply chain issues, and high inflation.

https://www.alvarezandmarsal.com/insights/tax-reform-redux-whats-old-new-again-except-when-its-not