United States: Highlights Of Substantial Tax Changes In The Consolidated Appropriations Act, 2016

Expiring tax provisions and "extenders" legislation have become fairly common in recent years. The typical pattern involves institution of one- or two-year provisions (short-lived due to revenue issues) that have expired with eleventh-hour congressional action to avoid a tax increase, often retroactively. This pattern initially looked as though it would repeat itself in 2015. Unlike previous years, however, the 2015 extenders legislation was far from typical. In case you missed it, this alert summarizes some of the more interesting provisions of The Protecting Americans from Tax Hikes Act of 2015 (the "Path Act"). The Path Act, which was part of the broader Consolidated Appropriations Act, 2016 (P.L. 114-113), became law on December 18, 2015, upon signature by President Obama. Among other things, the Path Act made many tax extender provisions permanent, extended through 2019 both bonus depreciation and the subpart F look-through rule under Section 954(c)(6), and made substantial changes to both the REIT tax rules and the FIRPTA rules. The state-level income tax impact of these new federal income tax rules will need to be determined on a state-by-state basis given each state's rules regarding the adoption of the federal income tax code.

I. Tax Extender and Certain Other Provisions

The Path Act both made permanent many of the tax provisions that had been temporarily extended on a continuing basis in past years and extended certain provisions through 2016 and others through 2019. Please see the Code Section Summary of Path Act Tax Extender Changes.

A.  Key Permanent Extensions Impacting Businesses

1. Research Credit (Section 41)

The research credit has been made permanent. Additionally, for taxable years beginning after December 31, 2015, eligible small businesses are allowed to utilize these research credits to offset both regular and AMT liabilities, and they can elect to claim a certain amount of their research credit as a payroll tax credit against their Social Security insurance liability rather than their income tax liability.

2. 15-Year Straight-Line Cost Recovery Period (Section 168)

The 15-year straight-line cost recovery period for qualified leasehold improvement property (Section 168(e)(3)(E)(iv)), qualified restaurant property (Section 168(e)(3)(E)(v)), and qualified retail improvement property (Section 168(e)(3)(E)(ix)) has been made permanent for property placed in service after December 31, 2014.3. Exclusion of 100% of Gain on Certain Small Business Stock (Section 1202)Taxpayers, other than corporations, may exclude gain from the sale of certain small business stock acquired at original issue and held for at least five years, subject to certain limitations. For stock purchases after September 27, 2010, and before January 1, 2015, the amount of the eligible gain exclusion was 100%. This 100% gain exclusion has been made permanent for purchases of qualifying stock on and after January 1, 2015.

4. S Corporation Built-in Gains Tax Recognition Period (Section 1374)

Under Section 1374, following the conversion of a C corporation into an S corporation, a corporate-level built-in gains tax is imposed on an S corporation's net unrealized built-in gain recognized during the 10-year period beginning with the first day of the first taxable year for which the S corporation election is in effect. For all conversions of C corporations to S corporations in taxable years beginning in 2012, 2013, and 2014, the applicable recognition period was shortened to five years. This five-year recognition period has been made permanent for taxable years beginning after December 31, 2014.

5. Subpart F Active Financing Exception (Section 953(e))

Certain United States shareholders of controlled foreign corporations are subject to current United States tax on (1) interest, dividends, royalties, rents, annuities, and other income qualifying as foreign personal holding company income; (2) foreign base company services income; and (3) certain insurance income. A temporary exception to income qualifying as foreign personal holding company income, foreign base company services income and insurance income subject to current inclusion under the subpart F rules was available for certain income derived in the active conduct of a banking, financing, or similar business; as a securities dealer; or in the conduct of an insurance business (i.e., "active financing income"). This temporary exception was made permanent for taxable years of foreign corporations beginning after December 31, 2014, and for taxable years of United States shareholders with or within which such taxable years of such foreign corporations end.

B. Key Extensions/Provisions Through 2016-2017

1. Credit for Biodiesel and Renewable Diesel (Section 40A) and Alcohol Fuel, Biodiesel, and Alternative Mixtures (Section 6426)

The expiration dates of both the credit for biodiesel and renewable diesel used as a fuel (Section 40A) and the credit for alcohol fuel, biodiesel, and alternative mixtures (Section 6426) were extended from December 31, 2014, to December 31, 2016. Additionally, guidance is required to be issued by January 17, 2016, to address submission of biodiesel mixture credit claims determined under Section 6426(c) for the period beginning January 1, 2015, through December 31, 2015.

2. Medical Device Tax (Section 4191)

No medical device tax imposed under Section 4191 will apply to sales beginning on January 1, 2016, and ending on December 31, 2017.

C. Key Extensions Through 2019

1. Bonus Depreciation (Section 168(k))

Bonus depreciation (Section 168(k)) was made effective for 2015 and extended through 2019. Modifications were made to the bonus depreciation rules as well, including:

  • For 2018 and 2019, the deduction percentage is reduced from 50% to 40% and 30%, respectively.
  • After 2015, additional first-year depreciation is allowed for qualified improvement property without regard to whether the improvements are property subject to a lease, and there is no requirement that property must be placed in service more than three years after the date the building was placed in service.
  • The election to accelerate AMT credits in lieu of bonus deprecation is expanded for five years to include property placed in service before January 1, 2020 (or before January 1, 2021, for certain longer-lived property).
  • Taxpayers may elect to deduct for the applicable deduction percentage of the adjusted basis of certain plants bearing fruits and nuts which are planted or grafted in the United States after December 31, 2015, and before January 1, 2020, for regular tax and AMT purposes, and the adjusted basis is reduced by the amount of the deduction.

2. The Look-Through Rule (Section 954(c)(6))

The Section 954(c)(6) look-through rule (which allows controlled foreign corporations, or "CFCs," to receive certain dividends, interest, rents, and royalties from related CFCs without giving rise to subpart F income) was made effective for 2015 and extended through 2019

3. New Markets Tax Credit (Section 45D) and Work Opportunity Tax Credit (Sections 51 and 52)

In addition, the new markets tax credit (Section 45D) and the work opportunity tax credit (Sections 51 and 52) were both extended through 2019.

II. REITs (Sections 856 and 857)

A. REIT Spin-Offs (Section 355)

Prior to enactment of the Path Act, a C corporation that owns REIT-qualified assets could create a REIT to hold such assets and could spin off that REIT without tax consequences, assuming that each of the requirements for a tax-free spin-off was met. The IRS approved this result in Rev. Rul. 2001-29, 2001-C.B. 1348, and PLR201337007. On and after December 7, 2015, a REIT generally is ineligible to participate in a tax-free spin-off as either a distributing corporation or a controlled corporation. There are, however, three exceptions to this general rule. First, this rule does not apply if both the distributing corporation and the controlled corporation are REITs immediately after the spin-off. Second, this rule also does not apply if (1) the distributing corporation has been a REIT at all times during the three-year period ending on the date of the distribution, (2) the controlled corporation has been a taxable REIT subsidiary ("TRS") of the distributing corporation at all times during such period, and (3) the distributing corporation had control (as defined in Section 368(c) and taking into account direct and indirect stock ownership) of the controlled corporation at all times during such period. Third, this rule does not apply to any distribution pursuant to a transaction described in a ruling request initially submitted to the IRS on or before December 7, 2015, provided that such request has not been withdrawn and that a ruling with respect to such request has not been issued or denied in its entirety as of such date.

B. Additional REIT Provisions

Under the Path Act, other substantive changes were made to tax rules affecting REITs, including the following:

  • No more than 20% of the value of total REIT assets may consist of securities of one or more TRSs in taxable years beginning after December 31, 2017 (the current limit is 25%).
  • Subject to a three-year look-back limitation, a REIT may sell no more than 20% of the aggregate basis or fair market value of its assets generally for taxable years beginning after December 18, 2015, before becoming subject to the prohibited transactions tax of Section 857(b)(6)(A) (the current limit is 10%).
  • The REIT "preferential dividend" rule for publicly offered REITs has been repealed for taxable years beginning after December 31, 2014. Moreover, for distributions in taxable years beginning after December 31, 2015, Congress has provided the Secretary of the Treasury with authority to provide an appropriate remedy to cure the failure of a REIT to comply with the preferential dividend requirements, in lieu of not considering the distribution to be a dividend for purposes of computing the dividends paid deduction, if the Secretary determines that such failure is inadvertent or is due to reasonable cause rather than to willful neglect, or if the failure is of a type identified by the Secretary as being so described.
  • Debt instruments issued by publicly offered REITs are treated as real estate assets, as well as interests in mortgages on real property or on interests in real property, for taxable years beginning after December 31, 2015.


III. FIRPTA (Sections 897 and 1445)

A. FIRPTA Withholding Rate Increase to 15%

The FIRPTA withholding rate will increase from 10% to 15% for dispositions of United States real property interests which occur after February 16, 2016. However, the withholding rate will remain at 10% in the case of United States real property which is acquired by a transferee for use by such transferee as a residence, if the amount realized for such property is greater than $300,000 but does not exceed $1 million. The FIRPTA withholding exclusion will continue to apply where a transferee acquires United States real property for use by such transferee as a residence, if the amount realized for such property does not exceed $300,000.

B. Exception From FIRPTA for Stock of REITs Held by Foreign Retirement and Pension Funds

Beginning after December 18, 2015, foreign retirement and pension funds are no longer subject to United States federal income tax on the disposition of a "United States real property interest" held directly (or indirectly through one or more partnerships) by, or to any distribution received from a REIT by, a qualified foreign pension fund. For this purpose, a "qualified foreign pension fund" is any trust, corporation, or other organization or arrangement (1) which is created or organized under the law of a country other than the United States, (2) which is established to provide retirement or pension benefits to current or former employees (or to persons designated by such employees), (3) which does not have a single participant or beneficiary with a right to more than 5% of its assets or income, (4) which is subject to government regulation and provides annual information reporting in its home country, and (5) to which, under the laws of its home country, contributions are deductible or excluded from its gross income or are taxed at a reduced rate, and for which investment income is deferred or is taxed at a reduced rate. Prior to this change, domestic pension funds generally were exempt from United States taxation on capital gains, while foreign pension funds were not.

C. Disposition of RIC and REIT Equity Interests Subject to FIRPTA Withholding

Beginning December 18, 2015, companies which have qualified as either RICs or REITs at any point in time during the five-year period ending on the date of the disposition of any interest in such companies are not eligible to be excluded from the definition of a "United States real property interest." Consequently, dispositions of an equity interest in a corporation which formerly qualified as a RIC or a REIT during such five-year period by a non-U.S. person or entity could be subject to FIRPTA withholding.

D. Increase in REIT Equity Ownership Threshold for FIRPTA Exclusion

Beginning December 18, 2015, if REIT stock is publicly traded, the Path Act increases from 5% to 10% the maximum REIT stock ownership that a non-U.S. shareholder may have held (taking into account applicable constructive ownership rules) in a class of stock of the REIT during the applicable testing period to avoid having that stock be treated as a United States real property interest upon disposition of that stock. Moreover, effective that same date, the threshold ownership percentage is increased from 5% to 10% such that a distribution attributable to gain from the sale or exchange of United States real property interests received by a non-U.S. REIT shareholder from the REIT is not subject to FIRPTA withholding, provided that (1) such shareholder owns (taking into account applicable constructive ownership rules) 10% or less of the class of stock of the REIT upon which such distribution is made, and (2) such class of stock is publicly traded on a securities market located in the United States. Finally, beginning December 18, 2015, qualified shareholders may dispose of any amount of stock of a REIT (whether public or private) without a requirement for FIRPTA withholding. For this purpose, a "qualified shareholder" is a non-U.S. person or entity that meets the following three requirements: (i) (a) it must be eligible for benefits of a comprehensive income tax treaty with the United States, which includes an exchange of information program, and the principal class of such non-U.S. person's equity interests must be listed and regularly traded on one or more recognized stock exchanges (as defined in such income tax treaty), or (b) it is a partnership created or organized under foreign law as a limited partnership in a jurisdiction that has an agreement with the United States for exchange of information with respect to taxes, and it has a class of limited partnership units which are regularly traded on the NYSE or NASDAQ, and such class of limited partnership unit's value is greater than 50% of the value of all partnership units; (ii) it must be a qualified collective investment vehicle; and (iii) it must maintain records on the identity of each person who, at any time during the foreign person's taxable year, holds 5% or more of the class of interest described in (i) above. A "qualified collective investment vehicle" is a non-U.S. person or entity (1) which, under the laws of the same income tax treaty referred to in the definition of "qualified shareholder" above, is eligible for a reduced rate of withholding with respect to ordinary dividends by a REIT even if such person or entity holds more than 10% of the stock of such REIT; (2) which (a) is a publicly traded partnership that is excepted from being treated as a corporation under Section 7704(a), (b) is a withholding foreign partnership for purposes of Chapters 3, 4, and 61; (c) would be, if such foreign partnership were a U.S. corporation, a U.S. real property-holding corporation (determined without regard to any modifications required by the Path Act to paragraphs (3) and (6)(C) of Section 897 ) at any time during the five-year period ending on the date of disposition of, or of distribution with respect to, such partnership's interests in a REIT; or (3) which is designated as a qualified collective investment vehicle by the Treasury and is either (a) fiscally transparent within the meaning of Section 894, or (b) required to include dividends in its gross income, but entitled to a deduction for distributions holding interests (other than interests solely as a creditor) in such foreign person or entity.

IV. Small Captive Insurance Companies (Section 831(b))

For taxable years beginning after December 31, 2016, for a property and casualty insurance company to elect to be taxed only on its taxable investment income under Section 831(b), (1) such mutual and stock company must have net written premiums or direct written premiums (whichever is greater) that do not exceed $2,200,000, with such amount indexed for inflation starting in 2016 (the current limit is $1,200,000 with no inflation index), and (2) such company also must meet a new diversification requirement in addition to other eligibility rules. The diversification requirement can be met either through a risk diversification test, in which no more than 20% of the net written premiums (or, if greater, direct written premiums) of the company for the taxable year are attributable to any one policyholder, or a relatedness test, which compares the ownership interests in the insurance company to the ownership interests in the trades or businesses, rights, or assets with respect to which the net written premiums (or direct written premiums) of the insurance company are paid. Additionally, for taxable years beginning after December 31, 2016, annual reporting relating to meeting the diversification requirements also must be made to the IRS for all insurance companies for which a Section 831(b) election is in effect for a taxable year.

V. Prevention of Transfer of Certain Losses From Tax-Indifferent Parties (Section 267)

Deduction for losses on the sale or exchange of property to certain related or controlled parties generally is disallowed pursuant to Sections 267(a)(1) and 707(b). Section 267(d), however, provides that a transferee may reduce gain that the transferee recognizes on a disposition of the asset where a loss on such asset has been disallowed, by the amount of the loss disallowed to the transferor. Effective for sales and other dispositions of property acquired after December 31, 2015, by a taxpayer in a sale or exchange to which Section 267(a)(1) applies, the general rule of Section 267(d) does not apply to the extent gain or loss with respect to property that has been sold or exchanged is not subject to federal income tax in the hands of the transferor immediately before the transfer so as to prevent the importation of losses.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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