On September 15, 2021, the House Ways and Means Committee approved tax provisions for proposed inclusion in the Build Back Better Act (the BBBA). If enacted in their current form, the proposals would, among other things:
- raise income tax rates for certain corporations and individuals;
- raise the long-term capital gains rate;
- impose new limitations on interest deductions for large corporations;
- increase U.S. taxes on foreign earnings of multinationals; and
- further curtail the tax benefits of carried interests.
The BBBA now heads to the House floor for consideration alongside the Infrastructure Investment and Jobs Act, which the Senate passed on August 10 and which would expand tax information reporting requirements for cryptocurrencies and other digital assets. The BBBA needs only a majority vote in each of the House and the Senate to pass. However, several Congressional Democrats have expressed reservations about the bill in its current form.
This memorandum summarizes the tax proposals that are of most interest to U.S. corporate taxpayers, financial institutions, hedge funds, private equity funds, and their investors. Part II discusses corporate tax measures. Part III discusses individual and partnership tax measures.
II. Corporate Tax Measures
- Raise the corporate income tax rate. The current federal corporate tax rate is 21%. Before the Tax Cuts and Jobs Act of 2017 (the TCJA), the highest marginal tax rate that applied to corporations was 35%. The BBBA would reintroduce graduated corporate income tax rates and apply a 26.5% marginal rate to income in excess of $5 million. The benefit of graduated rates would be entirely phased out for corporations with income in excess of $10 million.
The proposal would be effective for tax years beginning after 2021. For non-calendar-year corporations, the 2021-2022 tax rate would be 21% plus 5.5% times the portion of the tax year that occurs in 2022.
- Limit deductions for disproportionate U.S. leverage. Under section 163(j) (enacted by the TCJA), U.S. corporations generally are allowed a deduction for business interest expense only to the extent that it exceeds their business interest income plus 30% of EBITDA (or EBIT, beginning after 2021). The BBBA would further limit interest deductions of U.S. members of multinational groups that prepare consolidated financial statements if their net interest expense for financial reporting purposes exceeds 110% of their proportionate share (determined based on their share of the group's EBITDA) of the net interest expense reported on those financial statements.
The proposal would be effective for tax years beginning after 2021, and would apply only to U.S. corporations whose average annual net interest expense (determined on a three-year rolling basis and taking into account all U.S. corporations in the group) exceeds $12 million. Interest expense disallowed under either section 163(j) or new section 163(n) could be carried forward up to five years.
- Increase the GILTI tax. Under the TCJA, U.S. corporations generally are taxed annually at a 10.5% rate (increasing to 13.125% in 2026) on the excess of certain "global intangible low-tax income" earned by their controlled foreign corporations (CFCs) over a 10% imputed return on depreciable tangible property held by the CFCs. For tax years beginning after 2021, the BBBA would increase the GILTI tax rate to 16.5625% (after accounting for the increase in corporate tax rates) and replace the 10% imputed return with a 5% imputed return. The BBBA also would modify the GILTI regime to operate on a country-by-country basis, allow carryforwards of country-specific GILTI deductions, and increase the foreign tax credit for GILTI income.
- Reduce the FDII deduction. The TCJA grants U.S. corporations a 37.5% deduction (decreasing to 21.875% in 2026) for certain "intangible income" that they derive from exports (so-called "foreign derived intangible income"). The BBBA would reduce the deduction to 20.7% for tax years beginning after 2021.
- Modify the BEAT. Under the TCJA's "base erosion and anti-abuse tax," corporations with average gross receipts exceeding $500 million are subject to a minimum tax add-on generally equal to 10% (increasing to 12.5% in 2026) multiplied by the excess by which their "BEAT liability" (calculated by adding back certain deductible payments made to foreign affiliates) exceeds their regular tax liability. A de minimis exception generally allows up to 3% of a corporation's total deductions (or 2% for groups that include banks and securities dealers) to be made to foreign affiliates before the BEAT applies.
The BBBA would increase the BEAT to 12.5% beginning in 2024 and 15% beginning in 2026, and would eliminate the de minimis exception beginning after 2021.
- Curtail tax-free spinoff monetization. Under current law, subject to certain limitations, a subsidiary (Spinco) can issue debt securities to its parent corporation that the parent corporation can then distribute tax-free to creditors in redemption of its own outstanding debt in connection with a spinoff of the Spinco. Beginning after the date of its enactment, the BBBA generally would require the parent corporation to recognize gain to the extent that the amount of Spinco debt that it transfers to its creditors exceeds (1) the aggregate basis in any assets it transfers to the Spinco less (2) (a) any liabilities the Spinco assumes from it and (b) any payments the Spinco makes to it.
- Defer worthless stock deductions on subsidiary liquidations. Beginning after 2021, the BBBA would defer a corporate parent's worthless stock loss on the liquidation of an insolvent subsidiary (a so-called Granite Trust transaction) until the parent disposes of substantially all of the subsidiary's property to unrelated persons.
- Repeal CFC downward attribution. Taxpayers may be subject to adverse tax consequences, including "phantom income," if they are 10% United States shareholders in a CFC. Very generally, a CFC is any foreign corporation more than 50% of whose voting power or value is directly, indirectly, or constructively owned by 10% United States shareholders.
The TCJA expanded constructive ownership to include downward attribution, so that a subsidiary is deemed to own all of the stock owned by any 50% shareholder. As a result of this expansion, if (for example) a foreign parent owns a U.S. subsidiary and a foreign subsidiary, the U.S. subsidiary is deemed to own all of the stock of the foreign subsidiary, so that the foreign subsidiary is treated as a CFC, which could have adverse tax consequences for any 10% United States shareholders of the parent (even if 10% United States shareholders collectively own no more than 50% of the parent).
The BBBA would repeal downward attribution retroactively as if the TCJA had never introduced it, and would instead more narrowly target the transactions that downward attribution was intended to address, namely decontrol strategies effected in connection with corporate inversions. The retroactive application of this change could motivate (or require) taxpayers to revisit closed transactions and possibly amend their tax returns.
- Limit the participation exemption to dividends from CFCs. Section 245A (enacted by the TCJA) exempts U.S. corporations from tax on dividends paid by certain 10%-owned foreign corporations, even when the foreign corporations are not CFCs so that their earnings are not subject to current U.S. taxation under the subpart F and GILTI regimes. The BBBA would limit the exemption to dividends paid by CFCs, and would allow U.S. corporations to elect to treat certain foreign corporations as CFCs. The proposal would apply retroactively to tax years beginning after 2017.
- Modify the portfolio interest exemption. The broad "portfolio interest exemption" eliminates withholding tax on U.S.-source interest paid to foreigners. The exemption does not apply to 10% shareholders, who instead are subject to withholding on interest at a 30% rate unless an income tax treaty provides otherwise. Under current law, a 10% shareholder is a holder of at least 10% of the debtor corporation's voting power. The BBBA would amend the definition to include a holder of at least 10% of the value of the debtor corporation's stock. Thus, large foreign shareholders of a domestic corporation would not be able to avoid withholding tax by holding "low vote" stock. The amendment would apply to debt issued after the BBBA's enactment.
III. Individual and Partnership Tax Measures
- Increase the individual tax rate. Under the TCJA, the highest marginal federal income tax rate applicable to individuals is 37%, increasing to 39.6% after 2025. The BBBA would increase the rate to 39.6% for tax years beginning after 2021. In 2022, the rate generally would apply to taxable income over $450,000 for married individuals filing a joint return, $425,000 for heads of households, $400,000 for unmarried individuals, and $225,000 for married individuals filing separately.
This rate increase results in a top marginal federal income tax rate of 46.4% when combined with the 3.8% tax on net investment income and the 3% surtax on high earners described below.
- Increase the maximum long-term capital gains rate. Currently, individuals are subject to a 20% maximum rate on long-term capital gains and qualified dividends. The BBBA would increase the top rate to 25% for tax years ending after September 13, 2021, unless the sale occurs in 2021 pursuant to a binding contract entered into on or before September 13.
- Expand the 3.8% tax on net investment income. Currently, limited partners who materially participate in a partnership's business are not subject to self-employment tax, and S corporation members who materially participate in an S corporation's business are subject to self-employment tax only on "reasonable compensation" that they receive in their employee capacity. These individuals also are exempt from the 3.8% tax on net investment income under section 1411, which currently applies only to certain passive income and gains.
For tax years beginning after 2021, the BBBA would subject all trade or business income of individuals earning over $400,000 (in the case of single filers) or $500,000 (in the case of joint filers) to the net investment income tax, unless that income is subject to self-employment tax.
- Impose a 3% surtax on high-income earners. Beginning after 2021, the BBBA would impose a new 3% tax on a taxpayer's modified adjusted gross income in excess of $5,000,000 ($2,500,000 for a married individual filing separately).
- Limit the qualified business income deduction. Under section 199A (enacted by the TCJA), non-corporate taxpayers may deduct up to 20% of (1) their income from a U.S. trade or business operated as a sole proprietorship or through a partnership, S corporation, trust, or estate (qualified business income) and (2) their combined (a) qualified REIT dividends (very generally, REIT dividends that are subject to tax at ordinary income rates) and (b) qualified publicly traded partnership income (very generally, their allocable share of the partnership's ordinary income). Beginning after 2021, the BBBA would limit this deduction to $500,000 for joint filers, $400,000 for unmarried individuals, and $250,000 for married individuals filing separately.
- Modify the taxation of carried interests. As we have previously discussed, section 1061 (enacted by the TCJA) imposes a three-year holding period as a precondition to recognizing long-term capital gains on carried interests issued to investment professionals, and otherwise treats the capital gains as short-term capital gains (which are taxed at ordinary income rates). The three-year holding period is determined by reference to the owner of the asset sold, whether the asset is the carried interest itself or an asset held by the partnership that issued the carried interest.
The BBBA would significantly revise section 1061 for tax years beginning after 2021. Under the BBBA, (1) a three-year holding period would apply to real property businesses and to individual investment professionals with less than $400,000 of adjusted gross income, and (2) otherwise, a five-year holding period would apply. In each case, the holding period would begin on the later of (a) the date the taxpayer acquired "substantially all" of the carried interest and (b) the date the partnership acquired "substantially all" of its assets. The legislative text requires "similar" rules to apply to tiered partnerships. The application of these rules is not at all clear.
The BBBA would further require an investment professional to recognize gain on any transfer of its carried interest, presumably even by gift or bequeath.
As we previously reported, Senate Finance Committee Chair Ron Wyden has released a discussion draft of legislation that would repeal section 1061 and instead tax carried interest holders annually at ordinary interest rates on "deemed compensation."
- Tax transfers between grantor trusts and owners. The BBBA would treat transfers between grantor trusts and their deemed owners as taxable exchanges. By contrast, under current law, the deemed owners of a grantor trust are treated as if they already directly owned the trust's assets. In addition to having far-reaching estate-planning consequences, this provision of the BBBA could be detrimental to the leveraged finance industry, because many securitizations and other borrowing transactions are effected by (1) one or more taxpayers' contribution of a pool of assets to a grantor trust in exchange for ownership certificates and (2) the grantor trust's issuance of debt securities backed by the pool of assets.
The proposal would apply to grantor trusts formed on or after the BBBA's enactment and to any portion of a grantor trust attributable to a contribution made on or after the BBBA's enactment.
- Expand the wash sale rules. Section 1091(a) currently disallows a deduction for a loss realized from the sale or other disposition of stock or securities (or contracts to buy or sell stock or securities) if, within thirty days, the taxpayer acquires substantially identical stock or securities (or contracts).
Beginning after 2021, the BBBA would expand the scope of the wash sale rules to include foreign currencies, commodities, digital assets such as cryptocurrencies, and contracts to buy or sell these assets.
Business needs exception. The wash sale rules would not apply to foreign currency and commodity trades that are directly related to the taxpayer's business needs (other than the business of trading currencies or commodities) or are part of certain identified hedging transactions. The lack of a business needs exception for digital assets could be problematic for businesses that transact in these assets, although a number of commentators believe that bitcoin and ether are commodities. If the BBBA were enacted in its current form, commodity traders that have not already done so might want to consider making an election under section 475 to "mark to market" their assets each year and treat any resulting gain or loss as ordinary in nature; the wash sale rules do not apply to mark-to-market taxpayers.
Related parties. The wash sale rules also would apply when a "related party" acquires substantially identical specified assets within the thirty-day wash sale window. For this purpose, related parties generally include (1) the taxpayer's spouse and dependents, (2) individuals or entities that control or are controlled by the taxpayer or the taxpayer's spouse or dependents, and (3) certain retirement and tax-advantaged accounts of the taxpayer or the taxpayer's spouse or dependents.
Basis adjustment. The BBBA would preserve any losses disallowed by the wash sale rules on an acquisition by the taxpayer or the taxpayer's spouse by adding the disallowed losses to the acquirer's basis in the asset. However, losses disallowed as a result of other related party acquisitions would be permanently disallowed.
- Limit gain exclusion on sales of qualified small business stock. Section 1202 currently allows noncorporate taxpayers to exclude up to 100% of their gain on a sale of certain "qualified small business stock" held for more than five years. The BBBA would eliminate the 100% exclusion rate for individuals with adjusted gross income of at least $400,000 and for all trusts and estates. Instead, these taxpayers would be eligible for only up to a 50% exclusion. This change would apply for sales occurring on or after September 13, 2021, unless the sale occurs in 2021 pursuant to a binding contract entered into on or before September 13.
- Withhold on partnership derivatives. Section 871(m) currently imposes a 30% withholding tax on U.S.-source "dividend equivalent payments" under securities loans, repos, and certain high-delta swaps and other derivatives. The BBBA would expand the withholding tax to "income equivalent payments" under repos and high-delta swaps on (1) publicly traded partnerships and (2) "any other partnership as the Secretary by regulation may prescribe." An income equivalent payment would be any payment that is "determined by reference to income or gain in respect of" the partnership, or any other payment that the IRS determines is "substantially similar."
The BBBA provides that any income equivalent payment would be treated as a dividend paid by a U.S. corporation and the rate of tax imposed on nonresident aliens and foreign corporations would not be less than the rate that would be imposed with respect to a dividend from a domestic corporation in which the foreigner owned less than 1% of the stock, by vote or value. Presumably, this means that nonresident aliens and foreign corporations qualifying for the benefits of an income tax treaty would have to use the treaty's default dividend withholding rate instead of a lower rate that might apply to larger shareholders.
The BBBA's proposal would be very difficult for taxpayers to administer. A partnership discloses an investor's allocable share of U.S.-source dividends on Schedule K-1. The partnership is not required to provide Schedule K-1 to investors until the due date for filing the partnership's tax return, which may be later than the date that payments are required to be made on a repo or swap that references the partnership. Moreover, the payer under a repo or a swap might not actually own the referenced partnership interest, and thus might not even have access to the partnership's Schedule K-1. Accordingly, parties might have to avoid entering into repos and swaps that reference partnership interests, feel compelled to over-withhold on those repos or swaps, or demand indemnification for any liability they incur for under-withholding.
- Modify the rules for worthless partnership interests. Subject to satisfying certain evidentiary burdens, taxpayers may claim a deduction under current section 165(a) for partnership equity that becomes worthless during the taxable year. Taxpayers typically treat partnership equity worthlessness deductions as capital losses if they have a share of partnership liabilities (because a shift of partnership liabilities in connection with a partner's departure results in a deemed sale), but otherwise claim ordinary losses.
Beginning after 2021, the BBBA would apply deemed sale treatment to all partnership equity worthlessness deductions, so that taxpayers would have capital losses instead of ordinary losses except to the extent the deemed sale is attributable to inventory or other "hot assets." The BBBA also would revise section 165(g), which governs deductions for worthless corporate securities, to treat partnership debt as "securities" and to treat all worthless securities deductions as arising at the time of the identifiable event establishing worthlessness instead of at the end of the year.
- Expand the constructive sale rules. Section 1259 currently treats a taxpayer as having sold an appreciated position in stock, partnership equity, or certain debt if the taxpayer or a related person enters into certain offsetting transactions. Beginning after 2021, the BBBA would expand these rules to cover digital assets, and would provide that an appreciated short sale, short swap, or short forward or futures contract is constructively sold when the taxpayer enters into a contract to acquire the reference property (not just when the taxpayer actually acquires the reference property, as under current law).
- Apply section 163(j) at the partner level. As mentioned above, section 163(j) generally allows a deduction for business interest expense only to the extent that it exceeds business interest income plus 30% of EBITDA (or EBIT, beginning after 2021). Currently, section 163(j) applies both at the partnership and partner levels. The BBBA would amend section 163(j) so that it applies only at the partner level.
- Retain the SALT deduction limitation. The TCJA capped the deductibility of personal state and local income taxes against a taxpayer's federal tax liability at $10,000 through 2025. The BBBA would not change this result, although several Congressional Democrats have expressed a desire to provide relief from the cap.
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.