How the Tax Reform Conference Agreement Impacts the Publicly Traded Companies We Have Written About: REITs, MLPs, Other Investment Firms, International and Renewables

By Stuart E. Leblang, Michael J. Kliegman  and Amy S. Elliott

On Friday, December 15, the conference committee that had been reconciling the House and Senate versions of the Tax Cuts and Jobs Act (TCJA) released legislative text ¹ (503 pages) of the agreed-upon compromise bill to be voted on in the House and the Senate beginning Tuesday, December 19.

In this article, we outline some of the major provisions in the tax reform agreement that will impact the publicly traded companies we have written about, identifying the various changes in the conference report as an update to our prior articles on tax reform. ² Highlights include:

• The compromise agreement provides pass-through tax relief in the form of the Senate’s deduction (not the House’s special rate), but reduces the deduction to 20 percent (along with a reduction in the top individual rate to 37 percent until 2026, at which point it reverts back to 39.6 percent absent legislative action), continuing the preferential treatment for owners of real estate investment trusts (REITs) and master limited partnerships (MLPs), whose deduction is not subject to the wage cap.
• The compromise did not provide similar tax treatment to owners of business development companies (BDCs). Their dividends will be taxed at individual rates along with dividends from regulated investment companies (RICs).
• Publicly traded companies in the renewables space got some relief: The base erosion and anti-abuse tax (BEAT), which was included in the compromise agreement, can be reduced by a portion of the tax code Section 38 general business credits, including energy tax credits, until 2026.

Outline of Major Provisions Impacting Public Companies We Have Written About

• Beginning in 2018, corporations will pay a flat tax rate of 21 percent on much of their U.S.-source income, while much of their foreign-source income will be free of tax under a territorial system effected by way of a 100 percent participation exemption for dividends.
• The rate is higher than the 20 percent originally proposed both by the House and the Senate, but effective in 2018 (as opposed to 2019, as in the Senate bill).
• o Conferees decided to fully repeal the corporate alternative minimum tax (AMT), however net operating losses (NOLs) are only allowed to reduce a taxpayer’s taxable income by 80 percent (instead of 90 percent, although a purely domestic company is generally able to take advantage of expensing to zero out its tax liability). In the conference agreement, NOLs can be carried forward indefinitely.
• Businesses can immediately deduct the full cost of certain capital expenditures (property with depreciable lives of 20 years or less, including most equipment but not including most real property) acquired after September 27, 2017, and through 2022.
• The expensing benefit is phased down gradually until no amount of bonus depreciation is available in 2027. Expensing is optional. Taxpayers that would instead prefer to depreciate their investments over time may choose to do so.
• The conference agreement adopted the House’s provision that extends expensing to used property, which means that corporations may be able to deduct much of the cost of purchasing another business as long as they structure the acquisition as an actual or deemed taxable asset sale as opposed to a stock sale. This could impact the structure of M&A deals between unrelated parties at arm’s length terms.
• Certain regulated public utilities and electing real property businesses, among others, may not be able to take advantage of this expensing provision.
• Both corporations and partnerships will have their deduction for net interest expense (the cost of servicing their debt) limited to 30 percent of the business’s earnings before interest, taxes, depreciation and amortization (EBITDA), as the House proposed, beginning in 2018 and through 2021.
• This limit—revised tax code Section 163(j)—will go down for many businesses in 2022, when the Senate’s version is adopted (30% of EBIT, requiring that a business first take all of its depreciation, amortization and depletion deductions).
• The limit does not apply to those businesses that are not eligible for expensing.
• While both the House- and Senate-passed bills contained a second interest expense limitation tied to the overall leverage of the worldwide group, the conferees decided to get rid of that provision (possible tax code Section 163(n)). Keep in mind, however, that the BEAT (described in more detail below) could apply to further limit the value of interest expense deductions in some cases.

International Businesses

• All previously accumulated, deferred foreign earnings will be subject to a mandatory repatriation (repat) tax of 15.5 percent on cash and 8 percent on the remainder.
• The rate is higher than the 14 percent on cash and 7 percent on the remainder as proposed in the House bill (or 14.49 percent and 7.49 percent in the Senate bill).
• The repat tax is still applicable to all 10 percent U.S. shareholders, including REITs, S corporations and partnerships (unless the earnings are of a foreign corporation that is neither a controlled foreign corporation nor has at least one 10 percent shareholder that is a U.S. corporation).
• The conference report makes clear that the portion of deferred foreign earnings subject to the repat tax does not include any earnings and profits accumulated by the foreign corporation before it became a “specified foreign corporation” (i.e. before it became either a controlled foreign corporation or before one or more domestic corporations became a 10 percent shareholder of the foreign corporation).
• The conference report also states that “certain taxpayers may have engaged in tax strategies designed to reduce the amount of post-1986 earnings and profits in order to decrease the amount of the inclusion required under this provision. Such tax strategies may include a change in entity classification, accounting method, and taxable year, or intragroup transactions such as distributions or liquidations. The conferees expect the Secretary to prescribe rules to adjust the amount of post-1986 earnings and profits in such cases in order to prevent the avoidance of the purposes of this section.”
• The conference report adopts the Senate’s base erosion and anti-abuse tax (BEAT), which imposes a new minimum tax on U.S. corporations (but not RICs, REITs and S corps) that make certain deductible payments to related foreign corporations (but will not hit payments for cost of goods sold, unless the foreign corporation is itself or is related to a 60 percent to 80 percent surrogate foreign corporation, i.e. an inverted corporation). The BEAT also will not hit payments for services provided with no markup. The BEAT applies after the Section 163(j) net interest expense limit. The 4 percent base erosion payment threshold (used to determine whether the BEAT applies) was reduced to 3 percent in the conference report (or 2 percent for certain banks and securities dealers).
• If it applies, the BEAT would add back into taxable income the base eroding deductible payments a U.S. corporation makes to related foreign corporations and tax the whole amount at 10 percent (replacing the corporation’s regular income tax liability). However, conferees decided to add some transition relief and will impose the BEAT’s minimum tax at only a 5 percent rate for taxable years beginning in 2018. The rate goes from 10 percent to 12.5 percent in 2026.
• While foreign tax credits are not allowed to reduce the BEAT, the conferees decided to allow some tax code Section 38 general business credits (and not just the research and development credit) to reduce the amount of tax due (including the Section 45 wind production tax credit and the Section 46 credit to the extent it is allocable to the Section 48 solar investment tax credit). The portion of Section 38 credits that can be used to reduce the BEAT’s minimum tax is the lesser of: 80 percent of the Section 38 credits or 80 percent of the base erosion minimum tax amount absent this rule. This accommodation goes away in 2026.
• Qualified derivative payments remain excluded from the BEAT (although the BEAT rate is increased by 1 percentage point to 11 percent—or 6 percent in 2018 and 13.5 percent in 2026 and beyond—for certain banks and securities dealers), although the conference report states that the exception “does not apply if a payment with respect to a derivative is in substance, or is disguising, the kind of payment that would be treated as a base erosion payment if it were not made pursuant to a derivative, including any interest, royalty, or service payment.”
• The conference report also adopts the Senate’s global intangible low-taxed income (GILTI) tax, which imposes an additional U.S. tax of as much as 10.5 percent on all income earned in a foreign country not representative of a return on tangible investments if earned by a foreign corporation that is controlled by a U.S. corporation. The GILTI tax increases from 10.5 percent to 13.125 percent in 2026.
• If a foreign jurisdiction levies a tax of 13.125 percent on the foreign income, no additional U.S. tax is due (because, as the conference report explains, “13.125 percent equals the effective GILTI rate of 10.5 percent divided by 80 percent,” which represents the amount of foreign tax credits allowed).
• The foreign income potentially subject to the GILTI is calculated assuming a 10 percent rate of return on tangible investments in the foreign jurisdiction.
• The related GILTI deduction (sometimes referred to as a patent box like benefit) can serve to reduce the tax paid by U.S. corporations (to 13.125 percent instead of 21 percent) on certain income earned in the United States but that happens to be derived from foreign consumption (foreign-derived intangible income or FDII). The deduction goes down in 2026, increasing the effective tax rate on FDII to 16.406 percent.
• The conferees decided to make the FDII deduction unavailable for RICs and REITs.
• To the extent that U.S. exporters book their profits in the United States and have relatively low basis investments in tangible property in the United States, they could benefit from a nearly 8 percentage point reduction in their effective tax rates due to the GILTI-related deduction for FDII.
• In a future article, we will address how this export incentive, combined with the main GILTI provision, could incentivize U.S. multinationals to locate their tangible investments offshore.

Pass-through Businesses

• Beginning in 2018, certain owners of pass-through businesses (including, to some extent, REITs and MLPs) may be eligible for a reduced rate of tax on their business income (effected by way of a 20 percent deduction, instead of the 23 percent in the Senate-passed bill). The lower deduction rate should be evaluated in conjunction with the lower top individual tax rate on high-income earners (37 percent on income over $600,000 for taxpayers filing joint returns until 2026).
• Originally, the Senate proposed a top individual rate of 38.5 percent on joint income over $1 million and the House proposed a top individual rate of 39.6 percent on joint income over $1 million.
• The deduction for pass-through owners in the top income tax bracket (excluding the impact of the 3.8 percent net investment income tax, which is preserved in tax reform) would now result in an effective rate of tax on qualified pass-through income of 29.6 percent (instead of the ordinary top individual rate of 37 percent). This is the same effective rate of tax as resulted from the original 23 percent deduction contemplated in the Senate-passed bill, which would have imposed a top individual rate of 38.5 percent.
• The deduction is scheduled to sunset at the end of 2025, but the conference agreement makes clear that it is available to both itemizers and non-itemizers.
• There are two important limitations on the deduction: the wage cap and the specified service business carve-out. While the Senate had effectively provided that neither limitation applied to the first $500,000 of an owner’s joint taxable income, the conferees decided to reduce that amount to $315,000 (although to avoid a cliff effect, the limitations are phased in from $315,000 to $415,000, in the case of a joint return).
• The change was reportedly made to “to deter high-income taxpayers from attempting to convert wages or other compensation for personal services to income eligible for the 20-percent deduction under the provision.”
• In addition, the compromise agreement modifies the wage cap to include a capital element, which could help start-ups that invest their limited funds in equipment as opposed to workers. When it applies, the revised cap limits the amount of the 20 percent deduction to whichever is greater: a) half of the Form W-2 wages paid out by the pass-through and allocated to the owner, or b) 25 percent of such wages plus 2.5 percent of the unadjusted basis of certain depreciable, tangible property used in the business.
• The conferees also modified the definition of specified service business so that engineering and architectural businesses now benefit from the deduction. Investing and investment management remains in the definition. (Additionally, trusts and estates are now eligible to take the deduction.)

Key Takeaways:

1. The provisions in the Senate-passed bill that directly targeted inverters were all incorporated into the conference agreement. They include: 1) repatriation discount recapture that would tax at 35 percent earnings that had benefitted from a reduced rate of tax as part of the mandatory repat if, within 10 years after tax reform is enacted, the 10 percent owner becomes a surrogate foreign corporation (although the conference agreement clarifies that U.S. shareholders acquired by a surrogate foreign corporation are only hit if the surrogate foreign corporation inverted post-enactment, not if the U.S. shareholder was acquired post-enactment); 2) increased rate of tax on dividends beginning in 2018 if paid out by a surrogate foreign corporation; 3) the BEAT applies to deductible payments for cost of goods sold and payments for services provided without a markup if the payments were made by a U.S. corporation to a related inverter or a foreign affiliate related to an inverter; and 4) an increase rate (from 15 percent to 20 percent) for the excise tax on stock-based compensation of top executives of an inverter.
2. The modified 20 percent deduction for certain pass-through income is still available for REITs (both real estate and mortgage) and MLPs. Lowering the complete exemption from the wage cap to only the first $315,000 of an owner’s joint income (instead of $500,000) should not negatively impact the ability of retail investors to benefit from the deduction with respect to their interests in REITs and MLPs, because the text of the bill continues to provide special treatment for amounts from such entities, making them not subject to the wage cap.
3. The 20 percent pass-through deduction remains unavailable for BDCs and RICs. The conference committee report makes no mention of BDCs. Such entities may try to get their change incorporated into a clean-up bill.
4. Publicly traded clean energy companies got some relief, because the conferees decided to revise the BEAT to allow a portion of certain business tax credits (including energy tax credits) to reduce the minimum tax due, until 2026. However, because any credits that were disallowed in a year because of application of the BEAT cannot be carried forward, the industry is still seeking a fix. In addition, the corporate AMT was repealed, further alleviating concerns that investors such as multinational banks might pull out of tax credit partnerships, shrinking the available pool of capital for publicly traded firms involved in renewable energy projects. In addition, the conference agreement leaves the renewable energy tax provisions contained in the December 2015 Protecting Americans from Tax Hikes (PATH) Act as-is, deciding, for example, not to accelerate the phase-out of the of the production tax credit.
5. Interest income earned by a mortgage REIT and paid out to investors as dividends will still have a significant advantage over alternative mortgage investments. Compare the 29.6 percent effective rate for a REIT shareholder with the 37 percent rate if the interest income is earned through a private debt fund or a mutual fund that holds mortgages.

We continue to review the legislation and will provide additional updates in the coming days on the likely impact of tax reform on publicly traded companies.

^{[1] The full conference report, containing the legislative text of the agreement, a section-by-section summary and a preliminary revenue score from the Joint Committee on Taxation is available at: http://docs.house.gov/billsthisweek/20171218/CRPT- 115HRPT-%20466.pdf}

^{[2] In particular, the following of our prior reports touch on some of the points in this article: Dec. 14 “How Will Tax Reform Impact Old and New Inverters?”; Dec. 12 “Comparing Tax Reform’s Impact on Publicly-Traded Investment Funds: A Pass- through Investment Guide”; Dec. 6 “Explaining the Impacts of the House and Senate Tax Reform Bills on Publicly Traded Clean Energy Companies”; Dec. 4 “Mortgage REITs Could Be Big Winners in Tax Reform”; Dec. 3 “Senate Agrees to Exempt MLPs from the Wage Cap and Increases the Pass-through Deduction to 23 Percent”; Nov. 15 “Senate Modifies 17.4% Deduction for Pass- through Income to Expand Benefit for MLP Investors with Less than $500k Taxable Income”; Nov. 12 “Senate Bill—With Deduction for Pass-through Income—May Have Radically Different Impact on Certain MLPs than House Bill; Treatment of REITs More Ambiguous, But Likely Favorable”; and Nov. 3 “Some Unexpected Impacts of Proposed Tax Bill: REITs Could Be Big Winners, Impact on MLPs Mixed and Complicated, and Threat to Certain Multinationals from New Related-Party Payment Excise Tax.”}