Tax Provisions in Ways and Means Reconciliation Draft Could Have Far-Reaching Impacts on the Markets

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

Yesterday, House Ways and Means Committee Chairman Richard Neal (D-MA) released his draft of proposed amendments ¹ to the tax code to foot the bill for the $3.5 trillion human infrastructure and social spending FY2022 budget reconciliation package (also referred to as the Build Back Better Act).

The headline changes include various rate increases such as taking the corporate rate from

21 percent to as high as 26.5 percent with a new graduated structure (effective in 2022), taking the top marginal individual rate from 37 percent to 39.6 percent ² (effective in 2022), enacting a new Internal Revenue Code (IRC) Section 1A surcharge of 3 percent on modified adjusted gross income exceeding $5 million for joint filers (effective in 2022) and taking the top capital gains rate from 20 percent (not including the 3.8 percent Section 1411 tax on net investment income) to 25 percent (effective today). ³   There were some estate tax ⁴ and net investment income tax ⁵ surprises in the bill, but no repeal of stepped-up basis at death.

However, there are about a dozen lesser-publicized tax hikes (and even a few taxpayer-friendly changes) included in the package that could have outsized impacts on clients with significant exposure to certain liquid markets.  We will highlight them below, divided out into two main categories:  those changes that public companies directly care about (because they could impact effective tax rates) and those changes that investors directly care about (but that could have collateral impacts on public companies by increasing the cost of capital).

Tax Provisions Impacting Public Companies

    1. Change Corporate Tax Rate

Under current law, all corporations regardless of size are taxed at 21 percent.  Ways and Means is proposing to reduce the rate to 18 percent for the first $400,000 of income, leave it at 21 percent for income up to and including $5 million and increase the rate to 26.5 percent for income over $5 million (however, corporations making more than $10 million and personal services corporations will have all of their income subject to tax at the highest rate).  The domestic dividends received deduction is adjusted accordingly.  President Biden had wanted to increase the rate across-the-board to 28 percent, but we have reported that a rate of 25 percent is more likely.

(Revenue score for §138101:  $540B)

1. Impose New Section 163(n) Worldwide Interest Expense Limitation

As we wrote about in our September 11 report “Flurry of Last-Minute Reconciliation Proposals Could Significantly Impact Public Companies,” we were expecting Ways and Means to tighten the rules regarding the deductibility of business interest expense to make it harder for a multinational to lever up its U.S. entities and use the deductions for the borrowing costs to reduce the taxes it pays in the United States.  The draft confirms that Chairman Neal is proposing a number of changes to the provisions limiting interest in Section 163, including enacting new Section 163(n) (which was removed from the 2017 Tax Cuts and Jobs Act (TCJA) right before enactment) and making modifications to allow for the carryforward of interest expense otherwise disallowed in certain cases.

(Revenue score for §138111:  $35B)

1. Increase GILTI Rate (from 10.5 percent to 16.5625 percent), Calculate GILTI on a Country-by-Country Basis, Reduce QBAI from 10 percent to 5 percent, Reduce GILTI FTC Haircut (Taxpayer Favorable), Increase Rate on FDII Income (from 13.125 percent to 20.7 percent) and Determine FTCs on a Country-by-Country Basis

Combined, these changes to the global intangible low-taxed income (GILTI) rules of Section 951A and related provisions will generally increase the tax burden on foreign profits, which could impact U.S. multinationals operating in low-tax jurisdictions.  Note that the GILTI rate increase was not as large as expected (President Biden wanted it to go to 21 percent, although we thought it would end up somewhere between 12.5 percent and 18.75 percent).  Further, the deduction for qualified business asset investment (QBAI) was not entirely disallowed and the GILTI foreign tax credit (FTC) haircut was actually reduced from 20 percent to only 5 percent (which will help soften the blow of the other GILTI changes including the country-by-country change).

(Revenue score for §§138121, 138124, 138126, 138127:  $227B)

1. Modify BEAT to Increase Rate, Close COGS Exception and Make More Like SHIELD

Ways and Means is proposing to gradually increase the rate for the base erosion and anti-abuse tax (BEAT) from 10 percent to 12.5 percent in 2024 and to 15 percent in 2026.  Additionally, the BEAT rules would be modified so that they apply to payments for cost of goods sold (COGS) (getting at assets that are capitalized in inventory, so that—as we have previously written about ⁶ —taxpayers can no longer economically embed royalty payments into the price of goods to avoid the BEAT).  Ways and Means is also proposing various changes so that the BEAT looks more like President Biden’s Stopping Harmful Inversions and Ending Low-Tax Developments (SHIELD) proposal, along with incorporating various taxpayer-friendly changes including allowing FTCs to be used to offset the BEAT.  Firms in the pharmaceutical industry could be especially impacted.

(Revenue score for §138131:  $25B)

1. Impose New Limit on Leveraged Spin-Offs

Section 361 enables a corporation to lever up a subsidiary in connection with a Section 355 tax-free spin-off transaction, pulling out value in excess of the basis in the assets the corporation contributed to the subsidiary prior to the spin-off as long as the value extracted is in the form of debt securities that the corporation can then use to pay down its own debt.  This provision would amend Section 361 to trigger gain if value is extracted that exceeds asset basis, making leveraged spin-offs less common.

(Revenue score for §138143:  $21B)

1. Tighten the Rules Regarding Excessive CEO Compensation

As we predicted in our September 11 report “Flurry of Last-Minute Reconciliation Proposals Could Significantly Impact Public Companies,” Ways and Means decided to further tighten the Section 162(m) limitation on executive compensation deductions.  Specifically, while the American Rescue Plan Act of 2021 expanded which covered employees’ compensation is subject to the deduction limitation effective in 2027, Ways and Means is proposing that the change be accelerated so that it goes into effect in 2022.  At that point, the 10 most highly compensated executives (instead of only five under current law) at the company would be impacted.

(Revenue score for §138501:  $17B)

1. Postpone to 2026 the Expiration of R&E Expensing

In another taxpayer-favorable change, Ways and Means is proposing to push off until 2026 the requirement (that otherwise would have gone into effect in 2022) that taxpayers amortize research and experimentation (R&E or sometimes R&D) expenses over five years as opposed to deducting them in full in the year the cost is incurred.

(Revenue score for §138516:  -$4B)

1. End Certain Oil Tax Preferences

Ways and Means is proposing to repeal the exemption from GILTI for foreign oil and gas extraction income (FOGEI, which would be expanded to include income derived from oil shale and tar sands) and to modify the tax rule for dual capacity taxpayers (U.S. oil companies that claim certain FTCs).  The dual capacity change could impact BP p.l.c. (NYSE:  BP), Exxon Mobil Corporation (NYSE:  XOM), Royal Dutch Shell plc (NYSE:  RDS.A), Chevron Corporation (NYSE:  CVX) and ConocoPhillips (NYSE:  COP).

(Revenue score for §§138126, 138123:  not available)

1. End Prison REITS

Effective in 2022, Ways and Means would amend the real estate investment trust (REIT) Section 856 rules to prevent corporations with income from property primarily used as a prison or other detention facility to qualify as REITs.  This is not much of a surprise to the REIT world, which apparently saw the writing on the wall.  The GEO Group, Inc. (NYSE:  GEO) announced in April that it was “evaluating [its] corporate tax structure as a REIT” ⁷ and, in August 2020, CoreCivic, Inc. (NYSE:  CXW) announced that it had decided to revoke the company’s REIT election effective January 1, 2021. ⁸ 

(Revenue score for §138144:  negligible)

Tax Provisions Impacting Fund Investors

1. Modify Section 871(m) to Treat Certain Payments with Respect to PTPs and Other Partnerships as Dividend Equivalents

Section 871(m) was added to the tax code to ensure that foreign investors could not avoid U.S. withholding tax on dividends by simply entering into an equity swap or notional principal contract.  Ways and Means is proposing to expand application of the dividend equivalent rules of Section 871(m) to apply to situations where the derivative’s underlying security is a partnership interest in certain cases.  This could impact investors who hold interests in publicly traded partnerships (PTPs) or master limited partnerships (MLPs) through swaps, for example.

(Revenue score for §138146:  unavailable)

1. Limit the Section 199A Pass-Through Deduction for Qualified Business Income

TCJA enacted Section 199A to reduce the individual income taxes on pass-through business income (qualified business income or QBI) by way of a deduction of up to 20 percent of the QBI, where QBI includes, among other things, dividends from a REIT and income with respect to an interest in a PTP/MLP.  Ways and Means is proposing to cap the Section 199A deduction at $500,000 for joint filers ($250,000 for single filers), which could increase the cost of capital for REITs and PTPs/MLPs.

(Revenue score for §138204:  $78B)

1. Limit the Section 1202 Small Business Stock Gain Exclusion for High-Income Taxpayers

Current law Section 1202 provides for an exclusion for capital gains on certain C corporation small business stock (which, assuming the requirements are met, could apply to exclude $10 million of gain per individual from both the capital gains tax and the net investment income tax).  Ways and Means is proposing to retain the baseline 50 percent exclusion but repeal the 75 percent and 100 percent exclusion rates, effective September 14, for taxpayers with adjusted gross income of $400,000 or more.  Note that some of the small businesses whose investors were counting on the exclusion have since grown into large public companies.

(Revenue score for §138150:  $6B)

1. Extend Application of Section 1259 Constructive Sale Rules and the Section 1091 Wash Sale Rules to Cryptocurrency

Ways and Means would, starting in 2022, subject appreciated digital assets—think Bitcoin—to the same constructive sale and wash sale rules as other financial instruments.

(Revenue score for §§138151, 138153:  unavailable)

Provisions Missing from the Ways and Means Draft

While the scope of the tax provisions in the draft is remarkable—raising more than $2 trillion in new revenue over the next 10 years ⁹ (not taking into account dynamic scoring, additional revenue associated with increased funding for Internal Revenue Service enforcement efforts and revenue raised from proposed reforms to prescription drug pricing that could arguably get the haul within spitting distance of $3.5 trillion)—the Ways and Means draft did not include certain notable revenue raisers that have been previously floated.  Those absences include:

1. Stock Buybacks

There is no mention of an excise tax on stock buybacks or treating stock buybacks as deemed dividends.  For more coverage on this issue, see our prior report “Flurry of Last- Minute Reconciliation Proposals Could Significantly Impact Public Companies” (September 11, 2021).

1. Repeal of Stepped-Up Basis at Death

There is no mention of either repealing stepped-up basis in Section 1014 or triggering gain recognition at gift or death—both of which President Biden proposed—meaning that inherited appreciated assets with unrealized capital gains will not be treated as sold for fair market value and taxed, assuming carryover basis.

1. Carried Interest

There is no brand new regime introduced to tackle carried interest, but Ways and Means decided instead to simply extend the three-year holding period in Section 1061— used to determine if partnership interests held in connection with the performance of services can obtain preferential long-term capital gains treatment—to five years (for taxpayers with adjusted gross income of $400,000 or more) and expand the scope of Section 1061 to address avoidance through the use of so-called fee waivers and financial instruments, contracts or interests in entities other than partnerships (the expanded scope could also rope in Section 1256 contracts).

(Revenue score for §138149:  $14B)

1. SALT Cap

There is no mention of repealing (in whole or in part) the $10,000 limitation on deducting state and local taxes (SALT).

1. PTP/MLP Structure Limits

There is no proposal to end the use of the PTP/MLP structure for oil and gas businesses and, in fact, in a separate release, Ways and Means proposed expanding the PTP/MLP structure so that it is available to green energy firms. ¹⁰ 

(Revenue score for §136108:  -$1B)

1. Partnership Tax Reform

There is no mention of fundamental reforms to the partnership tax rules in subchapter K to take away some of the flexibility so that they are less able to facilitate the reduction or deferral of tax.  For more coverage of this issue, see our prior report “Flurry of Last- Minute Reconciliation Proposals Could Significantly Impact Public Companies” (September 11, 2021).

Just because these provisions were omitted from the Ways and Means markup draft does not mean that their absence from the final bill is certain.  For example, lawmakers are already promising that some form of SALT relief will be added to the bill before it comes to the House floor for a vote.¹¹ Further, just because a payfor was included in the Ways and Means markup draft, does not mean it will survive inclusion in the final bill.

As a reminder, the House can only afford to lose three votes.¹² Two House Democrats have indicated they may be willing to vote against the reconciliation bill, no matter the size (Rep. Jared Golden (ME) and Rep. Kurt Schrader (OR)), and Ways and Means Democrat Rep. Stephanie Murphy (FL) is expressing concern that the process is too rushed.^{13 “‘I don’t know how much we’re spending, how much we’re raising, how we’re spending some of the money and how we’re raising any of the money,’ [Rep. Murphy] said.  ‘We need more time.’” as reported by Brian Faler, Democrats put tax hikes on fast track — after knocking GOP’s haste on tax cuts, POLITICOPro, updated Sept. 13, 2021 (subscription required).}