On December 22, 2017, President Trump signed into law the Tax Cuts and Jobs Act (HR 1). This legislation, which was passed through Congress strictly on party lines, has made a significant number of changes and modifications to existing US tax law. Although the new tax law is getting an enormous amount of press coverage for its size, a large number of the changes will have a minimal impact on the average taxpayer. However, there are some changes that are clearly more significant and we have provided a summary of those provisions below.
TAXATION OF BUSINESSES
Corporate Income Tax
- The corporate income tax rate tables, which have long produced one of the highest effective tax rates in the world, will be drastically reduced and simplified. Currently there is a graduated tax rate system with a top tax rate of 35%, with a 34% tax rate starting at $75,000 of taxable income. Under the new tax law, there will be a flat corporate tax rate of 21% on all taxable income. When you blend the federal tax rate with the state corporate tax rates, most US corporate taxpayers will likely have an effective tax rate in the range of 27%. Note that this will closely mirror the effective federal plus provincial corporate tax rates in Canada. This change, along with most of the corporate tax law changes, is scheduled to be a permanent change to the tax code.
- The corporate alternative minimum tax (AMT) will be repealed. The corporate AMT rules were quite complex but impacted relatively few corporate taxpayers. Interestingly, the change to the corporate net operating loss (NOL) rules going forward and as explained briefly below, will effectively assure that corporate taxpayers using historic NOLs will pay federal tax even in tax years when they have accumulated NOLs that exceed their current year taxable income.
- Some of the current key attributes of corporate NOL carryforwards are that they can be carried back 2 years and carried forward 20 years, at which time they expire. Furthermore, putting aside the special loss limitation rules such as Code section 382 and 269, taxpayers can currently use 100% of their accumulated NOLs against their regular tax liability. Under the new tax law, NOLs arising in tax years beginning after December 2017 will no longer be able to be carried back and can be carried forward indefinitely, which is a taxpayer friendly modification. However, a taxpayer will only be able to offset 80% of their taxable income in future years with their NOL carryforwards. This latter modification is a substantial departure from the current rules.
- Under current law, a taxpayer can elect to take 50% bonus depreciation on “qualifying property” acquired and placed into service by the taxpayer in the taxable year. The new tax law will modify these rules and will generally allow taxpayers to fully expense (i.e., 100% deduct) the acquisition of qualifying property through 2022, after which the bonus depreciation percentage will be gradually but quickly reduced. The new tax law also expands the definition of qualifying property to include, generally speaking, newly acquired used property.
- The current interest stripping rules under Code section 163(j) provide an interest deductibility limitation, generally speaking, for interest paid by a US corporation to a related foreign person where the foreign person is subject to reduced US tax on such payment. The current interest stripping rules can be complex, but generally are applicable if a US corporation has a debt to equity ratio exceeding 1.5 to 1 (computed under special rules) and if the corporate payor’s net interest expense exceeds 50% of its adjusted taxable income (which very roughly equates to EBITDA). Under the new tax law, the interest stripping rules will largely be replaced with a more comprehensive business interest expense limitation applicable to a far wider range of transactions, both domestic and cross border. The rules will generally limit the interest expense deduction of a corporation or partnership (and regardless of how the recipient is taxed) to 30% of the entity’s adjusted taxable income. The calculation of adjusted taxable income will vary, with the calculation loosely based on EBIT through 2021 and based on EBITDA thereafter. One potentially significant exception from these new business interest expense limitation rules will be for applicable small business entities that have an average gross receipts for the 3 prior years of not more than $15 million.
- The domestic production activities deduction under section 199 will be eliminated under the new tax law.
- The business expensing provisions of section 179 will be modified under the new tax law. The dollar limitation under current rules of $500,000 will be increased to $1,000,000 and the phase out threshold under current rules of $2,000,000 will be increased to $2,500,000. These increased amounts will be indexed for inflation.
Pass-Through Income Tax
- As noted above, pass-through entities will be subject to the business interest expense limitation going forward whereas there was previously no limitations on business expense for pass-through entities.
- Under current case law, and putting aside the FIRPTA rules, a foreign person is generally not subject to gain on the sale of a partnership interest engaged in a US trade or business. Under the new tax law, a foreign person will be subject to US tax on the sale of a partnership interest when such partnership is engaged in a US trade or business to the extent the foreign person would have had effectively connected taxable income if the partnership had sold all of its underlying assets at fair market value on the date of the sale of the partnership. This change will significantly impact many Canadian investors who have invested in US trade or businesses through partnership vehicle (again putting aside the FIRPTA rules) in the past.
- The new tax law will allow for a brand new 20% deduction for certain qualified business income of a pass-through entity for tax years beginning after December 31, 2017 and before January 1, 2026. Qualified business income will be defined as all domestic business income from a qualified trade or business other than various types of investment income and capital gains. The availability of the deduction will be tied to the pass-through entity’s W-2 expense (wages paid to employees) and depreciable tangible property. The deduction will also be available to certain professional service businesses up to certain income limits.
International Tax Rules
- Most of the significant changes to US international tax rules will happen for US based companies with outbound foreign operations. Thus most of these rules will generally not impact Canadian persons doing inbound business into the US, with the notable exception of Canadian companies with hybrid debt instruments with their US subsidiaries (see below). With that said, it is still important to note some of the tax reform measures as they could be significant for US persons with business operations in Canada held through a Canadian corporation.
- Under prior law, a US corporation would be subject to US tax on dividends paid by its foreign subsidiaries. The US corporation would generally be allowed what was known as an indirect foreign tax credit to reduce its US taxes for the taxes paid by the foreign subsidiaries. However, the foreign tax credit rules could be exceedingly complex and subject to various limitations. Under the new tax law, a US corporation will be allowed a 100% deduction from its taxable income for dividends received from 10% or greater owned specified foreign subsidiaries to the extent the dividend is attributable to foreign earnings. In conjunction with this, the US corporation will not be entitled to a foreign tax credit with respect to the qualifying dividend and the indirect foreign tax credit rules will be repealed.
- To transition from the worldwide taxation rules of prior law to the rules under the new tax law that represent a more territorial system of taxation (at least for US corporations), the tax bill will provide that post-1986 earnings of foreign corporations will be taxed to the US shareholders of the foreign corporation at a rate of 15.5% for cash and cash equivalents of the foreign corporation and 8% on illiquid assets (e.g., IP). The resulting tax liability of the US shareholders will be payable over an eight year period. Importantly, note that this tax on deferred earnings of specified foreign corporations can be equally applicable to US corporate and US individual shareholders of the specified foreign corporation. See comments in Taxation of Individuals for the impact of these rules on US individuals.
- The new tax law will also introduce brand new international tax concepts to prevent US base erosion. These provisions are quite complex, but generally include a current year income inclusion for global intangible low taxed income (GILTI), provide for a deduction for foreign derived intangible income (FDII), and provide rules for a base erosion and anti-avoidance tax (BEAT). These rules are aimed more squarely at large US based multinational companies and will likely have minimal impact on Canadian businesses with inbound businesses into the US.
- The new tax law will also introduce new rules under Code section 267A that will disallow deductions for certain amounts paid by US persons to related parties involving hybrid transactions or hybrid entities. Furthermore, the tax bill will provide the US Treasury with broad authority to promulgate additional rules to address hybrid instrument issues, which it is safe to assume the Treasury will use with keenness to close all perceived loopholes. These rules will likely directly impact many financings into the US from Canada involving repo structures and other potential hybrid arrangements.
TAXATION OF INDIVIDUALS
Individual Income Tax
- Maintain seven tax brackets at slightly different rates: 10%, 12%, 22%, 24%, 32%, 35% and 37%. The top tax bracket will decrease from 39.6% and apply to those making more than $600,000 (for married individuals filing joint returns and surviving spouses), or more than $500,000 (for single individuals and heads of households). Lower tax rates and generally higher tax brackets will not always translate into a lower tax burden as the calculation of taxable income will also change.
- Increase the standard deduction to $12,000 for single individuals and $24,000 for married couples filing jointly. This is an increase from $6,350 and $12,700 permitted in 2017 under current law. The significant increase in the standard deduction is intended to compensate for the loss of the deduction for personal exemptions.
- Suspend the deduction for personal exemptions. The exemption allowed for 2017 is $4,050 per taxpayer.
- Suspend certain itemized deductions such as those for unreimbursed employee expenses, investment fees and expenses, safe deposit box rental fees, and tax preparation expenses. The suspension of these deductions and the modifications to many other itemized deductions (see below), along with the above mentioned increase in the standard deduction, is intended to significantly reduce the number of taxpayers itemizing their deductions and therefore simplify the tax return preparation process.
- Allow individuals to deduct as itemized deductions state, local, and foreign property taxes and State and local sales taxes only when paid or accrued in carrying on a trade or business.
- Allow an individual to claim an itemized deduction of up to $10,000 ($5,000 for a married taxpayer filing a separate return) for the aggregate of (i) State and local property taxes not paid or accrued in carrying on a trade or business and (ii) State and local income or sales taxes paid or accrued in the taxable year. Foreign (e.g. Canadian) real property taxes are no longer deductible.
- Limit the itemized deduction of qualified residence interest which is interest paid or accrued on debt incurred to acquire, construct or substantially improve a taxpayer’s residence by reducing the amount of debt that can be treated as “acquisition indebtedness” from the current level of $1 million to $750,000 ($375,000 in the case of married taxpayers filing separately). Acquisition debt also includes debt used to acquire a vacation home. Debt incurred before December 15, 2017 would not be affected by the reduction.
- Suspend the itemized deduction for interest on home equity indebtedness. This provision will impact those who use a home equity line of credit to fund general living expenses.
- Suspend the deduction for moving expenses and the exclusion from wages of employer paid/reimbursed qualified moving expenses.
Sole Proprietorship Income
- Allow individuals who are self-employed to take a deduction for up to 20% on the first $157,500 of business income (twice that amount or $315,000 in the case of a joint return). This will reduce their effective marginal tax rate to no more than 29.6% on that income. Limitations apply to income from specified service businesses which include those in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, and any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees.
Deferred Foreign Income of a Controlled Foreign Corporation
- Require US individual shareholders of certain foreign (e.g. Canadian) corporations to include into income in 2017 their pro-rata share of the corporation’s post-1986 accumulated profits (generally equivalent to after taxed retained earnings). This income would include all accumulated profits that have not been previously subject to US tax. This one-time deemed repatriation tax is calculated at a rate of 15.5% on the portion of accumulated profits attributable to liquid assets (such as cash, or cash equivalents) with the remainder being taxed at an 8% rate (i.e. on illiquid assets such as IP and real estate). This tax cannot be reduced by a foreign tax credit for the corporate tax paid in prior years (e.g. to Canada) on the same income. Shareholders can elect to pay the tax over an eight year period.
- Although this proposal was intended to target US multinational corporations, the rules unexpectedly apply to all US individual shareholders holding at least a 10% voting interest in a Canadian or other non-US corporation that is controlled by US persons who each have at least 10% of the corporation’s voting stock. Where the foreign corporation is not controlled by US shareholders the tax will still apply if at least one of the US shareholders is a US domestic corporation.
Capital Gains and Dividends
- Maintain the current rate structure for capital gains and qualified dividends.
Estate and Gift Tax
- Increase the estate and gift tax exemption to twice the current amount (to $11.2 million in 2018, from $5.6 million). This change will allow Canadian residents (who are not US citizens) who die after December 31, 2017 owning certain US assets to not be subject to US estate tax if their worldwide estate is less than $22.4 million and they leave their assets to their surviving spouse. A similar outcome can occur for US citizens living in Canada where there is a non-US citizen surviving spouse. These changes do not apply to decedents dying after December 31, 2025.
Alternative Minimum Tax
- Increase the AMT income exemption amount and the exemption amount phaseout thresholds. AMT will begin to apply to individuals earning over $109,400 (if married filing a joint return) and $70,300 for all other taxpayers. The phaseout thresholds for the income exemption amount are increased to $1,000,000 for married taxpayers filing a joint return, and $500,000 for all other taxpayers.
Alimony and Separate Maintenance Payments
- Effective for any divorce or separation instrument executed after December 31, 2018, alimony and separate maintenance payments are not included in income. Such payments are also not deductible by the payor spouse.
Childcare Tax Benefits
- Temporarily increase the child tax credit to $2,000 (from $1,000) per qualifying child. The credit would be refundable up to $1,400 and start to phase out for taxpayers with income in excess of $400,000 (in the case of married taxpayers filing a joint return) and $200,000 (for all other taxpayers). An additional $500 nonrefundable credit is provided for other qualifying dependents (such as parents and non-child dependents). This provision expires for taxable years beginning in 2026.
Health Insurance Mandate
- No further legal requirement to buy health insurance and repeal of the penalty tax for failure to maintain at least minimum essential coverage. The individual mandate is part of the Affordable Care Act (aka Obamacare). This rule doesn’t impact US citizens living in Canada as they were already exempt from the requirement to buy health insurance in the US due to participation in Canadian provincial health care.
For more information on these changes and how they may impact you, please contact Mark Patterson for individual tax queries and Eric Trumbull for corporate and pass through businesses or your DMCL advisor.