The American Jobs Creation Act of 2004
On October 22, 2004 (the “Date of Enactment”), President Bush signed tax legislation which will provide $137 billion in tax cuts over the next ten years. This new tax legislation is the fifth significant tax bill signed by the President during his term of office. The American Jobs Creation Act of 2004 (“Act”) delivers tax relief for U.S.-based manufacturing activities, provides a deduction for state sales taxes, restricts deductions for non-cash charitable contributions, reforms the taxation of multinational business, imposes severe penalties on tax shelters, and provides income tax relief for many businesses. Funding for changes to business taxation comes from many sources including the repeal of the Extraterritorial Income tax provisions that the World
Trade Organization has ruled illegal and $88 billion of other business tax increases.
This memorandum summarizes various provisions of the Act likely to be significant to many taxpayers. This summary is not intended to be a complete explanation of the Act, although it does address many provisions found in the 910 Sections into which the legislation is divided.
PART I: REPEAL OF EXPORT SUBSIDIES
SECTION 101: REPEAL OF EXTRATERRITORIAL INCOME REGIME. For almost two decades, the United States provided export tax incentives to U.S. manufacturers of goods and products shipped abroad through Foreign Sales Corporations (“FSCs”). In response to a determination by the World Trade Organization (“WTO”) that the FSC regime represented an illegal subsidy for exporters, the United States repealed the FSC rules and enacted new tax-based export incentives under the Extraterritorial Income regime (“ETI”) of Section 114 of the Internal Revenue Code of 1986, as amended (“Code”).
Under the ETI rules, taxpayers could reduce income derived from foreign sales for purposes of determining their U.S. income tax liability. These rules were also challenged in the WTO and in January 2002, the WTO appellate body held that the ETI regime was also a prohibited export subsidy under trade agreements between the United States and the European Community.
Section 101 of the Act repeals the ETI exclusion by a phase-out of the provision over the next two years. Foreign corporations that elected to be treated as domestic corporations in order to claim ETI benefits are allowed to revoke their elections within one year of the Date of Enactment. Generally, revocation of the election is without recognition of gain or loss but will be subject to anti-abuse rules which will apply in limited circumstances.
Repeal of Section 114 and the Extraterritorial Income Exclusion Rules contained therein is effective for transactions after December 31, 2004. However, a transition rule applies for 2005 and 2006 transactions as well as binding contracts in effect on September 13, 2003 and at all times thereafter.
For transactions occurring in 2005, the reduction in taxable income provided by Code Section 114 will continue to be available at eighty percent (80%) of its pre-2005 level. For transactions occurring in 2006, the ETI exclusion rules will be available at sixty percent (60%) of the pre-2005 level.
Exception for Binding Contracts:
The Extraterritorial Income Exclusion rules of Code Section 114 will continue to apply in the case of binding contracts between U.S. taxpayers and unrelated persons which were in effect on September 17, 2004.
Code Section Affected: Code Section 114 repealed.
SECTION 102: DEDUCTION FOR DOMESTIC PRODUCTION ACTIVITIES. The Act provides a deduction for income realized from Qualified Production Activities. The deduction is phased in over five years pursuant to the following table:
Taxable Year: Deduction as Percentage of Taxpayer’s
Qualified Production Activities Income:
2010 and subsequent years: 9%
The deduction is available to both corporate and individual taxpayers. The deduction is available for both regular and minimum tax purposes.
Domestic Production Gross Receipts: The Act begins the computation of Qualified Production Activities Income with the computation of Domestic Production Gross Receipts. The term “Domestic Production Gross Receipts” generally refers to receipts of a taxpayer that are derived from:
(1) any lease, rental, license, sale, exchange, or other disposition of
tangible personal property, computer software, audio recordings, or property which was manufactured, produced, grown, or extracted by the
taxpayer either entirely or primarily within the United States;
(b) movies and videos if at least half of the total compensation relating to production was paid to actors, production personnel, directors, and
producers performing services in the United States; and
(c) domestically produced electricity, natural gas, or potable water,
(2) domestic construction,
(3) domestically performed engineering or architectural services for domestic construction projects.
To arrive at Qualified Production Activities Income against which the deduction for Qualified Production Activities is computed, Domestic Production Gross Receipts are reduced by the total of (1) the cost of goods sold and allocable to such receipts, (2) other deductions, expenses, or losses directly allocable to such receipts, and (3) a ratable portion of other deductions, expenses, and losses that are not directly allocable to such receipts or another class of income.
The Qualified Production Activities Income of a taxpayer will be limited so as not to exceed fifty percent (50%) of the W-2 wages paid by the taxpayer for the taxable year. In addition, gross receipts from retail sales of food and beverages and transmission or distribution (as opposed to sale or disposition) of electricity, natural gas, or potable water are expressly excluded from the definition of Domestic Production Gross Receipts. Finally, Domestic Production Gross Receipts will also not include revenue derived by a taxpayer from lease, license, or rental income paid to the taxpayer by a related person determined pursuant to the provisions of Code Sections 52 and 414.
Special rules apply in the case of S Corporations, individuals, patrons of agricultural and horticultural cooperatives, and affiliated groups.
Taxable years beginning after December 31, 2004.
Code Section Affected: Section 199 added to the Code.
The deduction can not exceed fifty percent (50%) of the W-2 wages paid by the taxpayer. Therefore individuals operating sole proprietorships or partnerships will be unable to receive a deduction which takes into consideration compensation paid to those owners, because that compensation is not considered W-2 wages. In the case of an S-Corporation, only the amount paid to the owner(s) as wages will be considered. Consequently, for businesses taxed as sole proprietorships
or partnerships, some thought should be given to converting to a corporate entity. For businesses taxed as S-Corporations, consideration should be given to increasing the W-2 compensation of the owner(s). Of course, any such change would have a variety of other income tax consequences which must also be factored into the analysis.
BUSINESS TAX INCENTIVES
Small Business Expensing
SECTION 201: EXTENSION OF INCREASED EXPENSING FOR SMALL BUSINESSES. The Jobs and Growth Tax Relief Reconciliation Act of 2003 (“JGTRRA”) increased the amount a taxpayer may deduct for tangible personal property used in the active conduct of a trade or business from $25,000 to $100,000. The increased deduction was available for property placed in service for taxable years beginning before 2006. The Act extends the increased Code Section 179 deduction created by JGTRRA by two (2) years.
Property eligible for expensing under Code Section 179 includes off the shelf computer software. The $400,000 threshold above which the deduction under Code Section 179 is reduced is also extended by the Act as are provisions to index the Code Section 179 amounts for inflation.
On the Date of Enactment.
Code Section Affected: Code Section 179(b), (c), and (d).
SECTION 211: RECOVERY PERIOD FOR DEPRECIATION OF CERTAIN LEASEHOLD IMPROVEMENTS AND RESTAURANT PROPERTY.
The Act provides a 15-year recovery period for qualified leasehold improvement property placed into service before January 1, 2006. Current law defines qualified leasehold improvement property as improvements to the interior portions of a building which is nonresidential real property made pursuant to a lease
more than 2 years after the building was placed in service. However, the Act modifies the definition of qualified leasehold improvement property appearing in Code Section 168(k)(3) to exclude the subsequent owner of a qualified improvement from qualifying for the reduced recovery period.
Additionally, restaurant property is now included as qualified property if:
(1) it is placed into service more than 3 years after the building in which it is located began operating, and
(2) if more than 50% of the building’s square footage is devoted to preparation of, and seating for, on-premises consumption of prepared meals.
As the Act is written, this reduction in the recovery period is only available through 2005. Thus, taxpayers should consider accelerating improvements to the extent possible.
Effective Date: After the Date of Enactment for all property placed in service before 2006.
Code Section affected: Code Section 168(e)(3) and (k)(3).
221: MODIFICATION OF TARGETED AREAS AND LOW INCOME COMMUNITIES FOR NEW MARKETS TAX CREDIT.
The Act permits the Secretary of the Treasury to prescribe regulations to determine areas that may be treated as low-income communities. The Secretary’s regulations will include procedures for determining entities that qualify as active low-income community businesses with respect to populations within an empowerment zone or defined as a “low income community” for purposes of the New Market Tax Credit. Additionally, the Act defines when a population
census tract with less than 200,000 individuals can qualify as a low income community for the Credit.
Effective Date: After the Date of Enactment for designations made by the Secretary of the Treasury
Code Section affected: 45(D)(e) paragraph 2.
SECTION 231: MEMBERS OF A FAMILY TREATED AS ONE SHAREHOLDER.
The Act updates rules which limit the number of persons permitted as stockholders of S Corporations. In addition to a husband and wife being treated as one
shareholder, by election other members will also be treated as one shareholder. Eligible family members include common ancestors, lineal descendants of the common ancestor, and spouses (or former spouses) of such lineal descendants or the common ancestor. Common ancestors may go back as many as six generations from the youngest family member.
Effective Date: Tax years beginning after December 31, 2004.
Code Section Affected: Code Section 1361(c).
SECTION 232: INCREASE IN NUMBER OF ELIGIBLE SHAREHOLDERS TO 100.
The Act expands the number of shareholders S Corporations are permitted to have from 75 to 100.
Effective Date: Tax years beginning after December 31, 2004.
Code Section Affected: Code Section 1361(b).
SECTION 233: BANK S CORPORATION STOCK HELD IN IRAS.
Ownership of stock of a corporation which satisfies the definition of a “bank” for purposes of Code Section 581 may be held by an individual retirement account without jeopardizing the S election. However, the relief provided by the Act applies only to stock held by the IRA on the Date of Enactment. In the case of stock held by IRAs in corporations which make an S election, the sale of stock to a related person (including the owner of the IRA) will not be treated as a prohibited transaction if sold within one hundred twenty (120) days after the S election is made and at the fair market value at the time of sale (as established by an independent appraiser). Other conditions also apply.
Effective Date: On the Date of Enactment.
Code Section Affected: Code Sections 1361(c)(2)(A) and 4975(d).
SECTION 234: DISREGARD OF UNEXERCISED POWERS OF APPOINTMENT IN DETERMINING CURRENT BENEFICIARIES OF ELECTING SMALL BUSINESS TRUSTS.
Limited types of trusts are permitted as shareholders of S Corporations. The rules which limit the number of persons who may be beneficiaries of S
Corporations, generally treat each current beneficiary of these trusts as a separate shareholder. The Act clarifies that the persons in whose favor a power of appointment over trust property may be exercised will not be treated as current beneficiaries and will be disregarded for purposes of the limits on the number of permitted shareholders of S Corporations.
Section 234 of the Act also extends the period during which an electing small business trust can dispose of S
Corporation stock after an ineligible shareholder becomes a beneficiary of the Trust from sixty (60) days to one (1) year.
Effective Date: Taxable years beginning after December 31, 2004.
Code Section Affected: Code Section 1361(e)(2).
SECTION 235: TRANSFER OF SUSPENDED LOSSES INCIDENT TO DIVORCE, ETC.
Losses of an S-Corporation which flow through to its shareholders are deductible to the extent of the shareholder’s basis in the stock of the Corporation. Once basis is reduced to zero otherwise eligible losses of an S-Corporation are suspended until additional basis is acquired by the shareholder. The Act provides that in a case in which S Corporation stock is transferred in circumstances described in Code Section 1041(a) (generally, any transfer between spouses, as well as transfers between former spouses which are incident to a divorce), the suspended losses attributable to such shares will be available to the transferee subject to the preceding basis requirements. Thus, the suspended losses attributable to the shares will be available to the transferee spouse
once the transferee acquires additional basis, even though the losses were incurred by the S-Corporation when the transferee spouse was not a shareholder.
Effective Date: Tax years beginning after December 31, 2004.
Code Section Affected: Code Section 1366(d)(2).
SECTION 238: RELIEF FROM INADVERTENTLY INVALID QUALIFIED SUBCHAPTER S SUBSIDIARY ELECTIONS AND TERMINATIONS.
The Act expands the language of
Code Section 1361 to permit relief for invalid elections and inadvertent terminations of S elections by the Secretary of Treasury in the case of qualified Subchapter S subsidiaries to the same degree as other Corporations electing S status.
Effective Date: Tax years beginning after December 31, 2004.
Code Section Affected: Code Section 1362(f).
SECTION 239: INFORMATION RETURNS FOR QUALIFIED SUBCHAPTER S SUBSIDIARIES.
The Act expands Section 1361 by providing that a corporation which is a qualified subchapter S subsidiary will not be treated as a separate corporation for tax reporting purposes except as provided in regulations issued by the Secretary of the Treasury.
Effective Date: Tax years beginning after December 31, 2004.
Code Section Affected: Code Section 1361(b)(3)(A).
Stock Options and Employee Purchase Plan Stock Options
SECTION 251: EXCLUSION OF INCENTIVE STOCK OPTIONS AND EMPLOYEE STOCK PURCHASE PLAN STOCK OPTIONS FROM WAGES.
The Act clarifies that payroll taxes (FICA and FUTA) will not be imposed on income realized by an employee on exercise of an incentive stock option, receipt of stock under an employee stock purchase plan, or the disposition of the shares received as a result of the option or participation in the plan.
Further, the Act does not require employers to withhold federal taxes on a disqualifying disposition or on compensation resulting from a discount under an employee stock purchase plan.
Effective Date: Applicable to stock acquired on exercise of options after the Date of Enactment.
Code Section Affected: Code Section 3121(a).
TAX RELIEF FOR AGRICULTURE
SECTION 311: SPECIAL RULES FOR LIVESTOCK SOLD ON ACCOUNT OF WEATHER-RELATED CONDITIONS.
The Act permits a livestock owner to replace livestock destroyed by drought, flood, or other weather-related conditions for other property used for farming purposes. It also extends the period in which a farmer may replace livestock sold on account of drought, flood, or other weather-related conditions from two to four years.
Effective Date: Any taxable year with respect to which the due date for the return is after December 31, 2002.
Code Section Affected: Code Section 1033(e) and (f).
SECTION 314: COORDINATION OF FARMERS AND FISHERMEN INCOME AVERAGING AND THE ALTERNATIVE MINIMUM TAX.
The Act extends the benefits of income averaging to fishermen. In addition, it allows farmers and fishermen who use income averaging to compute their regular tax without regard to income averaging in order to determine their alternative minimum tax liability. Thus, the use of income averaging by farmers and fishermen
will not result in an alternative minimum tax liability if the AMT would not have otherwise applied.
Effective Date: Tax years ending after the Date of Enactment.
Code Section Affected: Code Section 55(c).
SECTION 315: CAPITAL GAIN TREATMENT UNDER SECTION 631(b) TO APPLY TO OUTRIGHT SALES BY LANDOWNERS. The Act suspends the requirement of current law that a taxpayer must retain an economic interest in the sale of timber
in order to qualify for capital gain treatment. In such a case, the special rules of Code Section 631(b) permitting income to be recognized at the time the timber is cut will not apply.
Effective Date: Tax years beginning after December 31, 2004.
Code Section affected: Code Section 631(b).
TAX REFORM AND SIMPLIFICATION FOR UNITED STATES BUSINESSES
SECTION 401: INTEREST EXPENSE ALLOCATION RULES.
The Act provides taxpayers with a one-time election to change the method by which the interest expense of U.S. group members is allocated and apportioned between U.S. source and foreign source group members. Additionally, the Act provides an election for financial institutions.
The result of this election
is that the worldwide affiliated party expense is allocated and apportioned to foreign source income in an amount equal to the excess (if any) of:
(1) The interest expense of the Worldwide Affiliated Group multiplied by the ratio which the foreign assets of the Worldwide Affiliated Group bears to all the assets of the Worldwide Affiliated Group, over
(2) The interest expense of all foreign corporations which are members of the Worldwide Affiliated Group to the
extent that the interest expense would have been applied to foreign source income had the Worldwide Affiliated Group consisted only of foreign corporations.
For purposes of the election, the term “Worldwide Affiliated Group” refers to all corporations in an affiliated group (as determined under present law for interest allocation purposes), plus all controlled foreign corporations with respect to which (either directly or indirectly), a common parent owns at least eighty percent (80%) of the total voting power or value of the foreign corporation’s stock.
The Act continues to afford taxpayers the
ability to apply the rules which currently exclude certain financial institutions from the world-wide affiliated group for interest allocation and apportionment purposes. The Act also expands the definition of a bank group for purpose of income expense allocation and appointment by providing a one-time election for this expansion.
Effective Date: Tax years beginning after December 31, 2008.
Code Section Affected: Code Section 864.
SECTION 402: RECHARACTERIZATION OF OVERALL DOMESTIC LOSS.
The Act allows taxpayers to undo the effect of domestic losses on their foreign tax credit limitations by allowing taxpayers a recovery that is similar to
the treatment of overall foreign losses. This is done by taking a portion of the taxpayer’s U.S. produced income for the years following an overall domestic loss and recharacterizing it as foreign source income in an amount equal to the lessor of:
(1) The amount of the loss (to the extent not used in prior years), or
(2) Fifty percent (50%) of the taxpayer’s U.S. source income for the succeeding year.
Effective Date: Losses for tax years beginning after December 31, 2006.
Code Section Affected: Adding new Code Section 904(g).
SECTION 403: LOOK-THRU RULES TO APPLY TO DIVIDENDS FROM NONCONTROLLED SECTION 902 CORPORATIONS.
The Act applies look-through treatment to all of the earnings and profits of a 10/50 company (a foreign corporation in which a U.S. taxpayer owns at least ten percent (10%) of the stock by vote but which is not a controlled foreign corporation), regardless of when those earnings and profits were accumulated. Generally, dividends of 10/50 companies will be allocated to separate categories of income identified in Code Section 904(d) that are proportionate to the earnings and
profits of the foreign corporation paying the dividend. However, dividends that have not been adequately substantiated will be treated as passive income.
Effective Date: Tax years beginning after December 31, 2002.
Code Section Affected: Code Section 904(d)(4).
SECTION 404: REDUCTION TO TWO FOREIGN TAX CREDIT BASKETS.
The Act reduces the number of foreign tax credit baskets from nine to two. (Foreign taxes are allocated to the same baskets as the income to which they relate.) The two remaining tax baskets are:
(1) passive category income and
(2) general category income.
Passive category income includes passive income, as well as foreign trade income, dividends from a DISC, and distributions from a FSC attributable to foreign trade income.
General category income is any income which is not passive category income and includes financial services income if it is earned by a member of a financial services group (an affiliated group which is predominately engaged in the active conduct of a banking, insurance, financing, or similar business) or any other person that is predominantly engaged in the active conduct of banking, insurance, financing, or similar business.
Additionally, the Act provides the Secretary of the Treasury with the authority to regulate financial services income received or accrued by partnerships and other pass-through entities which are not members of a financial services group.
Effective Date: Tax years beginning after December 31, 2006.
Transition Rule: In cases in which foreign law imposes a tax on an item of income that does not constitute income under U.S. tax principles (generally referred to as a “base difference” item), current law treats such taxes as imposed on general limitation income. In the case of such taxes arising in taxable years beginning after December 31, 2004 and before January 1, 2007 taxpayers may elect to treat such foreign taxes as imposed on
financial services income instead of general limitation income.
Code Section Affected: Code Section 904.
SECTION 405: ATTRIBUTION OF STOCK OWNERSHIP THROUGH PARTNERSHIPS TO APPLY IN DETERMINING SECTION 902 AND 960 CREDITS
The Act codifies the result in Revenue Ruling 71-141, 1971-1 C.B. 211 to permit domestic corporations owning stock of a foreign corporation through a partnership to claim a foreign tax credit with respect to foreign taxes paid by the foreign corporation. In order to be eligible to claim the deemed paid foreign
tax credits, the domestic corporation must own directly (or indirectly through the partnership) at least ten percent (10%) of the foreign corporation’s voting stock.
Effective Date: Applicable to taxes paid by foreign corporations in taxable years of such foreign corporations beginning after the Date of Enactment.
Code Section Affected: New Code Section 902(c)(7) added.
SECTION 406: CLARIFICATION OF TREATMENT OF CERTAIN TRANSFERS OF INTANGIBLE PROPERTY.
The Act provides that payments deemed to be received from outbound transfers of intangible property (generally treated as a sale under Code Section 367(d)) are to be treated as royalties for purposes of applying the separate limitation categories of the foreign tax credit. Such income will be classified as general category income.
Effective Date: Amounts treated as received on or after August 5, 1997 (effective date of the Tax Relief Act of 1997).
Code Section Affected: Code Section 367(d)(2)(C).
SECTION 407: UNITED STATES PROPERTY NOT TO INCLUDE CERTAIN ASSETS OF CONTROLLED FOREIGN CORPORATION.
U.S. shareholders owning ten percent (10%) or more of the stock of a controlled foreign corporation are required to include in taxable income their pro rata shares of the controlled foreign corporation’s earnings to the extent invested by the controlled foreign corporation in certain U.S. property in a taxable year. Code Section 956(c)(2) provides exceptions to the assets generally considered as “U.S. property”. The Act adds to new exceptions:
Securities (including those issued by related persons) that are acquired and held by a controlled foreign corporation in the ordinary course of its business as a dealer in securities; and
(2) Obligations of a U.S. person who is not a domestic corporation and not a United States shareholder (as defined in Code Section 951(b)) of the controlled foreign corporation, or a partnership, estate, or trust in which the controlled foreign corporation or any related person is a partner, beneficiary, or trustee.
Effective Date: Tax years beginning after December 31, 2004, and taxable years of United States shareholders with or within which such taxable years of the foreign corporations end.
Code Section Affected: New Code Sections 956(c)(2)(L) and (M) added.
SECTION 408: TRANSLATION OF FOREIGN TAXES. Foreign taxes paid directly by U.S. taxpayers, as well as foreign taxes paid by foreign corporations that are deemed to be paid by a domestic corporation as a shareholder of the foreign corporation, are calculated by translating the amount of foreign
taxes paid in foreign currencies into a U.S. dollar amount. Generally, for accrual basis taxpayers the U.S. dollar amount is determined by the average exchange rate for the taxable year to which the foreign taxes relate. The Act provides an election to translate foreign taxes into U.S. dollar amounts using exchange rates as of the time such taxes are paid. The election once made can be revoked only with the consent of the Secretary of the Treasury.
Effective Date: Tax years beginning after December 31, 2004.
Code Section Affected: New Code Section 986(a)(1)(D) added.
SECTION 409: REPEAL OF WITHHOLDING TAX ON DIVIDENDS FROM CERTAIN FOREIGN CORPORATIONS.
The Act eliminates the thirty percent (30%) withholding tax (often referred to as the “secondary withholding tax”) imposed on foreign corporations which draw twenty-five percent (25%) or more of their gross income from certain U.S. source income (typically interests and dividends) that is not effectively connected with the conduct of a U.S. trade or business.
Effective Date: Tax years beginning after December 31, 2004.
Code Section Affected: New Code Section 871(i)(2)(D) added.
SECTION 410: EQUAL TREATMENT OF INTEREST PAID BY FOREIGN PARTNERSHIPS AND FOREIGN CORPORATIONS.
Treasury Regulations Section 1.861-2(a)(2) provides that a foreign partnership will be treated as a U.S. resident for purposes of characterizing interest received from such foreign partnership as U.S. source income if the foreign partnership is engaged at any time during the taxable year in a trade or business in the United States. In contrast, interest paid by a foreign corporation engaged in a U.S. trade or business (or having gross income effectively connected with the conduct of a U.S. trade or business) is characterized as U.S. source income only to the extent attributable to such U.S. trade or business activity. Interest paid by a foreign corporation is treated as foreign source income to the extent it is attributable to business conducted outside of the United States.
The Act provides that interest paid by a foreign partnership will be treated as U.S. source income only if the interest is paid by a U.S. trade or business
conducted by the foreign partnership or is allocable to income that is treated as effectively connected with the conduct of a U.S. trade or business. In order for the foreign partnership to take advantage of this distinction between its U.S. source income and its foreign source income, the partnership must be predominantly engaged in the active conduct of a trade or business outside of the United States.
Effective Date: Tax years beginning after December 31, 2003.
Code Section Affected: New Code Section 1366(d)(2)(C) added.
SECTION 412: LOOK THROUGH TREATMENT UNDER SUBPART F FOR SALES OF PARTNERSHIP INTERESTS.
The Act provides that in the case of controlled foreign corporations owning directly, indirectly, or constructively at least a twenty-five percent (25%) interest in capital or profits of a partnership, the sale of the partnership interest by the controlled foreign corporation will be treated as a sale of its proportionate share of partnership assets attributable to such interest. Income realized by the partnership from the sale of its partnership interest will be
treated as Subpart F foreign personal holding company income.
Effective Date: For taxable years of foreign corporations beginning after December 31, 2004 and taxable years of U.S. shareholders with or within which such taxable years of the foreign corporations end.
Code Section Affected: New Code Section 954(c)(4) added.
413: REPEAL OF FOREIGN PERSONAL HOLDING COMPANY RULES AND FOREIGN INVESTMENT COMPANY RULES.
The Act reduces the complexity which results from overlapping provisions by:
(1) Eliminating the rules applicable to foreign personal holding companies and foreign investment companies,
(2) Excluding foreign corporations from the application of the personal holding company rules, and by
(3) Including as Subpart F foreign personal holding company income and personal services contract income that is currently subject to foreign
personal holding company rules.
Effective Date: Tax years beginning after December 31, 2004, and taxable years of United States shareholders with or within which such taxable years such foreign corporations end.
Code Section Affected: Code Sections 551-558, 1246, and 1247 Repealed; Code Sections 951-964 amended.
SECTION 414: DETERMINATION OF FOREIGN PERSONAL HOLDING COMPANY INCOME WITH RESPECT TO TRANSACTIONS IN COMMODITIES. The Act changes the requirements for gains or losses from a commodity hedging transaction to be excluded from foreign personal holding income for purposes of Subpart F.
Under the Act, commodity transactions entered into by a controlled foreign corporation in the normal course of its trade or business will not be treated as foreign personal holding company income if (1) used to manage the risk of price changes or currency fluctuations of property used in the trade or business, (2) satisfying the definition of hedging transaction under Code Section 1221(b)(2) and (3) which are identified as hedging transactions at the time the transaction begins.
The Act also modifies the requirements to be satisfied for active business gains or losses arising from the sale of commodities to qualify for
exclusion from foreign personal holding income. Gains or losses of this kind will not be considered foreign personal holding income if substantially all of the controlled foreign corporation’s commodities consist of the following:
(1) Stock in trade, inventory, or property held primarily for sale to customers in the ordinary course of the controlled foreign corporation’s trade or business,
(2) Depreciable property used in a trade or business of the controlled foreign corporation, or
(3) Supplies regularly used or consumed by the controlled foreign corporation in the ordinary course of its trade or business.
Effective Date: Transactions entered into after December 31, 2004.
Code Section affected: Code Section 954(c).
SECTION 417: 10-YEAR FOREIGN TAX CREDIT CARRYOVER; 1-YEAR FOREIGN TAX CREDIT CARRYBACK.
The Act increases the period with respect to which foreign tax credits may be carried forward from five (5) to ten (10) years and reduces the period with respect to which foreign tax credits may be carried back from two (2) years to one (1) year.
Effective Date: Tax years beginning after the Date of Enactment.
Code Section Affected: Code Section 904(c).
SECTION 421: REPEAL LIMITATION ON USE OF FOREIGN TAX CREDIT IN COMPUTING ALTERNATIVE MINIMUM TAX.
The Act repeals Code Section 59(a)(2) which limits the amount of foreign tax credits that may be offset against a taxpayer’s alterative minimum tax (“AMT”) liability. Current law limits the amount of AMT available to be offset by a foreign tax credit attributable to foreign source AMT income. The AMT Foreign Tax Credit is limited to ninety percent (90%) of AMT computed without any AMT net operating loss deduction and the AMT Foreign Tax Credit. The Act repeals the ninety percent (90%) limitation on the utilization on the AMT Foreign Tax Credit.
Effective Date: Tax years beginning after December 31, 2004.
Code Section Affected: Code Section 59(a)(2).
SECTION 422: INCENTIVES TO REINVEST FOREIGN EARNINGS IN THE UNITED STATES. The Act enables domestic corporations to deduct eighty-five percent (85%) of
cash dividends received from controlled foreign corporations. In order to qualify the cash dividend must satisfy several specific criteria.
(1) The dividend cannot exceed $500,000,000 unless it is permanently reinvested outside the United States.
(2) If the dividend is to be paid from funds borrowed from a related person, such as a U.S. shareholder, the increase in indebtedness to such lenders reduces the deductible amount of the dividend.
dividend must exceed a historical base average of dividend and other repatriation amounts over three of the five most recent years.
(4) An amount equal to the dividend must be invested in the U.S. as provided in a domestic reinvestment plan approved by the taxpayer’s executive officer before the dividend is paid, followed by approval of the taxpayer’s board of directors.
(5) The dividend reinvestment plan must require the dividend to be used as a source for funding worker hiring and training, infrastructure, research and development, capital investments, or the financial stabilization of the taxpayer for
purposes of job retention or creation.
Special rules apply for computation of credits, deductions, and alternative minimum tax. Fifteen percent (15%) of the dividends represents a floor below which the taxpayer’s taxable income cannot fall.
The eighty-five percent (85%) deduction under new Code Section 965 is only available either (a) for the taxpayer’s first taxable year beginning on or after the Date of Enactment or (b) the taxpayer’s last taxable year beginning before such date, at the taxpayer’s election. The deduction is not allowed for dividends received in any taxable year beginning one year or more after the Date of Enactment.
Effective Date: Applicable to taxable years ending on or after the Date of Enactment.
Code Section Affected: New Code Section 965 added.
DEDUCTION OF STATE AND LOCAL GENERAL SALES TAX
SECTION 501: DEDUCTION OF STATE AND LOCAL GENERAL SALES TAXES IN LIEU OF STATE AND LOCAL INCOME TAXES.
The Act gives individual taxpayers who itemize deductions the option of deducting their state and local income taxes or their state and local sales taxes, whichever is greater. The provision is intended primarily to provide relief to those taxpayers who reside in states that do not levy state income taxes.
Taxpayers can determine the amount they can deduct for state and local sales tax by using:
(1) Actual receipts on all purchases or
(2) Tables published by the Internal Revenue Service. (Individuals who use the Internal Revenue Service tables may also deduct sales tax actually paid on the purchase of motor vehicles, boats, and other items specified by the Treasury.)
The election to deduct state and local sales taxes will greatly benefit residents of Alaska, Florida, Nevada, South Dakota, Texas, Washington, Wyoming, New Hampshire, and Tennessee. (All of which are states which have no income tax.)
Effective Date: Taxable years beginning after December 31, 2003
Sunset Provision: Taxable years beginning after December 31, 2005.
Code Section Affected: New Code Section 164(b)(5) added.
Provisions to Reduce Tax Avoidance
SECTION 801: TAX TREATMENT OF EXPATRIATED ENTITIES AND THEIR FOREIGN PARENTS.
The Act largely eliminates the utility of converting domestic corporations into foreign corporations (“Corporate Inversion Transactions”). The Act applies to any plan or series of related transactions which result in the direct or indirect acquisition of substantially all of the assets owned directly or indirectly by a domestic corporation or substantially all of the assets constituting a trade or business of a domestic partnership completed after March 4,
2003 by a foreign corporation. If at least eighty percent (80%) of the stock (by vote or value) of the foreign corporation is held by former stockholders of the domestic corporation or former partners of the domestic partnership, the foreign corporation will be treated as a domestic corporation for U.S. tax purposes (a “surrogate foreign corporation”).
If the owners of the domestic corporation or partnership retain less than an eighty percent (80%) ownership interest in the surrogate foreign corporation, but more than a sixty percent (60%) ownership interest, the inverted corporation will maintain its status as “foreign” for tax purposes. However, the acquired domestic entities are denied the use of credits and deductions to shelter inversion gains from U.S. tax for at least ten (10) years. “Inversion Gains” are defined as gains recognized by reason of the transfer of the stock or other properties of the acquired domestic entities, as well as income received or accrued during the ten (10) year period following completion of the acquisition from a licenses of any property of the acquired domestic entities.
The adverse consequences imposed on Corporate Inversion Transactions will not apply if the affiliated group
which includes the surrogate foreign corporation conducts substantial business activities in the foreign country in which the surrogate foreign corporation is created or organized. The Act also creates a safe harbor from application of its provisions for Corporate Inversion Transactions in which the surrogate foreign corporation had acquired more than half of the properties of the acquired domestic entity prior to March 4, 2003.
Effective Date: Taxable years ending after March, 4, 2003.
Code Section Affected: New Code Section 7874 added.
SECTION 802: EXCISE TAX ON STOCK COMPENSATION OF INSIDERS IN EXPATRIATED CORPORATIONS.
To further discourage the use of Corporate Inversion Transactions, the Act imposes a nondeductible fifteen percent (15%) excise tax (which increases to twenty percent (20%) after 2008) on the stock-based compensation of officers, directors, and persons owning sufficient stock to be treated as “insiders” under Section 16(a) of the Securities Exchange Act of 1934 (generally, ten percent (10%) or more of the outstanding stock of the corporation). Individuals to which the Act applies will be subject to tax at a fifteen percent (15%) capital gains rate under Code Section(h)(1)(C) on the value of any stock option,
stock appreciation right, or other stock-based compensation received by such individual or a member of such individual’s family at any time during the period six (6) months before or six (6) months after the date the Corporate Inversion Transaction occurs.
The Act also impacts the corporation paying the compensation by reducing the $1,000,000 limit on deductible compensation imposed by Code Section 162(m) if the corporation pays the excise tax on behalf of the disqualified individual.
Effective Date: The excise tax is effective as of March 4, 2003, except that periods before March 4, 2003 are not taken into account in applying the excise tax to stock-based compensation during the six-month period before the date the Corporate Inversion Transaction occurs.
Code Section Affected: New Code Section 4985 added.
SECTION 804: REVISION OF TAX RULES ON EXPATRIATION OF INDIVIDUALS.
Individuals who relinquish their U.S. citizenship or terminate their U.S. residency for the principal purpose of avoiding U.S. taxes remain subject to U.S.
income taxation on U.S. source income at rates applicable to U.S. citizens for a ten (10) year period following expatriation under an alternative tax regime set forth in Code Section 877(b). The Act amends the definition of expatriates under Code Section 877(a) to include any former citizen or long-term resident unless the former citizen or long-term resident:
(1) establishes that his or her average net income tax liability for the prior five years did not exceed $124,000 (subject to cost-of-living adjustments after 2004) and his or her net worth is not in excess of $2 million and
(2) certifies under penalties of perjury that he or she complied with all U.S. federal tax obligations for the prior five years and provides evidence of their compliance with the Treasury Secretary.
Until notification of the State Department or Department of Homeland Security in a written statement satisfying the requirements of Code Sections 7701(n) and 6039G renouncing citizenship or terminating U.S. residency, the former citizen or long-term resident will continue to be considered a citizen or resident for U.S. income, gift, and estate tax purposes. If, after expatritation, the former citizen or long-term resident is physically present in the U.S. for more than thirty (30) days during any calender year, the former citizen or long-term resident will be considered a U.S. citizen or resident for U.S. income, gift, and estate tax purposes and thereby subject to U.S. taxation on worldwide income and assets. Special reporting requirements are imposed on former citizens and long-term residents during the ten-year expatriation period.
Effective Date: individuals who expatriate after June 3, 2004.
Code Section Affected: Code Section 877(a) and (c), 2107(a), 2501(a), 6039G(a), (b), (c), and (d) amended. New Code Sections 877(g) and 7701(n) added.
SECTION 805: REPORTING OF TAXABLE MERGERS AND ACQUISITIONS.
The Act imposes a reporting requirement on any corporation that acquires stock or property of another corporation in a taxable acquisition. The acquiring
corporation is required to disclose to the Internal Revenue Service the name and address of each shareholder of the acquired corporation who is required to recognize gain as a result of the transaction. This report must include the amount of money and fair market value of property transferred to each shareholder as part of the acquisition. Nominee shareholders are also required to report the same information.
Information provided to the Internal Revenue Service must also be provided to each shareholder identified in the acquiring corporation’s disclosure to the Internal Revenue Service on or before January 31 of the year following the calender year in which the taxable acquisition occurred.
Effective Date: Acquisitions made after the Date of Enactment.
Code Section Affected: New Code Section 6043A added.
Provisions Relating to Tax Shelters
SECTION 811: PENALTY FOR FAILING TO DISCLOSE REPORTABLE TRANSACTIONS.
The Act creates a new penalty for any person who fails to include with a return or statement information required to be disclosed with respect to any transaction determined by the Secretary to have the potential for either tax avoidance or evasion (“Reportable Transaction”) or specifically identified by the Secretary as a tax avoidance transaction (“Listed Transaction”). The new penalty applies without regard to whether the transaction ultimately results in an understatement of tax and applies in addition to any accuracy-related penalty that may be imposed.
The penalty for failing to disclose a Reportable Transaction is $10,000 in the case of a natural person and $50,000 in any other case. The penalty is increased to $100,000 and $200,000, respectively, if the failure is with respect to a Listed Transaction.
The penalty cannot be waived with respect to a Listed Transaction. As to Reportable
Transactions, the Internal Revenue Service Commissioner or his delegate can rescind (or abate) the penalty only if rescinding the penalty would promote compliance with the tax laws and effective tax administration.
Effective Date: Returns and statements required to be filed after the Date of Enactment.
Code Section Affected: New Code Section 6707A added.
SECTION 812: ACCURACY-RELATED PENALTY FOR LISTED TRANSACTIONS, OTHER REPORTABLE TRANSACTIONS HAVING SIGNIFICANT TAX AVOIDANCE PURPOSES, ETC.
The Act creates a separate accuracy-related penalty of twenty percent (20%) of the amount of the understatement arising from Reportable Transactions and Listed Transactions. If the taxpayer fails to disclose a Listed Transaction or Reportable Transaction with the intent to avoid taxes, the penalty on the amount of the understatement will increase to thirty percent (30%).
The penalty may be waived for reasonable cause, but reasonable cause will exist only if:
(1) the taxpayer made adequate disclosure of relevant facts affecting the tax treatment;
(2) the taxpayer’s position was supported by substantial authority; and
(3) the taxpayer reasonably believed the position was more-likely-than-not correct.
However, even when the taxpayer discloses the understatement, if the taxpayer’s belief is based upon a disqualified opinion then the penalty cannot be waived.
Effective Date: Taxable years after the Date of Enactment. However, a transaction completed before the Date of Enactment may give rise to a penalty if it creates an understatement on a 2004 calender year return.
Code Section Affected: New Code Sections 6662A and 6664(d) added.
SECTION 813: TAX SHELTER EXCEPTION TO CONFIDENTIALITY PRIVILEGES RELATING TO TAXPAYER COMMUNICATIONS. Code Section 7525(a) extends the common law
protection of confidentiality which applies to communications between taxpayers and their attorney to communications between a taxpayer and any federally authorized tax practitioner to the same degree that such communications would be subject to a confidentiality privilege if involving an attorney. Code Section 7525(b) however excepts from the confidentiality protection communications between a federally authorized tax practitioner and a director, shareholder, officer, employee, agent, or representative of a corporation in connection with the promotion or participation in any “tax shelter,” as that term is defined in Code Section 6662(d)(2)(C)(iii). The Act extends the exception to confidentiality under Code Section7525(b) to communications involving partners in a partnership.
Effective Date: All communications made on or after the Date of Enactment.
Code Section Affected: Code Section 7525(b) amended.
SECTION 814: STATUTE OF LIMITATIONS FOR TAXABLE YEARS FOR WHICH REQUIRED LISTED TRANSACTIONS NOT REPORTED.
The Act extends the statute of limitations for taxpayers failing to disclose a Listed Transaction to one year after the government is provided with the information required to be furnished under regulations prescribed by the Secretary of the Treasury.
Effective Date: Taxable years for which the period for assessing a deficiency did not expire before the Date of Enactment.
Code Section Affected: New Code Section 6501(c) added.
SECTION 815: DISCLOSURE OF REPORTABLE TRANSACTIONS.
The Act expands the group of persons who must register a potentially abusive transaction from promoters to “material advisors.” The Act defines a “material advisor” as anyone who:
(1) Provides material aid, assistance, or advice with respect to organizing, promoting, selling, implementing, or carrying out any Reportable Transaction, and
(2) is directly or indirectly compensated by more than $250,000 in gross income ($50,000 if
the tax benefits are for a natural person).
Each material advisor must file an information return disclosing the Reportable Transaction to the Internal Revenue Service and must maintain a list of those advised with respect to the Transactions.
Effective Date: Any transaction with respect to which material aid, assistance, or advice is provided after the Date of Enactment.
Code Section Affected: New Code Sections 6111 and 6112 added.
SECTION 816: FAILURE TO FURNISH INFORMATION REGARDING REPORTABLE TRANSACTIONS.
The Act creates a penalty for failing to furnish information concerning Reportable and Listed Transactions to the Internal Revenue Service. The penalty is $200,000 or fifty percent (50%)of the gross income generated by the person required to make the filing in connection with a Listed Transaction ($50,000 in the case of Reportable Transactions).
Effective Date: Returns due after the Date of Enactment.
Code Section Affected: Code Section 6707 amended.
SECTION 817: MODIFICATION OF PENALTY FOR FAILURE TO MAINTAIN LIST OF INVESTORS.
The Act imposes a penalty of $10,000 a day for failing to provide a list of investors to the Treasury within 20 business days after receiving a written request
Effective Date: Requests made after the Date of Enactment.
Code Section Affected: Code Section 6708(a).
SECTION 818: PENALTY ON PROMOTERS OF TAX SHELTERS.
The Act increases the penalty from $1,000 to fifty percent (50%) of the gross income derived by a promoter of a tax shelter who makes a false or fraudulent statement about tax benefits that arise from the proposed investment.
Effective Date: Activities occurring after the Date of Enactment.
Code Section Affected: Code Section 6700(a) amended.
SECTION 819: MODIFICATIONS OF SUBSTANTIAL UNDERSTATEMENT PENALTY FOR NONREPORTABLE TRANSACTIONS.
The Act amends the penalty imposed on corporations (other than an S corporation or personal holding company) for substantial understatements of income tax that involve transactions which are not Reportable Transactions or Listed Transactions. The penalty for corporations is increased to the lesser of ten percent (10%) of the correct liability or $10 million, but in no event less than $10,000.
Effective Date: Taxable years after the Date of Enactment.
Code Section Affected: Code Section 6662(d)(1)(B) amended.
SECTION 820: MODIFICATIONS OF ACTIONS TO ENJOIN CERTAIN CONDUCT RELATED TO TAX SHELTERS AND REPORTABLE TRANSACTIONS.
The Act grants the Secretary of the Treasury authority to enjoin conduct related to:
(1) promoting tax shelters,
(2) failing to provide information regarding Reportable Transactions, and
(3) failing to maintain a list of investors involved in Reportable Transactions.
Effective Date: The day after the Date of Enactment.
Code Section Affected: Code Section 7408 amended.
SECTION 821: PENALTY ON FAILURE TO REPORT INTERESTS IN FOREIGN FINANCIAL ACCOUNTS.
The Act penalizes individuals who fail to report their interests in foreign financial accounts by a fine of up to $10,000. Individuals who willfully violate the reporting requirements may be subject up to a minimum penalty of $100,000.
Effective Date: Violations occurring after the Date of Enactment.
Code Section Affected: U.S.C. Section 5321(a)(5) amended.
SECTION 833: DISALLOWANCE OF CERTAIN PARTNERSHIP LOSS TRANSFERS.
The Act attempts to prevent transactions intended to shift loses among partners. In the case of property with a basis in excess of its value, the Act
provides that only the contributing partner may account for the built-in losses. In determining the allocation of loss inherent in the contributed property to partners other than the contributing partner, the basis of the contributed property is valued at the property’s fair market value at the time of the contribution.
In the case of a transfer of partnership interest, the provisions of Code Section 743(b) will automatically be applied so as to prevent the transferee partner from being allocated any portion of the built-in loss existing in the partnership assets if the basis which the partnership has in its assets
is more than $250,000 less than the fair market value of the assets. Different rules are provided in the case of “Electing Investment Partnerships” so as to limit the transferee partner’s distributive share of losses from the sale or exchange of partnership property to amounts in excess of the loss recognized by the transferor partner on the sale of the transferor partner’s interest in the partnership. In order to qualify as an Electing Investment Partnership, the partnership must make an irrevocable election and satisfy a variety of other conditions consistent with organization of the partnership for investment purposes (for example, never engaged in a trade or business).
Effective Date: Contributions made after the Date of Enactment.
Code Sections Affected: Code Sections 704(c)(1) and 743 amended. New Code Sections 743(d), (e), and (f) added.
SECTION 834: NO REDUCTION OF BASIS UNDER SECTION 734 IN STOCK HELD BY PARTNERSHIP IN CORPORATE PARTNER.
The Act amends the basis allocation rules that apply on complete liquidation of a partner’s interest in a partnership. Allocations of a decrease in the adjusted basis of partnership property to stock in a corporation which remains a partner in the partnership will be disallowed. Instead, the basis decrease is
allocated to other partnership property. Allocations to other partnership property will result in a recognized gain to the partnership to the extent the allocation exceeds the aggregate adjusted basis which the partnership has in the other property.
Effective Date: Distributions made after the Date of Enactment.
Code Section Affected: New Code Section 755(c) added.
SECTION 836: LIMITATION ON TRANSFER OR IMPORTATION OF BUILT-IN LOSS.
Current law provides that in connection with a tax-free incorporation under Code Section 351, the basis of property received by the corporation is equal to the adjusted basis of the property in the hands of the contributing
stockholder, adjusted for gains or losses recognized by the current stockholder in the incorporation transaction.
The Act modifies current law in two ways. First, the Act steps down (or up) to the transferee’s basis in each item of property transferred to its fair market value. This mainly affects cross-border inbound transfers of property with an aggregate built-in loss. Second, with respect to all Code Section 351 transfers, the Act prevents duplication of aggregate built-in losses in both the stock received by the contributing stockholder and the contributed assets in the hands of the corporation. As such, the stockholders and the corporation can elect as to which of them will take a basis equal to fair market value (in either the stock or the contributed assets, respectively).
Similar rules will apply in connection with property received in complete liquidation of a foreign corporation by a domestic corporation to require the basis the domestic corporation takes in the property received in complete liquidation to not exceed the fair market value of the property.
Effective Date: Transactions and liquidations occurring after the Date of Enactment.
Code Section Affected: New Code Section 362(e) added. Code Section 334(b)(1) amended.
SECTION 838: DENIAL OF DEDUCTION FOR INTEREST ON UNDERPAYMENTS ATTRIBUTABLE TO NONDISCLOSED REPORTABLE TRANSACTIONS.
While individual taxpayers are not allowed to deduct interest which accrues on tax deficiencies or under payments, corporate taxpayers are permitted the deduction under Code Section 163. The Act denies a deduction for interest on an underpayment of tax which is attributable to the portion of any undisclosed Listed Transaction or any undisclosed Reportable Transaction with a significant tax avoidance purpose.
Effective Date: Transactions in taxable years after the Date of Enactment.
Code Section Affected: New Code Section 163(m) added.
SECTION 840: RECOGNITION OF GAIN FROM THE SALE OF A PRINCIPAL RESIDENCE ACQUIRED IN A LIKE-KIND EXCHANGE WITHIN 5 YEARS OF SALE.
Generally, current law allows individual taxpayers to selling a principal residence to avoid recognizing up to $250,000 of gain ($500,000 for married couples) realized on sale or exchange of principal residence. The Act disallows the relief provided by the Code Section 121 on the sale or exchange of a principal residence if that principal residence was obtained in a like-kind exchange within five years of the current sale or exchange.
Effective Date: Sales or exchanges made after the Date of Enactment.
Code Section Affected: Code Section 121(d) amended.
842: DEPOSITS MADE TO SUSPEND RUNNING OF INTEREST ON POTENTIAL UNDERPAYMENTS.
The Act allows taxpayers to make a cash deposit with the Internal Revenue Service to pay for potential income, estate, or gift tax liabilities and for certain excise taxes imposed on exempt entities. The Act provides that deposits will be applied against the tax liability, thereby suspending further accrual of interest from the date of the deposit. Deposits may also be made in connection with any potential income tax liability which is under dispute. The further accrual of interest on the portion of the underpayment to which the deposit applies is suspended as of the date of the deposit is made. Amounts deposited may be withdrawn upon the taxpayer’s written request.
Effective Date: Deposits made after the Date of Enactment. (Cash bonds posted by taxpayers under Revenue Procedure 84-58 will be treated as deposited on the date the taxpayer identifies the amount as a deposit made pursuant to New Code Section 6603.)
Code Section Affected: New Code Section 6603 added.
SECTION 843: PARTIAL PAYMENT OF TAX LIABILITY IN INSTALLMENT AGREEMENTS.
The Act clarifies that the Internal Revenue Service may enter into installment agreements with taxpayers for less than the full amount of the taxpayer’s liability.
Effective Date: Agreements entered into on or after the Date of Enactment.
Code Section Affected: Code Section 6159(a) amended.
SECTION 845: EXPANDED DISALLOWANCE OF DEDUCTER FOR INTEREST ON CONVERTIBLE DEBT. Current law disallows any deduction for interest paid or accrued on corporate debt which is payable in stock of the corporation or a related party if:
(1) the substantial portion of the principal or interest was required or could be paid at the option of the corporation or related party in the corporation’s stock,
(2) a substantial amount of the principal or interest is required or could be determined at the option of the corporation or related party by reference to the value of the corporation’s stock, or
(3) the corporate debt was part of an arrangement which could reasonably be expected to result in a transaction described in one or two.
The Act expands the prohibition on deductions for interest with respect to debt convertible into the stock of the corporate issuer or related person to also include debt which could be paid by the corporate issuer using stock of an unrelated corporation.
Effective Date: Debt instruments issued after October 3, 2004.
Code Section Affected: Code Section 163(l) amended.
Leases Involving Tax Exempt Entities
SECTION 847: REFORM OF TAX TREATMENT OF CERTAIN LEASING ARRANGEMENTS.
Sections 847, 848, and 849 of the Act are intended to address abuses involving leases to tax exempt organizations. Code Section 168(h) defines “Tax
Exempt Use Property” as tangible property leased to governmental entities, tax exempt organizations, or foreign persons or entities. Many of the transactions which were subject to abuse involved sales of property by an exempt entity to a unrelated for-profit business followed by a lease back to the exempt entity.
The Act significantly changes the income tax treatment of assets leased to tax exempt entities by:
(1) clarifying that the requirement of Code Section 168(g)(3) that the recovery period for Tax Exempt Use Property cannot be less than one hundred twenty-five percent (125%) of the lease term not withstanding any other provision of Code Section 168(g)(3);
(2) expanding the definition of Tax Exempt Use Property under Code Section 168(h) to
include computer software (thereby subjecting it to cost recovery under the alternative depreciation system (ADS));
(3) subjecting contract and similar rights granted by governmental units which have a duration of less than fifteen (15) years or are fixed as to amount and recoverable under a method similar to the unit of production method to a requirement that the period for amortization under Code Section 197 cannot be less than one hundred twenty-five percent (125%) of the lease term involved with such contract or rights ; and
(4) including in measuring the duration of the lease for Tax Exempt Use Property the term of any service contract or similar arrangement which is part of the same transaction including the lease or which applies to the Property which is the subject of the lease.
In contrast to the generally unfavorable treatment to which Tax Exempt Use Property is subject under the Act, the Act expands an exception currently found in the Code which allows short term leases of qualified technological equipment to not be subject to the current Code provisions and Act amendments applicable to Tax Exempt Use Property. Under current law, a lease with a term of five (5) years or less would generally not be treated as Tax Exempt Use Property. However, for purposes of measuring the duration of the lease, options to renew (or extend the lease) would be included. The Act clarifies that options to renew will not be treated as part of the original lease term for purposes of measuring the five (5) year period if the option to renew (or extend the lease) provides for rent during the renewal period to be computed at fair market value at the time of renewal.
Effective Date: Amendments are generally applicable to leases entered into after March 12, 2004. However, amendments to Code Section 197 regarding amortization of intangibles leased to a tax exempt entity are effective for leases entered into after October 3, 2004.
Code Sections Affected: Code Sections 167(f), 168(g)(3), 168(i)(3)(A)(ii), and 168(h)(3)(A)(ii) amended. Code Section 197(f)(10) added.
SECTION 848: LIMITATION ON DEDUCTIONS ALLOWABLE TO PROPERTY USED BY GOVERNMENTS OR TAX EXEMPT ENTITIES. The Act provides for disallowance of tax exempt use losses. A “tax exempt use loss” is defined as a loss which arises when the aggregate deductions for Tax Exempt Use Property exceed the aggregate income attributable to the Tax Exempt Property (typically arising from its lease to an exempt entity). (Including interest attributable to financing for the acquisition of the leased property.) When a tax exempt use loss arises because deductions with respect to the lease property exceed income produced by the property, the disallowed loss is carried forward and applied in computing the gain or loss from the use of the lease property in the following year. The disallowance of tax exempt use losses continues throughout the lease term with respect to the property that was initially characterized as Tax Exempt Use Property even if the property cease to be Tax Exempt Use Property during the lease term (the legislative history provides).
On disposition of the Tax Exempt Use Property, any current or suspended tax exempt use losses which are not allowed in prior years can be recognized.
In addition to the treatment of tax exempt use losses, the Act provides that the nonrecognition provisions of Code Sections 1031 (involving lifetime exchanges) and 1033 (involving involuntary conversions) will not apply if either the exchange property or the replacement property would be Tax Exempt Use Property otherwise subject to the provisions of the Act, but for the commencement of the lease before the effective date of the tax exempt lease provisions of
the Act (generally March 13, 2004). Further, the basis rules which customarily apply in lifetime exchanges and involuntary conversions will not apply to the replacement property acquired in such an exchange. Instead, the adjusted basis of the replacement property will be limited to the lesser of the fair market value of the property at the beginning of the lease term or the amount that would have been the lessor’s adjusted basis if Code Sections 1031 or 1033 did not apply to the transaction.
Effective Date: Leases entered into after March 12, 2004 and property exchanged or converted after the Date of Enactment.
Code Sections Affected: New Code Section 470 added.
Other Revenue Provisions
SECTION 881: QUALIFIED TAX COLLECTION CONTRACTS.
The Act allows the Internal Revenue Service to use private debt collection companies to contact taxpayers and arrange payments on any outstanding tax liability. Taxpayers will generally have the same civil damage remedies for claims against private debt collection companies that current law provides
under Code Section 7433 for a taxpayer to assert against any employee of the Internal Revenue Service who negligently, recklessly, or intentionally disregards the collection procedures under which the Internal Revenue Service operates.
Effective Date: Date of Enactment.
Code Section Affected: New Code Sections 6306 and 7433A added..
SECTION 882: TREATMENT OF CHARITABLE CONTRIBUTIONS OF PATENTS AND SIMILAR
The Act limits the charitable deductions taxpayers may claim for contributions of patents, trademarks, and other intellectual property. The deduction is limited to the lesser of (1) the taxpayer’s basis in the contributed property or (2) the fair market value of the property. To the extent that the donated property provides the charitable organization with income, a taxpayer may be able to, based on a sliding scale, take additional charitable contribution deductions. An additional charitable deduction may be claimed for amounts in the year of contribution or in a future tax year based upon a specified percentage of the income the charity receives or accrues as a result of its receipt and ownership of the contributed property. The additional charitable deduction for the income produced by the intellectual property contributed to the charity is computed using the following table:
Taxable Year of Donor Applicable Percentage:
Ending on or After Date
The additional deduction is only permitted to the extent that the sum of the amounts that are calculated using the table exceed the deduction claimed on contribution of the patent or intellectual property.
Disclosure and reporting requirements are imposed upon charities receiving contributions of qualifying intellectual property. The charity is required to file an annual information return reporting the income received from the intellectual property as well as additional information required by the statute and regulations.
Additional charitable deductions with respect to income produced by a qualified
intellectual property will not be available in case of contributions to private foundations (other than private operating foundations).
Effective Date: Contributions made after June 3, 2004.
Code Section affected: New Code Sections 170(m) and 6050L added. Code Section 170(e)(1) amended.
SECTION 883: INCREASED REPORTING FOR NONCASH CHARITABLE CONTRIBUTIONS. The Act increases reporting requirements for contributions of tangible personal property other than inventory held for sale to customers in the ordinary course of a trade or business and used motor vehicles, boats, and airplanes (addressed by Section 884 of the Act and discussed below). Individuals, partnerships, and corporations (other than C corporations
which are not personal service corporations or closely held) will be required to include a description of the property as well as other information required by the Secretary of Treasury to support a deduction of more than $500. In cases in which a contribution deduction of more than $5,000 is claimed, taxpayers must obtain a qualified appraisal of the property and submit the appraisal with the taxpayers return in the year in which the contribution is claimed. Specific appraisal requirements will be imposed under regulations in connection with contributions of property for which a deduction of more than $500,000 is claimed. Failure to comply with the reporting requirements will result in a denial of the deduction for the charitable contribution.
Effective Date: Contributions made after June 3, 2004.
Code Section Affected: Code Section 170(f).
SECTION 884: DONATIONS OF MOTOR VEHICLES, BOATS, AND AIRPLANES.
The Act limits deductions for vehicles, boats, and airplanes (other than inventory held for sale to customers in the ordinary course of business) donated to a
charity to the gross proceeds received by the charitable organization upon the subsequent sale of the vehicle in the case of any deduction in excess of $500. Additionally this provision requires the written acknowledgment by the charitable organization of the donation. Taxpayers who fail to provide this information or who provide fraudulent information will be subject to penalties.
Effective Date: Contributions made after December 31, 2004.
Code Sections Affected: New Code Sections 170(f)(12) and 6720 added.
SECTION 885: TREATMENT OF NONQUALIFIED DEFERRED COMPENSATION PLANS.
The Act codifies much of the law which has evolved with respect to nonqualified deferred compensation arrangements. The statute applies to any plan that provides for the deferral of compensation except tax qualified retirement plans, qualified tax-deferred annuities, and Code Section 457(b) plans. Additionally, bona fide vacation, sick leave, compensatory time, disability pay, and death benefit plans are not covered by the Act.
The Act’s application to different types of non-qualified deferred compensation plans is quite broad. Any arrangement that allows for the deferral of compensation can be considered a nonqualified deferred compensation plan including plans that cover one person or hundreds of different individuals together, including:
(1) account-based plans which allow an employee to elect to defer salary or a bonus,
(2) supplemental executive retirement plans (SERPs),
(3) restricted stock or phantom stock plans,
(4) stock options, other than on employer stock options the value of which is not less than the fair market value of the stock on the date of grant,
(5) stock appreciation rights (SARs), and
(6) bonus plans under which payment is made after the bonus is earned.
Many arrangements may already comply with the requirements of the Act, but it will be important to review each arrangement to ensure that it is in compliance and, if not, to revise the arrangement so that compliance is achieved before the Act goes into effect. Failure to satisfy the requirements of the Act will result in immediate taxation of all compensation deferred under the plan for the current taxable year and all preceding taxable years to the extent amounts deferred are not subject to a substantial risk of forfeiture (or not previously included in gross income).
Elections: This Act requires that elections to defer compensation must be made by the end of the taxable year preceding the year in which the services will be performed. Newly eligible employees are allowed thirty (30) days to make their deferral elections. An exception exists for performance- based compensation plansfor services over a period of at least twelve (12) months. For these plans a deferral election must be in place at least six (6) months before the end of the service period. Each plan or election must now include the timing and form of distribution. All choices in the plan or election must conform to the new rules of this provision. Additionally, plans and elections can differ from year to year and distribution elections can be different within the same year
The Act also allows for redeferrals of compensation. Redeferral of payments from the plan:
(1) must be made at least 12 months before the first scheduled payment under the plan,
(2) not take effect until at least 12 months after the election, and
(3) provide for a deferral of at least five years from the date such payment would otherwise be made.
However, the five-year requirement does not apply to distributions on account of death, disability, or an unforeseeable emergency. Once a redeferral election is made, a distribution cannot be made during the redeferral period.
Because of the requirement that the timing for distributions be set when compensation is initially deferred, the requirements of the Act will likely make it necessary to redesign plan distribution provisions of non-elective plans such as SERPs.
The Act substantially limits a participant’s ability to control the timing of distributions and, specifically, limits the ability to accelerate distributions. Participants may only receive distributions from a non-qualified plan at:
(2) on separation from service,
(4) at designated times pursuant to a fixed schedule,
(5) subsequent to a change in ownership or control of the employer-corporation or the sale of a substantial portion of its assets, or
(6) in the event of an unforeseeable emergency.
With respect to commencement of distributions, the Act adds additional qualifications and restrictions:
1. “Specified employees” (officers whose compensation is greater than $130,000, any five percent (5%) owners, one percent (1%) owners receiving compensation of more than $150,000 per year) of companies whose stock is publically traded must wait at least six months after retirement to receive a distribution upon separation from service.
2. Amounts to be paid pursuant to a fixed schedule or at a specified time (instead of upon the occurrence of an event) must be identified under the plan at the time deferral is elected.
3. In the case of distributions contingent on a change in ownership or effective control of the employer-corporation, the legislative history indicates that
regulations are intended to use a definition of change and control similar to that used for the golden parachute provisions of Section 280G. Guidance defining a change in control is to be issued within ninety (90) days from the Date of Enactment.
4. Unforeseeable emergencies include, severe financial hardships (from illness or accident of the participant, a spouse, or dependent) and property loss
due to casualty, as well as other similar extraordinary circumstances arising from events beyond the control of the participant. In such events, the distributions are limited to the amount needed to satisfy the emergency, as well as the amount needed for taxes resulting from the distribution.
5. A participant is deemed disabled if:
(a) the participant is unable to be employed as a result of a mental or physical impairment expected to last at least 12 months or
(b) the participant has been receiving income replacement benefits for at least 3 months under the employer’s accident and health plan as a result of a mental or physical impairment that is expected to last at least 12 months.
Prohibition on Acceleration of Distributions:
Except as provided in regulations, plans must prohibit any acceleration of distributions. Acceleration clauses are common in nonqualified deferred compensation plans created in recent years. Consequently, plans will need to be reviewed and amended in order to comply with the Act’s
prohibition on acceleration of distributions
Offshore and Financial Health Trusts:
Income recognition will be accelerated for amounts deferred under the plan in the case of assets set aside in a foreign trust or restricted in connection with a change in the employer-corporation’s financial condition. Income will be recognized either at the time the assets are set aside or transferred to the foreign trust or on the date on whichthe assets are restricted to satisfying the benefits payable under the deferred compensation plan. Exception is made in the case of assets located in a foreign jurisdiction if the services to which the deferred compensation relates are performed in the same jurisdiction.
In addition to current taxation on amounts deferred, the Act also imposes an additional twenty percent (20%) tax and annual interest at the underpayment rate plus one percent (1%) beginning with the first taxable year in which the amounts were first deferred or when the amounts became substantially vested, if later. For trusts, the tax applies beginning in the first year the assets are held in trust or subject to the financial health trigger, with interest beginning in the first year of deferral.
In designing new nonqualified deferred compensation plans and deferral arrangements, consideration should be given to including provisions permitting immediate payment of benefits in any case in which amounts deferred become immediately taxable.
Amounts deferred after December 31, 2004. Generally amounts deferred before 2005 will not be subject to these provisions. However, any plan that is materially modified after October 3, 2004 will be treated as a plan created after December 31, 2004 and subject to the requirements of the Act. Thus, amounts deferred before January 1, 2005 under a nonqualified deferred compensation plan that complies with current law will not be currently included in compensation, unless the plan is modified after October 3, 2004. The legislative history indicates that even subsequent deferrals with respect to amounts deferred before January 1, 2005 would remain subject to current law without requirement to conform to the provisions of the Act.
Code Section Affected: New Code Section 409A added.
SECTION 891: EXTENSION OF INTERNAL REVENUE SERVICE USER FEES.
The Act extends the Internal Revenue Service’s authority to charge fees for rulings, opinions, and determination letters through September 30, 2014.
Effective Date: Requests made after the Date of Enactment.
Code Section Affected: Code Section 7528(c) amended.
SECTION 893: PROHIBITION ON NONRECOGNITION OF GAIN THROUGH COMPLETE LIQUIDATION OF HOLDING COMPANY.
The Act subjects a distribution to a foreign corporation in complete liquidation of the domestic common parent of a U.S. affiliated group to treatment as a dividend, if substantially all of the liquidating U.S. corporation’s assets are stock of affiliates and the U.S. corporation has not been in existence for the entire five
years preceding the date of liquidation.
Effective Date: Distributions in complete liquidation occurring on or after the Date of Enactment.
Code Section Affected: New Code Section 332 (d) added.
SECTION 894: EFFECTIVELY CONNECTED INCOME TO INCLUDE CERTAIN FOREIGN SOURCE INCOME.
Under current law income, gain, or loss from foreign sources is treated as effectively connected with the conduct of a U.S. trade or business if attributable to an office or other fixed place of business in the United States. Items subject to inclusion include rents or royalties for the use of intangible property, dividends or interest derived in the act of conduct of a banking, financing, or similar business within the United States, and gain or loss from the sale or exchange of inventory or other property held for sale to customers in the ordinary course of business for use, consumption, or disposition in the United States. The Act expands the items specified in current law to include economic equivalents of the forgoing items.
Effective Date: Taxable years beginning after the Date of Enactment.
Code Section Affected: Code Section 864(c)(4)(B) amended.
SECTION 895: RECAPTURE OF OVERALL FOREIGN LOSSES ON SALE OF CONTROLLED FOREIGN CORPORATION.
Generally, U.S. persons may claim a credit for foreign taxes paid against U.S. tax on foreign source income. The amount of foreign tax credits which may be claimed in any year is subject to limitations which are affected by the amount of foreign losses which the taxpayer may experience in any given year. If losses for any taxable year exceed the aggregate amount of foreign income (producing an “Overall Foreign Loss”), the foreign losses will be recaptured by resourcing foreign source income earned in subsequent years as U.S. source income. The amount resourced as U.S. source income is generally limited to the lesser of (1) the amount of overall foreign losses not previously recaptured or (2) fifty percent (50%) of the taxpayer’s foreign source income in the given year. Current law applies a special recapture law to require recapture of an Overall Foreign Loss on sale or other disposition of property used in a trade or business outside of the United States. The disposition is treated as resulting in recognition of foreign source income (regardless of whether gain would otherwise be recognized on disposition of the assets). The amount of income on disposition of such assets equals the lesser of the excess of the fair market value of the assets over their adjusted basis.
In addition, if the U.S. corporation transfers its foreign branch business assets to a foreign corporation in an incorporation transaction in which gain or loss would otherwise go unrecognized under the provisions of Code Section 351, the taxpayer will be treated as having recognized foreign source income in the year of transfer in an amount equal to the excess of the fair market value of the assets contributed to the foreign corporation over the taxpayer’s adjusted basis in the assets. The Act extends these rules to also apply to dispositions of stock in controlled foreign corporations (“CFCs”) owned by the taxpayer. Dispositions of the stock of the CFC will result in recognition of foreign source income in an amount equal to the gain inherent in the stock. Gain realized on disposition of stock will be treated as U.S. source income for purposes of computing foreign tax credit limitations. The Act provides exceptions in the case of certain internal restructurings. However, boot recognized in connection with such transactions will also be resourced as U.S. source income. Exception is also provided in the case of a disposition of stock of a CFC in a transaction in which the taxpayer acquires the assets of the CFC in a liquidation under Section 332 or corporate reorganization described in Code Section 368(a)(1).
Effective Date: Dispositions made after the Date of Enactment.
Code Section Affected: New Code Section 904(f)(3)(D) added.
SECTION 896: RECOGNITION OF CANCELLATION OF INDEBTEDNESS INCOME REALIZED ON SATISFACTION OF DEBT WITH PARTNERSHIP INTEREST.
The Act provides that a partnership will recognize cancellation of indebtedness income on transfer of a partnership interest to a creditor in satisfaction of
partnership debt. The amount of income the partnership will recognize on transfer of a capital or profits interest in the partnership will be equal to the fair market value of the partnership interest transferred. Income will be recognized regardless of whether the debt is recourse or nonrecourse. Any cancellation of indebtedness income is split among the partners holding interests in the partnership before the debt is satisfied.
Effective Date: Cancellations of indebtedness occurring on or after the Date of Enactment.
Code Section Affected: Code Section 108(e)(8) amended.
SECTION 897: DENIAL OF INSTALLMENT SALE TREATMENT FOR ALL READILY TRADABLE DEBT.
The Act clarifies that the inability to qualify for installment sale treatment applies to any sale in which the seller receives readily tradeable debt, regardless of the identity of the issuer (including a state or local government or political subdivision thereof).
Effective Date: Sales occurring on or after the Date of Enactment of this Act.
Code Section Affected: Code Section 453(f)(4)(B) amended.
SECTION 900: MODIFICATION OF DEFINITION OF CONTROLLED GROUP OF CORPORATIONS.
The Act modifies the definition of a controlled group of corporations to include a brother-sister controlled group if five or fewer persons who are individuals, estates, or trusts own more than fifty percent (50%) of the total voting power or value of the stock of two or more corporations. In applying this rule the stock ownership of each person will be taken into account only to the extent the stock ownership is identical with respect to each corporation.
The amendment made by the Act applies to limits set forth in Code Section 1561 regarding corporate tax brackets, the $250,000 accumulated earnings credit, and the $40,000 exemption from the corporate alternative minimum tax. However, it does not affect other Code sections or other brother-sister provisions referenced in the Code.
Effective Date: Taxable years beginning after the Date of Enactment.
Code Section Affected: Code Section 1563(a)(2) amended.
SECTION 907: LIMITATION ON EMPLOYER DEDUCTION FOR CERTAIN ENTERTAINMENT EXPENSES.
Current law bars the deduction by a business of entertainment expenditures unless the expenditures are directly related to the active conduct of the taxpayer’s trade or business or the expenditure is for an item directly preceding or following a substantial bona fide business discussion associated with the active contact of the taxpayer’s trade or business. However, the preceding prohibition does not apply to the extent that the expenses are treated by the taxpayer as compensation to an employee (and subject to applicable income tax withholding rules) or, in the case of a recipient who is not an employee of the taxpayer, as non-employee compensation for services includable in the recipient’s income.
Because the value of the entertainment expenditure which is taken into income by the employee or non-employee may be less than the actual cost to the employer providing the entertainment (for example in the case of a corporate jet), employers have claimed deductions in excess of the amount of income recognized by the employee. The Internal Revenue Service’s challenge to this discrepancy was rebuffed by the Tax Court in Sutherland Lumber-Southwest Inc., 114 T.C. 197 (2000), aff’d 88 AFTR2d 2001-5026 (8th Cir. 2001). The Act reverses the results under Sutherland Lumber-Southwest Inc. and provides that as to certain specified individuals the employer’s income tax deduction cannot exceed the amount taken into income by the specified individual. The term “specified individuals” is defined to include corporate officers (chief executive officers, principal financial officers, principal accounting officers, vice-presidents in charge of principal business units, and any other officer performing policy making functions), directors, and ten percent (10%) or greater owners.
Effective Date: Expenses incurred after Date of Enactment.
Code Section Affected: Code Section 274(e)(2) amended.
SECTION 908: RESIDENCE AND SOURCE RULES RELATING TO UNITED STATES POSSESSIONS.
In recent years, citizens of the United States have attempted to establish residency in certain U.S. possessions (Puerto Rico, Virgin Islands, Guam, Northern Marianna, and American Samoa) in order to qualify income as possession source income or income effectively connected to the conduct of a trade or business within the possession in order to take advantage of special income tax rules which dramatically reduce (in some cases by ninety-three percent (93%)) the rates to which that income would otherwise be taxed. The Act replaces determinations relying on subjective facts and circumstances described in regulations under Code Section 871 with a set of statutory rules which require residency to be established by:
(1) presence in the possession for at least one hundred eighty-three days during the taxable year,
(2) absence of a tax home (as determined under Code Section 911(d)(3)) outside the possession, and
(3) absence of a closer connection to the United States or a foreign country other than the possession.
The Act further provides that rules currently in use to determine whether income from sources within the United States is effectively connected with the conduct of a trade or business within the United States will be applied for purposes of determining whether income from sources within a possession is effectively connected with a trade or business within the possession so as to qualify for whatever special treatment may be available with respect to in-possession income. Further, the Act imposes reporting requirements for individuals taking the position that the individual has become or ceases to be a resident of the possession. Reporting is also required of those individuals who during any of the three taxable years ending before the first taxable year ending after the Date of Enactment took a return position that the individual became or ceased to be a bona fide resident of the possession.
Effective Date: Taxable years ending after the Date of Enactment.
Code Section Affected: New Code Section 937 added.
SECTION 910: EXPANSION OF LIMITATION ON DEPRECIATION OF CERTAIN PASSENGER AUTOMOBILES.
The Act limits the amount which can be expensed under Code Section 179 for property used in the conduct of a trade or business (currently $100,000 in the case of taxable years beginning before 2008) to $25,000 in the case of sport utility vehicles and codifies the definition of such vehicles.
Effective Date: Property placed in service after the Date of Enactment.
Code Section Affected: New Code Section 179(b)(6).