On May 17, 2006, President Bush signed the Tax Increase Prevention and Reconciliation Act of 2005 (the "Act") into law. The Act is the product of months of negotiations between House and Senate conferees and contains certain anticipated provisions extending the 15 percent top tax rates for individual taxpayers on capital gains and dividends until 2010, an alternative minimum tax ("AMT") "hold harmless" provision designed to reduce the number of taxpayers who would otherwise become subject to the AMT during the 2006 tax year, a two-year extension of the active financing exception to Subpart F income, and a two-year extension of the Section 179 small business expense deduction. While the Act does not contain certain tax cut provisions and many of the more controversial revenue raising provisions contained in the Senate reconciliation bill, it is possible that many of those provisions will reappear in proposed legislation later this year. The Act contains a few unexpected revenue raising provisions, including a repeal of the grandfathering rules applicable to the repeal of FSC and ETI regime benefits and a limitation on the Section 199 domestic manufacturing deduction for a taxable year to 50 percent of the wages paid by the taxpayer that are allocable to domestic production gross receipts in the relevant calendar year.
The following is a summary of certain provisions of the Act.
Two-Year Extension of Reduced Rates on Capital Gains and Dividends
The Act extends the Internal Revenue Code’s maximum 15 percent top tax rate for long-term capital gains and dividend income of individual taxpayers through taxable years beginning on or before December 31, 2010. Correlative effects of the two-year extension of the sunset of these rates include extension of the sunset on repeal of collapsible corporation rules (recharacterizing some gains on sales of stock as ordinary income), reduction of the corporate accumulated earnings tax and personal holding company tax rates to 15 percent, and modifications to the alternative minimum tax inclusion of a portion of the gain on "small business corporation" stock).
Two Year Extension of Increased Section 179 Expensing for Small Business
The current law provision permitting small businesses to deduct up to $100,000 of investment in depreciable tangible personal property that is purchased for use in an active trade or business is extended to all taxable years beginning before January 1, 2010.
Provisions Affecting Section 355 Transactions.
Active Business Test. The Act temporarily simplifies the requirements that must be met by each of the distributing and spun-off corporations in order to satisfy the "active trade or business" test of Section 355. Effective on May 17, 2006, the active business test can be satisfied by reference to a qualifying business conducted by an "affiliated" subsidiary of the distributing and spun-off corporation. Affiliation for this purpose is determined under Section 1504(a) (generally requiring ownership of stock possessing 80 percent of vote and value of the subsidiary) without regard to exclusions for certain ineligible corporations, and by treating the distributing or controlled corporation as a hypothetical common parent corporation. In general, this provision is effective for distributions after May 17, 2006 and before January 1, 2011.
Distributions Involving Disqualified Investment Corporations. The Act also targets certain transactions commonly known as "cash rich split-off" transactions by denying tax-free treatment (at both the shareholder and distributing corporation levels) if (i) either the distributing or controlled corporation is a "disqualified investment corporation" immediately after the transaction (or a series of related transactions) and (ii) any person that did not hold 50 percent or more of the voting power or value of the stock of such distributing or controlled corporation immediately before the transaction holds a 50 percent or greater interest immediately after such transaction. In general, a "disqualified investment corporation" is any distributing or controlled corporation if the fair market value of the investment assets of the corporation is 75 percent or more of the fair market value of all assets of the corporation (66 2/3 percent in the case of distributions occurring more than one year after the date of enactment). The term "investment assets" generally includes assets that are the same as or similar to cash, stock, securities (other than a security held by a dealer which is marked to market pursuant to Section 475(a)), partnership interests, debt instruments, options, derivative contracts, or foreign currency. For these purposes, a look-through rule applies such that the distributing or controlled corporation is treated as directly owning its ratable share of the assets of any corporation which is a 20-percent controlled entity with respect to such distributing or controlled corporation. Assets held for use in the active and regular conduct of a lending or finance, banking or insurance business will not be treated as investment assets if substantially all the income of the business is derived from persons who are not related to the person conducting the business.
Treasury is given broad authority to prescribe regulations as may be necessary to carry out or prevent the avoidance of this provision. The provision is applicable to distributions after the date of enactment, except distributions pursuant to a transaction which is: (i) made pursuant to a binding agreement on May 17, 2006; (ii) described in a ruling request submitted to the IRS on or before May 17, 2006; or (iii) described in a public announcement or in a filing with the SEC on or before May 17, 2006.
Two Year Extension of Exceptions to Subpart F for Certain Insurance Income and Active Financing Income
The current law provision excluding income that is derived in the active conduct of a banking, financing or similar business, or in the conduct of an insurance business from categorization as Subpart F income is extended for two years to taxable years beginning before January 1, 2009, and to taxable years of U.S. shareholders with or within which such taxable years of such foreign corporations end.
New Exception under Subpart F for Certain Payments Between Related CFCs
Payments of dividends, interest (including factoring income equivalent to interest), rents and royalties received by one CFC from a related CFC will not be treated as "foreign personal holding company income" of the recipient corporation to the extent such payments are attributable or properly allocable to non-Subpart F income of the payor. A "related CFC" is defined for this purpose as a CFC that controls or is controlled by the other CFC or that is controlled by the same persons or persons that control the other CFC. "Control" for this purpose requires ownership of more than 50 percent of a corporation’s stock by vote or value. The Secretary is authorized to prescribe anti-abuse regulations as necessary. The provision is effective for taxable years of foreign corporations beginning after December 31, 2005 but before January 1, 2009 and for taxable years of U.S. shareholders with or within which the taxable years of the foreign corporations end.
Application of Earnings Stripping Rules to Partners Which Are Corporations
The Act amends the earnings stripping rules of Section 163(j) by providing that, except as may be provided in regulations, if a corporation owns a direct or indirect interest in a partnership, the corporation’s share of partnership liabilities is treated as liabilities of the corporation for the purposes of applying the earnings stripping rules. Similarly, a corporate partner’s distributive share of the partnership’s interest income and interest expense is treated as interest income or interest expense of the corporation. The Treasury is provided with additional regulatory authority to promulgate rules reallocating shares of partnership debt, or distributive shares of the partnership’s interest income or expense, as may be necessary to carry out the purposes of the provision. This provision is effective for taxable years beginning on or after May 17, 2006.
Application of FIRPTA provisions to Regulated Investment Companies ("RICs") and Real Estate Investment Trusts ("REITs")
The American Jobs Creation Act of 2004 (the "JOBS Act") provided that, through December 31, 2007, any distribution by a RIC to its foreign shareholders that are attributable to gain from the RIC’s sale or exchange of a "United States real property interest" (a "USRPI") is subject to U.S. federal income tax as gain effectively connected with the conduct of a U.S. trade or business under the Foreign Investment in Real Property Tax Act of 1980 ("FIRPTA"). In addition, a USRPI does not include any interest in a "domestically controlled" qualified investment entity, which includes a RIC in which less than 50% in value of the RIC has been owned directly or indirectly by foreign shareholders during the 5-year period ending on the date of disposition. The Act modifies these provisions.
Limitations on the Application of FIRPTA Distributions by RICs. The Act provides that any distribution by a RIC to a foreign shareholder that is attributable to gain from the RIC’s sale or exchange of a USRPI will not be subject to tax under FIRPTA unless the RIC itself is a USRPI (or would be a USRPI by taking into account the RIC’s holdings in certain interests in other RICs or REITs). This provision is effective for dividends with respect to taxable years of RICs beginning after December 31, 2004.
The Act also provides, as is already applicable to REIT distributions under the JOBS Act, that a distribution by a RIC to a foreign shareholder that is attributable to gain from the RIC’s sale or exchange of a USRPI will not be subject to tax under FIRPTA if the distribution is made with respect to any class of stock which is regularly traded on an established securities market located in the United States and if the foreign shareholder did not own more than 5% of such class of stock at any time during the one-year period ending on the date of the distribution. Instead, the distribution is treated as an ordinary dividend to the foreign shareholder. Because this rule requires RIC shares to be listed on an exchange, it does not appear to apply to open-end RICs. This provision is effective for taxable years of RICs beginning after December 31, 2005.
After December 31, 2007, the pre-JOBS Act rules that do not require the look-through of USRPI gains for RICs in any event generally will be applicable.
Withholding on FIRPTA Distributions. The Act explicitly requires withholding on distributions by a REIT or RIC (provided that the RIC itself is a USRPI or would be a USRPI, as described above) to foreign shareholders that are attributable to gain from the sale or exchange of a USRPI, at a rate of 35%, or, to the extent provided by regulations, at 15%. This withholding requirement had previously been imposed only under Treasury regulations. This provision is effective for taxable years of RICs and REITs beginning after December 31, 2005, except that no withholding is required for distributions before the enactment of the Act that were not subject to withholding under prior law.
Wash Sale Rules. Finally, the Act provides that a foreign shareholder that disposes of its RIC or REIT stock during the 30-day period preceding a distribution on that stock that would have been treated as a distribution from the disposition of a USRPI, that acquires a substantially identical interest, or enters into a contract or option to acquire such an interest during the 61-day period beginning the first day of such 30-day period preceding that distribution, and that does not in fact receive the distribution in a manner that subjects the foreign shareholder to tax under FIRPTA, will now be subject to tax under FIRPTA on an amount equal to the amount of the distribution that was not taxed under FIRPTA as a result of the disposition. This provision also applies to "substitute dividend payments" under stock loan transactions. However, no withholding is required on the proceeds of such dispositions. This provision is effective for taxable years of RICs and REITs beginning after December 31, 2005, except for any distribution or substitute dividend payment occurring within 30 days after the enactment of the Act.
New Look-Through Rule for FIRPTA Distributions. The Act provides that a distribution by a RIC or a REIT to another RIC or REIT that is attributable to gain from the sale or exchange of a USRPI will retain its character as gain from the sale or exchange of a USRPI in the hands of the RIC or REIT. The Act further provides that even after December 31, 2007 (when the law reverts back to pre-JOBS Act rules), a distribution by a REIT to a RIC that is attributable to gain from the sale or exchange of a USRPI will retain its character as gain from the sale or exchange of a USRPI in the hands of the RIC (provided that the RIC itself is a USRPI or would be a USRPI, as described above). These provisions are effective for taxable years of RICs and REITs beginning after December 31, 2005.
Repeal of FSC/ETI Binding Contract Relief
The FSC Repeal and Extraterritorial Income Exclusions Act of 2000, which generally repealed the foreign sales corporation ("FSC") regime and introduced the extra-territorial income ("ETI") exclusion, delayed the repeal of the FSC rules and the effective date of the ETI provisions for transactions in the ordinary course of a trade or business occurring before January 1, 2002 or after December 31, 2001 pursuant to a binding contract between the taxpayer and an unrelated person which was in effect on September 30, 2000 and at all times thereafter (the "FSC binding contract relief"). The American Jobs Creation Act of 2004 (the "JOBS Act") repealed the ETI exclusion, generally for transactions after December 31, 2004, with a transition rule that phases out benefits for transactions occurring in 2005 or 2006. However, the JOBS Act provided that the ETI exclusion provisions remain in effect for transactions in the ordinary course of a trade or business if such transactions are pursuant to a binding contract between the taxpayer and an unrelated person and such contract is in effect on September 17, 2003 and at all times thereafter (the "ETI binding contract relief"). In February 2006, the World Trade Organization ruled that both the FSC and ETI binding contract relief provisions were prohibited export subsidies. The Act repeals both the FSC binding contract relief and the ETI binding contract relief, and thereby avoids threatened retaliatory tariffs on U.S. exports by the European Union.
Wage Limit on Domestic Production Deduction under Section 199
Section 199 allows a taxpayer to claim a deduction equal to a specified percentage of the lesser of the taxpayer’s "qualified production activities income" or taxable income for the taxable year. The applicable percentage in 2006 is 3 percent, and will increase to 6 percent in 2007 and 9 percent in 2010. Under prior law, the deduction was limited to 50 percent of the total wages paid by the taxpayer in the calendar year which ended in the taxable year in which the deduction was being claimed. The Act revises this limitation so that the allowable deduction may not exceed 50 percent of the wages paid by the taxpayer that are allocable to its domestic production gross receipts for the taxable year in computing its qualified production activities income. As under prior law, wages paid by pass-though entities such as partnerships or S corporations are computed at the partner or shareholder level. This amendment is effective for taxable years beginning after May 17, 2006.
Elimination of Income Limitations on Roth IRA Conversions
Under prior law, a taxpayer with adjusted gross income of $100,000 or less was permitted to convert all or a portion of a traditional IRA to a Roth IRA. The amount converted is treated as a distribution from the traditional IRA for income tax purposes, except that the 10-percent tax on early withdrawals does not apply. The Act eliminates the income limits on conversions of traditional IRAs to Roth IRAs such that any taxpayer may make such a conversion without regard to the level of their adjusted gross income. This provision is effective for taxable years beginning after December 31, 2009. For conversions occurring in 2010, unless a taxpayer elects otherwise, the amount includible in gross income as a result of the conversion is included ratably in 2011 and 2012. However, if converted amounts are distributed to the taxpayer from the Roth IRA before 2012, the amount included in income in the year of the distribution is increased by the amount so distributed, and the amount included in income in 2012 (or 2011 and 2012 in the case of a distribution in 2010) is the lesser of (1) half of the amount includible in income as a result of the conversion; and (2) the remaining portion of such amount not already included in income.
New Excise Tax and Penalties on Tax-Exempt Accommodation Parties in Tax Shelter Transactions
Entity Level Excise Tax. The Act adds new Section 4965, which imposes an excise tax on certain tax-exempt entities that enter into a "prohibited tax shelter transaction". The types of tax-exempt entities that are subject to these provisions are entities described in Section 501(c) or (d), Section 170(c) (other than the United States) and Indian tribal governments. A "prohibited tax shelter transaction" means any listed transaction and any confidential transaction or any transaction with contractual protection which is a reportable transaction (as defined in Section 6707A(c)(1). The tax is equal to the product of the highest rate of corporate tax imposed under Section 11 multiplied by the greater of (i) the entity’s net income for such taxable year which is attributable to such transaction (after taking into account any tax imposed with respect to the transaction) or (ii) 75% of the gross proceeds received by the entity for the taxable year which are attributable to such transaction. If the transaction is not a prohibited tax shelter transaction when the tax-exempt entity becomes a party to the transaction, but it subsequently becomes a listed transaction, the excise tax for the taxable year in which the transaction first becomes a listed transaction is computed on the portion of the entity’s net income or gross proceeds from the transaction allocable to the portion of the year after the transaction became a listed transaction.
In a case where a tax-exempt entity knew or had reason to know a transaction was a prohibited tax shelter transaction at the time the entity became a party to the transaction, the amount of the tax is increased to the greater of (i) 100% of the entity’s net income for such taxable year which is attributable to the prohibited tax shelter transaction (after taking into account taxes imposed with respect to the transaction)or (ii) 75 percent of the gross proceeds received by the entity for the taxable year which are attributable to such transaction.
Excise Tax on Entity Managers. The provision also imposes an excise tax on any manager of a tax-exempt entity that approves such entity as a participant or otherwise causes the entity to participate in a prohibited tax shelter transaction and that knows or has reason to know that the transaction is a prohibited tax shelter transaction. The excise tax is equal to $20,000 for each approval or act causing participation. For this purpose, the class of tax-exempt entities is broadened to include qualified pension plans, IRAs and similar tax-favored savings arrangement such as Coverdell education savings accounts, health savings accounts and qualified tuition plans.
Disclosure Requirements. Any taxable party to a prohibited tax shelter transaction must disclose to the tax-exempt entity that the transaction is a prohibited tax shelter transaction or be subject to the penalty for failure to include reportable transaction information under Section 6707A (ranging from $10,000 to $200,000). Additionally, the tax-exempt entity must disclose its participation in a prohibited tax shelter transaction to the IRS or be subject to a penalty of $100 per day while the failure continues, up to a maximum of $50,000. A person that fails to comply with a demand by the IRS for disclosure by the tax-exempt entity is also subject to a penalty of $100 per day, up to a maximum of $10,000.
Effective Date. These penalties are effective for prohibited tax shelter transactions in taxable years ending after May 17, 2006, regardless of when the transaction was entered into, provided that the excise tax will not be imposed on net income or proceeds of a tax-exempt entity allocable to periods on or before August 15, 2006 unless the tax-exempt entity knew or had reason to know a transaction was a prohibited tax shelter transaction when it became a party to the transaction.