Congress Begins Work on ETI Replacement Legislation (08/01/03)

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1 Congress Begins Work on ETI Replacement Legislation (08/01/03) Prior to the start of a month-long August recess, the House and Senate tax-writing committees began consideration of potential solutions to the FSC-ETI trade dispute with the European Union. The EU has threatened to impose up to $4 billion in retaliatory trade sanctions at the start of 2004 unless significant progress has been made on U.S. compliance with a World Trade Organization (WTO) ruling that the FSC-ETI regime is a prohibited export subsidy. House Ways and Means Committee Chairman Bill Thomas (R-CA) July 25 introduced an ETI replacement bill (H.R. 2896) that includes international tax reforms from his bill last year (H.R. 5095) as well as additional tax relief provisions. Changes to last year s international tax provisions in H.R include reducing the number of foreign tax credit baskets from nine to two, making the worldwide interest allocation method elective, and adding subpart F deferral for foreign shipping income and an extension of subpart F deferral for active financing income. Additional tax relief provisions include depreciation reforms, a temporary rate reduction for repatriated foreign earnings, extension and expansion of the research credit and certain other expiring tax provisions, and corporate AMT relief. H.R also includes ETI repeal transition relief and taxpayer-favorable changes to the tax shelter, earnings stripping, and deferred compensation provisions that had been included in H.R The 10-year, $190 billion cost of H.R is partially offset by $70 billion in revenue raisers. Another approach to ETI-replacement legislation has been offered by Ways and Means Committee members Phil Crane (R-IL) and Charles Rangel (D-NY) and has the support of 136 co-sponsors. The Crane-Rangel legislation (H.R. 1769) would provide a deduction equal to 10 percent of domestic manufacturing income (phased in over five years). The amount of this deduction is reduced for taxpayers with foreign production activities, in proportion to the relative value of such activities. The bill also provides transition relief to current FSC-ETI beneficiaries for five years and permanently for certain binding contracts. In the Senate, the Finance Committee is developing ETI-replacement legislation that would include both international tax reforms and domestic manufacturing incentives. It is anticipated that Finance Committee Chairman Charles Grassley (R-IA) may propose ETIreplacement legislation soon after Congress reconvenes in early September. The Finance Committee is expected to take a revenue-neutral approach to the bill and therefore likely would include other revenue-raising tax provisions beyond ETI repeal, possibly including many of those that had been included in the Senate-passed economic growth bill. The following are summaries of the recently introduced bills of Ways and Means Chairman Thomas (H.R. 2896) and Congressmen Crane and Rangel (H.R. 1769). 1

2 Summary of H.R. 2896, American Jobs Creation Act of 2003, as Introduced by Chairman Thomas International Tax Reforms Subpart F Reforms Repeal foreign base company sales and services income rules with income from sales of products made and sold for use or consumption in U.S. still subject to tax. Extend active financing income exception for 1 year through the end of Provide look-through exception for payments between related CFCs to extent such payments are related to non-subpart F income of related CFC. Provide look-through exception for sales of partnership interest by CFC where CFC owns 25% of partnership. Repeal foreign personal holding company and foreign investment company rules. Provide exception to foreign base company oil-related income for pipeline transportation of oil or gas within foreign country. Conform exception for commodity hedging transactions to existing rules for asset hedging transactions. Repeal foreign base company shipping income rules. Foreign Tax Credit Reforms Allow taxpayers to expand affiliated group definition to include foreign corporations when allocating and apportioning interest expense. Allow taxpayers to recharacterize portion of overall domestic loss for tax year as income from sources outside the United States. Reduce the current nine baskets to two: passive and active income. Extend the carryforward period from 5 to 10 years. Apply look-through rules to all earnings and profits of a 10/50 company. Treat stock owned directly or indirectly by partnership as proportionately owned by its partners for ownership test for claiming indirect foreign tax credits. Clarify that transfers of certain intangibles are properly treated as royalties. Other International Tax Simplifications Apply UNICAP rules to foreign persons only for purposes of taxing income effectively connected with conduct of U.S. trade or business. Exclude from U.S. property definition certain securities held by securities or commodities dealer in ordinary course of trade or business if securities held primarily for sale to customers and disposed of within reasonable period. Exempt from U.S. withholding tax certain dividends received by nonresident alien individuals or foreign corporations from mutual fund. 2

3 Provide election to determine amount of foreign taxes paid by qualified business unit at spot rate in effect on date of payment rather than average exchange rate for taxable year if liability is denominated in currency other than functional currency. Repeal secondary withholding tax on dividends paid by foreign corporations. Foreign Repatriation For 6-month period, apply 80% dividends-received deduction to dividends in excess of base period distributions from CFCs. Depreciation Reform Reduce depreciable lives of manufacturing property used in United States: 10- year lives to 7 years, 7-year lives to 5 years, and 5-year lives to 3 years. Reduce depreciation period for leasehold improvements and restaurant property to 20 years and make eligible for 50% bonus depreciation. Extend 50% bonus depreciation for 1 year through the end of Corporate AMT Relief Repeal the 90% limitation for net operating losses and foreign tax credits. Reduce the depreciation adjustment by 50%. Increase the exemption for small companies from $7.5 million to $15 million. Research Tax Credit Extend the research credit for 2.5 years through the end of Provide an alternative simplified credit equal to 12% of the taxpayer s qualified research expenses (QRE) in excess of 60% of the taxpayer s average QRE for 3 out of the last 5 years. Other Expiring Tax Provisions Extend 5-year NOL carryback period to losses incurred during Extend transfer of excess pension assets for retiree health benefits through Stock Options Clarify that FICA and FUTA taxes do not apply to exercise of incentive stock option (ISO) or employee stock purchase plan (ESPP) stock option. 3

4 Small Business Tax Relief Reduce top corporate tax rate on companies with less than $10 million in taxable income to 32%, phased in over 8 years ( ). Extend increased Section 179 expensing ($100,000 expensing limit and $400,000 phaseout threshold) for 2 additional years through the end of Make various S corporation reforms such as increasing the shareholder limit from 75 to 100, and treating 3 generations of the same family as 1 shareholder. ETI Repeal Repeal exclusion for transactions after 2003 with transition relief. Companies would retain 65% of ETI benefits in 2004, and 35% of ETI benefits in The FSC grandfather rules would be retained. Tax Shelters Impose strict-liability, $200,000 penalty for failure to disclose a listed transaction and $50,000 penalty for failure to disclose a reportable transaction subject to IRS abatement in limited circumstances. Impose 20% accuracy-related penalty on understatements from disclosed listed transactions and reportable transactions with a significant tax avoidance purpose subject to strengthened reasonable cause exception. Impose strict-liability, 30% accuracy-related penalty on understatements from undisclosed listed transactions and reportable transactions with a significant tax avoidance purpose. Modify substantial understatement penalty by expanding to any understatement in excess of $10 million and requiring more-likely-than-not position to reduce understatement for item for which facts not adequately disclosed. Extend statute of limitations for listed transactions to taxable years for which the required listed transaction is not reported. Executive Compensation Impose tax and interest on vested amounts deferred under nonqualified deferred compensation plan unless specified distribution restrictions are satisfied. Impose tax and interest on amounts deferred through offshore trust and other arrangements funded or secured based on financial health of company. Earnings Stripping Repeal 1.5 to 1 debt-to-equity safe harbor threshold. Reduce ATI threshold to 25% (35% in 2004) for related-party debt. 4

5 Repeal 3-year excess limitation carryforward. Reduce carryover limit on disallowed interest to 10 years. Corporate Inversions Require inverting companies to pay the full U.S. tax on the transfer of U.S. assets. Impose 15% excise tax on certain stock-based compensation of insiders. Modify tax treatment of foreign reinsurance agreements. Individual Expatriation Adopt objective test for determining whether expatriation is tax-motivated and other changes to current-law rules recommended by JCT staff. Other Revenue Raisers Require reporting of taxable mergers and acquisitions by corporations. Authorize IRS regulations to extend current-law rules for stripped bonds and stripped preferred stock to stripped interests in bonds and preferred stock funds. Impose minimum holding period for foreign tax credit on withholding taxes on gain and income other than dividends. Affirm IRS authority to issue regulations treating corporations filing consolidated returns differently from corporations filing separate returns. Disallow certain partnership loss transfers. Provide no reduction of basis in stock held by partnership in corporate partner. Repeal the FASIT rules with exception for existing FASITs. Limit transfer of built-in losses on REMIC residuals. Clarify banking business for determining investment of earnings in U.S. property. Clarify the tax exemption for small property and casualty insurance companies. Clarify the definition of insurance company. Permit private-sector debt collection companies to collect tax debts. 5

6 Summary of H.R. 1769, Job Protection Act of 2003, as Introduced by Congressmen Crane and Rangel ETI Repeal Repeal ETI for transactions after date of enactment with transition relief. Continue ETI rules for transactions in ordinary course of trade or business under binding contract with unrelated person in effect on April 11, Allow base amount of ETI benefits, phased out as follows: 100% in , 75% for , 50% in 2008, and 0% in 2009 and thereafter. Domestic Production Activities Allow deduction for certain income attributable to domestic production activities, phased in as follows: 1% in 2006, 2% in 2007, 4% in 2008, 9% in 2009, and 10% in 2010 and thereafter. Reduce by ratio of domestic to foreign production. 6