Review of U.S. Tax Developments in 2021
Last year, we predicted that the biggest U.S. tax news in 2021
would be revenue-raising legislation that the Democrats would put
forward after the election of Joe Biden as the 46th president of
the United States. As we went to press last year, runoff senate
elections in Georgia had just given the Democrats a razor-thin
majority in both houses of Congress. As a result, many commentators
were predicting a revolution in progressive lawmaking that would
include a wish list of tax-the-rich revenue raisers.
The Democrats’ tax proposals were, in fact, the biggest U.S.
tax news this year, but no one could have predicted the way things
actually turned out. Initially, the package of tax policies and
provisions that would be known as the Build Back Better
Act (BBBA) looked as expected: The early descriptions of
the underlying tax policy raised income tax rates, included new
taxes for wealthy individuals, purported to close loopholes in
pro-business Trump tax provisions, and even allocated billions of
dollars to increase IRS enforcement efforts.
The Democrats, however, seem to have misunderstood how
precarious their position was. Generally, in order to avoid a
filibuster, at least 60 senators (out of a total 100) must support
a legislative bill for it to advance. An exception for “budget
reconciliation” bills allows the Senate to pass one bill per
year by a simple majority, as long as that bill relates only to
spending, revenues or the debt limit. Since the Democrats control
only half the seats in the Senate (with Vice President Kamala
Harris as the tie-breaker), the BBBA would have to be enacted under
the reconciliation procedure. The bottom line was that for the BBBA
to pass in the Senate, all of the Democrats would have to support
the bill.
This situation provided an opportunity for one or two Democrats
to seize power by blockading the entire process. Joe Manchin of
West Virginia and Kyrsten Sinema of Arizona withheld the final
votes needed to ensure the BBBA’s passage, which set off a long
process of negotiations and political grandstanding that ultimately
led to a much weaker form of the BBBA, which may not result in
meaningful legislation at all.
The U.S. tax community was exhausted by the process. Initially,
the ambitious new tax provisions in the BBBA promised a re-run of
the Tax Cuts and Jobs Act of 2017 (TCJA), which
generated reams of regulations and commentary intended to explain
how to apply the new rules. As the fate of the BBBA became clear,
however, efforts at statutory interpretation gave way to political
speculation. Ultimately, the United States saw little progress in
other areas of tax law during 2021.
In fact, the biggest step forward in tax policy during 2021 was
in respect of the OECD’s base erosion and profit shifting
(BEPS) initiative, which has been in development for almost a
decade. This year the proponents of BEPS produced several detailed
policy statements that advanced the two “Pillars” of the
project, which led to more than 130 countries signalling their
support for the project to date.
The following discussion reviews U.S. legislative, regulatory
and judicial developments in federal and state tax laws. For
previous annual tax law reviews, see our 2021 and 2020 bulletins.
Federal Tax Legislation
As noted above, the Biden administration and the U.S. Congress
spent 2021 drafting the BBBA, which included a number of tax
proposals intended to fund major public investment in American
infrastructure. The opposition of Senators Manchin and Sinema to
the BBBA, however, caused the policy statements and legislative
language to become increasingly less ambitious as the year wore on.
The following outline describes the development of the BBBA’s
tax provisions from ambitious policy proposals to compromised
statutory language.
The American Jobs Plan and STEP Act
On March 31, 2021, the Biden administration released the
American Jobs Plan (Plan), which proposed $2.3 trillion in
infrastructure investment over the next eight years. The tax
provisions intended to fund the investment read like a progressive
tax policy wish list. Provisions of the Plan that targeted
high-net-worth individuals included the following:
- increasing the top marginal tax rate to 39.6%, from 37%, and
subjecting qualified dividends and capital gains to ordinary income
rates for taxpayers making more than $1 million per year; - extending the 12.4% social security payroll tax to taxpayers
making more than $400,000 per year; - eliminating the step-up in basis at death;
- increasing the estate tax rate and decreasing the lifetime
estate tax exemption.
In connection with the Plan, a group of senators and
representatives introduced the Sensible Taxation and
Equity Promotion Act (STEP Act), which included the
following additional provisions that were intended to eliminate
certain wealth transfer strategies used by high-net-worth
families:
- taxing the built-in gains on lifetime gifts of appreciated
property; - taxing grantor trusts on the unrealized appreciation in their
assets every 21 years (like Canada); - taxing the built-in gains on appreciated property transferred
at death, subject to an exemption for the first $1 million and
certain exceptions (also like Canada).
The Plan also looked to domestic and international businesses to
raise revenue through changes to tax provisions that primarily
affect businesses:
- increasing the corporate income tax rate to 28%, from 21%;
- imposing a 15% alternative minimum tax on the book income of
corporations with at least $100 million in book income; - increasing the effective tax rate on global intangible
low-taxed income (GILTI) to 21%, and making other changes that
would have expanded the applicability of the GILTI regime; - imposing a 10% surtax on U.S. corporations that “offshore
manufacturing and service jobs to foreign nations in order to sell
goods or provide services back to the American market”; - eliminating the foreign derived intangible income (FDII)
deduction available to U.S. corporations with respect to sales made
to foreign buyers of goods and services that are tied to intangible
assets (e.g., patents and trademarks) held in the United
States; - repealing the base erosion and anti-abuse tax (BEAT) and
implementing an “under-taxed payments rule” to bring the
U.S. tax code more in line with Pillar Two of BEPS.
The Green Book
Most of the provisions in the Plan and the STEP Act became part
of the Biden administration’s budget proposal for 2022, which
was released at the end of May. The budget included details of $3.6
trillion in tax increases, which were described in the accompanying
Green Book. The Green Book included some additional proposals,
including the following:
- taxing carried interest as ordinary income;
- eliminating like-kind exchanges, with certain exceptions;
- expanding the 3.8% net investment income tax.
The Green Book also increased the IRS’s funding by almost
$80 billion over the next 10 years, mostly earmarked to increase
enforcement against taxpayers with an annual income of more than
$400,000. In addition, it proposed new reporting regimes applicable
to financial accounts and cryptocurrencies.
The Green Book did not include the increase in the estate tax
rate and reduction of the lifetime exemption, which was proposed in
the Plan.
House Ways and Means Version of the BBBA
Actual legislative language on these policy proposals did not
appear until September, when the House Ways and Means Committee
released its version of the revenue provisions of the BBBA. Many of
the controversial tax proposals from earlier in 2021 were scaled
back or even abandoned in the Ways and Means version. The changes
included the following:
- Corporate income tax rate would be increased to 26.5%, instead
of to 28%. - Top capital gains and qualified dividends rate would be
increased to 25%, instead of to 39.6%. - Effective tax rate on GILTI would be increased to 16.5625%,
instead of to 21%. - Deduction for FDII would be effectively reduced to 20.7%,
instead of being eliminated. - Elimination of like-kind exchanges would be abandoned.
The Ways and Means version contained a handful of provisions
that were not clearly part of previous proposals, such as a 3%
“surcharge” on the income of non-corporate filers with
more than $2.5 million in annual income (or $5 million for joint
filers), and tightened requirements for interest paid to non-U.S.
lenders to qualify for the “portfolio interest” exception
from withholding.
Some of the policy proposals affecting estate planning made it
into the Ways and Means version of the legislation, and others did
not. Specifically, the Ways and Means version included a (smaller)
reduction in the lifetime exemption, but the increase to the estate
tax rate was dropped. The trust-related provisions of the STEP Act
and the elimination of the step-up in basis at death were not
included, but a new provision appeared that would add any assets
held in a grantor trust back into the grantor’s estate at
death. Finally, the Ways and Means version included a number of new
limitations and caps on the amounts that could be contributed to or
held in IRAs and certain defined benefit plans.
The Version of the BBBA Passed by the House
In November, the House passed a further revised version of the
BBBA that was even more watered down than the Ways and Means
version. Specifically, this second version of the tax provisions
abandoned the proposed increases to the individual and corporate
tax rates altogether (although it retained the 3% surtax on
high-income taxpayers), and it failed to include the proposed
limitations on grantor trusts and tighter restrictions on carried
interests.
By the end of 2021, prospects for meaningful tax reform were
dim. Initially, the Democrats had thought they had a blank check to
pass whatever tax proposals they liked, but Senators Manchin and
Sinema succeeded in taking the edge off the Democrats’
razor-thin majority in the Senate.
Federal Administrative Developments
The IRS seems to have finished the most important regulatory
projects related to the TCJA. Relatively few significant
regulations were released in 2021.
In January, the IRS released final regulations under section
163(j), as amended by the TCJA. This package of regulations was
generally consistent with proposed versions of the regulations, but
also included clarifications on changes to section 163(j) as part
of the COVID-19 relief legislation passed in 2020.
Also in January, the IRS released final rules on the three-year
holding period to qualify income with respect to carried interests
for capital gain treatment. These regulations were generally
consistent with proposed versions of the regulations, although they
expanded an exception from the three-year holding period for
capital interests in partnerships.
At the end of December, the IRS finalized regulations on foreign
tax credits and the application of controlled foreign corporation
rules to domestic partnerships. It also proposed rules on passive
foreign investment companies, which generally provide an
“aggregate” approach to passive foreign investment
companies (PFICs) held through partnerships.
Tax Cases
A number of interesting tax cases were heard in 2021. A few
highlights follow:
Transfer Pricing Cases Continue. Last year we
reported on the IRS’s transfer pricing victory
in Coca-Cola v Commissioner, in which the Tax Court
allowed the IRS to proceed with almost $10 billion in transfer
pricing adjustments. During 2021, Coca-Cola hired a new team of
lawyers, headed by Laurence Tribe of Harvard Law School, but the
Tax Court denied the new legal team’s motion for
reconsideration. Another important transfer pricing
case, Medtronic Inc. v Commissioner, concerning the
appropriateness of adjustments to the comparable uncontrolled
transaction method for intercompany patent licences, received a new
trial in June, although the opinion has not yet been released.
Despite the IRS’s successes in these cases, taxpayers are still
defending allocation methodologies that push profit into related
foreign subsidiaries, particularly in licensing cases. See, for
example, Amgen v
Commissioner and Zimmer Biomet Inc. v
Commissioner.
Anti-Injunction Act Challenged. The
Anti-Injunction Act (AIA) prohibits taxpayers from suing
the IRS until after the IRS collects a tax (i.e., one cannot enjoin
the IRS from collecting a tax prospectively). In CIC
Services LLC v IRS, a taxpayer sued the IRS to challenge the
validity of certain information reporting requirements for captive
insurance companies. The IRS argued that the case should be
dismissed under the AIA because the IRS had not yet assessed
penalties against the taxpayer to enforce the reporting
requirements. The Court held that the AIA does not apply to
information reporting requirements, because a “reporting
requirement is not a tax; and a suit brought to set aside such a
rule is not one to enjoin a tax’s assessment or
collection.” This case may open the door to more aggressive
litigation by taxpayers against the IRS.
Obamacare Survives. In June, the U.S. Supreme
Court dismissed a challenge to the Affordable Care Act (ACA)
in California v Texas. The plaintiffs in this case
argued that the ACA was unconstitutional as a result of Congress
reducing the tax penalty for violating the ACA to zero. The Court
held that the plaintiffs had no standing to challenge the ACA
because they could not show that they were harmed by the law. In
addition, the Court stated that it could not prohibit the ACA’s
enforcement, because the reduction of the tax penalty to zero made
the ACA unenforceable. After California v Texas, the
ACA has withstood multiple judicial challenges, which suggests that
the ACA may be here to stay.
Section 280E Upheld. Section 280E disallows
federal tax deductions and credits for businesses that consist of
trafficking in certain controlled substances prohibited by federal
law, such as marijuana. In San Jose Wellness v
Commissioner, the taxpayer advanced technical arguments that
its business did not “consist of” trafficking in
controlled substances, because its business included services such
as acupuncture and chiropractic. The Tax Court was not convinced,
and accordingly San Jose Wellness joined a line
of cases that support section 280E.
Passport Program Challenged. Since 2015, the
U.S. Department of State has had the power to deny or revoke an
individual’s U.S. passport if the IRS certifies under section
7345 that the individual has seriously delinquent tax debt.
In Maehr v U.S. Department of State, the Tenth
Circuit heard a case in which the government ordered a taxpayer to
surrender his passport because of taxes and penalties from 2003
through 2006 totalling approximately $250,000. The taxpayer
challenged the order, claiming that the government action violated
his constitutional right to travel. The Tenth Circuit became the
first appellate court to join several lower courts in upholding the
constitutionality of section 7345 and its related revocations of
U.S. passports.
Update on Tax Treaties
After tax treaties with Japan, Luxembourg, Spain and Switzerland
were ratified in 2020, no further action on tax treaties was seen
in 2021. Treaties with Chile, Hungary and Poland are still pending
because of concerns that those treaties are inconsistent with the
U.S. BEAT rules.
State-Level Developments
One of the most controversial provisions of the TCJA was its
limitation of the federal deduction for state and local taxes to
$10,000. This “SALT cap” is widely regarded as political
punishment for high-tax “blue” states that generally vote
for Democrats in presidential elections. Many tax commentators
speculated that the Democrats’ tax legislation in 2021 would
roll back the SALT cap, but no proposal materialized.
Even though no federal relief appeared, many states in 2021
advanced legislation designed to allow at least some taxpayers to
effectively deduct state taxes despite the SALT cap. Generally,
these provisions work by allowing a pass-through entity to pay a
special entity-level tax on income that is passed through to the
entity’s owner. This results in a reduction in the owner’s
federal taxable income, because the IRS generally taxes income
allocated from a pass-through entity on a net basis (i.e., after
the allocation is reduced for expenses such as entity-level taxes).
The state then allows the owner to take a tax credit against his or
her own state tax liability to reflect the owner’s share of the
entity-level tax.
In late 2020, the IRS issued Notice 2020-75, which approved of
this kind of SALT cap work-around. Since then, at least 20 states
have enacted pass-through entity taxes, including New York,
California, Connecticut and New Jersey.
International Developments Affecting the United
States
The OECD’s BEPS project made progress in 2021, with over 130
countries (including the United States) signing on to a revised
“framework” for Pillars One and Two of the project on
July 1, 2021. Additional details and an implementation plan were
released in October. The development of the framework during 2021
is definitely a step forward, although much work remains to be
done.
One factor motivating the agreement on the Pillars may be the
proliferation of digital services taxes. Some large Internet
companies structure their affairs so that much of their income
escapes taxation under traditional tax nexus rules that are based
on physical presence in the taxing jurisdiction. Some countries
have adopted the policy that a company that benefits from that
country’s consumers should not be able to escape taxation on
the resulting income from the country. Accordingly, certain
countries have adopted or proposed unilateral digital services
taxes, which claim taxing jurisdiction over companies based on a
company’s economic activity in a particular country, even if
the company has no physical presence there.
Pillar One would provide modern nexus standards intended to
capture income generated from a country that would otherwise escape
taxation by that country. Many countries have promised to roll back
their digital services taxes once Pillar One goes into effect.
At the beginning of 2021, the Biden administration signalled its
support of the Pillars when Treasury Secretary Janet Yellin changed
the Treasury Department’s negotiating position to allow some of
the largest U.S. companies to be subject to the new rules. This
change in approach could reflect a hope that implementing the
Pillars will cause some countries to do away with their digital
services taxes, which are widely seen as targeted at U.S.
multinational companies.
Significant changes would be needed in U.S. tax law for it to be
consistent with the Pillars. Pillar One would require the United
States to cede taxing jurisdiction to countries with the relevant
markets, at least for the largest U.S.-based multinationals. Janet
Yellin has indicated a willingness to do this, but the BBBA did not
include any provisions that would be relevant to Pillar One.
Pillar Two presents a number of challenges for U.S. tax law.
- The BEAT. The United States currently
subjects large corporate groups to a minimum rate of tax if
cross-border payments to related parties exceed more than 3% of the
company’s total deductions. This is inconsistent with Pillar
Two’s “undertaxed payments rule,” which denies a
deduction (or requires some other adjustment) when one group member
makes a deductible payment to a second group member that is
resident in a low-tax jurisdiction (unless Pillar Two’s
“income inclusion rule” applies). The policy statements
that preceded the BBBA would have replaced the BEAT with “the
SHIELD,” which conformed more closely with the undertaxed
payments rule. The actual legislative text of the BBBA, however,
would have left the BEAT unchanged. - GILTI. Under current law, the minimum
effective tax rate on GILTI is 10.5%, which is below the 15% agreed
minimum corporate tax rate in Pillar Two. The effective GILTI tax
rate is scheduled to increase in 2026, but until then the U.S.
GILTI rate is too low for Pillar Two. Some other aspects of the
GILTI rules are also inconsistent with Pillar Two, such as the
exclusion of QBAI (qualified business asset investment) from
GILTI. - Soak-Up Taxes. The current GILTI rules
include a limitation on foreign tax credits, which is intended to
discourage low-tax jurisdictions from raising their tax rates to
“soak-up” tax revenue that the United states would
otherwise collect. If the U.S. GILTI rules were changed to conform
to Pillar Two, they would have to contend with the extent to which
taxes paid to low-tax jurisdictions would be creditable. - Dispute Resolution. Pillar Two requires
countries to coordinate highly complex tax systems based on an
international standard. Controversies are sure to arise.
Historically, the United States has been hesitant to submit to the
kind of international arbitration that would be necessary to
resolve those disputes. - Passage. Possibly the most daunting
challenge for the United States to conform to Pillar Two would be
making these changes happen if the Senate withholds its approval.
If the Republicans regain their majority in the Senate after the
midterm elections later this year, there may not be much support
for the Pillars in Congress.
A handful of these changes made it into the BBBA – for
example, the BBBA would have raised the rate of income tax on GILTI
to more than 15% and would have replaced the BEAT with the SHIELD,
a new regime aligned with Pillar Two’s undertaxed payments
rule. Now that the BBBA has been all but abandoned, it is unclear
whether these provisions will make it into new tax legislation.
U.S. Tax Development Outlook for 2022
U.S. tax news in 2021 was dominated by the unexpected opposition
of Senators Manchin and Sinema to some of the central policy
objectives of the Biden administration, including the tax
provisions of the BBBA. At the beginning of 2021, the
Democrats’ slim majority in the Senate was widely acknowledged,
but no one could have predicted that members of the Democrats’
own party would stand in the way of the party’s goals.
Senator Manchin has gone on record saying that the BBBA is
“dead.” There is some talk in Washington that some of the
BBBA provisions could be revived. President Biden even used his
State of the Union speech in early 2022 to advocate for several tax
provisions of the BBBA, such as increasing the tax burden on
taxpayers making more than $400,000 per year, and adopting the
minimum tax provisions and the changes to make the GILTI regime
consistent with Pillar Two. The midterm elections are likely to
occupy legislators’ attention beginning in the summer, so any
action on the BBBA provisions would have to be underway by April at
the latest.
Other than that, the crystal ball reveals only shadows. Certain
regulatory projects are expected, such as final regulations on
qualified foreign pension funds under section 897(l). Beyond that,
the midterm elections make the future too hazy for most
prognosticators. Will the Republicans gain seats and go back to the
business-friendly tax agenda of the Trump years? Or will the
Democrats cling to their majority and salvage some fragments of
their shattered tax policy? Check in with us next year for the
answers.
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