TIPRA: what it does ... and does not cover; The Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) was signed into law this May. Financial Executives Research Foundation (FERF) summarizes the Act's key elements and its impact on and implications for corporations.

Despite changes at all taxpayer levels, what seems to be most noteworthy about the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA)--signed into law on May 17, 2006 by President Bush--is what was not addressed. Though TIPRA became law--following months of deliberation--a number of planned provisions were excluded in order to keep the tax-cut package within the five-year, $70 billion limit in the budget resolution.

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Instead, extensions to expire or expiring tax provisions will be addressed in a separate "trailer" tax bill to be tied to pending pension-reform legislation. The provisions that were included in the final Act, however, include $91 billion in tax relief offset by $21 billion in revenue-raising provisions over a 10-year span. Analysis of the law's main provisions are discussed below.

Extraterritorial Income and Controlled Foreign Corporations. Some of the most significant business tax changes introduced by TIPRA are in the international arena. The first of these modify existing provisions relates to the foreign sales corporation and extraterritorial income regimes.

In previous years, Congress had repealed these regimes, since the World Trade Organization (WTO) ruled that they provided prohibited subsidies for exports, but provided some transition relief for transactions that were subject to binding contracts.

However, the WTO has recently ruled that this transition relief also constitutes prohibited export subsidies. The European Union (EU) had threatened to re-introduce sanctions if the transition relief continued. Consequently, effective for taxable years beginning after May 17, 2006, TIPRA has eliminated this relief. According to PricewaterhouseCoopers, this will impact manufacturers producing goods under what they thought were grandfathered long-term sales contracts.

FEI member Michael P. Reilly, vice president, Taxation for Johnson & Johnson and chairman of Financial Executive International's (FEI) Committee on Taxation (COT) agrees, noting that many companies had likely entered into long-term contracts with the hope that they would be able to continue to take advantage of the past relief provisions in future years. Additionally, financial services companies that priced equipment leases based on the benefits will also be hurt, notwithstanding the fact that the EU hinted that the transition relief for leases might be acceptable.

Another change for business applies to controlled foreign corporations (CFCs). Under subpart F of the Internal Revenue Code, 10 percent of U.S. shareholders of a CFC are subject to U.S. tax on certain income earned, whether or not it is distributed to the shareholders. For taxable years beginning after Dec. 31, 2005 through Jan. 1, 2009, TIPRA provides look-through treatment for payments between related controlled foreign corporations under the foreign personal holding company income rules.

This creates an exception from subpart F for cross-border payments of dividends, interest, rents and royalties that are funded with active income that has not been repatriated. PricewaterhouseCoopers notes this will provide U.S. multinationals with additional flexibility to move active foreign income without triggering U.S. tax consequences.

The CFC provisions have a big impact for multinationals, though some may not view them as positive, says Nanci S. Palmintere, vice president, Global Tax and Trade at Intel Corp.; she is an FEI member and member of FEI's COT. "The new provisions make sense and are potentially a bit more advantageous. These look-through rules will have a positive impact at Intel."

TIPRA also extends through 2008 the subpart F exception for active financing income earned on business operations overseas. The subpart F exemption permits American financial services firms doing business abroad to continue to defer U.S. tax on their earnings from their foreign financial services operations until those earnings are returned to the U.S. parent company.

Exclusions for U.S. Citizens Living Abroad. Under Section 911 of the Internal Revenue Code, U.S. citizens and others living abroad may be eligible to exclude from U.S. taxable income certain foreign earned-income and housing costs. Effective for taxable years beginning after Dec. 31, 2005, TIPRA creates three changes that affect these exclusions:

* The $80,000 income exclusion is indexed for inflation, starting in 2006;

* The base amount used in calculating the foreign housing cost exclusion is modified, and the housing cost exclusion is limited to 30 percent of the taxpayer's foreign earned-income exclusion; and

* Income excluded as either foreign earned income or as a housing allowance is included for purposes of determining the marginal tax rates applicable to non-excluded income.

According to an Ernst & Young analysis, these changes could significantly affect the cost of overseas assignments. Individuals working in low-tax or no-tax locations would be most impacted because foreign tax credits will likely not be available to offset additional U.S. federal taxes. Additionally, employers providing tax reimbursement assistance to expatriates could see an increase in costs.

Reilly points out that there will indeed be a net negative impact for most companies that have employees overseas, increasing the cost of expatriate assignments since most companies will generally absorb that additional cost for their employees.

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Palmintere says that this will be costly for Intel, based on the number of its expatriate workers. In response to this concern, which many have expressed, an article from the Bureau of National Affairs states that Senate aides have clarified that the Treasury Department has authority to adjust the 30 percent cap to address those living and working in higher-cost locations.

Additional Changes for Corporations

* Under previous law, the domestic manufacturing deduction was limited to 50 percent of a taxpayer's W-2 wages. TIPRA modifies the wage limitation so that taxpayers may only include wages that are properly allocable to domestic production gross receipts. Additionally, the special limitation on wages treated as allocated to partners or shareholders of passthrough entities is eliminated.

According to PricewaterhouseCoopers, pulling the W-2 wage component from cost of goods sold and from other costs properly allocable to domestic production gross receipts will be time-consuming. This provision may also impact salaries earned by workers in industries that use independent contractors that receive 1099s instead of W-2s--thus making the cost ineligible for the manufacturing deduction.

* For tax-free corporate spin-offs, TIPRA simplifies the active trade or business test for certain corporate distributions after the enactment date. This provision permits a taxpayer to look at all corporations in the distributing corporation's and the spun-off subsidiary's affiliated group to determine if the test is satisfied. Also, tax-free treatment of certain spin-offs is denied where either the distributing corporation or the controlled corporation is a disqualified investment corporation, which is defined as those that have investment assets that are two-thirds or more of the value of the corporation's total assets (three-fourths or more for distributions occurring within one year after the date of enactment).

* TIPRA also makes several changes to the quarterly estimated payments of a corporation's income tax liability. For firms with at least $1 billion in assets, estimated tax due in July, August or September 2006 is increased to 105 percent of the otherwise required amount, with the next payment similarly reduced. Estimated tax due in July, August or September 2012 is increased to 106.25 percent, with the next payment similarly reduced. Finally, tax due in July, August or September 2013 is increased to 100.75 percent, with the next payment similarly reduced.

* For all corporations in 2010, 20.5 percent of the estimated tax installment due on September 15 is now due October 1. In 2011, 27.5 percent of the estimated tax installment due on September 15 is now due October 1.

Among the other tax-administration provisions and incentives are:

Earnings-Stripping Rules -- Before the date of enactment, there were limits to the deductibility of certain interest expense directly incurred by U.S. corporate taxpayers with respect to certain debt to related persons. Effective for taxable years beginning on or after the enactment date, the liabilities, interest income, and interest expense of partnerships will be attributed proportionately to corporate partners for purposes of applying the general earnings-stripping rules.

Small Business Expensing -- TIPRA extends the current section 179 small business expensing limits--a $100,000 deduction limit with a $400,000 phase-out threshold--through 2009.

Interest Paid on Tax-exempt Bonds -- After Dec. 31, 2005, interest paid on tax-exempt bonds is subject to information reporting in the same manner as interest paid on taxable obligations.

Foreign Investment in Real Property -- When originally enacted, The Foreign Investment in Real Property Tax Act (FIRPTA) taxed gains from the sale of U.S. real property by foreign corporations and nonresident aliens. Applied retroactively, TIPRA modifies FIRPTA to target investors with significant property interests and change application for those who own 5 percent or less of certain qualified investment entities.

Changes for Individuals. Among other provisions, for 2006, TIPRA protects individuals from tax increases threatened by the expiration of temporary alternative minimum tax (AMT) relief after 2005. It extends lower rates for capital gains and dividend income through 2010 and will potentially provide benefit, since individuals will be allowed to convert traditional IRAs to Roth IRAs beginning in 2010.

For certain dividends and long-term capital gains through 2010, TIPRA extends preferential rates to investors. Long-term capital gains and dividends paid by domestic and qualifying foreign corporations will continue to be taxed at 15 percent for individuals with taxable income in the top four brackets through 2010. Individuals with taxable income in the lowest two brackets will be taxed at 5 percent through 2007 and at zero through 2010.

This is certainly good news for the stock market, says Pam Olson, who specializes in tax policy at law firm Skadden Arps. Olson, the former U.S. Department of the Treasury Assistant Secretary for Tax Policy, says, "This will influence companies when making decisions on whether or not to issue dividends. It will also have a positive effect on the investment portfolios of insurance companies and other financing institutions."

What the Act Does Not Address

At press time, the pension-reform legislation--to which the trailer bill is tied--was still in conference between the U.S. Senate and House of Representatives. Those expired or expiring corporate tax provisions that are expected to be addressed include the work opportunity tax credit, the state and local sales tax deduction and the 15-year recovery period for leasehold improvements and restaurant property.

The most important provision to be addressed in the trailer bill, and one that would have the broadest impact on most U.S. manufacturers, is the research and experimentation, or R & D, tax credit. This credit expired at the end of 2005. Permanency of the R & D credit would be a step toward corporate competitiveness, Palmintere maintains.

Reilly also points out that with respect to the credit, many corporations would be in a better position to plan their R & D budgets if the credit was made permanent. However, budget constraints pose a difficult hurdle to permanency.

Olson says that the R & D credit will likely be extended retroactively through the end of 2006 to 2007. Though the trailer bill attachment to pension reform may slow progress, she predicts that the final up-or-down congressional vote on the bill will occur before the July 4th recess, with enactment in July or August.

Cheryl Graziano ([e-mail]) is Vice President--Research and Operations at Financial Executives Research Foundation (FERF).

RELATED ARTICLE: Conference schedule.

Fall Private Company Forum

October 26-27, 2006

Boston, MA | Sheraton

Issues and information needs for private company financial executives will be addressed in this seminar. For information, visit FEI's website www.fei.org.

Current Financial Reporting

Issues: Shaping the Future of Financial Reporting

November 16-17, 2006

New York | Marriott Marquis

For information, visit FEI's website:

www.fei.org/cfri.

Speakers to include:

Neil Cavuto, FOX News

Robert H. Herz, FASB 

Thomas E. Jones, IASB 

Carol A. Stacey, SEC

Scott A. Taub, SEC

RELATED ARTICLE: takeaways

* Known as "TIPRA," the Tax Increase Prevention and Reconciliation Act of 2005 was signed on May 17, 2006.

* TIPRA includes $91 billion in tax relief offset by $21 billion in revenue-raising provisions over a 10-year span. Many provisions are expected to be addressed in a separate "trailer" tax bill, tied to pending pension legislation.

* One significant business tax change in the international area modifies existing provisions related to the foreign-sales corporation and extraterritorial income regimes.

* For 2006, TIPRA protects individuals from tax increases threatened by the expiration of temporary alternative minimum tax (AMT) relief after 2005.