August 01, 2022
On July 27, 2022, Senators Manchin and Schumer announced that they agreed to a proposed reconciliation package, the Inflation Reduction Act of 2022, H.R. 5376 (the “Bill”). If enacted, the Bill would finance climate programs, expand the Affordable Care Act through 2025, and allow Medicare to negotiate prescription drug prices. While the majority of the tax-related changes in the Build Back Better Act, H.R. 5376, are not included in the current draft of the Bill, the Bill would meaningfully change the current taxation of corporations and carried interests by (a) enacting a new corporate book minimum tax regime that is nearly identical to the proposal in the Build Back Better Act, and (b) limiting the ability of some taxpayers to be eligible for long-term capital gain treatment with respect to carried interests subject to section 1061 of the Internal Revenue Code of 1986, as amended (the “Code”).
Lawmakers said that the Joint Committee on Taxation has estimated that, over the 10-year budget window, the Bill would generate $313 billion from the new corporate book minimum tax and $14 billion from changes made to the taxation of carried interests.
A discussion of the key tax provisions in the current draft of the Bill is set forth below.
The Bill would impose a 15 percent minimum tax on the financial statement (or “book”) income of “applicable corporations” (the “Book Minimum Tax”). If enacted, the Book Minimum Tax would apply for taxable years beginning after December 31, 2022.
An applicable corporation may be subject to the Book Minimum Tax where, for example, (a) such corporation has significant book-tax differences (e.g., due to differences between the book and tax treatment of stock-based compensation or timing differences between book and tax depreciation) or (b) such corporation generated significant pre-2020 net operating losses (“NOLs”) for regular tax purposes, but did not generate book NOLs post-2019.
A one-pager released by Senators Warren, King and Wyden in connection with the Build Back Better Act stated that roughly 200 companies report over $1 billion in book profits.
While Congress may revise the Bill before the next release, we recommend that taxpayers potentially subject to the Book Minimum Tax consider the general framework of the tax and the impact it would have on them if enacted into law.
As proposed, the Book Minimum Tax applies only to corporations (excluding S-corporations, RICs and REITs) that meet the “average annual adjusted financial statement income test” (the “Income Test”) for one or more prior taxable years ending after December 31, 2021. Notably, once a corporation meets the Income Test in any year, the Book Minimum Tax continues to apply to the corporation in perpetuity unless, under limited circumstances, the Treasury Department (“Treasury”) determines it is no longer appropriate to apply the Book Minimum Tax to the corporation.
The Income Test differs for corporations in international financial reporting groups the common parent of which is a U.S. corporation (“U.S.-Parented Corporations”) and corporations in international financial reporting groups the common parent of which is a foreign corporation (“Foreign-Parented Corporations”). The application of the Income Test to each type of corporation is discussed at a high level below.
A U.S.-Parented Corporation meets the Income Test in a taxable year if (after applying the aggregation rule described below) its average annual adjusted financial statement income (discussed in more detail below) for the three-taxable-year period ending with the tested taxable year is greater than $1 billion.
A Foreign-Parented Corporation meets the Income Test in a taxable year if: (a) the average annual adjusted financial statement income of all U.S. and foreign members of the international financial reporting group for the three-taxable-year period ending with the tested taxable year is greater than $1 billion and (b) the average annual adjusted financial statement income of the Foreign-Parented Corporation (and any adjusted financial statement income that is treated as income of such corporation under the aggregation rule discussed below) for the three-taxable-year period ending with the tested taxable year is at least $100 million. The additional test in clause (b) ensures that a Foreign-Parented Corporation is subject to the Book Minimum Tax only if it and its group members have sufficient income that is subject to U.S. tax (either paid at the level of a domestic corporation or based on the ECI of a foreign corporation that is not a CFC of a U.S. shareholder in the group).
Solely for purposes of applying the Income Test to a corporation, all adjusted financial statement income of a person that is treated as a single employer under section 52(a) or (b) is treated as adjusted financial statement income of the tested corporation (the “Aggregation Rule”). Accordingly, the Aggregation Rule generally requires that the adjusted financial statement income of any U.S. or foreign affiliate of a corporation be taken into account in applying the Income Test to such corporation; provided, that: (a) in the case of a foreign affiliate that is a CFC of which such corporation is a U.S. shareholder (within the meaning of section 951(b)), only such corporation’s pro rata share (determined under rules similar to section 951(a)(2)) of the income or loss of such CFC is taken into account and (b) in the case of a foreign affiliate that is not a CFC, only the income of such affiliate that is ECI is taken into account.
For example, under the aggregation rule, adjusted financial statement income of CFCs of a U.S. corporation would be taken into account for purposes of applying the Income Test to a U.S. corporation. Furthermore, in applying the Income Test to a corporation (including for purposes of applying the $100 million test to a Foreign-Parented Corporation), any ECI of a foreign parent of a U.S. corporation would be taken into account for purposes of applying the Income Test to such corporation. Finally, as a result of the application of section 52(b), a corporation that is owned by a private equity fund would be required to take into account the income of one or more corporations or other entities that are treated as a single employer with such corporation under section 52(b) for purposes of applying the Income Test to such corporation.
For example, assume that foreign parent, the common parent of an international financial reporting group (“FP”), owns 100 percent of the stock of a United States corporate subsidiary (“USS”) and USS owns 100 percent of the stock of a CFC (“FS1”). Also, assume that: (a) FP had $975 million of adjusted financial statement income in the applicable taxable year ($10 million of which was ECI), (b) USS had $50 million of adjusted financial statement income in such taxable year and (c) FS1 had $25 million of adjusted financial statement income in such taxable year (none of which was ECI). Applying the Aggregation Rule and the special test applicable to Foreign-Parented Corporations to USS, USS would not be an applicable corporation. In particular, the adjusted financial statement income of the international financial reporting group (including income of foreign affiliates that is not ECI) would be $1.05 billion. However, applying the Aggregation Rule to the second prong of the Income Test applicable to Foreign-Parented Corporations, USS’s adjusted financial statement income would only be $85 million ($10 million of ECI of EP, $50 million of adjusted financial statement income of USS itself and USS’s pro rata share of the $25 million adjusted financial statement income of FS1).
In addition, in applying the Income Test, certain adjustments are made to the normal computation of adjusted financial statement income. The adjustments to the computation of adjusted financial statement income generally require the corporation to include all income of partnerships (rather than limiting the amount to the group’s distributive share) and to disregard adjustments generally required regarding the income and deduction related to certain defined benefit plans.
As noted above, once a corporation satisfies the Income Test for a taxable year ending after December 31, 2021, the corporation generally is treated as an applicable corporation for all subsequent taxable years (even if its adjusted financial statement income falls below the $1 billion threshold in any of such years). However, the Bill would provide that a corporation that previously met the requirements of the Income Test will no longer be treated as an applicable corporation where (a) either (i) such corporation experiences a change in ownership or (ii) such corporation does not satisfy the Income Test for a specified number of consecutive taxable years (to be determined by the Secretary and which shall, where appropriate, take into account facts and circumstances of the taxpayer) and (b) the Secretary determines that it would not be appropriate to continue to treat such corporation as an applicable corporation.
Unless the government issues general guidance to taxpayers through a revenue procedure, regulations or other means, a corporation that is not otherwise an applicable corporation that acquires a corporate subsidiary from a large financial reporting group would need to (a) determine whether the acquired subsidiary was an applicable corporation in prior years (including by asking for representations and warranties from the seller in the transaction documents) and (b) consider the potential impact of the Book Minimum Tax to both such entities post-acquisition.
In general, a corporation’s “adjusted financial statement income” for a taxable year would include the net income or loss of the corporation set forth on its applicable financial statement (as defined in section 451(b)(3) or as specified in regulations or other guidance) for such taxable year, with adjustments, including:
As with certain of the adjustments described above, the Bill would instruct Treasury to issue regulations or other guidance to require adjustments as Treasury deems necessary to carry out the purposes of the Book Minimum Tax, including adjustments (a) to prevent the omission or duplication of any item and (b) to carry out the principles of the U.S. tax rules applicable to corporate liquidations, corporate organizations and reorganizations, and partnership contributions and distributions.
If the Bill is enacted in its current form, we anticipate that Treasury will swiftly exercise its mandate to issue regulations or other guidance to address, among other items, provisions that on their face appear to result in duplication. For instance, the adjustments described above require a U.S. shareholder to take into account its pro rata share of a CFC’s adjusted financial statement income and separately limit a foreign corporation’s tax base under the rules to the foreign corporation’s income determined under ECI principles. If a foreign corporation is included in the same financial reporting group as its U.S. shareholder—not an unusual fact pattern—it is easy to imagine that this rule could result in double, or possibly triple (if the CFC’s earnings are ECI), tax on the same CFC’s earnings (once based on the U.S. shareholder’s pro rata share of all of the CFC’s income, a second time at the foreign corporation level based on its income determined under ECI principles and a third time once the earnings have been distributed as a dividend). Indeed, this clear duplication issue is the impetus for excluding a CFC’s ECI from its computation of subpart F and GILTI tested income under general U.S. tax principles that apply to CFCs.
If a corporation’s adjusted financial statement income (determined after the adjustments described above) is negative (i.e., creating a financial statement NOL) for taxable years ending after December 31, 2019, the Bill would permit the corporation to carry forward the financial statement NOLs indefinitely to reduce its adjusted financial statement income in a later taxable year. Accordingly, although the Bill is effective only for taxable years beginning after December 31, 2022, under the current draft of the Bill, taxpayers may benefit from financial statement NOLs generated in taxable years beginning after December 31, 2019, in determining the amount of the Book Minimum Tax.
Applying rules that are similar to the provisions applicable to regular NOLs under section 172(a)(2)(B), a corporation’s adjusted financial statement income in a particular taxable year is reduced by an amount equal to the lesser of: (a) the aggregate amount of financial statement NOLs carried over to such taxable year and (b) 80 percent of the corporation’s adjusted financial statement income computed without regard to its financial statement NOLs. The Bill does not specify whether financial statement NOLs (a) would be subject to limitation under section 382 or the separate return limitation year rules, (b) would be subject to attribute reduction under section 108 or (c) would be taken into account by an acquiring corporation in a section 381(a) transaction. However, we would expect that such issues would be addressed through regulatory guidance.
If a corporation elects to credit foreign income taxes, the Bill would provide for separate rules regarding such corporation’s ability to utilize direct foreign income taxes and deemed-paid foreign income taxes (i.e., amounts attributable to CFC-level taxes) to determine the amount that may be credited against its Book Minimum Tax liability.
With respect to a domestic corporation’s direct foreign income taxes (as defined in section 901), it may credit the amount of such taxes that are (a) taken into account on the corporation’s applicable financial statement and (b) paid or accrued by the corporation. The Bill would not impose a section 904-like limitation on a corporation’s ability to credit such direct foreign income taxes, but it also would not allow for the corporation to carry forward any unused direct FTCs.
The Bill would provide different rules for the amount of foreign income taxes that are paid by a CFC that a U.S. shareholder of such CFC is deemed to pay for purposes of these rules. With respect to a U.S. shareholder’s pro rata share of a CFC’s foreign income taxes, the Bill would provide a limitation on the U.S. shareholder’s ability to credit such deemed-paid foreign income taxes that mimics the general limitation under section 904. Specifically, the Bill would allow a U.S. shareholder of a CFC to credit the lesser of (a) the corporation’s pro rata share of the foreign income taxes taken into account on its CFCs’ applicable financial statements or (b) 15 percent of the U.S. shareholder’s pro rata share of such CFC’s adjusted financial statement income taken into account by the corporation in computing its Book Minimum Tax. By limiting the U.S. shareholder’s allowable FTCs for its deemed-paid foreign income taxes to the amount of its Book Minimum Tax on its pro rata share of such CFCs’ income, the Bill would effectively prevent the U.S. shareholder from using its deemed-paid FTCs to reduce the Book Minimum Tax imposed on non-CFC income. As noted above, however, a similar limitation does not apply to foreign income taxes that are incurred directly by a domestic corporation (or through a foreign disregarded entity). Unused FTCs attributable to such deemed-paid foreign income taxes would be carried forward for up to five years.
The Bill would modify section 53 to allow a corporation to offset the amount of Book Minimum Tax it pays against its regular tax liability in a future year. Because the credit would be included in section 53, such credit would be subject to the limitation under section 383 and would also appear to be subject to attribute reduction under section 108(b).
The Bill would amend section 38 in connection with the enactment of the Book Minimum Tax. The Bill would limit a taxpayer’s ability to use general business credits to an amount equal to (a) $25,000 plus (b) 75 percent of the taxpayer’s net income tax over $25,000. For this purpose, a taxpayer’s net income tax is equal to the excess, if any, of (a) the sum of the taxpayer’s regular tax liability, its minimum tax liability and its tax liability under section 59A over (b) the credits allowed under subpart A or B of Part IV of the Code.
The Bill also would amend current section 1061, which addresses partnership interests held in connection with the performance of services (carried interests).
The Bill’s amendments to section 1061 expand the scope of gain subject to characterization as short-term, by generally increasing the holding period requirement to five years from three years, changing how the relevant holding period is determined, and making all transfers of an “applicable partnership interest” (an “API”) gain recognition events. Importantly, however, the Bill makes only minor changes to the definition of API and the definition of an “applicable trade or business” (an “Applicable TOB”) (relevant for determining whether a partnership interest is an API). As a result, the application of section 1061 would continue to be limited to partners in partnerships engaged in an Applicable TOB.
The amendments to section 1061 set forth in the Bill would apply to taxable years beginning after December 31, 2022.
Section 1061 limits long-term capital gain treatment for capital gain recognized by a partner with respect to an API by requiring a greater than three-year holding period instead of a greater than one-year holding period.
The characterization of an API holder’s distributive share of capital gain as long-term or short-term generally is determined by applying the three-year threshold to the partnership’s holding period in the underlying asset sold. Because section 1061 affects only the characterization of gain under section 1222, current section 1061 does not recharacterize a partnership’s long-term capital gain under sections 1231 and 1256, qualified dividends under section 1(h)(11)(B) that are taxed at the same rate as long-term capital gain, or any other capital gain characterized as long-term without regard to the holding period rules under section 1222 (“Excluded LTCG Items”). Capital gain resulting from the sale or disposition of an API is characterized as long-term or short-term by applying the 3-year threshold to an API holder’s holding period in its API (without regard to the holding period for the partnership’s assets).
A partnership interest is treated as an API if the API is held in connection with the performance of services in an Applicable TOB. An Applicable TOB generally refers to a trade or business that involves raising or returning capital and investing in (or disposing of), or developing, certain types of investment assets (i.e., investment management activity).
In the case of a transfer of an API to a related party, any long-term capital gain recognized on the transfer of the API is recharacterized as short-term to the extent a hypothetical sale of partnership property would generate gain attributable to property held for three years or less that would be allocable to the transferor. If the transfer is a nonrecognition transaction (e.g., a contribution under section 351(a) or section 721(a)), the nonrecognition provision controls such that no gain is recognized and the API remains an API in the hands of the transferee.
The Bill would amend section 1061 to provide that an API holder’s “net applicable partnership gain” is treated as short-term capital gain. “Net applicable partnership gain” (“NAPG”) would be defined as the sum of (a) a taxpayer’s net long-term capital gain with respect to APIs and (b) any other amounts with respect to an API that are either treated as long-term capital gain or subject to long-term capital gain rates. Thus, the Bill (through the definition of NAPG) would expand the types of income subject to recharacterization to include Excluded LTCG Items, which are not currently subject to recharacterization under section 1061.
The Bill would except certain amounts from being treated as NAPG. NAPG would not include any amount realized more than five years after the latest of (a) the date the taxpayer acquired substantially all of the API with respect to which the amount is realized or (b) the date that the partnership that issued the API acquired substantially all of the assets held by such partnership. The new holding period standard would not only lengthen the period required for an API holder to obtain the long-term capital gain rate benefit, but would also make it harder to reach the threshold holding period by requiring both that substantially all of the API has been held for more than five years and that the issuing partnership has held substantially all of its assets for more than five years. As described above, the relevant holding period under current law for measuring a partner’s distributive share of gain is the partnership’s holding period in the asset sold or disposed of. Thus, an API holder’s distributive share of gain from the sale of an asset held by the partnership for more than three years is not subject to recharacterization under current section 1061 even if the API holder acquired its API more recently. Under the Bill, however, even if a partnership acquired substantially all of its assets more than five years before the date of the gain realization event, an API holder’s distributive share of such gain would not be excluded from NAPG unless substantially all of the API was acquired more than five years before such date.
While the Bill would employ the same “later of” approach to all API holders, the Bill would retain the three-year threshold of current law, in lieu of the five-year threshold, in the case of (a) taxpayers (other than a trust or estate) with an adjusted gross income of less than $400,000 and (b) any income with respect to an API that is attributable to a real property trade or business (within the meaning of section 469(c)(7)(C)).
The Bill would remove the special rules for related party transfers and, instead, would provide for recognition of gain (but not loss) in the case of any transfer of an API (even where the transfer would otherwise qualify for the benefit of a nonrecognition provision). This change would, in many cases, impose substantial costs on the restructuring of a fund manager’s legal entities and could create traps for the unwary.
The Bill expressly provides for the promulgation of Treasury Regulations addressing the application of section 1061 to distributions of partnership property and carry waivers to prevent the avoidance of section 1061, as well as to financial instruments, contracts or interests in entities other than partnerships as necessary to carry out the purpose of section 1061.
Special thanks to associate Ira Aghai who contributed to this publication.
 All “section” references herein are to sections of the Code.
 However, in some situations, book-tax differences may also be taxpayer-favorable, which may be the case where (a) assets are fully or partially written-off for book purposes, but a loss cannot be claimed for tax purposes, (b) interest payments that are not deductible for tax purposes but are deductible for book purposes and (c) deductions for fines, penalties and other executive compensation that are disallowed for tax purposes, but that are allowed for book purposes.
 For example, if a corporation first satisfies the Income Test in its 2022 taxable year, it would be an applicable corporation beginning in its 2023 taxable year.
 For purposes of this clause, the adjusted financial statement income of foreign corporation members is taken into account regardless of whether such foreign corporation members are controlled by foreign corporations (as defined in section 957(a) (“CFCs”)) and/or any such income is effectively connected with the conduct of a trade or business within the United States (as defined in section 864 (“ECI”)).
 As a general matter, two or more corporations are treated as a single employer under section 52(a) where they are connected with a common parent corporation through stock ownership of more than 50 percent (by vote or value). Section 52(b) contains a similar rule that applies for non-corporate taxpayers, including partnerships and trusts.
 The term “change in ownership” is not defined for this purpose. Although the Bill does not reference section 382, it is possible that the “ownership change” rules in section 382 would be utilized for this purpose.
 The House bill does not further elaborate as to (a) when it would be appropriate to treat a corporation as an applicable corporation or (b) whether the Secretary would apply these exceptions on a categorical basis (for example, through a revenue procedure) or through individualized advice to taxpayers.
 The tainting of a target corporation as an applicable corporation based on its pre-acquisition status may be able to be addressed by structuring the acquisition of the target through an asset acquisition or other transaction that is treated as an asset acquisition for tax purposes, such as a stock sale with an election under section 338 or a pre-sale conversion of the target to a limited liability company followed by a post-conversion acquisition of the membership interests in the target.
Furthermore, due to the successor concept contained in the Bill, converting the target to a limited liability company post-acquisition in a section 332 liquidation would presumably not solve the issue, as the parent corporation would presumably be treated as a successor to the target corporation. Although a successor is not defined for this purpose, a corporation that acquires the assets of another corporation in a tax-free transaction has generally been viewed as the successor of the acquired corporation. See, e.g., Treas. Reg. § 1.1502-1(f)(4) (a successor is a person that acquires assets in a transaction to which section 381(a) applies or a transaction in which the successor’s basis in the assets are determined, directly or indirectly, by reference to the basis of the assets in the hands of the predecessor).
 It would appear that the dividends-received-deductions contained in sections 243, 245 and 245A would not be available to reduce any such dividend income for purposes of computing adjusted financial statement income.
 As drafted, the Bill only takes into account the income of disregarded entities. However, it is unclear why an adjustment would not be made for losses of a disregarded entity (similar to the rule for partnerships described below).
 The Bill does not provide for a special tax basis increase or decrease to a partner’s tax basis in its partnership for any income or loss of the partnership that is taken into account under this rule.
 The income that a U.S. shareholder is required to take into account under this rule appears to include any income of the CFC regardless of whether or not such income would otherwise be “subpart F income” (within the meaning of section 952) or “tested income” (within the meaning of section 951A(c)(2)(A)).
To avoid double inclusions of the same items of income, (a) any dividends that are received from a CFC and which were taxed to the U.S. shareholder under this rule should be excluded from the adjusted financial statement income of the recipient corporation under rules similar to the previously taxed earnings and profits (“PTEP”) rules set forth in section 959(a) and (b) a U.S. shareholder’s tax basis in a CFC should be increased by any inclusions under this rule under rules similar to those set forth in section 961.
 Treasury is instructed to prescribe such regulations or other guidance as may be necessary and appropriate to provide for the proper treatment of current and deferred foreign income taxes for purposes of this adjustment, including the time at which such taxes are properly taken into account.
 In this example, a foreign subsidiary with far less than $1 billion of ECI may be treated as an applicable corporation because the aggregation rule described above would cause the adjusted financial statement income of the U.S. corporate parent to be treated as adjusted financial statement income of the foreign subsidiary for purposes of applying the Income Test to the foreign subsidiary.
 Because a corporation can carry forward financial statement NOLs from years when it was not an applicable corporation (limited, as described above, to taxable years beginning after December 31, 2019), a corporation that becomes an applicable corporation in a later year will need to go back and compute its adjusted financial statement income in prior years to determine its financial statement NOL carryforward balance.
 Section 1061(a).
 Treas. Reg. § 1.1061-4(b)(8) (the partnership’s holding period in the asset being sold or disposed of is the relevant holding period for purposes of section 1061 when the gain recognized by the API holder is their distributive share of gain from such sale or disposition). This approach is consistent with section 702(b) and Revue Ruling 68-79.
 Treas. Reg. § 1.1061-4(b)(7).
 Special holding period rules apply to profits interests (including carried interests) under Treas. Reg. § 1.1223-3.
 Section 1061(c).
 Section 1061(d); Treas. Reg. § 1.1061-5(c). “Related” for this purpose is defined in section 1061(d)(2) and Treas. Reg. § 1.1061-5(e).
 Treas. Reg. § 1.1061-5(b) (“transfer” limited to sale or exchange in which gain is recognized) and Treas. Reg. § 1.1061-2)(a)(1)(i). See also Treas. Reg. § 1.1061-5(f)(1), Example 1.
 The Bill does not explain what constitutes “substantially all” for this purpose. However, in other sections of the Code, substantially all has been interpreted to represent a percentage between 70 percent and 90 percent.
The Bill would also propose a rule providing that in a tiered partnership structure, the five-year threshold is determined by applying rules similar to those in clauses (a) and (b) in the case of any lower-tier partnership.
 Treas. Reg. § 1.1061-4(b)(8). See also section 702(b) and Revenue Ruling 68-79.
 Adjusted gross income for this purpose is determined without regard to sections 911, 931 and 933.