Editor's note: US citizens, whether at home or living overseas in regions such as Asia, need to know the latest developments in US tax law as the country's lawmakers seek to deal with a huge deficit and public debt burden. Erik Wallace, an Asia-based partner at Withers, the international law firm, has given a briefing on recent highlights from the American Taxpayer Relief Act of 2012
January 7, 2013. Wallace has spoken to WBA in the past about such issues - click here.

After briefly plunging over the “fiscal cliff” – the
combination of tax increases and spending cuts that automatically came into
effect on 1 January, 2013 – Congress quickly passed the American Taxpayer
Relief Act of 2012 (the “Act”), which has now been signed into law by President
Obama.

Following is a brief summary of those aspects of the Act
that we believe are most relevant to our clients in the areas of (i) gift and estate
taxes, (ii) personal income tax, and (iii) business tax.

Gift and Estate Taxes

Exemption Amounts: The estate tax, gift tax and generation-skipping
transfer tax exemptions have been set at $5 million, adjusted annually for
inflation from 2011.

-- Planning Note: Though it seems a minor detail, the
inflation-adjustment provision may offer significant additional gifting
opportunities. For example, it is estimated that by 2020, the exemption will increase
to $6.5 million (assuming 3 per cent inflation), allowing additional tax-free
gifts of close to $1.5 million above and beyond the 2012 exemption. The
exemption amount for 2013 is estimated to be roughly $5.25 million, a $130,000
increase from the $5.12 million exemption amount in 2012.

Gift and Estate Tax Rate: Any gift or gross estate that
exceeds the exemption amount will be taxed at a 40 per cent rate. Though this
is higher than the 35 per cent rate that was in effect for 2012, it is
significantly lower than the 55 per cent rate that would have automatically
taken effect if the Act had not been passed.

-- Planning Note: For those subject to state transfer taxes,
bear in mind that many states still have a high estate tax rate (in some cases
as high as 20 per cent) with much lower exemption amounts, so combined federal
and state estate taxes may be well above 50 per cent in many cases and there is
no state level foreign tax credit. Currently, only one state (Connecticut) has a gift tax, but many people
are concerned that state budgetary constraints may lead other states to
institute or reinstitute gift taxes and/or estate taxes.

Portability: Surviving spouses will be able to utilize any
unused portion of their deceased spouse’s exemption for their own gifts and
estate. This provision, which was first enacted in 2010, has been made permanent.
Portability only applies to gift and estate taxes; the GST tax exemption is not
portable.

-- Planning Note: The lack of portability of GST tax
exemption, coupled with the fact that many states have not adopted portability
provisions, means portability is not a panacea, and it remains important to
consider utilizing both spouses’ exemptions during their lifetimes where
possible.

What Wasn’t Covered: From our perspective, one of the main
highlights of the Act was the range of previously-proposed law changes that
were not included. The Obama Administration and the IRS have proposed various
law changes that would effectively eliminate or greatly curtail the use of
grantor retained annuity trusts, valuation discounts, grantor trusts and
dynasty trusts. However, none of these planning techniques were covered by the
Act.

Personal income tax

Income Tax Rates: The Act preserves the 2012 tax rates for
individuals earning less than $400,000 and married couples earning less than
$450,000. For those with income over this threshold -- referred to as “High-Income
Taxpayers” in the Act – any income over the threshold is taxed at 39.6 per cent.

-- Planning Note: The 39.6 per cent tax rate does not take into
account the additional 0.9 per cent increase in the Medicare Tax on individuals
who earn more than $200,000 and joint filers who earn more than $250,000,
bringing the total employee-paid Medicare Tax to 2.35 per cent and the Medicare
tax on self employment income to 3.8 per cent.

Investment Income Rates: Capital gains tax for High-Income
Taxpayers (defined using the same $400,000/$450,000 thresholds) has increased
from 15 per cent to 20 per cent. The 0 per cent and 15 per cent rates will
remain in effect for the other brackets. Qualified dividends continue to be
treated as long-term capital gains for this purpose.

-- Planning Note: Though not covered directly by the Act, as
of January 1, 2013, investment income of taxpayers with income in excess of
$200,000 (individual) or $250,000 (joint) is subject to an additional 3.8 per
cent Medicare Tax. This applies to capital gains, ordinary investment income
and income from flow-through entities where the taxpayer is not an active
participant in the business.

Tax Rates for Trusts: Non-grantor trusts (i.e., trusts that
pay tax on their own income) are, in effect, treated under the Act as High-Income
Taxpayers; the 39.6 per cent income tax rate and the 3.8 per cent Medicare tax are
assessed on trust income in excess of $11,850 (for 2013, indexed for inflation
thereafter).

Itemized Deductions: Most important, the Act did not impose
any new limitations on key itemized deductions, such as the mortgage interest
and charitable deduction; for the time being, these deductions remain in
effect. However, the Act did re-introduce a “haircut” on itemized deductions
for taxpayers above a threshold (confusingly, $250,000 for individuals and
$300,000 for joint filers). Itemized deductions for affected taxpayers are
reduced by 3 per cent of their income above the threshold.

-- Planning Note: For most high-income taxpayers --
especially those in states with income tax rates higher than 3 per cent - this
provision effectively results in a tax increase of roughly 1.2 per cent.

Personal Exemption Phaseout: For taxpayers earning more than
$250,000 (individual) or $300,000 (joint), the Act re-introduced a gradual
phase-out of the personal exemption (currently $3,800 per person/dependent)
based on the level of income above the threshold.

Charitable Contributions from IRAs: For 2013, the Act
permits individuals over 70.5 years to donate up to $100,000 annually from
their IRA to a US
charity and to exclude the amount from income. The legislation also allows taxpayers
to (i) make a contribution in January 2013 and treat it as a 2012 transfer and
(ii) contribute to a charity in January 2013 out of a December 2012 IRA
distribution and treat the contribution as though it were a 2012 contribution
made directly from the IRA.

Conservation Easements: The Act reinstated provisions
allowing taxpayers to take a deduction of up to half of their adjusted gross
income for donations of a conservation easement made in 2012 or 2013. Excess
deductions may be carried forward for 15 years. Note that this deduction may
not be available under non US
income tax rules.

What Wasn’t Covered: While Congress continues to express
interest in the topic, this legislation once again declined to enact
previously-proposed “carried interest” rules, which would tax profit
participation to fund principals (and other providers of services to investment
partnerships) at ordinary income rates without regard to the tax character of
the profit.

Business taxes

Qualified Small Business Stock: The Act extends the 100 per
cent exclusion of the gain on the sale of qualifying small business stock that
was held for more than five years. This provision applies to stock acquired
prior to January 1, 2014.

S Corporation Recognition Period for Built-in Gain: When a
taxable “C Corporation” makes a subchapter S election, its built-in gains at
the time of conversion remain subject to double taxation for a “recognition period”
of a number of years thereafter. The designated holding period has fluctuated
over the past decade and would have increased to 10 years had previous
legislation been allowed to expire. However, the Act extended the current
5-year recognition period for sales occurring in 2012 and 2013.

Depreciation: Three major provisions related to depreciation
of business assets were in the Act. First, the phase-out threshold under
Section 179 (which allows, in lieu of depreciation, a deduction of up to $500,000
for property newly placed into service) will remain at $2 million. Second, the
15-year straightline depreciation for qualified properties will be extended for
buildings placed into service prior to 1 January, 2014. Finally, businesses are
allowed to take an additional 50 per cent depreciation deduction for
depreciable property placed into service prior to January 1, 2014.

Look-Through Rule for Subsidiary/Related Controlled Foreign
Corporations (CFCs): The Act extends through 2013 the current law allowing a
CFC receiving certain payments (dividends, interest, royalties, rents) from
subsidiary or related CFCs to look through to the activities of the paying CFC
and, to the extent such activities constitute the conduct of an active
business, to avoid characterization of such

payments as “Subpart F income” taxable currently at ordinary
income rates to 10 per cent US
shareholders.

Subpart F Exceptions for Active Financing: The Act extends
through 2013 the current law permitting a US parent company to defer tax on
income earned by a foreign subsidiary that actively engaged in the conduct of a
banking financing or similar business.

Research and Development: The research and development tax
credit has been extended so that it now applies to the 2012 and 2013 tax years.

What Wasn’t Covered: Broad-based corporate tax reform,
lowering rates but closing loopholes, generally thought to be near the top of
President Obama’s tax agenda, was not addressed by the Act.

Further developments
to come

While the Act describes many of these changes as
“permanent,” this term can be misleading. In this context “permanent” merely
means that the provisions are not scheduled to expire automatically, so any
“permanent” provision can be changed by future legislation.

Though the Act took steps to pull us back from the fiscal
cliff, the coming months are expected to bring two major debates that may re-open
discussion of any or all of these provisions: one over the debt ceiling and one
over the automatic spending cuts that were postponed to February by the Act.
Both political parties continue to discuss reform to the tax code for
individuals and corporations as a means of raising revenue, and we expect to
see further developments this year.