Previewing US Tax Reform
The latest Tax Reform Business Barometer survey, issued by The Tax Council and Ernst & Young, found that tax professionals expect Congress to approve tax reform legislation no earlier than 2017, with most congressional leaders having all but given up hope that tax reform is achievable in the remainder of President Barack Obama’s term. However, congressional gridlock hasn’t stopped lawmakers from discussing the idea of tax reform fairly extensively, and this special feature looks at some of the tax reform ideas that could be put into law in the next few years.
Why Is Tax Reform Needed?
In short, this is because the US tax code has become highly complex. According to National Taxpayer Advocate Nina E. Olson’s 2013 report to Congress, US taxpayers (both individuals and businesses) spend more than 6.1bn hours to complete tax filings, and it was estimated that it cost individual and corporate taxpayers USD168bn to comply with the tax code in 2010. The situation has hardly been helped by the enactment of piecemeal changes to the tax code at regular intervals. Indeed, Olson’s report said that Congress had made nearly 5,000 changes to the tax code since 2001, an average of more than one a day.
Another issue affecting US taxpayers is that while most countries have steadily reduced their corporate taxes over the past 10 years or so, the failure on the part of Congress to approve a tax reform bill has left the US with comparatively high rates of tax. This is especially the case for taxpayers under the corporate tax code. In fact, since Japan cut corporate tax a few years ago, America has the dubious honor of levying the highest statutory rate of corporate tax in the OECD, and the third highest in the world, at 35 percent.
It is generally accepted that under current tax law, US corporations are incentivized to keep income earned from foreign operations out of the United States. The US taxes corporate income on a “worldwide” basis, but there is a deferral system for the active earnings of foreign subsidiaries of US multinational companies, as long as the profits remain abroad. Therefore, tax is only payable when these profits are repatriated as dividends to the US. But rather than repatriate income and face a high statutory corporate tax rate of 35 percent, US corporations have instead stockpiled an estimated USD2 trillion overseas, a state of affairs also known as the profit “lock-out.”
Indeed, it is a sad indictment of the US tax system that the country is now in 55th place out of 189 jurisdictions in PwC’s latest Paying Taxes Index, which measures how easy (or not) it is for a case study manufacturer to discharge its tax responsibilities. That’s just ahead of Vanuatu and just behind Jordan. Canada, where corporate tax has fallen to just 15 percent, is in ninth place.
Why Can’t Congress Fix The Problem?
While both parties in Congress agree on the need for tax reform, they disagree fundamentally on what the outcome of tax reform should be. The Democrat line is that tax reform should ultimately raise additional revenue for deficit reduction and ensure that large corporations and wealthy individuals pay their “fair share” of tax. Republicans on the other hand, are staunch in their belief that tax reform should not raise taxes by a single dime, should be revenue neutral and make the US economy more competitive.
Until recently, a split Congress, with the Republicans controlling the House of Representatives and the Democrats enjoying a majority in Senate, ensured a stale-mate on the issue of taxation, as well as wider budgetary policy, as the numerous last-minute government funding deals have demonstrated. Following the 2014 congressional elections, Republicans regained control of the Senate, but crucially, they lack sufficient votes to overcome the chamber’s higher procedural hurdles. Thus they have been frustrated in their attempts to push their legislative agenda through, despite an overall majority in Congress. In any case, President Obama has dug his heels in on many key issues, including taxation. Generally, the White House has refused to move closer to the Republican position on tax and spending, and he has threatened to exercise his power of veto on legislation that cuts tax for the wealthy. However, by dogmatically maintaining a principled position on tax, the President has merely sustained the legislative deadlock.
Nevertheless, while only the most urgent tax legislation stands any chance of passing, there are plenty of legislative proposals floating around Washington that could be included in a future tax reform bill. With an emphasis on corporate tax, the most significant proposals are summarized in the next sections.
President Obama’s Minimum Corporate Tax
In his 2016 Budget plan, President Obama proposed a 14 percent one-time tax on the USD2 trillion in previously untaxed foreign income that US companies have accumulated overseas. The earnings subject to the one-time tax could then be repatriated without any further US tax, and the additional revenue so obtained would be used to stabilize the Highway Trust Fund and invest further in infrastructure.
Additionally, a 19 percent minimum tax would be imposed on the foreign income of US multinationals, reduced (but not below zero) by 85 percent of the effective foreign tax rate imposed on that income. It was said that this “minimum tax on foreign earnings (that otherwise would be eligible for indefinite [tax] deferral under current law) would directly address the incentives under the current system to locate production overseas and to shift and maintain profits abroad.”
There would also be restrictions on the corporate tax deductions available for interest, a limiting of the “inappropriate shifting” of income from the US through intangible property transfers, and a restriction on the use of “hybrid” arrangements creating income that is not subject to tax in any jurisdiction.
Finding ways to unlock these profits has become something of an obsession for many in Congress, and most of the proposals in this area center on allowing US corporations to repatriate foreign earnings subject to a special – usually much lower – rate of corporate tax, albeit with certain strings attached relating to US investment and employment.
Two of the more recent examples were both announced in February 2015. The first was introduced in the Senate and the House of Representatives by Senator John McCain (R – Arizona) and Representative Trent Franks (R – Arizona), respectively. This legislation would set the preferential tax rate at 8.75 percent, falling to 5.25 percent if companies were able to show that they were expanding their payroll by 10 percent through net job creation or higher payroll. In addition, the proposed bill would discourage US companies from reducing employment by adding a USD75,000 penalty per full-time position that is eliminated from a company’s gross income calculation.
The second was announced by senators Rand Paul (R – Kentucky) and Barbara Boxer (D – California). This bipartisan legislation would allow companies to return their foreign earnings voluntarily to the US at a tax rate of 6.5 percent. The rate would only be for repatriations that exceed each company’s average repatriations in recent years, and companies would have up to five years to complete the transfer. All tax revenues from the bill would be transferred into the troubled Highway Trust Fund (HTF) to help plug its deficit. However, the bill is also designed to encourage US corporations to invest in the domestic economy, with the requirement that a portion of the repatriated funds be invested in such items as increased hiring, wages and pensions, and research and development. Notably, the bill prohibits repatriated funds from being used to increase executive remuneration, shareholder dividends, and stock buybacks for three years after the program ends.
US Innovation Box
One of the newer ideas being discussed in Congress is a special tax regime for intellectual property income, and in July 2015, a discussion draft released on legislation to create an “innovation box” regime in the United States, to encourage domestic investment in research and development.
A bipartisan initiative, the draft was put forward by two senior members of the House of Representatives Ways and Means Committee, Charles Boustany (R – South Louisiana) and Richard Neal (D – Massachusetts). They said that introducing an innovation (or patent) box – like those in several European countries whose rates range from 5-14 percent – “would provide a lower effective tax rate for most corporations across many industries, encourage greater investment in R&D, and attract R&D jobs back to the United States from overseas.”
Known as the Innovation Promotion Act of 2015, the draft defines “Qualified Intellectual Property” as patents, inventions, formulas, processes, designs, patterns, and know-how (and property produced using such IP), as well as other types of IP such as computer software. A company’s eligibility to tax breaks would be calculated by taking qualifying IP gross receipts, deducting the cost of goods sold and expenses, and multiplying that value by the fraction of a company’s budget spent on US R&D. That amount would be subject to a tax rate of 10 percent, rather than the general corporate rate of 35 percent.
Under current law, the repatriation of appreciated IP by a foreign subsidiary of a US company is a taxable event. Under the Boustany-Neal discussion draft, companies with overseas IP would be permitted to bring it back to the United States without triggering a taxable event.
Senate Tax Reform Panels
In January 2015, to coincide with the start of a series of US tax reform hearings, the Senate Finance Committee announced the formation of working groups covering individual income tax, business income tax, savings and investment, international tax, and community development and infrastructure. These groups reported their findings to the committee in July 2015.
Specific bipartisan proposals have been made by the international tax reform working group, led by Rob Portman (R – Ohio) and Charles Schumer (D – New York), including the adoption of “a dividend exemption or hybrid territorial-type system, paired with appropriate base erosion measures,” together with recommendations on patent boxes and deemed repatriation.
“Our report shows a bipartisan framework for how we can update our international tax code, giving US companies the tools they need to compete and win on a level playing field with their international competitors, leading to more jobs and higher wages here at home,” stated Portman.
In particular, Portman and Schumer have agreed that legislative action is needed to “combat the efforts of other countries to attract highly mobile US corporate income through the implementation of our own innovation box regime that encourages the development and ownership of intellectual property (IP) in the United States, along with associated domestic manufacturing.”
They said that they “will continue to work to determine appropriate eligibility criteria for covered IP, a nexus standard that incentivizes US research, manufacturing, and production, as well as a mechanism for the domestication of currently offshore IP.”
The working group has also backed the imposition of a transitional deemed repatriation tax at a rate significantly lower than the US statutory corporate rate on the deferred earnings held abroad by US multinationals, during the transition to the new international tax system. President Barack Obama’s budget proposal to impose a 14 percent one-time tax on all past corporate earnings accumulated abroad has been studied.
Complicating the issue of corporate tax reform is the emotive issue of tax “inversions,” whereby US multinationals move their tax residences abroad – away from the high 35 percent US headline federal corporate tax rate – and unlock unrepatriated earnings held offshore while maintaining management and operations in the United States.
Spurred by reports of talks between Pfizer Inc and Allergan Plc, Mark Pocan (D – Wisconsin) introduced two bills into the House of Representatives in November 2015 to discourage US multinational companies from undertaking corporate tax inversions.
The Putting America First Corporate Tax Act would cancel the provision in the current US tax code that allows corporations to defer paying corporate tax on foreign profits until that money is repatriated back to the US. It would require corporations to pay US taxes on all future domestic and foreign active income beginning from December 31, 2014.
Pocan’s second Bill, the Corporate Fair Share Tax Act, is to curb the practice of “earnings stripping” whereby domestic subsidiaries borrow from their new foreign parent company to increase their interest payments and reduce their US taxable income. Specifically, the legislation limits the US tax deductions a corporation may claim to a level at which the US entity’s share of interest on debt is proportionate to the US entity’s share of a financial reporting group’s earnings.
Rocan’s proposed legislation takes a different approach to the Stop Corporate Inversions Act, which was introduced by other Democrat lawmakers earlier this year. That Bill would change the current law, under which a company that merges with an offshore counterpart can move its residence abroad so long as at least 20 percent of its shares are held by the foreign company’s shareholders after the merger. It would restrict corporate inversions by putting the minimum foreign shareholding cap at 50 percent.
However, all of the bills appear to have little chance of progressing through Congress at the present time, as there remains a political divide about the right course of action to tackle inversions. Nevertheless, on November 19, 2015, US Treasury Secretary Jack Lew presented further non-legislative rules that largely build on the measures put forward by the Obama Administration in September last year to deter US multinationals from using corporate inversions to move their tax residences abroad.
The proposed measures, which apply to deals closed on or after November 19, are intended to make it more difficult for US companies to undertake a corporate inversion by (1) limiting the ability of US companies to combine with foreign entities using a new foreign parent located in a “third country,” (2) limiting the ability of US companies to inflate the new foreign parent corporation’s size and therefore avoid the 80-percent ownership rule, and (3) requiring the new foreign parent to be a tax resident of the country where the foreign parent is created or organized.
Simmering away in the background is the looming fight between the two parties in Congress on how to approach “tax extenders” legislation, a rag bag of 50-plus temporary tax provisions for individuals and businesses which last expired at the end of 2014.
The tax extenders have previously been rolled forward annually, but this has caused problems for taxpayers relying on the credits and deductions, as Congress has extended them very late each year. This year, the Republicans have decided to take a different approach, proposing to permanently extend select extenders deemed to be of most benefit to the economy. However, these proposals are largely unfunded by offsetting tax hikes or spending cuts elsewhere on the ledger, and therefore will add to the federal budget deficit, Democrats argue.
Unperturbed, the Republican-led House of Representatives Ways and Means Committee marked up the permanent extension of a further five “tax extenders” on September 17, 2015, following its approval of ten provisions earlier this year. The five measures passed by the Committee included: a permanent extension to bonus depreciation that would allow businesses to immediately deduct 50 percent of their investment in equipment and software, with the remainder depreciated over time. The other permanent tax extenders included two to allow American corporations to defer paying taxes on their overseas profits – extending the rules allowing financial companies to defer tax on their overseas income (subpart F) – and allowing corporations to transfer funds between international subsidiaries without paying tax.
The Committee’s ten measures passed in February this year, at a total cost of USD319bn, had included a permanent extension to the research and development tax credit, small business Section 179 expensing, and the deduction for state and local sales tax.
The Committee’s former Chairman Paul Ryan (R– Wisconsin) said that “making these provisions permanent will give people the certainty they need to create more opportunity in our economy,” but its Ranking Member Sander Levin (R – Michigan) pointed out that “this is being proposed at a time when we are reaching the debt ceiling and the Republicans are now proposing that we push the deficit through the roof.”
The Presidential Candidates: Clinton
The expected frontrunners for next year’s presidential race have also weighed in on the tax reform debate, having presented their own visions of tax reform if elected to the White House.
Democratic Party presidential candidate Hillary Clinton gave her first indication of how she would look to reform the US tax code if elected next year in a speech to the New School in New York on July 13, 2015. According to a transcript of her remarks released by her campaign, she called for tax changes that would increase employment by incentivizing companies “to make the longer-term investments that create jobs.” Companies would also be given “a USD1,500 tax credit for every worker they train and hire,” and be encouraged “to expand profit sharing with their employees.” Broader corporate tax reform, Clinton said, would include the closing of “those loopholes that reward companies for sending jobs and profits overseas.”
The Presidential Candidates: Trump
In September 2015, the leading Republican Party US presidential candidate Donald Trump presented a “revenue neutral,” but much more comprehensive, tax reform plan that cuts both business and individual income tax rates.
With regard to business taxation, Trump would drop the current 35 percent US headline federal corporate tax rate to only 15 percent, thereby “making corporate inversions unnecessary by making America’s tax rate one of the best in the world.” That rate would also be extended to “freelancers, sole proprietors, unincorporated small businesses, and pass-through entities” that are taxed within the individual income tax code. In addition, his plan would “reduce or eliminate corporate loopholes that cater to special interests, as well as deductions made unnecessary or redundant by the new lower tax rate on corporations and business income. We will also phase in a reasonable cap on the deductibility of business interest expenses.”
The Trump tax cuts are to be paid for by the reduction or elimination of deductions within both the individual and corporate tax codes, the additional economic growth stimulated by the tax rate cuts, and a one-time deemed repatriation tax at a reduced rate of 10 percent, followed by “an end to the deferral of taxes on corporate income earned abroad.”
The Presidential Candidates: Jeb Bush
Republican Party presidential candidate Jeb Bush also set out his US tax reform plan in September 15, presenting proposals which would establish a territorial tax system and cut both individual and corporate tax rates through the elimination of tax preferences.
Bush would look for a cut in the headline US federal corporate tax rate from the current 35 percent to 20 percent, through the repeal of “most” corporate deductions and credits. Businesses would be allowed a 100 percent immediate write-off for their capital investments, rather than the application of the existing system of depreciation schedules, but the present tax deduction for interest on corporate borrowing would be completely taken away.
He also proposed a move from the present US system of taxing foreign earnings worldwide to a territorial system, without giving further details. He confirmed that he would allow the repatriation of the more than USD2 trillion in earnings held abroad by US multinationals, subject to a one-time tax of 8.75 percent, which would be payable over 10 years.
Is Compromise Possible?
Paul Ryan, the new Speaker of the House, certainly seems to think so. During an interview televised by CBS’s 60 Minutes on November 15, Ryan expressed the hope that US business tax reform remains possible in the short term. “If we can find common ground, we can on highways, we will on funding the Government, hopefully we can on tax policy,” Ryan said. “Those are three things that will produce certainty in this economy in the next few months – let’s go do that.”
However, the indications are that as we draw ever nearer to a presidential election year, the chances of any major changes to the US tax code, whether that be across the board (individual and corporate tax), business-only or international-only reform are receding fast. In any case, judging by recent statements, the Republican Congress and the Democrat Administration would appear to be too far apart on tax and wider fiscal policy. Therefore, as most US businesses now accept, 2017 is likely to be the earliest date when tax reform will doable. Thanks to recent tax proposals, we have some idea of what a reformed tax code might look like. However, its exact make-up will depend heavily on the outcome of next year’s election.