In his State of the Union speech before Congress on February 12, President Obama again called upon members of Congress to reform the tax code, increase jobs and continue to grow our economy. He continued to endorse his set of corporate tax proposals, including international tax revisions, that he had announced last February in a Joint Report with the Treasury Department.
On February 22, 2012, President Obama released a Joint Report by The White House and the Department of the Secretary of the Treasury labeled “The President’s Framework for Business Tax Reform”. Among the key elements would be the reduction in the maximum marginal corporate income tax rate from 35% to 28% and eliminate approximately $250 billion in business tax expenditures. The Framework would also impose a minimum tax on foreign earnings, such as the earnings of a foreign subsidiary of a U.S. parent corporation, and reduces the top effective rate on manufacturers to 25% through a manufacturing deduction designed to encourage “greater research and development” as well as the production of clean energy.
Among the casualties of the Framework would be the oil and gas industry’s sacred cowl, the depletion allowance rules and write off of intangible drilling costs. The carried interest rule would be eliminated and taxed at ordinary income rates. The LIFO accounting method would also be eliminated. The overhaul would be fully paid for, according to the framework.
This post sets forth some of the more notable features and aspects of the Joint Report.
“PRESIDENT OBAMA'S FIVE ELEMENTS OF BUSINESS TAX REFORM
I. Eliminate dozens of tax loopholes and subsidies, broaden the base and cut the corporate tax rate to spur growth in America: The Framework would eliminate dozens of different tax expenditures and fundamentally reform the business tax base to reduce distortions that hurt productivity and growth. It would reinvest these savings to lower the corporate tax rate to 28 percent, putting the United States in line with major competitor countries and encouraging greater investment in America.
II. Strengthen American manufacturing and innovation: The Framework would refocus the manufacturing deduction and use the savings to reduce the effective rate on manufacturing to no more than 25 percent, while encouraging greater research and development and the production of clean energy.
III. Strengthen the international tax system, including establishing a new minimum tax on foreign earnings, to encourage domestic investment: Our tax system should not give companies an incentive to locate production overseas or engage in accounting games to shift profits abroad, eroding the U.S. tax base. Introducing a minimum tax on foreign earnings would help address these problems and discourage a global race to the bottom in tax rates.
IV. Simplify and cut taxes for America's small businesses: Tax reform should make tax filing simpler for small businesses and entrepreneurs so that they can focus on growing their businesses rather than filling out tax returns.
V. Restore fiscal responsibility and not add a dime to the deficit: Business tax reform should be fully paid for and lead to greater fiscal responsibility than our current business tax system by either eliminating or making permanent and fully paying for temporary tax provisions now in the tax code.”
I. Cut Loopholes and Subsidies, Broaden the Base, and Cut the Corporate Tax Rate
The United States has the second highest statutory tax rate among advanced countries. In April 2012, after the scheduled reductions in Japanese tax rates go into effect, the United States will have the highest statutory corporate income tax rate in the Organization for Economic Cooperation and Development (OECD).
COMPARISON OF STATUTORY CORPORATE TAX RATES
IN THE UNITED STATES AND OECD COUNTRIES
TABLE 1: 2011 G-7 STATUTORY CORPORATE TAX RATES (IN PERCENT)
Statutory Corporate Effective Marginal
Tax Rate (including Tax Rate (including
Country subnational taxes) subnational taxes)
Canada 27.6 33.0
France 34.4 28.3
Germany 30.2 23.3
Italy 31.3 24.0
Japan 39.5 42.9
United Kingdom 26.0 32.3
United States 39.2 29.2
G-7 average excl.U.S. 32.3 31.9
Distorting The Form of Investment by Industry and Asset Type
The Joint Report recognizes that our federal tax system is replete with industry type tax preferences which have the effect of favoring certain industry sectors over others and at wide margins. Take one comment made for example, “because of accelerated depreciation and other features of the tax code, in 2005 income from a typical investment in structures for oil and gas faced an effective total marginal tax rate (including corporate and investor level taxes) of about 9 percent as compared to a 32 percent rate for manufacturing buildings.”
This hodge-podge system of preferences produces an unlevel planning field that distorts investment decisions. This lack of horizontal equity based on industry tax incentives (or the lack of such incentives) is reflected in another table contained in the Joint Report.
TABLE 2: EFFECTIVE ACTUAL FEDERAL CORPORATE TAX RATES
BY INDUSTRY FOR 2007 - 2008
Industry Effective Actual Corporate Tax Rate
Agriculture, Forestry, Fishing and Hunting 22%
Wholesale and Retail Trade 31%
Transportation and Warehousing 19%
Finance and Holding Companies 28%
Real Estate 23%
All Services 29%
Average Effective Actual Tax Rate 26%
Source: U.S. Department of the Treasury, Office of Tax Analysis
Distortion in Financing Investment: Overuse of Debt
As we know, the corporate tax provisions, as with Chapter 1 of the Code in general, favors financing capital by the use of debt over equity. This is because interest is generally deductible in computing taxable income while dividends are not. Adding to the advantage of debt is that depreciation allowances, including accelerated depreciation, yields even lower costs associated with debt capital. In many instances the advantages of debt-financed capital investment can yield an effective marginal tax rate that is negative. But added debt brings on added risk which is can ultimately result in bankruptcy or perhaps “quick” or “fire” sales of assets to avoid bankruptcy.
EFFECTIVE MARGINAL TAX RATES FOR DEBT AND EQUITY
FINANCED CORPORATE INVESTMENTS: SELECTED OECD COUNTRIES
Effective Marginal Effective Marginal
Tax Rate Tax Rate
Country Equipment (Equity) Equipment (Debt) Difference
Australia 31 -23 -54
Austria 27 -14 -41
Belgium 5 -50 -55
Canada 28 -21 -49
Finland 27 -18 -45
France 29 -59 -88
Germany 32 -10 -42
Greece 14 -26 -40
Ireland 15 -4 -19
Italy 38 1 -37
Japan 49 -4 -53
Netherlands 27 -14 -41
Norway 33 -11 -43
Portugal 22 -34 -56
Spain 36 -22 -58
Sweden 24 -24 -48
Switzerland 22 -18 -40
UK 30 -9 -40
United States 37 -60 -97
Average, Excl. US 34 -17 -51
G-7 Average, Excluding U.S. 37 -15 -51
Source: U.S. Department of Treasury, Office of Tax Analysis.
Distortion of Form of Business Organizations
The Joint Report then compared our tax entity friends, Subchapter S, Subchapter K and noted the double tax, non-integrated tax system under Subchapter C. Subchapter S is partially integrated with the built-in gains tax under Section 1374 being the main corporate tax vestige. Subchapter K offers a fully integrated tax regime with taxes imposed at the owner level. The combined effect of this varying tax treatment has contributed to a lower effective tax rate for pass-through entities relative to C-corporations. The effective marginal tax rate on new investment by C-corporations is now 32.3 percent, while the effective marginal tax rate on new investment by pass-through businesses 26.4 percent. As a result, large companies are increasingly avoiding corporate tax liability by organizing themselves as pass-through businesses. Pass-through businesses represented less than one quarter of net business income in 1980, but more than 70 percent of net business income in 2008.
Distortions in Favor of Shifting Production and Profits Overseas
The higher corporate income tax rate in the U.S. is a major factor in outsourcing capital and labor from the United States to lower tax jurisdictions. In fact, there is no offsetting benefit in many instances by doing business overseas realized by the U.S. companies through foreign tax credits when the jurisdictions in which they are doing business have no or little tax.
The Joint Report notes that income-shifting behavior by multinational corporations is a significant concern. Note the controlled foreign corporation provisions which can be used to block or defer income in which case only the local country tax is paid which in many cases is lower than the United States.
Subject to the rigors of transfer pricing rules, there is more than anecdotal evidence to confirm that companies generally purposely engage in efforts to shift income from high-tax foreign countries to low-tax foreign countries, and that this phenomenon is particular hard-felt in the United States. There are also "intangibles" relocations of brandnames, trademarks, and similar valuable intangibles to low tax jurisdictions. High U.S. corporate income tax rates also discourage foreign investment in the U.S. and many merger activity results in a non-U.S. situs for the pooled entities. These somewhat long-standing trends are viewed by the current Administration as matters which need to be corrected, corrected quickly and in a manner which attracts capital and labor to the U.S.
President's Framework for Reform
Well, many of us who have worked with our domestic and international tax laws have known the bias in favor of moving business operations overseas for many, many years. It was somewhat shocking to see the delay in not responding to this capital and labor drain from our economy. Perhaps some influential lobbyists kept the Congress asleep long enough to move business operations overseas. Indeed Congress did not wise up until perhaps the inversion provision was enacted which is contained in Section 7874.
Now, The President's Framework would eliminate dozens of different tax expenditures and fundamentally reform the business tax base to reduce distortions that hurt productivity and growth. The Reforms proposed by the President are designed to remove the distortions and bias under current law, and restore the United States to a more competitive environment for promoting growth in the United States for U.S. based companies and attract far more foreign investment.
The Specifics of the President’s Framework.
• Reduce the corporate tax rate from 35 percent to 28 percent.
• Eliminate dozens of business tax loopholes and tax expenditures. This would include. reductions in tax expenditures and loophole closers that should be part of any reform:
1. Eliminate "last in first out" accounting. Under the "last-in, first-out" (LIFO) method of accounting for inventories, it is assumed that the cost of the items of inventory that are sold is equal to the cost of the items of inventory that were most recently purchased or produced. This allows some businesses to artificially lower their tax liability. The Framework would end LIFO, bringing us in line with international standards and simplifying the tax system.
2. Eliminate oil and gas tax preferences. This includes repeal of the expensing of intangible drilling costs, a provision that allows oil companies to immediately write-off these costs rather than recovering the cost over time as for most capital investments in other industries. This includes repeal of percentage depletion for oil and natural gas wells, which allows certain oil producers and royalty owners to recover the cost of oil and gas wells based on a percentage of the income they earn from selling oil and gas from the property rather than on the exhaustion of the property..
3. Reform taxation of insurance products and the insurance industry. Under current law, companies can invest in life insurance for their officers, directors, or employees, benefit from "inside build up" (gains on that investment) that are tax-deferred or never taxed, and finance that investment through debt that allows the corporation to take interest deductions earlier than any gain realized on the life insurance. The Framework would close this loophole and not allow interest deductions allocable to life insurance policies unless the contract is on an officer, director, or employee who is at least a 20 percent owner of the business. The Framework would also make a number of other reforms to the treatment of insurance companies and products to improve information reporting, simplify tax treatment, and close loopholes.
4. Taxing carried (profits) interests as ordinary income. Currently, many hedge fund managers, private equity partners, and other managers in partnerships are able to pay a 15 percent capital gains rate on their labor income (on income that is known as "carried interest"). The President proposes to tax carried interests in investment services partnerships (by its managers) at ordinary income tax rates.
5. Eliminate special depreciation rules for corporate purchases of aircraft. Extend the useful life of aircraft (non-commercial) from 5 to 7 years.
6. Reform the corporate tax base to invest savings in cutting the tax rate and reducing harmful distortions. This Framework lays out a menu of options that should be under consideration in reform. At least several of these would be necessary to get the rate down to 28 percent:
7. Lighten up on accelerated depreciation. Lower corporate tax rates and a base broadening would end up with lower or slower rates of deprecation.
8. Reducing the bias toward debt financing. This is accomplished by lowering the corporate tax rate and perhaps reducing the overall deductibility of interest.
9. Establishing greater parity between large corporations and large non-corporate counterparts.
10. Improve transparency and reduce accounting gimmicks. Corporate tax reform should increase transparency and reduce the gap between book income, reported to shareholders, and taxable income, reported to the IRS. These reforms could include greater disclosure of annual corporate income tax payments.
Strengthen American Manufacturing and Innovation
The President wants to increase U.S. based manufacturing. He wants to enhance the continuation of R&D activities in the United States with building bridges for producing U.S. manufacturing and IT jobs that are produced from such new processes and inventions. The Framwork notes that R&D is especially important for manufacturing, which is a technology-intensive sector. In the 1980s, the United States was the leader in providing tax incentives for R&D through the Research and Experimentation Tax Credit (R&E Tax Credit). Today, however, many nations provide far more generous tax incentives for research than does the United States.
The President also wants to move to a clean energy economy will reduce air and water pollution and enhance our national security by reducing dependence on oil. Cleaner energy will play a crucial role in slowing global climate change, meeting the President's goal of producing 80 percent of our nation's electricity from clean sources by 2035.
President's Framework for Reform To Strength American Manufacturing and Innovation
• Effectively cut the top corporate tax rate on manufacturing income to 25 percent and to an even lower rate for income from advanced manufacturing activities by reforming the domestic production activities deduction. See Section 199. It would focus the Section 199 deduction more on manufacturing activity, expand the deduction to 10.7 percent, and increase it even more for advanced manufacturing. This would effectively cut the top corporate tax rate for manufacturing income to 25 percent and even lower for advanced manufacturing.
• Expand, simplify and make permanent the R&E Tax Credit. Currently, businesses must choose between using a complex formula for calculating their R&E Tax Credit that provides a 20 percent credit rate for investments over a certain base and a much simpler one that provides a 14 percent credit in excess of a base amount. The complex formula is outdated that it takes into account the amount of a business's R&D expenses from 1984 to 1988. The President's Framework would increase the rate of the simpler credit to 17 percent and make it permanent.
• Extend, consolidate, and enhance key tax incentives to encourage investment in clean energy. The President's Framework would make permanent the tax credit for the production of renewable electricity, like wind and solar. In addition, the structure of renewable production and investment tax credits has required many firms to invest in inefficient tax planning through tax equity structures so that they can benefit even when they do not have tax liability in a given year because of a lack of taxable income. The President's Framework would address this issue by making the permanent production tax credit refundable.
Strengthen the International Tax System to Encourage Domestic Investment
The Framework reiterates that the current U.S. tax system subjects foreign subsidiaries of U.S.-based multinationals to taxes on their overseas income (while allowing a tax credit for foreign taxes paid). However, often corporations do not need to pay taxes in the United States on such income until repatriated. Many companies never repatriate foreign earnings which results in economic loss and reduced tax revenues. The use of the CFC rules and other planning schemes has made the payment of U.S. tax by U.S. multinationals somewhat elective. Indeed, the Administration knows that many companies are sensitive to higher rates of tax, and why not? So the country needs to be more competitive by lowering tax rates here while at the same time changing some of the tax incentives to moving business operations overseas. A table set forth in the report demonstrates that profits of some U.S. corporations reported in select, small countries with very low tax rates far exceeds the country's actual output, which indicates that the earnings were generated outside of the tax havens.
The Framework notes that there are different proposals to reform the international tax rules. One proposal, previously finding support from the Bush 43 Administration is to switch to a pure territorial system under which all active foreign income would either be taxed little or not at all in the United States. However, President Obama believes that a pure territorial system could aggravate, rather than ameliorate, many of the problems in the current tax code.
Under a territorial system, foreign earnings of U.S. multinational corporations would not be taxed at all creating even greater incentives to locate operations abroad or use accounting mechanisms to shift profits out of the United States. This could also foster a “race to the bottom” on international tax rates.
Instead, the Joint Report states that tax reform should be a foundation to maximize investment, growth and jobs in the United States. It should reduce tax incentives to locate overseas with the need for U.S. companies to be able to compete overseas; some overseas investments and operations are necessary to serve and expand into foreign markets in ways that benefit U.S. jobs and economic growth.
President's Framework for Reform In the Area of International Taxation
• Require companies to pay a minimum tax on overseas profits. The President believes we must prevent companies from reaping the benefits of locating profits in low-tax countries, put the United States on a more level playing field with our international competitors, and help end the race to the bottom in corporate tax rates. Specifically, under the President's proposal, income earned by subsidiaries of U.S. corporations operating abroad must be subject to a minimum rate of tax. Foreign income deferred in a low-tax jurisdiction would now become subject to immediate U.S. taxation up to the minimum tax rate with a foreign tax credit allowed for income taxes on that income paid to the host country.
• Remove tax deductions for moving productions overseas and provide new incentives for bringing production back to the United States. The tax code currently allows companies moving operations overseas to deduct their moving expenses -- and reduce their taxes in the United States as a result. The President is proposing that companies will no longer be allowed to claim tax deductions for moving their operations abroad. At the same time, to help bring jobs home, the President is proposing to give a 20 percent income tax credit for the expenses of moving operations back into the United States.
• Other reforms to reduce incentives to shift income and assets overseas. The Framework would also clean up the international tax code and reduce incentives and opportunities to shift income and assets overseas. For example, as noted above, U.S. companies may use accounting rules or aggressive transfer pricing to shift profit offshore. This is particularly true in the case of profits associated with intangible assets (assets like intellectual property). The Framework would strengthen the international tax rules by taxing currently the excess profits associated with shifting intangibles to low tax jurisdictions. In addition, under current law, U.S. businesses that borrow money and invest overseas can claim the interest they pay as a business expense and take an immediate deduction to reduce their U.S. taxes, even if they pay little or no U.S. taxes on their overseas investment. The Framework would eliminate this tax advantage by requiring that the deduction for the interest expense attributable to overseas investment be delayed until the related income is taxed in the United States.
Simplify the Internal Revenue Code and Cut Taxes for America's Small Businesses
President's Framework for Reform
• Allow small businesses to expense up to $1 million in certain qualified investments.
• Allow cash method of accounting on businesses with up to $10 million in gross receipts. Small businesses with up to $5 million in gross receipts are currently allowed to use this simplified form of accounting. Under the President's Framework, this threshold would increase to $10 million.
In the Budget, the President has also proposed a number of discrete reforms that simplify the tax code for small businesses and provide them with tax relief -- and that Congress could act on immediately and should also be included in any fundamental reform.
• Double the deduction for start-up costs. This would double the amount of start-up expenses entrepreneurs can immediately deduct from their taxes from $5,000 to $10,000. This offers an immediate incentive for investing in starting up new small businesses, and it also simplifies accounting for small businesses, which must otherwise write off start-up expenses over a period of 15 years.
• Reform and expand the health insurance tax credit for small businesses. This credit, created in the Affordable Care Act, helps small businesses afford the cost of health insurance. This reform would allow small businesses with up to 50 workers to qualify for the credit (up from 25), provide a more generous phase-out schedule, and substantially simplify and streamline the tax credit's rules.
Back to where we are now with the sequestration already upon us. Congress continues to engage in a partisan bickering that never seems to end. Still there may be hope that a compromise will be reached. The President has his own set of tax reforms on the table from the Joint Report as well as perhaps some new ones to be unveiled. There are other tax proposals, including on the international side, that are being made by members of Congress. It may be that this year both sides of the political fence will agree to rate reduction in exchange for base broadening. But then, maybe not. We shouldn't be surprised though if one Spring or Fall day in 2013, we learn that Congress has agreed on a comprehensive tax reform measure one that will hopefully lower the rate of tax on C corporations and create incentives to provide greater economic growth in the manufacturing, energy and other business sectors operating in the United States or looking to bring new capital and add jobs to our country.
Its about time!