Today, the House Tax Reform Task Force unveiled its blueprint for tax reform. The blueprint proposes to move the US tax code towards taxing cash-flows, described in the materials as a move towards a consumption-based system without imposing new consumption taxes, such as a value-added tax (VAT) or sales tax. The proposal would also reduce taxation of savings and investment, which the blueprint notes “will stimulate much-needed investment, job creation, and wage growth.” The proposal also would reform the IRS to make it more customer-service oriented.
The blueprint aims to be revenue-neutral. To achieve this, while at the same time providing for the “largest corporate tax rate cut in U.S. history,” the blueprint relies on dynamic scoring and assumes that the remaining extenders are permanently extended so that the baseline, or starting point for determining the cost of tax reform, is higher. It also assumes the repeal of the tax increases that were enacted by the Affordable Care Act, including the additional 3.8% tax on net investment income and the medical device tax.
I. Background on Tax Reform
The blueprint represents the latest House proposal in the tax reform debate, following former Ways and Means Chair Dave Camp’s tax reform plan (the so-called “Camp Draft”) in February 2014. For prior coverage of the Camp Draft, click here. Representative Devin Nunes introduced the American Business Competitiveness Act (HR 4377) (ABC Act), which would move to a business consumption tax that taxes businesses on their cash flow at a uniform 25% rate.
In the Senate, Chairman Orrin Hatch and Ranking Member Ron Wyden of the Finance Committee formed five bipartisan tax reform working groups, focused on business income, community developmentE and infrastructure, individual taxes, international taxes, and savings and investment taxes. Each of the five groups produced a report with materials for the Finance Committee to consider as it worked towards reforming the tax system. For prior coverage of the working group reports, click here. Sen. Hatch is also working on a corporate integration proposal to eliminate double taxation of corporate income.
The White House has focused largely on business tax reform, releasing a Framework for Business Tax Reform in February 2012 and an update to that Framework in April 2016. For prior coverage of the Framework, click here. The Obama Administration’s FY 2014-2017 budget proposals have elaborated on the business tax reforms by reserving revenue associated with particular budget proposals for the business tax reform effort. In addition, the Obama Administration’s budget proposals have included additional proposals focusing on individuals, in particular improvements to the Earned Income Tax Credit and Child Tax Credit and the permanence of American Opportunity Tax Credit. For small businesses, the Obama Administration’s budget proposed increasing the small business investment expense deduction to $1 million and simplifying accounting rules for businesses with gross receipts of less than $25 million. For prior coverage of the Administration’s most recent budget, click here.
II. Overview of Blueprint
The blueprint is a general outline of a tax reform plan, and thus, it lacks specifics in many areas. However, the details provided point to some key differences from the Camp Draft. Among the most significant are an even lower corporate tax rate (20% in the blueprint compared with 25% in the Camp Draft) and a higher top individual rate (33% in the blueprint compared with 25% in the Camp Draft).
In addition, while none of the specific provisions appear to break new ground, the blueprint as a whole shifts the focus of the income tax system toward taxing cash flow, similar to Nunes’ ABC Act. Without proposing an actual consumption tax, the blueprint seeks to move to a consumption-based system within the current income tax framework by reducing taxes (or retaining current tax benefits) on investment and saving. Many of the reform proposals to date have been so-called 1986-style reforms, which propose to lower the tax rates and broaden the tax base. The blueprint represents a significant move away from this.
On the business side, the blueprint would allow 100% business expensing all property except land, resulting in no tax on a new investment. In addition to the 20% corporate rate mentioned above, the top rate on pass-throughs and other small businesses would be 25%. Double taxation on corporate income would be reduced through the reduction in the tax on dividends and capital gains of individual shareholders. Interest expenses would be deductible only to the extent of interest income, and net interest expense could be carried forward indefinitely and allowed as a deduction against net interest income in future years. The blueprint explains that immediate expensing of business investments acts as a more neutral substitute for deducting interest on debt incurred to finance that investment. The blueprint contemplates special rules for financial services companies that would take into account the role of interest income and interest expense in that industry. Most business credits and deductions (called “special-interest” tax benefits) would be eliminated, though the research and development credit would be retained. The proposal also repeals the corporate alternative minimum tax (AMT). While the blueprint provides some details regarding the treatment of manufacturing, many areas still remain to be developed, such as the treatment of tax-exempt organizations or individual industries like financial services and insurance. In addition, the impact of the treatment of interest is hard to determine without more details.
In the international tax area, the proposal would move to a territorial system with a 100% exemption for dividends from foreign subsidiaries. Accumulated foreign earnings of approximately $2 trillion would be taxed at 8.75% for cash and 3.5% for other assets (with companies able to pay the resulting tax liability over an eight-year period). It would also provide border adjustments that tax only imports and not exports. This means that, no matter where the business is located, sales to US customers will be subject to US tax and sales to foreign customers will not, thus putting US products and services on a more equal footing globally. The blueprint states that these provisions (combined with the lower corporate rate) are intended to stop inversions, prevent cash from being “trapped” overseas, and remove incentives for transferring money or businesses out of the country. The proposal would also eliminate the subpart F rules, except for the foreign personal holding company rules that prevent the shifting of passive income to low-tax jurisdictions.
On the individual side, the blueprint would reduce the number of tax brackets from seven to three (0%/12%, 25%, and 33%) and allow a 50% deduction for capital gains, dividends, and interest income. The blueprint would consolidate many basic family tax deductions—the standard deduction, personal and dependency exemptions, child tax credit, and over a dozen education tax benefits—into a larger standard deduction, enhanced child and dependent tax credit, and simplified education tax benefits. The blueprint would eliminate all itemized deductions, except for the deductions for mortgage interest and charitable giving. The Ways and Means Committee will continue to develop options for encouraging retirement savings. The AMT and the estate tax would be repealed.
Additional details of the blueprint are outlined in section IV below.
In addition, the blueprint would make significant changes to streamline the IRS. The IRS would be organized with three units: (1) families and individuals, (2) businesses (large and small), and (3) a new, independent “small claims court” to resolve smaller issues more quickly. The position of IRS Commissioner would be replaced by an “Administrator” appointed by the president and confirmed by the Senate who would serve a three-year term with one reappointment. The IRS would also have a team of legal professionals dedicated to providing guidance and other information to taxpayers.
III. Further Development of Tax Reform Legislation
The roll-out materials indicate that the Ways and Means Committee will begin developing legislation based on the blueprint, with a goal of being ready for legislative action in 2017. The process contemplates “ongoing dialogue with stakeholders” in crafting the package.
Because the blueprint is a relatively high-level framework for tax reform, the lack of details makes engagement in the process by taxpayers essential. For example, how interest income and expenses are defined can make a big difference in the impact of this provision, as will the special interest expense rules for financial services companies that the blueprint contemplates developing. Fleshing out the technical aspects of the international tax rules, such as the role of the foreign tax credit, the treatment of branches, and the level of ownership of foreign subsidiaries required for the 100% exemption on dividends, will also be important. The application of transition rules will also need to be considered in further detail.
While tax reform has been discussed at length in recent years, and many have grown skeptical of the possibility for action in the near-term, this blueprint demonstrates continued interest in tax reform by Republican House leadership and lays additional groundwork for future action on reform. Thus, all taxpayers would be advised to review this blueprint and consider how this framework might affect them.
IV. Summary of Blueprint Features
The following is a summary of the key features of the House Tax Reform Task Force Blueprint:
- 20% flat corporate tax rate
- Double taxation of corporate income reduced through reduction in dividend and capital gains rate of individuals (taxed at half regular individual rates)
- Repeal of corporate AMT
- Interest expense deductible against interest income
- No current deduction allowed for net interest expense; net interest expense can be carried forward indefinitely and allowed as deduction against net interest income in future years
- Ways and Means will develop special interest expense rules for financial services companies
- Net operating losses (NOLs) can be carried forward indefinitely
- No NOL carryback
- NOL carryforwards will be increased by an interest factor, but they will only be permitted to offset 90% of the taxable income determined without regard to the carryforward
- 100% expensing (equivalent to a 0% marginal effective tax rate on new investment)
- Applies to investments in tangible and intangible property (but not land)
- 25% top rate on small business and pass through income
- “Special-interest” deductions and credits eliminated
- For example, section 199 domestic production deduction would be eliminated
- R&D credit retained; Ways and Means will continue to look for ways to improve current credit
- LIFO preserved
- Ways and Means still looking at options for treatment of inventory
- Territorial system
- 100% exemption for dividends from foreign subsidiaries
- Accumulated foreign earnings taxed at 8.75% for cash and 3.5% for other assets, payable over eight years
- Most subpart F rules eliminated; foreign personal holding company rules retained
- New border adjustments for exports and tax imports
- Three tax brackets: 0%/12%, 25%, 33%
- Individual AMT repealed
- Investment income taxed at 6%, 12.5%, and 16.5% through 50% deduction of net capital gains, dividends and interest income
- Estate and goods and services taxes repealed
- Current incentives for savings retained; Ways and Means will work to consolidate the multiple retirement savings provisions and explore creating more general savings vehicles
- Current five “family tax benefits” consolidated into two: larger standard deduction and larger child and dependent tax credit
- All itemized deductions repealed except mortgage interest and charitable contribution deductions; other “special interest” provisions also repealed
- Earned income tax credit retained
- Higher education tax benefits will be simplified