This week saw important developments related to U.S. tax reform, with Senate Finance Committee Chairman Max Baucus issuing tax reform drafts proposing significant changes in several key areas of tax law. These proposals break new ground in the U.S. tax reform effort as they suggest dramatic changes in cost recovery (depreciation) and accounting, as well as international tax provisions — offering detailed legislative drafts for both proposals — that could significantly increase the tax burden for many U.S. businesses, in particular those in capital intensive areas like oil and gas and real estate, those with significant advertising expenses, or those with substantial foreign operations.

As we have counseled clients throughout this exercise, we believe that it is important to take these proposals seriously. Though committee action will not take place in 2013, it is still possible that a bill could move next year. Whether or not a bill does move, once a provision is put in a bill, it will be harder to remove or modify down the road.

Key elements of the two Baucus proposals include:

Cost recovery and accounting tax reform

  • Eliminates current accelerated depreciation and instead uses slower, longer “economic” depreciation
  • Tangible assets are depreciated on a “pooled” basis, with depreciable lives and depreciation percentages determined based on grouping assets among just four “pool” categories based on economic life
  • Real estate is depreciated on a straight-line basis over 43 years
  • Deduction of advertising expenses is limited to 50% of current expenses, with the other 50% amortized over five years
  • R&D expenses are amortized over five years, instead of being fully deductible currently
  • 1031 Like Kind Exchange deferral is eliminated, though some deferral for pooled assets would still be available
  • Percentage depletion for oil and gas is eliminated
  • All other oil and gas, mining, etc. “extraction” benefits (e.g., intangible drilling costs, tertiary injectants, mining exploration expenditures, etc.) are eliminated; all such expenses are amortized over five years
  • Amortization period for intangible assets is increased from the current 15 years to 20 years
  • LIFO tax accounting method for inventory is repealed
  • Completed contract method of accounting is generally repealed
  • The lower of cost or market rule for inventory is repealed

International tax reform

  • Two possible options are currently offered for taxing the income of U.S. multinationals from products and services sold into foreign markets:
    • A minimum tax that immediately taxes all such income at 80% of the U.S. corporate tax rate with full foreign tax credits, coupled with a full exemption for foreign earnings upon repatriation, or
    • A minimum tax that immediately taxes all such income at 60% of the U.S. corporate rate if derived from active business operations, but at the full U.S. rate if not, coupled with a full exemption for foreign earnings upon repatriation
  • Passive and highly mobile income is taxed annually at full U.S. rates
  • Earnings of foreign subsidiaries from periods before the effective date of the proposal that have not been subject to U.S. tax are subject to a one-time tax at a reduced rate of, for example according to the draft, 20%, payable over eight years
  • Foreign tax credits generally are allowed for taxes paid to foreign jurisdictions to the extent the associated income is subject to U.S. tax
  • Income from selling products and providing services to U.S. customers is generally taxed annually at full U.S. rates
  • Interest deductions for domestic companies may be limited to the extent that the earnings of their foreign subsidiaries are exempt from U.S. tax and to the extent that the domestic companies are deemed “over-leveraged” when compared to their foreign subsidiaries
  • Eliminates the “check-the-box” rule under which U.S. multinationals can elect to disregard certain foreign subsidiaries for U.S. tax purposes
  • Limits income shifting through intangible property transfers
  • Denies deductions for related party payments arising in a base erosion arrangement
  • Apportions interest expense on a worldwide basis for purposes of matching interest expense to income resulting from the borrowed funds
  • Limits the extent to which foreign tax credits can eliminate U.S. tax on income from investments in foreign companies that are not controlled foreign corporations
  • Restores withholding taxes on interest paid by domestic corporations to residents of countries not providing similar tax benefits for U.S. investors
  • Prevents foreign investors from using partnerships to avoid U.S. taxation
  • Modernizes the tax rules governing foreign investment in U.S. real estate

For any business seeking to better understand, and/or to influence the potential consequences of a tax reform bill, it is critical to become engaged now, beginning with the task of scrutinizing the details of the emerging tax reform plans and assessing the potential impact on their businesses, including running numbers regarding tax and financial statement impacts.

Our tax policy experts, including several veterans of the 1986 Tax Reform Act, are watching and engaged closely in developments in this area. If you have concerns regarding how U.S. tax reform will affect your U.S. business operations, we would be happy to provide you with our thoughts on the latest developments and how we can assist you in protecting your interests.