On January 15, 2015, Senate Finance Committee Chairman Orrin Hatch (R-UT) and Ranking Member Ron Wyden (D-OR) announced the formation of five bipartisan Finance Committee Tax Reform Working Groups to examine current tax law and propose legislative solutions with respect to the group’s designated topic area. The five topic areas are:
- International tax
- Business income tax
- Individual income tax
- Community development and infrastructure
- Savings and investment
In March, after five tax reform hearings, the Finance Committee asked stakeholders and the public to submit ideas to the working groups. The Finance Committee released over 1,400 submissions on April 29, 2015. On July 7, 2015, the five working groups released their much-anticipated reports, each prepared with the assistance of the nonpartisan Joint Committee on Taxation (JCT).
This client alert summarizes the policies proposed in each of the reports. While the reports collectively identify overarching principles that should guide tax reform in the US, many of the groups’ policy proposals lack detail or consensus on particular proposals set forth, suggesting that it will be some time before the Senate’s efforts at comprehensive tax reform will become a reality. Nonetheless, through this good-faith process, the working groups gained a better understanding of the options and the policy trade-offs, and consensus is beginning to form in certain areas, in particular in international tax and tax administration. Further, it is not outside the realm of possibility that one or more ideas may move forward in a piece-meal fashion. For example, a proposal by Senators Rob Portman (D-OH) and Charles Schumer (D-NY), the co-chairs of the International Tax Working Group, to tax overseas profits has been gaining momentum to provide a funding source for the federal Highway Trust Fund.
The International Tax Bipartisan Tax Working Group Report
The Senate Finance Committee’s International Tax Working Group’s final report provides a bipartisan framework for international tax reform, and perhaps moves the ball forward more than any other of the working groups. The working group’s co-chairs, Senators Rob Portman (R-OH) and Charles Schumer (D-NY), explained that the two key factors that drove their decision to call for an overhaul of the US’s current system of international taxation included (i) the need to stave off additional tax inversions, and (ii) the OECD’s Base Erosion and Profit Shifting (BEPS) project. The report summarizes two recent international tax reform proposals: the Tax Reform Act of 2014 (TRA14), introduced by former House Ways and Means Committee Chairman Dave Camp, and President Obama’s FY 2016 Budget Proposal. The report also notes that “[w]hile not within the jurisdiction of the international working group, there is no doubt that the policies [proposed in the report] . . . work best with a substantial corporate tax rate reduction and broader tax reform for all businesses.” The policies considered in the report are described below.
- Ending the lockout effect. In order to combat the substantial lockout of foreign earnings (that is, the ability of US multinationals to defer paying US tax on some foreign earnings until they are repatriated), the co-chairs “believe that it is imperative to adopt a dividend exemption regime in conjunction with robust and appropriate base erosion rules.”
- Patent box regime. The co-chairs recommend implementing an innovation box regime, which will provide a substantially discounted tax rate on certain forms of intangible business income to encourage the development and ownership of intellectual property in the US and combat other countries’ efforts to attract highly mobile US corporate income. The co-chairs are “continu[ing] to work to determine appropriate eligibility criteria for covered IP, a nexus standard that incentivizes U.S. research, manufacturing, and production, as well as a mechanism for the domestication of currently offshore IP.”
- Base erosion. The co-chairs continue to consider different options that will help dissuade companies from shifting money to tax haven jurisdictions, including imposing a minimum level of tax on a subset of earnings by controlled foreign corporations (CFCs). According to the co-chairs, the type of income subject to a minimum level of tax and the applicable rate “should meet the twin goals of preventing base erosion while ensuring that U.S. multinational companies are more competitive vis-à-vis their overseas rivals.”
- Interest expense limitations. The co-chairs are “working to determine the appropriate net limitation necessary to allow for legitimate intra-group lending while at the same time stopping disproportionate leveraging to avoid U.S. taxation and gaming of interest expense limits in place.” The co-chairs are also “continu[ing] to examine the appropriate use of excess limitation and carryforward rules for disallowed interest expense; as well as whether additional limits should be placed on domestic companies that choose to invert.”
- Deemed repatriation. The co-chairs endorse implementing a one-time transition toll charge at a rate significantly lower than the statutory corporate rate. The co-chairs continue to consider the appropriate rate and whether a multitiered rate structure is appropriate to account for income already permanently reinvested overseas.
- Miscellaneous issues. In the final section of the report, the co-chairs recommend largely retaining the subpart F foreign personal holding company income rules and the active financing exception, increasing the ownership stake (from five percent to 10 percent) that a foreign investor can take in a US publicly traded real estate investment trust without triggering liability under the Foreign Investment in Real Property Tax Act (FIRPTA), and exempting foreign pension funds from FIRPTA. The co-chairs continue to consider whether limits should be placed on the deductibility of reinsurance premiums paid to non-taxed foreign affiliates, tax issues relating to Puerto Rico and other US possessions, and the possibility of overhauling the taxation of individual Americans living overseas.
While the report indicates that the co-chairs have come to a broad agreement on a range of significant international tax reform issues, most of the policies are described in general terms. Indeed, the co-chairs readily concede that they are still considering specific ways to tackle most of the problems addressed in the report. However, it is significant that many of the policies proposed in the final report were proposed previously in TRA14 and/or President Obama’s FY 2016 Budget Proposal, suggesting that the parties have begun to coalesce behind these proposals from a policy perspective.
The Business Income Tax Working Group Report
The final report prepared by the Senate Finance Committee’s Business Income Tax Working Group, co-chaired by Senator Benjamin L. Cardin (D-MD) and Senator John Thune (R-SD), reflects member and staff discussions over how to fairly and responsibly improve taxation of business income in order to boost the economy, create good-paying jobs, and raise incomes for American workers. The report concludes that the following four key principles should drive business tax reform: (i) creating an internationally competitive and modern business tax code that lowers business tax rates and encourages job creation and economic growth; (ii) addressing structural biases and promoting investment; (iii) promoting American innovation; and (iv)removing complexity, encouraging certainty, and improving the taxpayer experience. Additionally, the report highlights the challenges of lowering the corporate income tax rate and treating pass-through entities equitably as the “threshold issues” of business tax reform. Each of these items is discussed in greater detail below.
- Create an internationally competitive and modern business tax code that encourages job creation and economic growth, including by lowering business tax rates. The report acknowledges the broad support for a substantially lower corporate tax rate. If the corporate tax rate is not lowered, the co-chairs argue that “despite the non-tax advantages that the U.S. offers, it may become more difficult for the U.S. to attract jobs and investment.” One of the main challenges to lowering the corporate tax rate identified by the report is the “constraints of revenue-neutral ‘1986-style’ tax reform”—that is, approximately $1 trillion of base broadening provisions would be needed to reduce the corporate tax rate to 25% on a revenue-neutral basis.
- Equitable treatment of pass-through businesses. Although members of the working group were unable to specifically resolve the treatment of pass-through businesses in business tax reform, the co-chairs conclude that business tax reform must “ensure that these businesses are not ignored in an effort to reduce the corporate tax rate.” The report considers several options to ensure equitable treatment, including (i) a business equivalency rate that would apply to all active business income, regardless of business form; (ii) a targeted tax benefits approach that would provide pass-throughs with more generous tax preferences while leaving the tax rate unchanged; and (iii) a new deduction that would apply only to active pass-through business income.
- Address structural biases and promote investment. The report specifically notes that our current system of taxing corporations violates the “tax neutrality” concept by subjecting large amounts of corporate profits to a double tax, while most other forms of business or investment income are subject only to a single layer of tax. This double tax also provides an incentive to finance corporations with debt rather than equity. The report considers but does not recommend a particular corporate integration proposal, but urges the committee to further consider integration. The report also concludes that income taxation creates a bias against savings and toward current consumption, while a shift towards consumption taxes should result in greater growth. The co-chairs acknowledge that moving towards a consumption-based tax is a fundamental shift that may not occur in the near term, but note that such options deserve the attention of the committee as tax reform efforts continue.
- Promote American innovation. The co-chairs state that the US “cannot continue to fall further and further behind if we expect to continue to lead the world in innovation and creativity” and to attract research and development. While the report provides an overview of recent research and experimentation (R&E) credit reform proposals and existing innovation box regimes, it does not endorse any specific proposal. Regardless of the design of the R&E credit, the report endorses a permanent rather than temporary credit. The report also cautions against considering an innovation box as a replacement for tax reform that lowers rates for business income. With respect to energy tax reform, the report states that members of the working group differed on whether the federal government should continue to favor certain types of energy sources or production or whether it should create a neutral tax system for all types of energy. The report also notes that the extension of master limited partnership treatment to renewable energy could be beneficial to private investment in renewable energy projects.
- Remove complexity, encourage certainty, and improve the taxpayer experience. The report concludes that administrative reforms (such as modifying tax return due dates so taxpayers and the IRS have information in a more timely manner), simplification measures, and other smaller changes may reduce noncompliance, improve taxpayer interactions with the IRS, and increase the time and money that businesses and organizations can spend on more productive purposes. The report notes that simplification measures could potentially move stand-alone apart from the broader tax reform effort.
Although the report identifies overarching principles that should guide business tax reform and endorses a lower corporate tax rate, it does not suggest a specific business tax reform plan. Much of the report summarizes, without endorsing, certain provisions from previous tax reform proposals, including TRA14 and the Bipartisan Tax Fairness and Simplification Act of 2010, introduced by Senators Ronald Wyden (D-OR) and Judd Gregg (R-NH). The co-chairs admit that “real and meaningful tax reform is likely to be a once-in-a-lifetime legislative accomplishment,” and stress the need for bipartisan cooperation in order to make tax reform successful, but note that comprehensive tax reform is “long overdue.”
The Individual Income Tax Working Group Report
The focus of the Senate Finance Committee’s Individual Income Tax Working Group’s final report is limited to charitable giving, higher education credits, and tax administration, which, according to co-chairs Senator Chuck Grassley (R-IA), Senator Mike Enzi (R-WY), and Senator Deborah Stabenow (D-MI), are the “only three [areas that] provided room for potential bipartisan agreement.” The working group originally chose to focus on home ownership as well, but they were apparently unable to reach sufficient consensus to include it in the final report. The proposals considered by the report are discussed below.
- Individual retirement accounts. The report discusses the option of reinstating and making permanent the exclusion from gross income for qualified charitable distributions from an IRA and the option of expanding the scope of excludable distributions to, for example, include different types of charities.
- Deduction for qualified conservation contributions. The working group considered the following options relating to the charitable deduction for qualified conservation contributions: (i) permanent extension of the enhanced deduction for qualified conservation contributions, and (ii) rules to ensure the integrity of qualified conservation contributions. Although the report does not make specific recommendations, it encourages the committee to examine proposals that would provide greater certainty to taxpayers and increase the flow of funds to charity.
- Higher education expenses. Existing education tax benefits include the Hope credit, the American opportunity tax credit (AOTC), the lifetime learning credit, tax deduction for tuition and fees, and beneficial treatment for Pell grants, scholarships, and fellowships. The working group reviewed three different proposals, each of which is “intended to consolidate and simplify the tax benefits for taxpayers who incur expenses for higher education.” Although the report notes that the existence of multiple tax incentives may enable more taxpayers to take advantage, different requirements, interactions between the incentives, and reporting and recordkeeping requirements add confusion and complexity. While the report does not make any specific recommendations, it suggests that the committee “may want to explore proposals to consolidate existing credits to reduce complexity and improve compliance.”
- Identity theft protections. The working group reviewed four proposals to combat identity theft, which include tools such as extending IRS authority to require truncated social security numbers on Form W-2 and adding civil and criminal penalties specifically targeted at identity theft. The report asks the committee to take action in this area, including consideration of these four, significantly overlapping proposals.
- Tax return due date simplification. Finally, the report considers several proposals, which significantly overlap, that would reorder filing due dates for tax returns to simplify tax compliance and improve IRS access to information returns to “assist the IRS in efficient processing of returns and detection of errors through verification.”
The co-chairs acknowledge that while there are many options for reforming the individual tax code, there is a “lack of agreement on many key issues.” The report only briefly touches on proposals focusing on changing individual income tax rates or modifying tax benefits associated with home ownership, suggesting that the working group does not believe that bipartisan agreement on these topics is currently feasible and strongly indicating that much work needs to be done to achieve more comprehensive individual tax reform. Nonetheless, in the relatively narrow areas addressed in the final report, there has been considerable overlap in recent proposals, particularly in the tax administration area.
The Community Development & Infrastructure Bipartisan Tax Working Group Report
In the Community Development and Infrastructure Working Group’s final report, co-chairs Senator Dean Heller (R-NV) and Senator Michael Bennet (D-CO) (i) explore the current state of infrastructure financing, including the Highway Trust Fund, tax-exempt bonds, and public-private partnerships, (ii) examine tax expenditures related to community development and Indian tribal issues, and (iii) analyze the current state of the tax code as it relates to the energy industry. The working group’s final report provides a short-term recommendation to ensure the sustainability and solvency of the Highway Trust Fund (the Interim Option) and a long-term recommendation to ensure that users and direct recipients of infrastructure systems pay the cost of their use (the Long-Term Option). Each of these recommendations is described below.
- Interim Option. The co-chairs recommend imposing a one-time transition tax on all previously untaxed foreign earnings and profits to pay for six-year infrastructure spending package.
- Long-Term Option. The co-chairs propose implementing a mileage-based tax system, also known as a vehicle miles traveled tax (VMT), which generally taxes users based on the number of miles traveled. According to the co-chairs, a VMT “has the potential to improve the efficiency of highway financing because the tax can be calibrated closely to the costs that vehicles impose in terms of road damage and congestion.” The co-chairs caution that a nationwide VMT program could take up to a decade to implement.
While the working group’s final report offers some specific recommendations, the co-chairs acknowledge that the participation of the other working group members “does not indicate that they agree with any or all of the details of the report.” This statement suggests that not all of the working group members endorsed the options described above. The report also indicates that several details still need to be worked out before either of the options can be implemented.
The Savings & Investment Bipartisan Tax Working Group Report
The final report prepared by the Savings and Investment Working Group, co-chaired by Senator Mike Crapo (R-ID) and Senator Sherrod Brown (D-OH), focuses only on private retirement savings, although the working group also considered options on capital gains and dividends, financial products, and defined benefit pension plans, thus suggesting that the group could not reach consensus in the other areas. The final report identifies three key goals for policy makers to pursue in this area, including (i) increasing access to tax deferred retirement savings; (ii) increasing participation and levels of savings; and (iii) discouraging leakage while promoting lifetime income. Each of these goals is described in greater detail below.
- Increasing access to plans. The working group recommends that the Finance Committee consider proposals that (i) permit employers to join multiple employer plans; (ii) increase the value of the “start-up” credit for all plans and further increase the credit for employers who offer automatic enrollment plans; and (iii) expand the safe harbors for automatic enrollment plans and provide a new credit to further help small employers offer matching contributions.
- Increasing participation and contribution levels. The working group encourages consideration of proposals that (i) allow long-term, part-time employees to contribute to employee-sponsored plans; (ii) promote efforts to reach additional middle-income families, such as by expanding the saver’s credit; (iii) alleviate uncertainty for church retirement plans; and (iv) encourage employee-ownership in S corporations.
- Preserving savings and making them last through retirement. The working group supports the consideration of proposals that would (i) allow a percentage of otherwise taxable lifetime annuity payments received by an individual from an IRA or any type of defined contribution plan to be excluded from gross income; (ii) promote the portability of lifetime income; and (iii) prevent leakage (that is, the use of retirement benefits for purposes other than retirement, such as hardship distributions) and ensure more secure retirements for taxpayers who take advantage of retirement plans.
Like many of the other reports, the Savings and Investment Working Group’s final report cautions that “there are differences among the [working group] members, not only as to which particular proposals a member may support, but also in what forum that consideration should be given (i.e., stand-alone retirement savings legislation or only as part of comprehensive tax reform).” Nonetheless, the report notes that many strong bipartisan proposals have been introduced in Congress, and “there is general consensus from this working group that such proposals should be given strong consideration as the Finance Committee moves forward with fiscally-responsible tax legislation.”
It is clear from the reports that the co-chairs of the working groups took their tasks seriously, with good-faith efforts to find common ground with their counterparts across the aisle. Chairman Hatch and Ranking Member Wyden are currently reviewing the reports and will determine the next steps. The outcome of the working group reports demonstrates that consensus on even the smallest parts of tax reform would be considered a great accomplishment, and that comprehensive reform may remain elusive at least in the near term.
However, some members of Congress remain hopeful that they can combine pieces of tax reform, particularly international tax reform, with other “must pass” legislation later this year. For instance, House Ways and Means Committee Chairman Paul Ryan (R-WI) has expressed his desire to finance a long-term highway reauthorization bill with a tax on repatriated foreign earnings – the most readily identified revenue source to finance a six-year infrastructure package. Congress will also consider a package of “tax extenders” later this year that may provide an opening for changes to the tax code.