The last two weeks have seen significant developments in building the blocks for what could eventually form the base of U.S. tax reform. Most significant is the 979-page “Tax Reform Act of 2014” discussion draft from House Ways and Means Chairman Dave Camp (R-MI) — a sweeping, comprehensive reform package that would reduce U.S. corporate and individual rates, reform U.S. international tax rules, and significantly alter the existing landscape of industry tax preferences. The Obama Administration also released its tax proposals this week as part of the FY15 Budget.
Most Washington pundits have dismissed the Obama and Camp proposals as “dead on arrival.” With respect to the Camp proposal in particular, we believe the truth to be very much the opposite if one takes a longer term perspective. It’s important for business to pay attention now to these proposals because:
- The tax revenue-raisers are being proposed by a Republican.
- The Camp tax reform proposals are being presented as the “right answer” on the policy merits, and so become the “correct policy” baseline for ongoing tax reform and future efforts.
- Although the Camp and Obama plans differ greatly in many aspects, there are also significant areas of overlap.
- Once a revenue-raising proposal is out there, it remains available as a “pay for” to fund unrelated tax proposals.
- If the affected business sector does not vigorously respond to an adverse proposal, that quiescence can be taken as acquiescence by those on the Hill.
Thus, Camp’s bill remains “on the shelf” and close at hand for as long as it takes for Congress to move tax reform.
For many business taxpayers, both those based in the U.S. and foreign based businesses with operations in the U.S., there is a risk that when Congress does finally move a tax reform bill, whether in 2015 or later, the final bill could eliminate or modify existing U.S. tax preferences important to the company’s bottom line, without providing enough offsetting benefit — in the form of a lower rate — to compensate for the lost preferences. When tax reform does happen, as with any reform bill, there will be winners and losers, and, as always, the outcome will in significant part depend on the efforts of industries and companies to educate Congress as to the potential consequences of various proposals.
Key elements for business of House Ways and Means Chairman Camp tax reform proposal:
- Corporate rate reduced to 25 per cent -- in annual increments of two per cent per year over five years, beginning in 2015.
- Corporate AMT repealed.
- New territorial tax system — 95 per cent exemption for dividends received by the U.S. parent from its foreign subsidiaries. Foreign intangible income would be taxed currently as earned at a concessional rate of 15 per cent once the proposal is fully phased-in.
- One-time tax for all U.S. taxpayers owning 10 per cent or more of foreign subsidiaries with unrepatriated foreign earnings — Assessed on accrued E&P since 1986, at a rate of 8.75 per cent on cash E&P and 3.5 per cent on remaining (reinvested in plant and equipment) E&P. Foreign tax credits could partially offset tax. Tax could be spread over back-loaded eight-year period.
- CFC look-through rule for payments between foreign subsidiaries — Made permanent.
- Excise tax on assets of large banks — Systemically Important Financial Institutions (as defined under Dodd-Frank) must pay a quarterly excise tax of 0.035 per cent of total consolidated assets in excess of US$500 billion.
- Business interest expense deductibility — In general, the current deductibility of business expense is preserved, but new “thin capitalization” rules would be adopted that would apply to limit interest expense deductibility where the U.S. affiliate has a higher debt leverage ratio relative to the foreign members of the corporate group and interest expense of more than 40 per cent of its adjusted income (adding back interest expense, depreciation/amortization).
- Depreciation — The current law accelerated depreciation system (MACRS) would be repealed, effective for property placed in service after December 31, 2016, and would be replaced by slower straight-line depreciation rates over longer lives. The depreciable basis of the property would be indexed for inflation.
- R&D expenses — Would be amortized over a five-year period as opposed to the full current deductibility. The new rules would be phased in over six years. The current R&D tax credit would be modified to a 15 per cent credit for the excess of current year R&D expenses over the average of the previous three years.
- Carried interest — Recharacterizes, when a capital gain event occurs, the service partner’s share of partnership’s invested capital as generating ordinary income based on the service partner’s maximum share of profits and an assumed rate of return. Only applies to partners in the business of raising or investing capital, identifying, investing in or disposing of other businesses, and developing such trades or businesses.
- 20-year amortization of intangibles (extended from the current 15 years)
- Section 199 manufacturing deduction phased out.
- Mark-to-market for financial instruments — A mark-to-market approach would be applied to derivatives to tax unrealized gains and losses on a current basis.
- Advertising expense deductibility — The present law current full deductibility of advertising expenses as incurred would be replaced by a partial capitalization rule under which 50 per cent of the advertising expenses incurred in the year would remain currently deductible, with the remaining 50 per cent being amortized and deductible over a 10-year period.
- Pass-through entities (partnerships, S corps., etc.) — While the Camp package would reduce the top statutory tax rate for individuals to 25 per cent, it would adopt a new 10 per cent surtax for income above US$450,000 (joint filers) and would broaden the income base to include employer-provided health insurance, section 401(k) plan contributions, and tax-exempt interest, but would exclude “domestic manufacturing income” (defined as sales/leases of tangible personal property and construction) and charitable contributions.
- Capital gains and dividends — Would be taxable at ordinary income rates, subject to a 40 per cent exclusion from income.
- LIFO inventory — The current law LIFO (Last-In/First Out) rules for inventory accounting repealed.
- Like-kind exchange deferral — Repealed.
- Energy and other preferences — Almost all energy and other industry-specific tax preferences would be repealed, with the exception of a handful of tax incentives that would be retained.
Some of the key business tax proposals in the Obama Administration budget:
- Top corporate rate reduced — to 28 per cent, and 25 per cent for domestic manufacturing income.
- Bank tax — the previously released Administration proposal to impose a 0.15 per cent tax on banks with assets in excess of US$50 billion.
- Limit on interest deduction attributable to unrepatriated foreign earnings — previously released proposal to defer the deduction of U.S. interest expense attributable to unrepatriated foreign earnings until such earnings are brought back to the U.S.
- A new form of limit on the deductibility of U.S. interest expense of the U.S. parent — The U.S. parent’s interest expense deduction would be limited based on its relative share of the total earnings of the corporate group as determined for consolidated financial statement reporting purposes under GAAP. More specifically, the U.S. parent’s interest expense deduction would be limited to the same proportionate share of total group interest expense as the U.S. parent’s proportionate share of the group’s total earnings (as computed by adding back net interest expense, taxes, depreciation, and amortization) as reflected in the corporate group’s consolidated financial statements.
- A new subpart F income category created for income of a foreign subsidiary from transactions involving digital goods or services — The proposal would create a new category of subpart F income, for, which generally would include income of a CFC from the lease or sale of a digital copyrighted article or from the provision of a digital service, in cases where the CFC uses intangible property developed by a related party (including property developed pursuant to a cost sharing arrangement) to produce the income and the CFC does not, through its own employees, make a substantial contribution to the development of the property or services that give rise to the income.
- Higher taxes on individual income earners — 30 per cent minimum tax on household income in excess of US$1 million, and limits on the value of itemized deductions for taxpayers with incomes in excess of US$250,000.
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, and responding to the Hill.