From November 19 through 22, 2013, Senator Max Baucus, Chairman of the Senate Finance Committee (the "Committee"), released three staff discussion drafts that propose sweeping changes to the federal rules regarding international corporate tax, general business provisions concerning deductions for capital expenditures and tax accounting, and tax administration. The releases of the discussion drafts coincided with the releases by the Joint Committee on Taxation of three corresponding Technical Explanations.
Although revenue estimates of these proposals were not released, Chairman Baucus stated that tax reform as a whole should raise significant revenue for deficit reduction. The Chairman stated that the international proposals are intended to be revenue neutral in the long-term, and that the general business provisions are intended to raise significant revenue that would be used to finance a decrease in the corporate tax rate. However, he did not state how much new revenue the business provisions would generate, and the proposals do not specifically include the resetting of the corporate income tax rate.
Although Ranking Member Orrin Hatch's staff worked alongside the Chairman's staff, Sen. Hatch politely distanced himself from the discussion drafts, stating that he disagreed with the Chairman's decision to release the drafts before the budget conference negotiations were completed and that significant policy differences remain between the Republican and Democratic Committee members. Although Sen. Hatch pledged to continue to try to find common ground with Sen. Baucus, it remains to be seen whether Hatch will continue to work with Baucus in 2014. However, it is noteworthy that Sen. Baucus has been a leader in working closely on tax reform with both Sen. Hatch and House Ways and Means Committee Chairman Dave Camp.
DISCUSSION DRAFT ON INTERNATIONAL CORPORATE TAX
The stated goals of Chairman Baucus' draft of international tax reform are to:
- Increase the competitiveness of the United States in attracting investment and jobs;
- Increase the ability of U.S.-based businesses to compete against foreign businesses in foreign markets while reducing incentives to move business operations abroad;
- Reduce incentives for companies to shift profits to low-taxed countries;
- End the "lock-out" effect of deferral; and
- Simplify the international tax rules.
The international tax proposals would repeal the deferral system for the earnings of foreign subsidiaries of U.S. companies and replace it with a system under which all such foreign income would be either taxed immediately or forever exempt from U.S. tax. Two separate subpart F mechanisms are proposed to achieve this, "Option Y" and "Option Z," both of which are hybrid territorial/anti-deferral regimes that can be fine-tuned for revenue by adjusting the key inclusion percentages. However, it appears that both options are likely to impose current U.S. tax upon a larger proportion of foreign income than under present law, and in that sense, the proposal is more of an anti-deferral proposal. In addition, the discussion draft includes certain proposals common to both Option Y and Option Z.
In general, Option Y would impose a minimum tax that would modify subpart F to immediately tax only the following types of income earned by a controlled foreign corporation (CFC), at a rate equal to 80 percent of the U.S. corporate tax rate, while allowing full foreign tax credits and full exemption for foreign earnings upon repatriation. Other types of active income that are presently included in subpart F would be excluded from subpart F. The taxed items of income would be:
Foreign personal holding company income, often referred to as "passive income." However, certain present-law exceptions to passive income would be significantly modified and made permanent:
- The exception for regular dealers in property, including, but not limited to, hedging transactions,
- Income of a CFC that is either a regulated financial institution or 80 percent (up from 70 percent) of the gross income of which is derived from the active and regular conduct of a lending, finance, or financial services business, and
- Certain income from the active conduct of the insurance business;
- Income subject to an effective rate of foreign tax lower than 80 percent of the maximum U.S. corporate rate. In general, dividends from other CFCs would be completely excluded from all categories of subpart F;
- Income attributable to sales of property imported, or intended for import, into the United States, including as a component part, and property used in the manufacturing of such imported property. There would be no exception for manufacturing income; and
- Income derived in connection with services (including financial services) provided with respect to persons and property located in the United States.
Under Option Z, subpart F would include all income of CFCs except for 40 percent of a CFC's active income derived from activities outside the United States in connection with property sold for use outside the United States or services for persons outside the United States. In general, passive income would be effectively taxed at the full U.S. tax rate; however, income of a type that would be exempted from passive income under Option Y (as described above) may qualify for the 40 percent exclusion.
Proposals common to both Option Y and Z
The discussion draft provides for several proposals common to both Option Y and Option Z, for example:
- Previously deferred income of CFCs would be subject to tax after a deduction that would yield an effective rate of 20 percent, with credits available for foreign taxes paid on the nondeductible portion, and the tax would be payable in installments over eight years;
- Current income not immediately taxed would be exempt forever, as noted above;
- Deemed repatriations through loans under section 956 would be repealed;
- As discussed above, active banking, finance, and insurance income exceptions to subpart F would be modified and made permanent;
- Foreign tax credits would be available only with respect to currently taxed income, and credit "baskets" would be modified to generally correspond to types of currently included income. There would be six categories of foreign tax credits and income under Option Y, and three categories under Option Z;
- Indirect foreign tax credits from 10/50 companies would be repealed;
- Entities owned in whole or in part by a CFC would be treated as "per se" corporations ineligible to elect pass-through status through "check the box;"
- The "look through" provision of sec. 954(c)(6) would be repealed and the "same country" exception would be tightened (Option Y) or eliminated (Option Z); and
- Other significant changes to the foreign tax credit rules would be made. These changes include implementing worldwide interest allocation, allowing allocations only on the basis of tax basis (not fair market value as under current law), and sourcing sales of inventory as 100 percent U.S. source if a taxpayer's office or fixed place of business is a material factor in the sale. This proposal may impose significant costs on U.S.-based multinationals.
Transfer pricing of intangible property and other base erosion proposals
Although the discussion draft leaves the basic approach of existing transfer pricing rules largely intact, it attempts to bolster transfer pricing rules of current law, including recent Treasury Regulations. The draft revises and expands the definition of intangible property under section 936(h)(3)(B) by specifically including workforce in place, goodwill, and going concern value as intangible property, as well as "any other item the value of which is not attributable to tangible property or the services of an individual." The discussion draft also reinforces the Commissioner's authority to specify the method used to determine the value of intangible property, both with respect to outbound restructurings of U.S. operations and inter-company pricing allocations. In addition, the discussion draft codifies the "realistic alternative principle" of current regulations.
In the more general area of base erosion, the discussion draft contains proposals which:
- Disallow (not merely defer) interest expense deductions attributable to exempt foreign income of a CFC, on a basket-by-basket basis;
- Limit the deductions for non-taxed reinsurance property and casualty premiums that are payable to affiliates;
- Eliminate the portfolio interest exemption on corporate debt (except under a treaty); and
- Deny deductions for payments to related parties for certain transactions utilizing a hybrid entity, certain exemptions, or conduit financing.
- New rules for passive foreign investment companies (PFICs)
The discussion draft makes several significant changes to the current treatment of PFICs. The discussion draft would repeal the current law rules imposing an interest charge on certain transactions with respect to PFIC stock or permitting an election for current taxation of income. Instead, the proposal would require a U.S. person owning non-publicly traded PFIC stock to include as income a deemed return on the PFIC stock equal to the federal short-term rate plus five percent. Marketable PFIC stock would be required to be annually marked to market. Coordinating adjustments would be provided for actual distributions.
The proposal also modifies the test to determine if a foreign corporation would be a PFIC. The income test threshold would be reduced from 75 to 60 percent and the asset test would be eliminated.
Implications for taxpayers
Overall, the international tax proposals are expected to be revenue neutral in the "long-term," which apparently means after consideration of the revenue-raising effects of taxation of previously deferred income. However, it is difficult to understand how this would be the case, as many of the proposals appear to be significant revenue raisers. In broad terms, the international proposals tend to reduce or eliminate some of the existing benefits and planning opportunities currently available for structuring the foreign activities of U.S. corporate taxpayers. Whether these proposals would also increase the competitiveness of U.S. firms operating abroad in foreign markets, and of the United States generally in attracting investment and jobs, appears to be in doubt. Furthermore, although some of the international proposals may simplify compliance for the government, many, in particular the determination of what portion of foreign income would be subject to subpart F (under Option Y or Z), would be quite complex in operation. For example, the imported property provision may require new systems to track certain supply chain component information and link it to the property's destination.
Even if the international proposals as a whole are, in fact, revenue neutral over the long-term as claimed, every corporate taxpayer should carefully consider the impact of these proposals on its operations and finances because the impacts are likely going to be different, perhaps significantly different. This disparity makes the discussion draft very controversial. In particular, taxpayers with a significant amount of deferred foreign earnings (particularly low-taxed earnings) should carefully evaluate the impact of these proposals on their financial statements. In evaluating the impact of the proposals, consideration must be given to the post-reform corporate income tax rate. The following chart may be helpful in modeling the ultimate impact of various underlying corporate tax rates under the two options, under the current 35 percent corporate income tax rate, and assuming possible reductions in the corporate tax rate to 28 percent and 25 percent, as examples:
Option Y and Option Z; Rate Considerations
Click here to view the table.
Multinational taxpayers should also take into account that a number of the proposals would negatively impact legal or tax structures that they currently have in place. These taxpayers should consider whether those structures would remain viable. Examples of these proposals affecting numerous multinationals include the repeal of the "check the box" election in the foreign context, the repeal of the look through provision of section 954(c)(6), and the disallowance of interest expense deductions attributable to exempt foreign income.
DISCUSSION DRAFT ON DEDUCTIONS FOR CAPITAL EXPENDITURES AND TAX ACCOUNTING
Unlike the international tax proposals, these domestic cost recovery and accounting proposals are intended to raise enough revenue from corporations to finance a significant corporate rate reduction. In addition, the proposals attempt to better approximate economic depreciation and to simplify the cost recovery system. Committee staffers have reportedly claimed that the proposals would generate about $700 billion over a decade, enough to reduce the corporate tax rate by "several" percentage points.
Cost Recovery and Depreciation of Tangible Assets
Most notably, the discussion draft would generally repeal the current Modified Accelerated Cost Recovery System (MACRS) and Alternative Depreciation System (ADS) and replace them with a simplified cost recovery system based on pooling of assets. Four separate depreciation pools would be depreciated using rates from 5 to 38 percent under a 100 percent declining balance method. Real property would continue to be depreciated using a straight-line method, but the depreciation period would be extended to 43 years (up from the current 27.5 years for residential rental property and 39 years for nonresidential real property). Gain would be realized for a pool if, taking into account additions, dispositions, and depreciation, the pool balance dropped below zero at year end. In addition, the like-kind exchange exemptions would be repealed. Committee staffers claim that, although this proposal would initially result in slower cost recovery, costs should flatten in the long run.
The discussion draft also proposes to raise the permissible limit of expensing certain property under section 179 by extending the 2013 limit of $500,000 to 2014 and by permanently increasing the limit after that to $1 million. Certain capitalized expenditures described in the section below on intangible assets would be eligible for this treatment. Several industry-specialized expensing provisions would also be repealed (or not extended), including accelerated deductions for certain film and television productions under section 181.
Cost recovery of intangible assets
The discussion draft makes several changes to the cost recovery of intangible assets. In general, the amortization period for intangible assets under section 197 would be increased from 15 to 20 years. Taxpayers would be required to capitalize and amortize research and experimental expenditures over five years. The same treatment would be required for certain exploration and development costs and percentage depletion would be repealed. Fifty percent of advertising costs would be capitalized and amortized over five years and fifty percent would be expensed.
Repeal of LIFO and LCM
The discussion draft proposes to repeal the last-in-first-out (LIFO) and the lower of cost and market (LCM) methods of accounting for inventory. The taxable income resulting from this change in accounting method would be included in income at the new tax rate over a period of eight years. These proposals would have a large effect on the industries of manufacturing and oil and gas.
Restriction of Cash Method of Accounting to Small Businesses
The discussion draft would restrict the use of cash accounting to businesses with average annual gross receipts of $10 million or less (based on the previous three years). All businesses over the gross receipts threshold would be required to use the accrual method of accounting, including those businesses engaged in farming and personal services (which may use cash accounting at present).
Implications for taxpayers
These domestic proposals appear to cut against the intent of the international proposals to encourage business investment and job growth in the United States. If they are ultimately revenue neutral when balanced against the intended corporate rate cut, they may not create an overall disincentive. Although Chairman Baucus clearly is attempting to spread the pain across different sectors, unless these proposals are carefully fine-tuned in the legislative process, they are likely to have a disparate impact on different sectors of the economy. Again, it would be wise for companies impacted by any of these proposals to model their effects on their cash flow and financial statements.
DISCUSSION DRAFT ON TAX ADMINISTRATION
The proposals in the discussion draft on tax administration are intended to simplify the filing process and utilize technology, provide the IRS with new tools to address the increasing problem of identity theft and fraudulent tax refund claims, and to increase tax compliance through more efficient and expansive informational reporting.
The staff discussion drafts represent a serious attempt by Chairman Baucus to move forward on tax reform, notwithstanding the current political situation. Whether the international proposals are considered to be a modified territorial system or a modified anti-deferral system, they actually lay somewhere between both, and could ultimately form the basis for a compromise between the two possibilities and the two political parties. Chairman Baucus has staked out a position somewhere between the Obama Administration and the proposals of Chairman Camp. At the same time, the international proposals also tend to neutralize the so-called "lock-out" argument, by imposing tax on a CFC's earnings either currently or not at all. Thus, the staff discussion draft, while imperfect, must be taken seriously as a major step on the road to tax reform.
Unlike Chairman Camp's proposals, the Senate Finance staff discussion drafts contain numerous revenue raisers that eliminate special tax benefits granted to specific industries. Although Chairman Camp has stated that this "offset" approach is also his general tax reform approach, he may not have the political support at this time to take that step with respect to broad groups of taxpayers. He has acknowledged that he will not introduce a tax reform bill (or even an extenders bill for expiring provisions for that matter) in 2013.
While Chairman Camp appears to be pausing for the moment, Chairman Baucus has reiterated his goal of releasing additional tax reform discussion drafts in 2013. Presumably, at least one of these drafts will raise significant revenue for deficit reduction, as promised. Taxpayers should keep a careful watch for such proposals to be issued as we approach the holiday season.
If you have any questions about this alert, please contact Paul M. Schmidt at or 202.861.1760; Jeffrey H. Paravano at or 202.861.1770; Allen J. Littman at or 202.861.1686; or any member of BakerHostetler's Tax Group.