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President and Treasury update plan for dramatic business & international tax reform

The President’s Framework for Business Tax Reform: An Update.

One day prior to the issuance of major corporate inversion regs, the Administration and Treasury Department released a joint report titled “The President’s Framework for Business Tax Reform: An Update.” In addition to providing the President’s vision for tax reform, the report includes recent figures to demonstrate the urgent need for such reform, including statutory vs. effective tax rates, effective rates broken down by industry, and global corporate tax rate trends.

Background. This report is the follow-up to “The President’s Framework for Business Tax Reform,” released in 2012. The updated report emphasizes that “[t]he urgency of closing loopholes and reforming the tax system more broadly has grown” significantly since 2012, pointing to the increased number of corporate inversions occurring over the past couple years and the global problem of base erosion and profit shifting (BEPS), currently being tackled by the Organization for Economic Cooperation and Development (OECD). The report states that “[i]n the face of these challenges, inaction is not an option.”

In addition to eliminating these “undesirable incentives,” the updated report states that reform should also provide incentives to support positive, beneficial economic activities. To that end, it noted that some of the proposals set out in the 2012 report aimed at spurring innovation, helping small businesses, and promoting clean energy have since been enacted. Specifically, the Protecting Americans from Tax Hikes (PATH) Act of 2015 made the research credit permanent, enhanced a number of incentives to promote small businesses, and extended tax credits for renewable energy production and investments in clean energy technology. The updated report called these measures “significant improvements” but notes that they were not paid for, and that business tax reform should be revenue-neutral—which now includes paying for the provisions that have already been enacted.

Need for reform. The updated report notes that the current U.S. business tax system includes the highest statutory rate among advanced economies and a “base narrowed by loopholes, tax expenditures, and tax planning strategies.” Some companies are allowed to avoid significant tax liability, while others pay tax at a high rate, and tax considerations distort important economic decisions. The current rules are also complicated and result in reduced productivity and investment in the U.S.

Statutory vs. effective tax rates. The U.S. has the highest statutory corporate tax rate among G-7 countries (Canada, France, Germany, Italy, Japan, the United Kingdom (U.K.), and U.S.) at 39%, with the average among the other six countries being 29.6%. However, the report cautions that effective tax rates don’t “give a complete picture of how the tax code affects decision-making and the competitiveness of the U.S. economy and U.S. firms in world markets.” The effectivemarginal tax rate in the U.S. is 18.1%—which is significantly closer to the 19.4% average marginal tax rate among the other six G-7 countries. The difference between the statutory and effective rates in the U.S. suggests that corporate tax reform should lower the statutory rate while broadening the base to maintain the same level of revenue. Eliminating loopholes and subsidies would “level the effective marginal tax rates,” and encourage decisions to be made for business and investment reasons instead of tax.

Distortions by industry. Distortions resulting from the current tax system are apparent in the figures examining effective tax rates on a more specific level. For instance, over the 2007-2010 period, over thirteen different industries, the effective corporate tax rate ranged from 14.5% (for utilities) to 30.3% (for construction). The finance and insurance industries were both at 23.1%, and wholesale-retail was 27.9%. During 2015, the effective tax rates for corporations based on assets held ranged just over 20% (for intangibles) to almost 40% (for inventories).

Bias in favor of debt. The current system—specifically, the deductibility of interest and nondeductibility of dividends—also encourages corporations to finance themselves with debt rather than equity. This also has important macroeconomic consequences, including increased risk of financial distress (and likelihood of bankruptcy) and a less resilient economy.

Distortions by organizational form. Under the current system, businesses can be organized under a variety of different forms which offer different features. For tax purposes, the biggest distinction is that C corporations are subject to corporate tax and pass-through entities (partnerships, S corporations, etc.) are not. The overall effect of this difference is a lower effective tax rate for pass-through entities. For 2015, the effective tax rate on new investment by C corporations was 30.1%, compared to 25.3% for pass-throughs. This has led to companies increasingly choosing to organize themselves as pass-throughs on the basis of avoiding corporate tax liability.

Distortions in location of production & allocation of products. Under the current rules, U.S. companies can reduce their tax by shifting their reported profits to lower-tax jurisdictions and/or engaging in corporate inversions (i.e., changing their tax residence to a low-tax country by merging with a foreign corporation). This causes economic distortions both from encouraging firms to invest and grow business activities abroad—and by causing firms to spend their money on tax planning instead of productive investment.

President’s framework. The President’s framework for business tax reform is intended to reduce tax distortions, including those discussed above, and to address problems with the current international tax system. Specifically, it would:

  • Reduce the top corporate tax rate from 35% to 28%.
  • Eliminate the corporate alternative minimum tax (AMT).
  • Revise current depreciation schedules that generally overstate the true economic depreciation of assets. (The report notes that many other large countries have scaled back depreciation allowances as a way of paying for rate-lowering corporate tax reform.)
  • Limit the deductibility of interest.
  • Cut the top corporate tax rate on manufacturing income to 25% and to an even lower rate for income from advanced manufacturing activities. This would be accomplished by reforming the Code Sec. 199 domestic production activities deduction to: focus more on manufacturing activity; increase the credit to 10.7%; and increase it even more for advanced manufacturing.
  • Eliminate tax breaks for specific industries “with the few exceptions that are critical to broader growth or address certain externalities.” Specifically, the President’s framework would: eliminate last-in, first out (LIFO) accounting; eliminate tax breaks for the oil and gas industry; reform the treatment of the insurance industry and products; and reform the measurement and character of gains, including modifications to the rules for like-kind exchanges.
  • Provide reforms specific to the financial sector, including imposition of a financial fee (i.e., a tax on large financial institutions based on the amount of their liabilities), increase certain transaction fees, close the “carried interest” loophole, and modernize the taxation of certain financial products to prevent tax arbitrage.
  • Promote innovation by expanding and simplifying the now-permanent research credit.
  • Consolidate, enhance, and permanently extend key tax incentives to encourage investment in clean energy while repealing fossil fuel subsidies.
  • Effectively cut the top corporate tax rate on manufacturing income to 25% by reforming the Code Sec. 199 domestic production activities deduction and increasing the credit to 10.7%.
  • Establish a new per-country minimum tax (19%, less a foreign tax credit equal to 85% of the per-country average foreign effective tax rate) on foreign earnings that would reduce firms’ ability to avoid U.S. tax by shifting profits overseas, reduce the incentive to shift production overseas, and increase the global competitiveness of U.S. corporations.
  • Impose a one-time 14% tax on unrepatriated earnings, which could then be repatriated without any further U.S. tax.
  • Limit U.S. interest expense deductions to curb “earnings stripping.”
  • Limit inversions by preventing firms from acquiring smaller foreign firms and changing the tax residence as a result, and from changing their tax residence to any country where they do not have substantial economic activities if their operations in the U.S. are more valuable than their operations in the other country and they continue to be managed and controlled in the U.S.
  • Close loopholes and stop strategies that facilitate BEPS, including tightening rules governing cross-border transfers of intangible property, closing loopholes by expanding the scope of the existing Subpart F rules, and restricting the use of “hybrid” arrangements that take advantages of differences in tax rules. The report notes that these reforms are consistent with the cooperative efforts being made by the OECD’s BEPS project, which were endorsed by President Obama and other world leaders at the 2015 G-20 Summit.
  • Allow small businesses to expense up to $1 million in investments.
  • Allow cash accounting for businesses with up to $25 million in gross receipts.
  • Simplify additional accounting rules for small business and harmonize eligibility.
  • Quadruple the deduction for start-up costs (from $5,000 to $20,000).
  • Reform and expand the health insurance tax credit for small businesses.

 

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