The Obama administration unveiled a set of proposals for business tax reform on Wednesday aimed at lowering the corporate tax rate to 28 percent from a high of 35 percent, while eliminating dozens of tax loopholes and subsidies.
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The President's Framework for Business Tax Reform, which was jointly released by the White House and the Treasury Department, calls for refocusing the manufacturing deduction and using the savings to reduce the effective rate on manufacturing to no more than 25 percent, while encouraging greater research and development and the production of clean energy.
“The current Tax Code was written for a different economy in a different era,” said Treasury Secretary Timothy Geithner in unveiling the proposals. “It needs to be reformed and modernized. Our business tax system is not just outdated. It is unfair and inefficient.”
He had previewed some elements of the proposals during testimony before Congress last week (see Obama Administration Plans Corporate Tax Overhaul).
Another element of the tax reform proposals involves strengthening the international tax system, including establishing a new minimum tax on foreign earnings, to encourage domestic investment. “Our tax system should not give companies an incentive to locate production overseas or engage in accounting games to shift profits abroad, eroding the U.S. tax base,” the proposal said. “Introducing a minimum tax on foreign earnings would help address these problems and discourage a global race to the bottom in tax rates.”
The framework also includes proposals for simplifying and cutting taxes for small businesses and entrepreneurs.
The business tax reforms would be fully paid for, under the proposals, to avoid adding to the budget deficit by either eliminating or making permanent and fully paying for temporary tax provisions now in the Tax Code. One such provision that the administration wants to make permanent is the Research and Experimentation Tax Credit.
The document noted that many large corporations are able to avoid corporate tax liability by organizing themselves as pass-through corporations, such as S corporations.
“The ability of large pass-through entities to take advantage of preferential tax treatment has placed businesses organizing as C corporations at a disadvantage,” said the document. “By allowing large pass-through entities preferential treatment, the Tax Code distorts choices of organizational form, which can lead to losses in economic efficiency; business managers should make choices about organizational form based on criteria other than tax treatment.”
Lowering the Corporate Rate
Among the reforms are lowering the top tax rate for corporations from 35 to 28 percent. “The President believes we should eliminate dozens of tax subsidies and loopholes so that we can lower the statutory corporate tax rate to help promote economic growth and encourage investment in the United States,” said Geithner. “By getting rid of special preferences for special types of activity and specific industries, we can reduce distortions that hurt productivity and economic growth, permitting us to lower corporate tax rates in a fiscally responsible way. The President’s framework recommends lowering the corporate tax rate from the current top rate of 35 percent to 28 percent, which is close to the average of those that prevail across the other major developed economies. This will help make our corporate tax system more competitive and improve incentives for investing in the United States.”
Michael Mundaca, a former Assistant Treasury Secretary for Tax Policy who is currently co-director of Ernst & Young LLP’s National Tax Department, praised the move. “It is a very positive development to see the administration lay out a framework for lowering the overall corporate tax rate," he said in a statement. "A lower rate could benefit U.S. businesses, encourage investment in the United States, and create U.S. jobs. At the same time, because under this framework overseas earnings would continue to be subject to U.S. tax upon repatriation, U.S. multinationals will continue to be concerned about the U.S. tax cost of accessing their earnings overseas and the competitiveness implications of that cost. Moreover, companies will have to consider carefully how the lower rate will be paid for in determining whether the package overall is something they can support."
The plan would also eliminate the “last in, first out,” or LIFO, method of inventory accounting, which assumes that the cost of the items of inventory that are sold is equal to the cost of the items of inventory that were most recently purchased or produced. International Financial Reporting Standards currently does not permit the use of LIFO, and it is one of the many sticking points holding up convergence of U.S. GAAP with IFRS.
“This allows some businesses to artificially lower their tax liability,” said the administration. “The Framework would end LIFO, bringing us in line with international standards and simplifying the tax system.”
Eliminating Oil and Gas Industry Preferences
The framework also calls for eliminating oil and gas industry tax preferences, including repealing the expensing of intangible drilling costs, a provision that allows oil companies to immediately write-off these costs rather than recovering the cost over time as for most capital investments in other industries. The administration’s framework also includes repealing percentage depletion for oil and natural gas wells, which allows certain oil producers and royalty owners to recover the cost of oil and gas wells based on a percentage of the income they earn from selling oil and gas from the property rather than on the exhaustion of the property. “Percentage depletion allows deductions that can exceed the cost of the property,” the administration noted.
The document also calls for reforming the treatment of insurance industry products, noting that the Tax Code currently allows insurance to be used as a form of tax shelter for major corporations. “In particular, corporations can invest in life insurance for their officers, directors, or employees, benefit from ‘inside build up’ (gains on that investment) that are tax-deferred or never taxed, and finance that investment through debt that allows the corporation to take interest deductions earlier than any gain realized on the life insurance,” said the document. “The Framework would close this loophole and not allow interest deductions allocable to life insurance policies unless the contract is on an officer, director, or employee who is at least a 20 percent owner of the business.” Other reforms include improved information reporting on insurance products.
Carried Interest Reforms
The framework also calls for taxing carried interest profits as ordinary income. The document notes that currently, many hedge fund managers, private equity partners, and other managers in partnerships are able to pay a 15 percent capital gains rate on their labor income (on income that is known as “carried interest”). “This tax loophole is inappropriate and allows these financial managers to pay a lower tax rate on their income than other workers,” said the document. “The Framework would eliminate the loophole for managers in investment services partnerships and tax carried interest at ordinary income rates.”
House Ways and Means Committee ranking member Sander Levin, D-Mich., has repeatedly introduced legislation to repeal the carried interest tax break, but the financial industry has successfully fought off the changes. Most recently, he introduced another bill last week (see Legislation Introduced to Eliminate Carried Interest Tax Break).
The framework also proposes eliminating special depreciation rules for corporate purchases of aircraft that allow owners of non-commercial aircraft to depreciate their aircraft more quickly over five years, than commercial aircraft, which are depreciated over a seven-year period. Obama has repeatedly called for repealing tax breaks for corporate jets and criticized Republicans for refusing to eliminate the tax breaks.
Other reforms include addressing depreciation schedules to discourage accelerated depreciation. “In an increasingly global economy, accelerated depreciation may be a less effective way to increase investment and job creation than reinvesting the savings from moving towards economic depreciation into reducing tax rates,” said the document.
The administration also hopes to reduce the bias toward debt financing by reducing the incentive for corporations to deduct interest payments.