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.
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 Our business tax system is not just outdated.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.
The document notes that additional steps, such as reducing the deductibility of interest for corporations, should be considered as part of the reform plan. “This is because a tax system that is more neutral towards debt and equity will reduce incentives to over-leverage and produce more stable business finances, especially in times of economic stress,” said the document . “In addition, reducing the deductibility of interest for corporations could finance lower tax rates and do more to encourage investment in the United States than keeping rates higher or paying for the rate reductions in other ways."
To reduce the bias toward pass-through entities, the plan also calls for establishing greater parity between large corporations and large non-corporate counterparts, by using ideas suggested by various presidential advisory commissions, but in such a way to avoid a negative impact on small businesses.
“Establishing greater parity between large corporations and their large non-corporate counterparts should be considered as a way to help improve equity, reduce distortions in how businesses organize themselves, and finance lower tax rates,” said the document. “A variety of ways to do this have been proposed, including ones discussed in the 2005 report of President Bush’s Advisory Panel on Tax Reform, and in reform options developed by President Obama’s Economic Recovery Advisory Board in 2010. It is essential that any changes in this area should not affect small businesses.”
The framework also calls for improving transparency and reducing “accounting gimmicks.”
“Corporate tax reform should increase transparency and reduce the gap between book income, reported to shareholders, and taxable income, reported to the IRS,” said the document. “These reforms could include greater disclosure of annual corporate income tax payments."
To improve incentives for manufacturing, the framework calls for making the Research and Experimentation Tax Credit permanent, noting that it has been extended temporarily 14 times since its creation in 1981, with some extensions lasting just 6 months. The credit was allowed to lapse for 12 months in the mid-1990s, and, as of Jan. 1, 2012, the R&E Tax Credit has expired again.
“Making the R&D Tax Credit permanent is a good thing,” said Steve Henley, national tax practice leader at CBIZ MHM. “Having all these extenders expiring, and Congress coming in and extending them again is not good tax policy.”
The framework also proposes to make the credit simpler, noting that currently, businesses must choose between using a complex formula for calculating their R&E Tax Credit that provides a 20 percent credit rate for investments over a certain base and a much simpler one that provides a 14 percent credit in excess of a base amount. “The complex formula is so outdated that it takes into account the amount of a business’s R&D expenses from 1984 to 1988,” said the document. “The President’s Framework would increase the rate of the simpler credit to 17 percent, which would make it more attractive and simplify tax filing for businesses. In addition, the credit would be made permanent to increase certainty and effectiveness.”
Another major incentive for promoting manufacturing proposed in the framework would be cutting the top tax rate for manufacturing income to 25 percent, and to an even lower rate for income from advanced manufacturing activities by reforming the domestic production activities deduction. “Reflecting manufacturing’s key role in innovation and the intense international competition facing the sector, the President’s Framework would reform the current domestic production activities deduction,” said the document. “It would focus the deduction more on manufacturing activity, expand the deduction to 10.7 percent, and increase it even more for advanced manufacturing. This would effectively cut the top corporate tax rate for manufacturing income to 25 percent and even lower for advanced manufacturing.
The framework would also extend and enhance the tax incentives for clean energy investment, making permanent the tax credit for the production of renewable electricity, in order to provide a strong, consistent incentive to encourage investments in renewable energy technologies like wind and solar.
“As with the R&E Tax Credit, the United States has to date provided only a temporary production tax credit for renewable electricity generation,” said the document. “This approach has created an uncertain investment climate, undermined the effectiveness of our tax expenditures, and hindered the development of a clean energy sector in the United States. In addition, the structure of renewable production and investment tax credits has required many firms to invest in inefficient tax planning through tax equity structures so that they can benefit even when they do not have tax liability in a given year because of a lack of taxable income. The President’s Framework would address this issue by making the permanent production tax credit refundable.”
“They’re going to expand the Section 199 deduction and double it for companies doing advanced technologies,” said Alliantgroup national managing director Dean Zerbe, a former senior counsel and tax counsel to the Senate Finance Committee, in an interview last week. He believes the administration’s proposals will probably prompt the Republican nominees to tighten up their own economic proposals.
International Tax Reforms
The administration's tax reform proposals would also reduce incentives for multinational companies to shift and defer their income to other countries.
“Because of deferral, U.S. corporations have a significant opportunity to reduce overall taxes paid by shifting profits to low-tax jurisdictions—either by moving their operations and jobs there or by relying on accounting tools and current transfer pricing principles to shift profits there,” said the document. “There is ample evidence that U.S. multinationals’ decisions about the choice of where to invest are sensitive to effective tax rates in foreign jurisdictions. There is also strong evidence that corporations use accounting mechanisms to shift profits from where they are actually earned to tax havens and other low-tax jurisdictions.”
The proposed reforms would require companies to pay a minimum tax on overseas profits. Foreign income deferred in a low-tax jurisdiction would be subject to immediate U.S. taxation up to the minimum tax rate, with a foreign tax credit allowed for income taxes on that income paid to the host country. “This minimum tax would be designed to balance the need to stop rewarding tax havens and to prevent a race to the bottom with the goal of keeping U.S. companies on a level playing field with competitors when engaged in activities which, by necessity, must occur in a foreign country,” said the administration.
The framework also includes removing tax deductions for moving productions overseas and providing new incentives for bringing production back to the United States. “The Tax Code currently allows companies moving operations overseas to deduct their moving expenses—and reduce their taxes in the United States as a result,” said the document. “The President is proposing that companies will no longer be allowed to claim tax deductions for moving their operations abroad. At the same time, to help bring jobs home, the President is proposing to give a 20 percent income tax credit for the expenses of moving operations back into the United States.”
Other reforms aimed at discouraging companies from moving income and assets overseas include cracking down on the use of aggressive transfer pricing to shift profits offshore, particularly for profits associated with intangible assets such as intellectual property.
“The Framework would strengthen the international tax rules by taxing currently the excess profits associated with shifting intangibles to low tax jurisdictions,” said the administration. “In addition, under current law, U.S. businesses that borrow money and invest overseas can claim the interest they pay as a business expense and take an immediate deduction to reduce their U.S. taxes, even if they pay little or no U.S. taxes on their overseas investment. The Framework would eliminate this tax advantage by requiring that the deduction for the interest expense attributable to overseas investment be delayed until the related income is taxed in the United States.”
Small Business Tax Breaks
The framework also calls for making the Tax Code simpler and less complex for small businesses and to allow small businesses to expense up to $1 million in investments.
The administration noted that in 2004, small businesses devoted between 1.7 and 1.8 billion hours and spent between $15 and $16 billion on tax compliance. On average, each small business devoted about 240 hours to complying with the Tax Code, and spent over $2,000 in tax compliance costs. “An overwhelming share of the time burden is due to recordkeeping, while most of the money burden is spent on compensation for paid tax preparers,” said the document.
Under the President’s Framework, small businesses would, on a permanent basis, be allowed to expense up to $1 million of qualified investments, to help offset other changes to the tax base in reform that would affect small businesses. “This would provide significant tax relief to America’s small businesses and would allow small businesses to avoid the complexity of tracking depreciation schedules,” said the administration.
Other incentives for small businesses would allow cash accounting on businesses with up to $10 million in gross receipts. Small businesses with up to $5 million in gross receipts are currently allowed to use this simplified form of accounting, the document noted. Under the President’s Framework, this threshold would increase to $10 million. “This simplifies taxes for many more of America’s small businesses, since cash accounting can be much easier than accrual accounting—which requires businesses to immediately recognize for income tax purposes their future cash receipts and costs,” said the document.
For entrepreneurs, President Obama’s budget already proposes doubling the deduction for start-up expenses that entrepreneurs could immediately deduct from their taxes, from $5,000 to $10,000 (see Obama Proposes Tax Reforms in 2013 Budget). “This offers an immediate incentive for investing in starting up new small businesses, and it also simplifies accounting for small businesses, which must otherwise write off start-up expenses over a period of 15 years,” said the administration.
The budget plan also proposes to reform and expand the health insurance tax credit for small businesses. “This credit, created in the Affordable Care Act, helps small businesses afford the cost of health insurance,” said the framework. “This reform would allow small businesses with up to 50 workers to qualify for the credit (up from 25), provide a more generous phase-out schedule, and substantially simplify and streamline the tax credit’s rules.”
Congresssional Republicans already have their own corporate tax reform proposals, including ones advanced by House Ways and Means Committee Chairman Dave Camp, R-Mich., and Senator Mike Enzi, R-Wyo., both calling for a move to a territorial tax system where multinational corporations would only be taxed on income they earn in the U.S.
Geithner noted that he had already spoken with the Democratic and Republican leaders of Congress's two tax-writing committees, the Senate Finance Committee and the House Ways and Means Committee, to move forward on tax reform.
"Our tax reform framework is designed to begin the process of building bipartisan consensus on a better growth strategy for the long term," he said. "I have already spoken to Chairmen Baucus and Camp as well as Ranking Members Hatch and Levin, and we plan to meet in the coming weeks to begin the process of building a bipartisan consensus."
Camp had a mixed reaction to the proposals. “This administration will find a ready and willing partner in House Republicans when it comes to comprehensive tax reform that cuts rates to spur economic growth and job creation," he said in a statement. "We put it in our budget last year, we have spent more than a year debating it in committee and we have worked with the Senate to advance this cause.”
However, he expressed disappointment over the scope of the tax reform proposals. “Notably, the administration’s proposal fails to address the need for comprehensive reform of our Tax Code," said Camp. "More than half of all business income is taxed at the individual (rather than corporate) tax rates, and a corporate-only proposal does not address the needs of those job creators, the vast majority of which are small businesses. If we want to truly reinvigorate our economy and get Americans working again, we must address comprehensive tax reform. So, while this is a good step by the administration, I will borrow from the President’s own words to Congress from just yesterday: Don’t stop here. Keep going."
His Democratic counterpart greeted the proposals more effusively. “I applaud the work of the President and the Secretary in making clear that reform must be driven by a clear set of goals, not only a number," said House Ways and Means ranking member Sander Levin, D-Mich. "The administration has put the focus of corporate tax reform where it needs to be: on promoting investment, job creation and especially manufacturing in the United States, not overseas. Effectively reforming our corporate tax system will require constructive and open-minded dialogue on all sides regarding responsibility and equity in our tax code and the appropriate level of private-public roles in our economy.”
However, an influential senator on the Senate Finance Committee, former chairman Chuck Grassley, R-Iowa, voiced skepticism about the proposals.
“The President’s proposal for business tax reform is disappointing for its lack of substantive leadership, especially considering the importance of tax reform and tax certainty in getting America back to work and keeping America competitive in the global economy," he said in a statement. "The President’s proposal is overly vague with the exception of demagogic political proposals, like those related to aircraft and oil and gas depreciation rules. Instead of a campaign document, and one that isn’t a credible plan of action, American workers need and deserve leadership from the White House for a Tax Code that will encourage economic growth and job creation.”