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Expat Briefing Editorial Team, 21 May, 2014
No, it wasn't some kind of April fool's joke. April 1, 2014, really was the second anniversary of the United States having the dubious distinction of possessing the highest total corporate tax rate among member countries of the Organisation for Economic Co-operation and Development (OECD). It is a situation that some in Congress are acutely embarrassed at, and that President Barack Obama himself is also keen to rectify. But with both sides differing on the details, and on what tax reform should ultimately achieve, the path towards fixing the problem has been frustratingly slow, as this feature shows.
It has been pointed out by those pushing for an overhaul of the US tax code that at 39.1 percent (consisting of a combination of the 35 percent federal rate and the average rate levied by US states), the US's corporate tax rate is a full 10 percent higher than the OECD average. It has also been noted on both sides of America's political divide that the US could learn a lesson or two from Japan, from whom it took over the mantle of the highest corporate tax rate on April 1, 2012. Japan reduced its corporate tax rate two years ago, and recently announced that it would seek to widen its corporate tax base further so as to continue to lower corporate tax rates. As Elaine Kamarck, a former adviser to President Bill Clinton, and James Pinkerton, a former domestic policy adviser to Presidents Ronald Reagan and George H.W. Bush, who co-chair the RATE Coalition observed: "America's tax code has not been reformed in almost thirty years, while our competitors in the international marketplace, such as Japan, the United Kingdom and Canada, among others, have lowered rates and undertaken significant reforms aimed at creating jobs and attracting foreign companies, including from here in the US."
"Our inaction has resulted in a tax code that is incredibly complex and a world-leading rate that incentivizes US companies to move abroad, taking jobs and investment with them," they added. "However, with leaders in both parties agreeing on the goals of an internationally competitive rate and a simpler, fairer tax system, now is the opportunity for comprehensive reform that will spur job creation and economic growth."
Indeed, according to a survey undertaken by PwC and the Organization for International Investment, the corporate tax rate is the most significant concern of chief financial officers of foreign-owned companies investing in the US. It was found that "foreign corporations are increasingly optimistic about investing into the US, yet many say tax overhaul is needed to lower the corporate rate." 54 percent of the 101 CFOs interviewed said, out of all the US tax policies that affect their businesses, the tax rate has the most impact.
The peppering of the tax code with special interest tax breaks by Congress in the thirty-year period since the last major tax overhaul has also resulted in a hugely complex and inefficient tax system. The most recent report from the Joint Committee on Taxation lists more than 200 separate tax expenditures, which account for a total of more than USD1 trillion in lost revenues annually. The top 20 preferences, taken together, represent around 90 percent of that total. Needless to say however, Congress is unlikely to come to an agreement on which of these tax expenditures should be jettisoned given the recent history of legislative gridlock.
Furthermore, it isn't just America's high tax rate that tax reformists are trying to change, but also the basis of US corporate income tax. America is unusual in that it taxes on a worldwide basis whereas most of its competitors lean more towards territorial corporate taxation. However, current rules allow US multinational corporations to defer US tax on income derived from active investments in foreign jurisdictions until it is repatriated to the US. And given the high rate of US corporate tax, it isn't surprising that the vast majority choose not to repatriate foreign income. It is said that as a result of this "lock-out" around USD2 trillion in foreign earnings has been stockpiled abroad by US corporations.
According to a November 2013 report from the Berkeley Research Group multinational companies would repatriate USD1 trillion, or around one-half of their foreign-earned profits held overseas, leading to a significant increase in gross domestic product (GDP) and jobs, if the United States switched to a territorial corporate tax system. However, while there appears to be general agreement that the US international tax system already provides incentives for US multinationals to locate their production facilities in countries with low taxes as a way to reduce their tax liability at home, in turn reducing investment in the US and suppressing US federal tax revenues, Democrats and Republicans differ, often fundamentally, on the solution to this problem.
President Obama's Approach
In his State of the Union Address, which concentrated on policy areas where he could act without the passage of legislation through the divided United States Congress, President Barack Obama provided few new ideas on tax reform, but included the corporate tax cut arrangements he has proposed many times before.
Where he could work with Congress, he said, would be in "reforming business taxes and closing loopholes that help companies ship jobs overseas." President Obama again put forward the plan he has floated since 2012 – to eliminate corporate "tax loopholes" and provide for a minimum tax on foreign earnings, while lowering the top corporate tax rate from 35 percent to 28 percent. And by "loopholes," he especially means the corporate income tax deferral rules.
"Both Democrats and Republicans have argued that our tax code is riddled with wasteful, complicated loopholes that punish businesses investing here, and reward companies that keep profits abroad," he said. "Let's flip that equation. Let's work together to close those loopholes, end those incentives to ship jobs overseas, and lower tax rates for businesses that create jobs here at home."
Such proposals have already been discounted in the past, not least because they do not take account of small businesses, the majority of which are transparent for tax purposes and pay their taxes at the individual income tax rate. So, under the President's plan, these pass-through businesses would remain unaffected by the proposal to reduce the corporate tax rate, but could potentially end up paying more tax if certain business deductions are eliminated.
In addition, the President continued to restrict his commitment to comprehensive tax reform, by insisting it should provide additional tax revenue for deficit reduction as supported by Democrats, in the knowledge that Republicans are looking for revenue-neutral reforms, with no overall increase in the level of taxation.
Baucus Discussion Drafts
Towards the end of 2013, then-Senate Finance Committee Chairman Max Baucus (D – Montana) released four discussion drafts outlining proposals for reforming various aspects of the US tax system, the culmination of around 30 hearings on the subject by the committee over the previous couple of years. By far the most controversial of these papers was his plan for changing the US international tax code.
The Baucus draft would repeal the deferral system for the earnings of foreign subsidiaries of US companies and replace it with what is said to be a more competitive system under which all such income is either taxed immediately when earned or exempt from US tax, after which no additional US tax is due. In particular, passive and highly-mobile income and income from selling products and providing services to US customers would be taxed annually at full US rates, and the draft includes two options that apply an annual minimum tax to income from products and services sold into foreign markets. One option would apply immediately, to tax all such income at a minimum rate (80 percent of the US corporate tax rate with full foreign tax credits), coupled with a full exemption for foreign earnings upon repatriation, while the second would immediately tax all such income at a lower minimum rate (60 percent of the US corporate rate) if derived from active business operations but at the full US rate if not, coupled with a full exemption for foreign earnings upon repatriation.
In addition, historical earnings of foreign subsidiaries that have not been subject to US tax would be subject to a one-time tax at a reduced rate of, for example, 20 percent payable over eight years. Credits are allowed for taxes paid to foreign jurisdictions to the extent the associated income is subject to US tax.
Amongst other provisions, the discussion draft limits income shifting through intangible property transfers; denies deductions for related party payments arising in a base erosion arrangement; and limits interest deductions for domestic companies to the extent that the earnings of their foreign subsidiaries are exempt from US tax and the domestic companies are over-leveraged when compared to their foreign subsidiaries.
While Baucus wanted tax reform as a whole to raise significant revenue for deficit reduction, the international tax reform discussion draft was intended to be long-term revenue neutral. "While not a final plan," he added, "the discussion drafts are intended to spur a conversation about areas where Republicans and Democrats may be able to reach agreement on how to fix the broken tax code."
However, his overall revenue-raising objective for tax reform, which ties in with the Democratic Party's previously-expressed view, immediately raised the hackles of Republicans, who view revenue-neutral tax reform as an opportunity to reduce tax rates. It reinforced doubts over whether tax reform can now receive bipartisan support.
Furthermore, the Business Roundtable concluded that "Baucus's goal of increasing the ability of US businesses to compete abroad is critical. Unfortunately, we do not believe that the international discussion draft supports that goal because it would make many American companies even less competitive than their non-US counterparts."
In addition to the international tax discussion draft, Baucus had just enough time to publish additional discussion papers on energy tax reform, cost recovery and tax accounting, and tax administration before being taking up the post of US Ambassador to China, making the process feel somewhat incomplete. However, Baucus's counterpart in the House of Representatives has since released a much more complete tax reform discussion draft, summarized next.
Camp Tax Reform Discussion Draft
House Ways and Means Committee Chairman Dave Camp (R – Michigan) issued his long-awaited comprehensive tax reform discussion draft in February 2014, which proposes to reduce maximum tax rates and simplify the tax code over 182 pages of a section-by-section "summary."
Highlights of the proposed revenue-neutral Tax Reform Act of 2014 include a new individual and corporate income tax rate structure. Using changes to individual and business tax breaks, it flattens the individual tax code by reducing rates and collapsing the current brackets into two of 10 percent (encompassing the present 10 percent and 15 percent bands) and 25 percent, "ensuring that over 99 percent of all taxpayers face maximum rates of 25 percent or less."
The reform package would also cancel the Alternative Minimum Tax (AMT) for individuals, pass-through businesses and corporations, while long-term capital gains and dividends would be taxed as ordinary income, with an exemption for the first 40 percent of such income from tax.
Of specific interest to those pass-through business owners paying individual income taxes, it is pointed out that nearly every small business would benefit from paying no more than a top tax rate of 25 percent; the double taxation of investment income being lowered to historic lows; the repeal of the AMT; simplified compliance through various reforms of business deductions and credits; permanent section 179 (full deduction on cost of qualifying equipment) expensing on as much as USD250,000 in capital investments each year, including real property; an expansion of the use of cash accounting for businesses with gross receipts of up to USD10m; and a maintenance of the current law on the estate tax.
Using the reform of a large number of business-related exclusions and deductions, the plan also reduces the maximum corporate tax rate from 35 percent to 25 percent on a gradual basis. For taxable years beginning in 2015, the maximum rate is 33 percent; for taxable years beginning in 2016, the maximum rate is 31 percent; for taxable years beginning in 2017, the maximum rate is 29 percent; and for taxable years beginning in 2018, the rate reduces to 25 percent.
The corporate tax break changes include making the research & development tax credit permanent and improving its terms. The simplified research credit would be equal to 14 percent of qualified research expenses that exceed 50 percent of those expenses for the three preceding taxable years.
Significantly, the package would also transform US international tax rules by replacing the current "worldwide" system with a "quasi-territorial" 95 percent dividend exemption for foreign business income. The exemption would apply to dividends paid by foreign companies to US corporate shareholders owning at least 10% of their shares, and no foreign tax credit would be allowed for any taxes paid or accrued with respect to any dividend for which the 95-percent deduction is allowed. Thus, the effective US tax rate on most foreign dividends would be 1.25 percent (the new 25 percent rate multiplied by the 5 percent of income that is not exempt) – putting, it is considered, American companies on a more level playing field with foreign competitors while also ending the "lock-out effect" that discourages companies from bringing foreign earnings back to the US.
Predictably, the Camp plan has gained much more support from the business community than Baucus's proposals. Berkeley found that that under the hybrid system advocated by Camp, repatriated foreign earnings would increase by about USD114bn per year, leading to at least 154,000 more US jobs per year and annual GDP gains of about USD22bn. Overall, it was estimated that US GDP would grow by about USD208bn, 1.46m new jobs would be created, and about USD80bn in additional tax revenues would be generated.
Despite the thoroughness of Camp's draft, it seems extremely unlikely that his plan will be considered this year by Congress given the differences between the Democrats and Republicans on tax and spending. And with the departure of Baucus, tax reform momentum on the Democratic side of Congress seems to have fizzled out for now, although his successor Ron Wyden (D – Oregon) seems keen enough to revive the process. "By uniting around the goal to create an internationally competitive tax code, we can keep American job-creators from looking to leave in the first place," he said recently.
Certainly, leading business tax executives believe that tax reform is off the agenda this year if the results of another survey, announced in March, are an accurate measure of their views on this matter. While respondents to the 2014 Tax Policy Forecast Survey by Law firm Miller & Chevalier and the National Foreign Trade Council overwhelmingly supported fundamental tax reform, not one respondent predicted tax reform will be enacted in 2014, due to the combination of a divided Congress and the Obama Administration's other priorities. In fact, more than three quarters of respondents believe that split party control of the House and Senate will result in little or no tax legislation this year.
Interestingly, most respondents were apprehensive over the tax policies tied directly to the global competitiveness of US businesses. Topping the list of tax concerns respondents would like addressed are the enactment of revenue offsets (24 percent), the statutory tax rate (18 percent), and taxation of international operations (18 percent). Respondents said changing the worldwide tax system (32 percent) and reducing the statutory tax rate (35 percent) could be game changers in the global marketplace.
More optimism was expressed in the survey that Congress can do a deal on more short-term tax policy measures, i.e. a "tax extenders" legislative package that will renew more than 50 temporary tax provisions that expired at the end of 2013. But even here partisan divisions have emerged, with Wyden favouring one final two-year extension before some or all of these tax breaks are made permanent within the framework of tax reform, while Camp is only interested in renewing those tax breaks that genuinely benefit taxpayers and the economy in general, such as the R&D tax credit and investment expensing provisions. What's more Republican Senators are viewing Wyden's EXPIRE Act as an opportunity to score some political points by attempting to add amendments repealing aspects of the Affordable Care Act, for example.
The problems is, if Congress remains paralyzed on tax matters in 2015, then the following year will be a Presidential election, which makes the period in which comprehensive tax reform can realistically be enacted quite short. As Wyden has observed: "The window of opportunity to enact comprehensive tax reform that both the business community and individual taxpayers desperately need is short. Recognizing the unique dynamics that come with a presidential election, there is just over a year to get the job done."
Responding to Camp's discussion draft, Hank Gutman, Director of KPMG's Federal Tax Legislative and Regulatory Services group in the firm's Washington National Tax practice and a former JCT chief of staff, warned that even if comprehensive tax reform does not advance this year, tax reform is likely to remain on the legislative agenda and therefore "business leaders would be wise to take the time to understand these proposals, so that they can begin to assess their potential implications."
The upcoming midterm elections could of course have a major bearing on the tax reform debate next year. But if Congress remains split, it is difficult to see tax reform advancing beyond the discussion draft stage. Stranger things have happened, but perhaps the only certainty for taxpayers is that the future of the tax code will remain unclear for the foreseeable future.