U.S. Tax Reform Proposal Highlights Potential Sweeping Changes
The Situation: The Trump Administration, in collaboration with the House and Senate, has introduced a Framework for tax reform legislation that could bring sweeping changes to U.S. tax laws.
The Provisions: The reforms include a reduction in corporate tax rates, immediate expensing (versus depreciation over time) of certain business assets, a shift to a territorial system of international taxation, and rules to "level the playing field" on foreign-based multinationals.
Looking Ahead: Tax-writing committees in the House and Senate will prepare draft legislation. It remains to be seen if the reforms will be included as part of the budget reconciliation process or addressed in separate legislation.
On September 27, 2017, the Trump Administration, in collaboration with the House and Senate, issued a unified framework for tax reform ("Framework"). The Framework proposes sweeping changes that incorporate several previous proposals while providing the White House and Congress with breathing room to negotiate among their numerous constituencies.
Tax Reform Framework Summary
- Corporate tax rate reduction from 35 percent to 20 percent
- Creates a new 25 percent rate for pass-through "business" income
- Full expensing of new investments in certain assets made after September 27, 2017
- Shift to a territorial system of international taxation with 100 percent exemption of (presumably active) business income earned by at least 10 percent-owned foreign subsidiaries
- One-time deemed repatriation tax on U.S.-based multinationals' foreign earnings
- Current tax on certain (presumably passive) foreign income earned by U.S.-based multinationals
- Adoption of rules to "level the playing field" on foreign-based multinationals
Business Tax Reform
Under the Framework, business tax rates would be lowered across the board. Entities taxed as corporations for U.S. federal income tax purposes would see their income tax rate lowered from 35 percent to 20 percent, and the alternative minimum tax would be eliminated for such entities. "Small and family-owned businesses" held through sole proprietorships, partnerships, and S corporations would be taxed at a rate of 25 percent on their business income, but rules would be adopted to prevent the recharacterization of personal income into business income. As these entities are already taxed on a flow-through basis, the rate decrease would lower the single level of tax paid by such entities' owners from the new proposed top individual income tax rate of 35 percent (lowered from the current top rate of 39.6 percent) to 25 percent for business income. We note that the Framework is silent as to which categories of business (such as personal service companies) would be eligible for the reduced 25 percent rate.
Observation: It will be challenging to draft rules that prevent individuals from converting their personal income (subject to tax at the 35 percent rate) into business income (subject to tax at the 25 percent rate). For example, an employee of an S corporation who would otherwise receive compensation income may instead become a nominal shareholder who receives "distributions" as a tax planning mechanism.
The Framework also would allow businesses the immediate, full expensing of new investments in depreciable assets other than structures, effective September 27, 2017. This would allow the full cost of acquiring depreciable assets to be deducted in the year of purchase for U.S. federal income tax purposes, rather than depreciating the assets over time as currently required.
Observations: The expensing rule is the only proposal in the Framework with an explicit effective date. On a September 26, 2017 press call, a White House spokesperson indicated that the September 27, 2017, effective date was inserted to make clear that businesses would not benefit from accelerated expensing for any property acquired prior to the effective date. That is, any depreciable property acquired prior to September 27, 2017, would not have its remaining depreciation deductions accelerated into immediate expensing. This is consistent with the Framework's goal of incentivizing future investment in U.S. property. A consequence of this effective date, however, is that if a tax reform bill is not signed into law until 2018, any qualifying purchases made after September 27, 2017, but prior to January 1, 2018, would seemingly be eligible for immediate expensing at the current corporate income tax rate of 35 percent. Finally, this proposal does not apply to structures, which is novel among recent tax reform packages (some of which have proposed full expensing with the exclusion of land, but not "structures").
To offset these tax rate reductions, the Framework describes a number of potential tax reforms that would raise government revenues. First, the Framework provides that deductions for net interest expense by entities taxed as corporations for U.S. federal income tax purposes would be "partially limited," with the impact upon non-corporate taxpayers to be "considered." Next, the Framework states that "numerous" special exclusions and deductions would be repealed or restricted, and that special tax regimes for certain industries and sectors would be modernized. The only example provided by the Framework is that the domestic production deduction under section 199 of the Internal Revenue Code would be eliminated. The framework also "envisions" repeal of some business credits, but caveats that certain credits may be retained to the extent budgetary limitations allow. The framework would explicitly retain the business credits for research and development and low-income housing.
Observations: The "partial" limitation on net interest deductions differs from prior proposals, which either called for the complete elimination of net interest deductions or required businesses to elect between net interest deductions or full expensing of investments in depreciable property. The potential repeal of business credits only as required by budgetary constraints is also more ambiguous than prior proposals that called for the elimination of all but a handful of credits. Finally, the Framework does not address last-in first-out, or LIFO, inventory accounting or carried interest, both of which are special tax rules targeted by prior tax reform proposals.
U.S. International Tax Reform Proposals
With respect to U.S. international taxation, the Framework would transition from taxation on a worldwide basis to a "territorial" system whereby dividends from foreign subsidiaries to U.S. parent companies would be 100 percent exempt from U.S. federal income tax (provided that the recipient owns at least 10 percent of the foreign subsidiary). To transition to this system, the Framework would treat all accumulated foreign earnings as deemed repatriated, subjecting them to a one-time tax paid over multiple years. The rate for this one-time deemed repatriation tax is still being discussed, although the Framework provides that earnings held in cash and cash equivalents would be subject to a higher rate. Despite transitioning to a territorial tax system, the Framework suggests that anti-deferral rules would be enacted, subjecting certain foreign earnings of foreign subsidiaries of U.S. corporations to current, worldwide taxation at a reduced rate. Finally, the Framework provides that rules would be created "to level the playing field between U.S.-headquartered parent companies and foreign-headquartered parent companies." No further explanation is provided in the Framework for such rules, but they call to mind the oft-criticized border adjustment tax proposed by congressional Republicans as part of their "A Better Way" tax reform plan blueprint published on June 24, 2016.
Observations: The switch to a fully territorial system may be a surprise to some that expected to retain a portion of the current system of worldwide taxation (for example, a prior proposal by former Chair of the House Ways and Means Committee Dave Camp, discussed below, provided for a 95 percent deduction on dividends from foreign subsidiaries). The anti-deferral rules described for certain foreign earnings are reminiscent of Camp's proposal to tax passive and intangible-related income of U.S. multinationals' foreign subsidiaries. Finally, the rules intended to level the playing field between U.S. and foreign companies reportedly may come in the form of a new tax on foreign-parented multinationals that sell into the United States—potentially a close cousin of the above-mentioned border adjustment tax.
Comparison to Past Proposals
The Framework follows on the heels of many other reform proposals that have been published over the past several years. It builds upon the tax reform pronouncement issued by the Trump Administration in April 2017 and contains many of the Trump campaign's tax reform proposals.
The Framework appears to differ significantly in critical respects from the Better Way tax reform blueprint. That blueprint focused upon a border adjustment tax that would tax goods and services imported into the United States at a higher rate than those exported from the United States to other countries. Although the border adjustment tax proved unpopular, the Framework continues to allude to a "leveling" mechanism between U.S. and foreign multinationals, suggesting that the concept may not be as dead as once thought. Other hints may also be gleaned from the Better Way blueprint, such as its proposal to subject foreign earnings to one-time taxation at a rate of 8.75 percent if represented by cash and cash equivalents, or 3.5 percent otherwise. These rates could be used as a starting point for analyzing the similar repatriation tax envisioned by the Framework, although President Trump is on record as favoring a repatriation tax rate of 10 percent.
Perhaps the most detailed analogue to the Framework is Camp's proposed Tax Reform Act of 2014. That draft legislation also included a transition to a territorial system of income taxation while including an anti-deferral regime for foreign-held intangibles indirectly owned by U.S. multinationals.
Many challenges and procedural steps remain before any part of the Framework can become law. The Framework has been provided to tax-writers in the House Ways and Means Committee, and their next step will be to prepare draft legislative language. Any consideration of tax reform legislation must wait until the House and Senate pass fiscal 2018 budget resolutions, which could contain language allowing tax reform to be decided by a simple majority (without the possibility of a 60-vote filibuster) if made part of the budget reconciliation process. However, key Republican congressmen have indicated that they believe tax reform to be too significant and permanent to be decided via budget reconciliation, which could suggest that proposed tax legislation will need bipartisan support from Democrats and Republicans. In any event, any tax reform bill will need to satisfy multiple constituencies that each have their own, potentially diverging interests, and it remains to be seen how much the ultimate legislation, if any, will resemble the Framework.
Three Key Takeaways
- The tax reform Framework includes a reduction in the corporate tax rate from 35 percent to 20 percent.
- Regarding U.S. international taxation, the Framework would transition from taxation on a worldwide basis to a "territorial" system whereby dividends from foreign subsidiaries to U.S. parent companies would be 100 percent exempt from U.S. federal income tax.
- Depending on how the Framework's reforms are introduced (either by budget reconciliation or independent legislation), bipartisan support could be crucial.
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