‘Gaming the System,' Border Taxes Questioned in GOP Tax Plan

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By Kaustuv Basu, Laura Davison and Aaron E. Lorenzo

June 24 — Early concerns about the House Republican tax blueprint have centered on the plan’s potential for gaming the system, its proposed shift to full expensing, and border adjustments, though supporters believe the various changes would boost U.S. economic growth.

The plan, which would tax individual income at a top rate of 33 percent and passthrough business income at 25 percent, could open the door to people taking advantage of the difference, said Eric Toder, co-director of the Urban-Brookings Tax Policy Center, and other practitioners. It could trigger temptation to game the system, Toder said.

“I could go to my employer,” he said, “and say, ‘I am tired of being an employee here. I am going to quit. But by the way, I’m happy to work for you as a consultant.’ ”

Others agreed.

“What it is seems to be saying is never take income in except through a passthrough form, because you get a higher rate as an individual,” said Linda Carlisle, a member at Miller & Chevalier Chartered.

The difference between the passthrough rate and top individual rate would introduce the need for “reasonable salary” rules so that partners are paying the higher individual rates on their salary and the lower passthrough rate on business income.

This could create a lot of fighting about what a reasonably salary is, Steven Schneider, a partner at Baker & McKenzie LLP, said. If there is an eight percentage point gap in the rates, people have a lot of incentives to take a lower salary and take more of the money as business profits, he said.

M&A Slowdown

Acquisitions would also likely slow if the interest expense deduction were to be axed. Private equity funds, which use highly leveraged financing to buy companies, can count on not paying taxes for the first few years of a deal, because the interest deduction overwhelms the operating income and the business reports a loss for tax purposes.

“Active acquirers tend to finance with debt, and naturally the interest expense deduction is an important part of the equation,” Robert Willens, tax and accounting consultant in New York, said. “Industry players would become more active versus private equity.”

Ways and Means Republicans have heard this message, according to a lobbyist who spoke on condition of anonymity due to client sensitivities. Some members have concerns that losing interest deductibility could be a barrier to entry for new companies and would hurt cyclical industries, given their feast and famine cycles.

“They are having to borrow money because this is how their business works and so that raises a lot of issues for members because you are basically punishing borrowing,” the lobbyist said. “Now staff would say, ‘We are not punishing it, we are just taking away one of the benefits.’ ”

Full Expensing Victory

Nevertheless, the blueprint moved in the direction of full expensing, a different choice than that made in 2014 by former House Ways and Means Committee Chairman Dave Camp (R-Mich.).

“Full expensing is a dramatic victory for the highly capitalized industries,” Russell Sullivan, a partner at McGuireWoods LLP, said. “This is like a reversal of Camp in a way. Camp picked interest expense over depreciation.”

This change would shift the incentive from debt financing to equity financing. Manufacturers are likely to favor the plan, while the utility industry is less likely to be enthused because it isn't even able to use all of its bonus depreciation, Sullivan said.

Ideas that show up in the Camp draft and this proposal, such as moving toward a territorial system and the elimination of the corporate alternative minimum tax, are provisions that could be likely to make it into an overhaul of the tax system as early as next year, Carlisle said.

Border Bucks

The blueprint also proposed taxing imported products and exempting exports as part of border adjustments under a new destination-based tax system (see related story). But some on Ways and Means believe the border adjustments might be a problem, the lobbyist said.

“People like retailers get all their stuff from overseas, and oil guys and high tech guys,” the lobbyist said. “This would be devastating to them.”

But the border adjustments would raise a substantial sum of revenue, estimated at $775 billion over 10 years in a decade-old tax overhaul report for former President George W. Bush. That revenue could come closer to $1 trillion today, the lobbyist said. In contrast, the expensing component of the blueprint could cost $1 trillion, said Rep. Kenny Marchant (R-Texas), a Way and Means member.

“Full expensing helps a lot of people,” the lobbyist said. “But for some people it can’t even slightly make up what the border adjustment is. So you have whole industries that have issues and you can’t just tweak that because it is too much money.”

But the import-export part of the plan would benefit U.S. manufacturing and generate political upside, too, for “Made in the U.S.A.” products, the lobbyist said.

“I would describe it more like a campaign proposal,” said Toder, who pointed out that the blueprint lacks phase-ins, details on deductions that would get eliminated and scoring.

The plan is meant to produce a revenue-neutral tax overhaul when scored dynamically, according to current Ways and Means Committee Chairman Kevin Brady (R-Texas). It won’t be revenue neutral on a static scoring basis, he said.

The blueprint isn’t expected to yield comprehensive legislation until next year, but parts of it could come out as bills later this year.

To contact the reporters on this story: Kaustuv Basu in Washington at kbasu@bna.com, Laura Davison in Washington at ldavison@bna.com and Aaron E. Lorenzo in Washington at aaron@bna.com

To contact the editor responsible for this story: Brett Ferguson at bferguson@bna.com

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