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By Philip Morrison, Esq.
McDermott Will & Emery, Washington, DC
When this commentary is being written (in mid-December), several recent developments and comments from important people have made it modestly worthwhile to discuss the prospects for enactment of international tax reform during the 114th Congress. It's still an exercise in crystal ball gazing, of course, but at least there are a few fuzzy signals worth analyzing. Besides, the holiday season is always a time for looking back at what we've done in the past year and planning for the new year. Whether or not predictions of any value can be made, corporate clients and C-suite bosses of company tax executives will likely demand some information about the prospects for corporate and international tax reform. Perhaps the most important question to analyze is whether business/corporate-only tax reform has a chance.
First, let's review where we stood just before the mid-term elections in November 2014. Representative Camp, then-Chairman of the Ways and Means Committee, unveiled a comprehensive and detailed business and individual tax reform proposal in February 2014. While it was greeted with considerable opposition by many in the business community, it has been lauded as at least a very good starting point by Congressmen and Senators on both sides of the aisle. In the final few days of the 113th Congress, Mr. Camp introduced his proposal as a bill.
One thing the Camp draft pretty clearly does is demonstrate in some detail what a difficult job enacting tax reform will be, at least if it must be revenue neutral. To achieve a 25% corporate tax rate and a modified territorial system a lot of pain must be endured.
The challenges in the international area alone are formidable. The proposal has a tough thin cap rule in addition to providing a participation exemption of only 95%. Subpart F is significantly broadened by taxing all IP-related income, though at a lower rate if related to selling into foreign markets. And IP-related income, defined by formula, is quite broad. Accumulated CFC earnings are taxed over eight years under a split rate system, depending on whether those earnings are invested in cash or cash equivalents versus less liquid assets.
The "domestic" business revenue raisers are also likely tough to enact. They include limits on the use of NOL carryforwards, the phase-out of §199, the amortization of research expenses and advertising expenses, a repeal of LIFO accounting, application of deduction limits to performance-based compensation (i.e., stock options), an excise tax on big banks, and many more. Perhaps most problematic to business taxpayers, similar to the 1986 Act, the proposal raises roughly $700 billion in revenue from business and international provisions over the 10-year budget window, which it uses to pay for individual tax reduction.
Yet for all this pain, the Camp proposal does significantly lower the corporate rate, achieves a sort of rough parity with the corporate tax for most business income reported (through pass-throughs or otherwise) on individual returns (all with little change in the distribution tables), "unlocks" accumulated CFC earnings, and provides a bit of progress towards making many U.S. multinational enterprises less tax-disadvantaged compared to their foreign competitors. Still, while these accomplishments are laudatory, given the pain inflicted one must rate the chances of passage of such a bill, or a similar one, as very low. Since such pain (though perhaps $700 billion less in a corporate-only package) is a necessary part of reform in a revenue neutral bill, this augers against real progress in the next two years.
Second, the recent (again, as of mid-December) actions involving the so-called "extenders" provide some possibly important, though conflicting, signals about the prospects for reform in the next Congress. As readers will recall, just before Thanksgiving a bipartisan, bicameral deal was struck to make permanent 10 of the most popular extenders, including the research credit, and to extend to the end of 2015 the rest of the list. This deal apparently had more than enough votes to pass. Given Washington's dysfunction in recent years, this compromise was mildly remarkable. Among the provisions to be made permanent were items of importance to both Republicans and Democrats. By making permanent a big ticket item like the research credit it also made corporate reform in the future a tad easier (i.e., the revenue baseline would have been lowered). It appeared to be a signal that perhaps the parties could work together and reach a compromise. True, there was no pain—the deal included no revenue raisers or spending cuts to offset the costs of the bill—but at least there was a balance in the provisions.
Of course, this baby step towards bipartisan compromise was too good to be true. The Obama Administration, after it assured that it had the votes to sustain a veto, issued a threat to veto it. As a result, the compromise deal was abandoned and both houses passed a retroactive one-year extension of all extenders to the end of 2014, a mere two weeks from the bill's date of Senate passage. Outgoing Senate Finance Chairman Wyden, who voted against it, noted that it had a "shorter shelf life than a carton of eggs."
The Administration's veto threat, and the reason for it, is mildly informative to the analysis of the prospects for corporate and international tax reform in the next two years. The Administration objected to the lack of inclusion in the list of extenders to be made permanent the expansion of the EITC and child care credit, both of which expansions expire at the end of 2017. Republicans objected to these expansions being made permanent because, among other things, they thought that these were benefits that exacerbated, from their view, President Obama's executive action on immigration. Given this focus, the veto threat could just be a signal of the Administration's intent to use every tool available to fight any attempt to roll back or limit in even the remotest of ways its executive actions on immigration.
On the other hand, especially given the rhetoric used regarding an imbalance of corporate versus individual benefits in the compromise package, the veto threat could be an indication of reluctance on the part of the Administration to use any political capital to achieve corporate-only reform. If Democrats' major focus in the near future is to address the economic woes of the middle class, improving corporate taxation as a means to that end looks more like a page out of the Republicans' playbook, not the Democrats'. While comments noted below may undercut this theory of what the extenders veto threat augers, this commentator subscribes to the old adage that actions speak louder than words.
Third, the new chairmen of the tax-writing committees have each made some comments about their priorities, including tax reform. Incoming Chairman of Ways and Means, Paul Ryan, while putting tax reform among the highest of his priorities, has stated that it could happen in either 2015 or 2017. Suggesting a 2017 target, of course, before the 114th Congress has even convened, does not suggest quick action will be forthcoming. While a prior supporter of Rep. Camp's proposal, Ryan also recently has described that proposal "as a marker, not necessarily a starting point." This, too, indicates that a lot of distance must be travelled before we see reform. But corporate-only reform is not off the table for Chairman Ryan. While noting that individual reform is critical since a majority of businesses are pass-throughs or sole proprietorships, Mr. Ryan has, however, opened the door to corporate-only reform, as a sort of phase one or a "good step in the right direction" towards more comprehensive reform. This indication of a willingness to move forward on a corporate and international package alone is a very important concession, even though packaged as a "first step" towards more comprehensive reform.
Incoming Senate Finance Committee Hatch's staff recently published a 300-plus-page report laying down some important principles and ideas for tax reform. While an important and informative document to read to evaluate Chairman Hatch's and Senate Republicans' thinking, it shies away from making many explicit proposals and, critically, does not fully describe the trade-offs necessary to achieve the rate reduction it advocates in a revenue neutral fashion (though, in its defense, it was not intended to). On the international side, the report suggests a "low-tax kick-in" as a possible expansion to Subpart F and a participation exemption for CFC dividends, with a haircut to partially account for the deductibility in the United States of expenses that helped create the exempt income. It also endorses corporation/shareholder integration through either a dividends paid deduction or a dividend exclusion. Assuming the top corporate and individual rates could be made close to each other, it suggests that corporate tax be imposed only on public entities, with flow-through taxation for all other businesses. It is hard to see how the principles in this report could lend themselves to a corporate-only tax reform effort.
Fourth, the Administration has made vaguely positive noises about corporate tax reform. This is tremendously important given that Congress, both Members and staff, both Democrat and Republican, have complained for at least the last year of a lack of leadership on this subject from the Administration/Treasury. President Obama made comments to the Business Roundtable that corporate tax reform was an area where he could see common ground (perhaps better described as differences that might be bridged by possible compromise) with Republicans if they'd only not insist on individual reform at the same time. Treasury Secretary Lew has made similar remarks.
Importantly, these high-level remarks were followed up by remarks from Assistant Treasury Secretary Mazur on two important fronts. First, Mr. Mazur indicated that, if it was necessary to advance reform, Treasury would promulgate a detailed business tax reform proposal in the next six to 12 months. So long as this is not limited to simply a gathering together of budget proposals made over the last six years (though certainly one should expect them to be a part), a detailed proposal would indicate that the Administration wants to put at least some muscle behind the corporate and international tax reform effort. It would also focus the debate more sharply than an outline of principles. Second, Mr. Mazur indicated that Treasury was thinking of ways to assure that the base broadening necessary for corporate rate reduction did not result in pass-through businesses "essentially subsidizing" corporate reform. He specifically mentioned expanding expensing under §179 and expanding the availability of the cash method of accounting. This is critical to both Republican and Democratic members of Congress, given how much more of American business income runs through pass-through entities than was the case in 1986.
In addition to the analysis above, a complete analysis of the prospects for corporate and international tax reform in the 114th Congress requires a careful look at specific substantive proposals/guidelines promulgated by the various players mentioned above. Unfortunately, space does not permit that here. It is instructive, however, to note some general similarities in the international arena. All parties appear to endorse some significant expansion to Subpart F, whether through a general low-tax kick-in, an expansive definition and moderate taxation of IP income or regular taxation of "excess returns," a new toll manufacturing income category, or a combination of these ideas. All also seem inclined to tax, at a lower rate, the accumulated unrepatriated earnings of CFCs, though there is a difference of view as to whether that temporary revenue pickup should be used to offset other permanent corporate tax benefits (like rate reduction). And whether one calls it a minimum tax on CFC income or a participation exemption with a haircut, the parties seem to endorse an exemption of some portion of future earnings of CFCs. The differences, while important, are matters of degree, not fundamental principles.
So, what is the bottom line for the prospects of corporate and international tax reform in the 114th Congress? With a fair amount of "sort-of" common ground in the international arena, a recognition that some special provisions must give way to achieve rate reduction, and the positive comments from the chief players, surely one must give corporate and international tax reform some decent chance of passage in the next two years, shouldn't one? That certainly is not an unreasonable conclusion. However, given that both tax-writing committees in Congress have new leaders, given the Administration's demonstrated willingness to veto a bill which, like the extenders deal, doesn't contain most everything it wants, given the likelihood that Republicans will not give the Administration most everything it wants, given the intense lobbying that will continue to protect the tax provisions that must be pared back to raise the revenue for rate reduction, and given the very vocal complaints likely to be heard from either extreme on the left or the right with respect to any compromise, this commentator still rates the chances of such reform in the 114th Congress as low.
This commentary also will appear in the February 2015 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Isenbergh, 900 T.M., Foundations of U.S. International Taxation, and in Tax Practice Series, see ¶7110, U.S. International Taxation: General Principles.
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