Business tax legislation uncertain: though little is expected from Washington this election year, will Congress act at all on significant tax reform or simply wait for 2013? Regardless of timing, financial executives should pay careful attention to the details of ongoing tax discussions.
Another consideration is the federal government's budget picture, with significant deficits and growing debt still on the horizon. This, too, will influence tax legislation, particularly from an affordability standpoint.
While some lawmakers are pushing for quick action on small business tax relief, renewal of expired tax provisions such as the research credit and extension of the 2001 and 2003 individual tax cuts, legislation appears unlikely to be completed on these items until after the November elections, possibly during a post-election "lame duck" session of Congress.
Since the post-election session will be relatively short and faced with unfinished business on many fronts, Congress will be laying the foundation for these tax issues during the summer months. It is important that businesses pay careful attention to the details of the tax discussions, particularly regarding possible tax increases to offset the cost of legislation. Indeed, tax increases recently surfaced as a possible way to fund changes to federal transportation and student loan programs.
In addition, the congressional committees responsible for tax legislation have spent considerable time preparing for comprehensive tax reform, and legislation could emerge as early as next year. President Barack Obama joined this effort earlier this year by releasing a set of principles for tax reform and a "framework" for business tax reform. The general concepts being discussed by tax reform supporters include lowering tax rates, broadening the tax base by reducing or eliminating tax deductions and credits and revising the taxation of global business income to enhance competitiveness.
Based on discussions to date, reform legislation would be "revenue neutral" overall, meaning that aggregate tax cuts would be offset by aggregate tax increases. As a result, tax reform can be expected to produce winners and losers when compared to the present tax code.
Small Business Tax Relief
An effort is underway to give temporary tax relief to small businesses for 2012. So far, the House of Representatives and the Senate are pursuing different approaches. The House has passed H.R. 9, the Small Business Tax Cut bill to provide a temporary 20 percent deduction for domestic business income of small businesses with fewer than 500 employees. Assuming the 35 percent rate under present law, the effect of the House bill would be to lower the top tax rate on small businesses to 28 percent for 2012.
In contrast, Senators are seeking to extend 100 percent bonus depreciation and provide a temporary tax credit for increasing payroll (up to a maximum of $5 million) through new hires or increased wages (S. 2237, the Small Business Jobs and Tax Relief Act). The Senate approach applies to all businesses regardless of size.
While there appears to be ample support to provide tax relief to small businesses, it is uncertain whether the House and Senate will be able to reconcile these different approaches before the November elections.
Expired Tax Provisions
Congressional lawmakers have expressed bipartisan support for renewing numerous business, energy and individual tax provisions that expired at the end of 2011. Although these provisions are expected to be renewed retroactively back to the beginning of 2012, their expiration creates uncertainty for financial and planning purposes.
Expired provisions of importance to many businesses include the research credit, deferral of tax on global active financing income, look-through treatment of related-party payments of controlled foreign companies, increased expensing of tangible personal property and a 15-year cost-recovery period for leasehold, restaurant and retail improvements.
The cost of a one-year renewal of the expired tax provisions is $35-40 billion (exclusive of extending AMT relief). It is unclear at this time whether Congress would decide to offset this cost and, if so, whether through tax increases or spending cuts. There is an effort underway to review the merits of specific expired provisions to analyze whether they should be continued. The cost of "tax extender" legislation would be reduced if some expired provisions are not reinstated.
The president's budget proposes making the research credit permanent and extending other expired tax provisions for two years. His business tax re-form framework, discussed below, recommends that expired and expiring business tax provisions either should be eliminated or made permanent on a revenue-neutral basis as part of any tax re-form effort. The administration estimates that making all business tax extenders permanent would cost approximately $250 billion over 10 years.
Notwithstanding bipartisan support for renewal, enactment of temporary extensions of some or all expired tax provisions appears unlikely to occur until after the November elections.
Interestingly, the last time a group of expired tax provisions was renewed was during the post-election session of Congress in 2010, when a two-year extension through 2011 was approved. Achieving permanency will have to wait for tax reform.
The 2001/2003 Tax Cuts
The lower tax rates, estate tax relief and other individual items that originally were enacted in 2001 and 2003 are scheduled to expire at the end of 2012. If present law is not extended, the top rate on ordinary income will rise from 35 percent to 39.6 percent, and the 15 percent tax rate on capital gains and dividends will rise to 20 percent and 39.6 percent, respectively. Similarly, the estate tax will revert back to a top rate of 55 percent, with a $1 million exemption.
In his budget submission, President Obama proposes to extend the 2001 and 2003 tax cuts, but only for individuals with income under $200,000 and married couples with income under $250,000. The president also has recommended a 30 percent minimum tax on individuals with income above $1 million. This proposal, often referred to as the "Buffett rule"--named for Warren Buffet, the founder of Berkshire Hathaway Inc.--is intended to address concerns first raised by Buffett that his executive assistant pays a higher rate of tax on her income than he does.
Note: Beginning in 2013, an additional 0.9 percent Medicare hospital tax on wage and self-employment income and a new 3.8 percent tax on net investment income of individuals with income over $200,000 and married couples with income over $250,000 will go into effect. These provisions are intended to help fund health reforms enacted in 2010.
The 2001 and 2003 tax cuts enjoy broad support and affect all individual taxpayers, including business owners who are self-employed or operate flow-through entities such as partnerships and S Corporations. However, there is disagreement over whether the tax cuts should be renewed for all taxpayers or only for those with income under a certain income level.
In addition, the issue of how long the tax cuts should be extended is up in the air since the ongoing work on comprehensive tax reform is focused on lowering tax rates even further. As a result, it is expected that action to address the scheduled expiration of the 2001 and 2003 individual tax cuts also will be delayed until after the November elections.
If no action is taken on renewal of the tax cuts this year, the top tax rates for individuals will increase significantly, as shown in the table 2013 Individual Top Tax Rates, on page 40.
Comprehensive Tax Reform
Since the current Congress convened in January 2011, congressional committees have conducted almost 40 hearings on a wide range of tax reform topics and have held numerous informational meetings for members and staff. These meetings will continue as the year progresses. In general, the overall concepts being discussed include lowering tax rates, broadening the tax base by cutting back on tax deductions and credits and revising the taxation of global business income to enhance competitiveness.
Several developments in recent months shed light on the direction of tax reform. In addition to President Obama's business tax reform framework (noted earlier), House Republicans passed a budget for fiscal year 2013 that recognizes the need for comprehensive tax reform and outlines priority goals to be achieved by this effort.
The presumptive Republican nominee for president in November, Mitt Romney, has outlined his own recommendations for tax reform.
* THE PRESIDENT'S FRAMEWORK. The 25-page framework for business tax reform proposes reducing the corporate tax rate from 35 percent to 28 percent. For manufacturing, the framework proposes a further reduction in effective rates to 25 percent generally and an even lower rate for "advanced manufacturing." The cost would be offset by eliminating industry-specific tax benefits (such as for oil and gas businesses, insurance companies and hedge funds) and tax provisions viewed as distorting investment (debt financing and choices of business form).
In particular, the president's framework includes recommendations to repeal accelerated depreciation, limit the deductibility of interest for corporations and establish greater parity in tax treatment between large corporations and large flow-through entities (such as partnerships and S Corporations).
With respect to flow-through entities, it is notable that recent trends show that business income earned by flow-through entities has grown significantly and in some years has exceeded the business income earned by corporations [see the table Corporate and Non-Corporate Shares of Business Income, above].
Since flow-through entities do not pay tax at the entity level--instead, the income flows through and is taxed to the owners--a concern has surfaced, as evidenced by the president's framework recommendation, that large flow-through entities may be viewed as a mechanism to avoid the corporate tax.
On taxation of international income, the president's framework does not support adoption of a so-called "pure" territorial system, citing concerns about potential incentives to shift operations and earnings out of the United States. Instead, the framework recommends maintaining and strengthening the existing worldwide system of taxing global income earned by U.S. multinationals.
To this end, the framework includes a minimum tax on the foreign earnings of U.S. companies, under which foreign income earned 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 paid to the host country.
The framework also includes administration budget proposals to deny deductions for shifting operations outside of the U.S. ("outsourcing" expenses) and create a new 20 percent tax credit for moving operations to the U.S. ("insourcing" expenses).
* HOUSE REPUBLICAN BUDGET. In March, the House of Representatives approved a Republican-designed budget for the upcoming fiscal year that accommodates revenue-neutral individual and corporate tax reform and incorporates tax reform principles recommended by Republican members of the Committee on Ways and Means.
The proposals for individuals include reducing the number of tax rate brackets from six to two (10 and 25 percent), maintaining the current law 15 percent top rate on capital gains and dividends and repealing the alternative minimum tax (AMT).
The corporate proposals include a reduction in the top rate to 25 percent and adoption of a territorial tax system. Under the House budget, individual and corporate tax reform is intended to be revenue neutral through base broadening, the details of which are to be determined at a later time.
The corporate proposals in the House budget stem from a discussion draft released last year by Rep. Dave Camp (R-Mich.), chairman of the Committee on Ways and Means. This draft included a 25 percent top corporate tax rate and a specific legislative proposal of a new territorial tax system for active business income earned outside of the U.S. Both the corporate rate reduction and the territorial proposal are intended to be revenue neutral.
The territorial proposal in Camp's discussion draft includes a 95 percent dividend deduction for active business income earned by controlled foreign corporations as well as options to prevent income shifting. Income earned prior to the effective date would be subject to special transition rules. Under present law, the United States taxes U.S.-based companies on their worldwide income. U.S. tax on active business income generally is deferred until it is brought back to the U.S.; a foreign tax credit is allowed at that time.
* THE ROMNEY TAX PLAN. Gov. Romney's tax recommendations focus on both individuals and corporations. For individuals, tax rates would be reduced across the board by 20 percent and tax on investment income (interest, dividends and capital gains) would be totally eliminated for taxpayers with income under $200,000. The AMT and estate tax would be repealed.
For corporations, there are two key recommendations: reducing the top rate to 25 percent and adopting a territorial system. Romney has expressed a desire to pursue a long-term goal of a "fairer, flatter, simpler tax structure," citing the approach of the National Commission on Fiscal Responsibility and Reform (known as the "Simpson-Bowles Fiscal Commission") as a useful starting point for discussions.
* LEADING TAX REFORM APPROACHES. As illustrated in the comparison of four leading tax reform approaches (in the table Comparison of Tax Reform Proposals, on page 42), the key decision points include lower individual and corporate tax rates, domestic manufacturing, domestic research incentives, taxation of global business earnings, flow-through entities, capital gains and dividend rates and elimination of deductions and credits to achieve a broader tax base.
In particular, tax base broadeners that impact businesses could involve a wide range of tax deductions and credits, including accelerated depreciation, LIFO [last-in, first-out] and other inventory methods, expensing of research and experimental costs, interest expense and the domestic manufacturing deduction.
What is Driving Tax Reform?
Several factors are at the heart of the effort to reform the tax code. There is universal agreement that the tax code is too complicated for individuals and businesses. Other factors are stability and certainty. As noted above, significant parts of the tax code currently are temporary, and timely renewal is a growing concern. Thus, putting in place a permanent and predictable tax system is another often-discussed goal. Promoting economic growth and efficiency are discussed as key factors as well.
A tax code with a broader tax base has the potential to reduce distortions in decisionmaking, which in turn could produce efficiency gains and economic growth effects.
Another important driver of tax re-form is concern about the impact of the present tax code on competitiveness of U.S.-based businesses in the global marketplace. Many countries have revised their tax systems in recent years to assist their companies in competing globally. These reforms include lower corporate tax rates, as shown in the table Comparison of Corporate Tax Rates, on this page; adoption of territorial or exemption regimes for active business income and strengthened domestic research tax incentives.
In contrast, the U.S. now has the highest statutory corporate tax rate of Organisation for Economic Co-operation and Development (OECD) countries; taxes U.S.-based companies on worldwide income (tax on active business income generally is deferred until it is brought back to the U.S.); and is ranked 24th of the 38 OECD countries on research tax incentives (2008 data).
The present U.S. system has the unintended effect of discouraging earnings from being bought home to the U.S. (also known as the "lockout" effect).
The combined effect of tax reform trends by other countries on global competition--lower corporate rates, adoption of territorial or exemption regimes for active business income and enhanced domestic research tax incentives--has become a key focus of congressional hearings and discussions.
Existing Challenges for Reform
Even so, tax reform faces many challenges. The federal government's fiscal situation, with historically high deficits and rising debt, continues to be a perplexing issue. Deficits well in excess of $1 trillion for the last three years and projected for the current year are more than three times the historic average (as a percent of gross domestic product). Debt held by the public has increased to almost 70 percent of GDP.
In 2010, the Simpson-Bowles Fiscal Commission prepared recommendations to reduce deficits and strengthen the long-term fiscal position of the federal government. The commission's recommendations included tax reform options on low rates and broadened tax bases that would produce an overall increase in revenues. While tax reform discussions currently assume revenue neutrality, it is possible that Congress might conclude that overall revenues should be increased.
It is notable that as other countries reformed their business tax systems by lowering tax rates, broadening tax bases and adopting territorial or exemption tax regimes, they were able to offset some of the cost of these reforms by increasing border-adjustable goods and services taxes. This may have helped mitigate the net impact on businesses that otherwise would have been harmed by additional base broadening.
Since the U.S. is one of the few countries without a goods and services tax (broad-based consumption tax) at the federal level, this tool is not available to lawmakers to assist with revenue-neutral U.S. tax reform.
Some other challenges that tax re-form will face include the inherent difficulty involved in eliminating or reducing tax deductions and credits to broaden the tax base, balancing the differing impacts on industries and business sectors, achieving overall revenue neutrality, providing a rational transition to the reformed system that minimizes disruptions and maintaining progressivity of the income tax system.
As discussed, a comprehensive tax reform effort can involve important trade-offs for businesses. Lower tax rates are costly and would have to be coupled with offsetting tax increases to achieve revenue neutrality.
For example, according to congressional estimates, each one-percentage-point reduction in the corporate tax rate reduces revenues by approximately $100 billion over 10 years. It is critical that businesses evaluate the impact of various tax reform approaches and prepare for the upcoming debate.
Sweeping tax reform is a significant undertaking and commitment of resources. The 1986 tax reforms took almost two years of intense work to complete, with a strong commitment from the president and Congress. While the foundation for a comprehensive tax reform effort is well under way, full development of legislation likely will not begin until next year.
What's Coming Next?
Work on tax legislation will continue through the summer and fall. Small business tax relief, renewal of expired tax provisions and extension of the tax cuts first enacted in 2001 and 2003 are priority items.
Progress will continue to be made but, due to differences between controlling parties in the House and the Senate, it is unlikely that action on these legislative items will be completed until after the November elections.
A post-election lame-duck session of Congress is scheduled for November and December, and work on priority tax legislation will continue at that time. In addition, the post-election session is expected to have a full agenda of fiscal items, including annual funding of federal agencies and programs, increasing the limit on federal debt issuances and renewing Medicare physician payments.
Due to fiscal pressures, extensions of tax provisions will only be temporary, possibly for one or two years, with permanent changes to the tax code deferred until there is action on tax reform.
Meantime, congressional committees responsible for initiating tax legislation will continue to lay the foundation for a comprehensive tax reform effort, which could begin to crystallize into specific legislation in 2013.:
2013 Individual Top Tax Rates (** Assumes 2001 and 2003 tax cuts are not renewed for 2013) Wage Capital Dividends Income Gains 2012 Top Rate 36.45% * 15.0% 15.0% 2001/2003 rate cuts expire ** +4.6% +5.0% +24.6% Repeal of phase-out of itemized +1.2% +1.2% +1.2% deductions expires ** Medicare hospital surtax to fund +0.9% +3.8% +3.8% health reform (2013 is first year) Total increase in rate +6.7% +10.0% +29.6% 2013 Top Rate ** 43.15% 25.0% 44.6% * Includes 1.45% Present-law employee/self-employed share of Medicare hospital tax. Source: PwC Comparison of Tax Reform Proposals Proposal Bowies-Simpson President House Fiscal Obama Republican Commission Budget/Camp Draft Individual 12%, 22%, and 10%, 15%, 25%, 10% and 25% rates 28% 28%, 33%, 36%, and 39.6%; 30% minimum tax on $1 million of income Corporate 28% top rate 28% top rite 25% top rate rates Capital gains Tax at ordinary 20% top rate 15% top rate and income rates for capital dividends Cams, tax dividends at ordinary income rates Non-corporate No proposal Greater parity To be businesses of large determined corporations and non-corporate businesses Domestic Repeal Target and To be manufacturing increase to determined deduction 10.7% (18% for (9%) advanced manufacturing) Research Amortize over 5 Permanent R8iD To be expenditures years credit with 17% determined alternative credit International Territorial Minimum tax on Territorial foreign with anti-base earnings, erosion reduce income shifting overseas Cost recovery Repeal Repeal To be accelerated accelerated determined depreciation depreciation, expense up to $1 million for small business Interest No proposal Limit for Limit for thin expense unremitted capitalization foreign earnings, reduce bias of debt financing over equity Proposal Governor Romney Individual 8%, 12%, rates 20%, 22.4%, 26.4%. and 28% Corporate 25% top rates rate Capital gains 15% top rate and and no tax dividends on incomes below $200.000 Non-corporate To be businesses determined Domestic To be manufacturing determined deduction (9%) Research To be expenditures determined International Territorial Cost recovery To be determined Interest To be expense determined Source: PwC
Lindy L. Paull, Esq., is a principal in the Washington National Tax Services office of PwC US. She previously worked on tax legislation for Congress for 17 years, including as chief of staff for the Congressional Joint Committee on Taxation and Republican chief of staff of the U.S. Senate Committee on Finance. Brian A. Meighan, CPA, is a partner in the WNTS office of PwC and formerly served as a legislation accountant for the Congressional Joint Committee on Taxation.
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|Title Annotation:||Cover Story|
|Author:||Paull, Lindy L.; Meighan, Brian A.|
|Date:||Jun 1, 2012|
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