President Clinton's tax proposal: a fiscal balancing act.
Investment tax credit (ITC). The ITC proposed is estimated to cost $29 billion in revenue over the six-year period. It will be some,what different from the credit taxpayers are used to dealing with; it will be both temporary and incremental and will be earned at a 7% rate, as opposed to the 10% rate in effect before the previous credit's 1986 repeal. The proposed credit will apply to investments made between December 3, 1992, and December 31, 1994.
Central to an understanding of the ITC is the concept of eligible property. Such property historically included depreciable tangible personal property with a useful life of at least three years. As was the case in the past, President Clinton's ITC will continue to exclude most buildings and their structural components, so real estate will not qualify for the credit. The cost of eligible property will be converted into a qualified investment figure to arrive at a taxpayer's ITC.
Qualified investment is the key ITC concept and will encompass the cost of depreciable tangible personal property adjusted to reflect its estimated useful life. The credit will equal 7% of the amount by which the qualified investment exceeds a fixed base (a taxpayer's average historic investment from 1987 to 1991 or from 1989 to 1991, indexed for growth in gross domestic product and multiplied by 70%, for 1993, and 80%, for 1994). In no event will a taxpayer be able to claim credits for more than 50% of its qualified investment in a taxable year.
The ITC also will feature stringent recapture rules: Credits earned must be repaid if the taxpayer's investment for 1995 to 1997 falls below 80% of the fixed base, computed by multiplying indexed average historic investment by 80%.
The credit will offset no more than 25% of a taxpayer's alternative minimum tax (AMT) liability. This is a matter of concern because the companies most affected by the AMT are the very companies that can be counted on to invest most heavily in production equipment. A 25% limit on offsetting AMT will partially dilute the ITC'S stimulative impact.
For small corporations with gross receipts of $5 million or less, the credit will be permanent and initially will begin at a 7% rate; after 1994 it will scale down to a 5% rate. For these corporations the credit will not be incremental but will be earned on the first dollar of qualified investment.
Research and development (R&D) credit. This stimulus provision will have a revenue cost of $10 billion over the six-year period. The credit will be extended permanently retroactive to July 1, 1992. While this credit has a fairly high revenue loss estimate, it will be taken by a small number of companies, principally those in the pharmaceutical and computer industries.
The R&D credit will equal 20% of the excess of qualified research expenditures over a base amount. (Historically, it was an incremental credit, like the proposed ITC.) Calculating the base amount will be fairly complex: It will equal a taxpayer's fixed-base percentage (aggregate research expenditures divided by aggregate gross receipts for the period from 1984 to 1988) multiplied by its average gross receipts for the preceding four years. It is important to note the base period amount can never be less than 50% of the current year's qualified research expenses.
To encourage multinational companies to perform R&D in the United States, the proposal will allow them to allocate R&D expenses attributable to activities performed here solely to U.S. source income for purposes of calculating foreign tax credit limitations.
Capital gains. The proposed capital gains tax break will apply largely to the stock of small capitalization companies bought in initial public offerings. A so-called qualified small business corporation generally is a C corporation engaged in an active trade or business with less than $50 million of aggregate capitalization at all times from January 1, 1993, through the date the taxpayer acquires the stock.
Individuals who invest in these companies and hold the position for at least five years will be able to exclude 50% of their realized gains (the gain eligible for exclusion cannot exceed the greater of $10 million or 10 times the investor's basis) on the stock's disposition. Moreover, 50% of the excluded gain will be a preference item for AMT purposes. Certain industries, including banking, leasing, real estate, farming, mineral extraction and hospitality, will be excluded from small business status. It is estimated this provision will cost the government $714 million from 1993 to 1998.
REAL ESTATE INCENTIVES
The proposal's real estate provision are not particularly expensive - they are projected to cause a loss of only $5.5 billion in revenue over six years. The provisions will extend the low income housing credit. President Clinton also spoke of modifying the passive loss rules for real estate. Under the 1986 Tax Reform Act, whose real estate provisions are quickly being eroded by these proposals, deductions from passive activities exceeding the activities' income cannot be deducted against other income. The passive activity rules were the key factor in the demise of the tax shelter industry. When a taxpayer has excess deductions from a passive activity, suspended deductions are allowed in full, but only when the taxpayer disposes of its entire interest in the activity to an unrelated party.
For purposes of the passive loss rules, rental activities are inherently passive regardless of the taxpayer's involvement in the operation. The president's proposal generally will exclude rental real estate activities from passive status if the taxpayer materially participates in them. The deductible loss, however, cannot exceed net income from the taxpayer's nonpassive real estate business activities. President Clinton clearly is targeting real estate professionals, not individuals who merely dabble in the activity: To be eligible for this benefit, a taxpayer must devote more than half of his or her professional time to real estate activities in which there is material participation.
Under current law, pension funds as well as other tax-exempt entities generally are not subject to tax. They are, however, taxed on income derived from debt-financed property. There are several exceptions for income from debt-financed real estate investments provided certain requirements are met. The following are some of these requirements:
* The real estate's purchase price must be fixed at the time of the acquisition
* Neither the time for paying off the acquisition debt nor the amount of the payments can be dependent on the property's earnings.
* The property acquired by the pension fund cannot be leased back to the seller.
* The seller cannot provide financing to the pension fund for the acquisition.
The proposal will allow a leaseback to the seller of real estate acquired by the pension fund of up to 25% of the property's leaseable floor space. It also will relax the rules for seller financing. Unfortunately, the current law's fixed price and participating loan restrictions will not be relaxed except when a pension fund acquires foreclosed property from a financial institution.
A slight negative is the proposal's extension of the depreciation period for nonresidential real estate from its current 31 1/2 years to 36 years. However, this is likely to have only a minor adverse impact.
Corporate tax increase. An increase in the corporate tax rate from 34% to 36% for companies with taxable income over $10 million is slated to raise some $30.5 billion over the six-year period. In addition to the obvious impact, the proposal will have a subtle effect on an item found on the liability side of virtually every balance sheet: deferred taxes. A small but meaningful number of companies have deferred tax assets, not deferred tax liabilities, on their books.
Deferred taxes are an accounting convention created by Financial Accounting Standards Board Statement no. 109, Accounting for Income Taxes, that requires companies to acknowledge they will pay taxes in the future to offset certain currently realized tax benefits. A deferred tax liability arises when a company takes deductions for tax purposes before it takes the same deductions for accounting purposes. A classic example is the use of accelerated depreciation for tax purposes and straight-line depreciation for accounting purposes. The future tax liability created when that difference turns around has to be recorded as a deferred tax liability.
It is important to note most companies established deferred tax liabilities assuming a 34% tax rate. Statement no. 109, however, requires companies to adjust deferred tax liabilities when there is a change in tax laws or rates. If President Clinton's proposal is enacted, companies with deferred liabilities on their books at 34% will have to write them up to reflect a 36% rate. That writeup, in turn, will be accompanied by a charge to earnings generally equal to 2% of taxable income. By the same token, companies with deferred tax assets (mainly banks and companies with tax loss carryforwards) will enjoy a corresponding credit to income because they will be able to write up their deferred tax assets to reflect the new 36% rate.
Marking inventories to market. This provision is designed to raise about $4.5 billion over six years and will affect securities broker-dealers. Currently, securities dealers are allowed to value inventories using the lower of cost or market (LCM) method, which permits them, when calculating taxable income, to take into account unrealized losses on inventory positions without having to account for unrealized gains. The proposal will require dealers simply to be on a full mark-to-market system, meaning both unrealized gains and losses must be taken into account. The increase in income resulting from converting from an LCM system to a market system will be included ratably over a five-year period.
Double dipping. This colorfully named provision will raise some $2 billion and has an interesting history dating back to the late 1980s when the Federal Saving and Loan Insurance Corporation (FSLIC,) entered into a number of well-publicized agreements with buyers of troubled thrifts. The FSLIC promised to compensate these buyers for the difference between the book values and the ultimate sales proceeds of so-called covered assets acquired in these transactions. As one can imagine, covered assets were either non-performing or troubled at the time of the acquisition.
In addition to being compensated for the loss, the FSLIC apparently also promised these taxpayers they would be able to take a tax deduction for the loss, even though no tax deduction generally is allowed for a loss on the sale of property to the extent the loss was compensated by insurance or otherwise. As a result, taxpayers are reimbursed for losses for which they also claim a tax deduction. The president's proposal will disallow losses on the sale of covered assets or deductions for the worthlessness of covered receivables to the extent the taxpayer is entitled to FSLIC assistance. The provision will apply to FSLIC assistance credited after March 3, 1991.
This provision will have not only a cash but also an accounting impact, especially for companies entitled under Statement no. 109 to establish deferred tax assets to reflect the future tax benefit of net operating loss carryforwards (NOLs). Clearly, to the extent troubled thrift buyers recorded accounting benefits as a result of these erroneous deductions, they will be forced to write off these assets in 1993.
Internal Revenue Code section 936 credit. One of the industries hardest hit by these proposals will be pharmaceuticals. For a long time, the industry has benefited from the so-called section 936 credit. Section 936 grants domestic companies a tax credit generally equal to the portion of their tax attributable to income derived from the active conduct of a business within a U.S. possession and from qualified possession source investment income.
President Clinton requested a reduction in the credit to 60% of wages paid to possession employees (up to $57,600). In addition, a supplemental credit would be allowed equal to 80% of the corporation's qualified tangible business investment. From 1994 to 1995, companies will be allowed to take the greater of the wage-based credit or 80% and 60% of the old credit, respectively. The Treasury Department estimates $7 billion in revenue will be gained from this change.
Corporate estimated tax payments. This provision will raise an estimated $5 billion. Corporations are subject to a penalty if they fail to deposit sufficient estimated taxes during the year. A corporation does not have an underpayment, however, if it makes four timely estimated payments totaling 97% of the tax liability ultimately reflected on its current-year return. The old threshold was 90% of current tax liability. The proposal will make the higher threshold permanent, which may cut into cash flows if corporations must make increased estimated payments to avoid a penalty.
Transfer pricing. It's surprising there are few proposals pertaining to international business. During the presidential campaign candidate Clinton claimed he could raise some $45 billion over a four-year period simply by enforcing the tax law's transfer-pricing provisions more vigorously. IRC section 482 allows the Internal Revenue Service to allocate income and deductions between commonly controlled organizations to ensure they deal with each other on an arm's-length basis. The president is concerned mainly with enforcing these provisions with respect to foreign-controlled U.S. taxpayers.
President Clinton's new proposal is solely an enforcement initiative and will require taxpayers to keep contemporaneous documentation of the methodology used in setting an arm's-length transfer price. The reasoning is that if an entity is required to document its methodology, it will be more vigilant in adhering to arm's-length standards. The revenue estimate, formerly $45 billion, is way down to $3.8 billion over the six-year period. The president also promised to double the audit rate on these taxpayers through a program to hire more IRS agents who exclusively will audit transfer-pricing activities.
Foreign tax credits. Two arcane foreign tax credit proposals will cost taxpayers a total of $3.6 billion. Both are designed to limit the ability to credit foreign taxes against U.S. tax liabilities. The first is directed primarily at the drug industry and pertains to royalties earned on intellectual property licensed to offshore producers. The goal is to limit a company's ability to receive foreign tax credits - and thereby to bring the production of the licensed property back to the United States. According to the information currently available, these royalties (even though derived in active conduct of a business) will be considered passive income.
The second proposal will limit the foreign tax credit capabilities of oil companies and cost the industry roughly $1.8 billion over six years. The proposal will treat interest on temporary investments of working capital in connection with foreign-oil-related income as passive income for foreign tax credit purposes. In most cases this will reduce a company's ability to enjoy foreign tax credits.
Earnings-stripping. Another initiative will enhance the earnings-stripping rules, which restrict a U.S. corporation's ability to deduct interest on debt owed to a related foreign party. For example, if BP America borrows money from BP UK, there will be restrictions on its ability to deduct currently the interest payments made to BP UK. The proposal will extend these restrictions to U.S. taxpayers borrowing money from a third party: For example, if BP America borrows money from the Bank of America and the debt to the Bank of America is guaranteed by BP UK, the interest deductions will be treated as if the borrowing ran directly from BP America to BP UK.
Taxes on deemed dividends. U.S. corporations will be taxed currently as if they received a dividend on earnings of foreign subsidiaries the president conclude have accumulated excess earnings. Taxes will be assessed when a foreign subsidiary has accumulated passive assets in excess of 25% of its total assets. The deemed dividend will equal the lesser of the subsidiary's current and accumulated earnings and profits or the amount by which its passive assets exceed 25% of the total.
If the following proposals are added together, a taxpayer subject to all of them, including the millionaire's surtax, will have an effective tax rate exceeding 42%, not including state and local taxes.
Individual tax rate increase. This will be the real source of revenue in the president's proposal, raising a whopping $126 billion over six years. A 36% tax bracket will be added to the existing three and will apply to joint filers with taxable incomes of more than $140,000 and to single filers with taxable incomes exceeding $115,000.
Millionaire's tax. A 10% surtax will be assessed on the tax liability attributable to taxable income, excluding net capital gains, in excess of $250,000.
AMT. The proposal will raise the AMT rate from 24% to 26% for taxpayers with alternative minimum taxable income (AMTI) of up to $175,000 and 28% for those with AMTI exceeding $175,000.
Limits on itemized deductions and personal exemptions. These limits will be made permanent. They have two aspects. The first will reduce a taxpayer's itemized deductions - other than medical expenses, casualty losses, investment interest and gambling losses - by 3% of the amount by which adjusted gross income exceeds $108,450 (in 1993). The second will reduce the personal exemption (currently $2,350) by 2% for each $2,500, or fraction thereof, by which adjusted gross income exceeds $162,700.
Medicare tax. By subjecting all wages, not just the first $135,000, to the 1.45% Medicare tax, the proposal will raise $29 billion in revenue. This is a dual tax, with the employer paying the same amount as the employee.
Executive compensation. This proposal has generated considerable confusion on Wall Street. It is designed to limit the deductions for executive compensation in excess of $1 million per year, unless the compensation is justified by productivity. The proposal would apply to compensation paid by publicly held corporations to their five top executives. Compensation is linked to productivity if it is paid as a commission or is based on attaining performance goals that are established by independent directors and approved by shareholders.
Travel and entertainment. Two proposals that will raise a total of $7.5 billion concern business-related meals and entertainment expenses. These expenses are currently deductible only if they are directly related to, or associated with, the active conduct of a business and are neither lavish nor extravagant. At present, only 80% of the expenses are deductible. The proposal will reduce the amount of deductible expenses to 50%. In addition, there will be no deduction for club dues, even if the facility is used primarily for business. Meals and entertainment expenses incurred at the club will continue to be deductible, subject to the 50% limit.
Estate tax. It is estimated nearly $3 billion will be raised over six years by the proposal to reinstate the top estate tax rate of 55% for taxable estates exceeding $3 million. A 53% rate will apply to transfers between $2.5 million and $3 million. In 1993, the rate dropped to 50% for taxable transfers in excess of $2.5 million. It is important to note that in its current form President Clinton's proposal will not tax capital gains at death, so a stepped-up basis still will be available.
Energy tax. This proposal is the result of President Clinton's attempt to raise revenue to the tune of $71.4 billion and avoid a backlash from any region hit too hard. The tax will be based on a fuel's energy content measured in British thermal units (BTUs). This particular "contribution" will be structured to hit oil the most. There will be no tax on feed stocks - energy that becomes part of a finished product (for example, the oil that goes into tires).
Beginning on July 1, 1993, coal, hydro-electricity, natural gas and nuclear power will be taxed at a rate of 25.7 cents per million BTUs. Oil will be slapped with a tax of 59.9 cents per million BTUs. The 34.2-cent discrepancy between the two rates represents Clinton's so-called national security tax. In the short term, home heating oil will be exempt from the tax until 1995.
According to a Treasury Department official, the president's plan has three parts. After the first step is implemented in 1994, the general consumer will be confronted with a 2.5-cent increase in the price of a gallon of gasoline, home heating oil will cost 2.72 cents more per gallon and there will be an 8.75-cent rise in the cost of each cubic foot of natural gas. By the time, the last phase is implemented in 1997, consumers can expect to pay an additional 8 cents per gallon of gasoline.
Miscellaneous provisions. The Clinton administration proposal includes several other provisions.
* The proposal will encourage capital formation by eliminating the depreciation component of the adjusted current earnings (ACE) preference for AMT purposes. For regular AMT purposes, depreciation will be calculated using the 120% declining-balance method over regular tax useful life.
* The proposal will promote philanthropy by providing for a full fair market value deduction for contributions of appreciated property for both regular and AMT purposes.
* The amount of Social Security benefits that is subject to tax for certain taxpayers will increase from 50% of benefits to 85% Of benefits.
* The 25% credit for health insurance premiums paid by self-employed persons will be extended.
* PRESIDENT CLINTON HAS proposed a tax and economic stimulus proposal with a net revenue goal of $244 billion over the period from 1993 to 1998.
* INCLUDED IN THE PROPOSAL are stimulus provisions such as an investment tax credit, a research and development credit and a capital gains break for investment in small capitalization companies.
* REAL ESTATE INCENTIVES in the Clinton proposal are projected to cost $5.5 billion and include an extension of the low income housing credit.
* REVENUE-RAISING provisions include an increase in the corporate tax rate and rules targeting specific areas such as broker-dealers in securities and pharmaceutical companies. The revised corporate estimated tax rules will be made permanent.
* AN INCREASE IN THE TOP individual tax rate to 36% will raise an estimated $126 billion over six year. Additional revenue will come from implementing a "millionaire's tax," increasing the alternative minimum tax rate, subjecting all wages to the Medicare tax, limiting travel and entertainment deductions and reinstating the top 55% estate tax rate.
* A CENTERPIECE OF THE proposal is an energy tax designed to raise $71.4 billion by taxing a fuel's energy content. The tax will be phased in over several years in a three-part proposal.
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|Author:||Phillips, Andrea J.|
|Publication:||Journal of Accountancy|
|Article Type:||Cover Story|
|Date:||May 1, 1993|
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