Developments in U.S. Tax Reform

The month of June saw an increase in momentum for U.S. tax reform. We review those events below.

Senators Baucus and Hatch Propose Reforming the Tax Code Starting With a “Blank Slate”

In a letter to their Senate colleagues dated June 27, 2013[1], Sen. Max Baucus, the chairman of the Senate Finance Committee and Sen. Orrin Hatch, the committee's ranking (minority) member requested input as the finance committee moves forward with comprehensive tax reform legislation.  The senators state that the Finance Committee would start with a blank slate, i.e. the starting point would be a tax code without any tax expenditures (e.g., exclusions, deductions or credits).

Senators are asked to submit either legislative language or detailed proposals for “tax expenditures” that should be included in the new tax code because “there is clear evidence that they: (1) help grow the economy, (2) make the tax code fairer, or (3) effectively promote other important policy objectives.” The letter also acknowledges that there is a division among the senators as to whether revenue raised from eliminating tax expenditures should go to reduce the deficit or to lower tax rates. Democrats tend to favor the former while Republicans tend to favor the latter.

The letter also observes that comprehensive tax reform will involve looking at much more than just income tax expenditures. It concludes optimistically "we are determined to complete tax reform this Congress.”

Senate Finance Committee’s Staff Considers Options for Reforming Taxation of Income and Business Entities

On June 6, 2013 the staff of the Senate Finance Committee released a paper of options for reform of the taxation of types of income and business entities.[2] This report is the eighth in a series of ten option papers that the staff of the Senate Finance Committee has prepared thus far. The list of options is non-exhaustive and is not necessarily endorsed by the committee's leadership, Senators Baucus and Hatch. The papers are intended to encourage discussion among senators with the goal of reaching consensus concerning tax reform options.

Background

The option paper begins with a chart showing the disparity in U.S. federal income tax rates for various types of income. For example, the top income tax rate for wages and salaries is 39.6%, as is the top rate for interest, non-qualified dividends, rents, royalties and short-term capital gains. However the top rate for long-term capital gains and qualified dividends is only 20%.

Another key attribute of the U.S. taxation of business income is that business income earned by a C corporation is taxed twice: first in the hands of the corporation in the year earned and again in the hands of the shareholder when distributed as a dividend. On the other hand, business income earned by a partnership or an S corporation generally is taxed only once, i.e., in the hands of the partner or shareholder in the year earned.

The option paper discusses some potential goals for tax reform. These include: (i) simplifying the law in order to reduce tax compliance costs, (ii) making the tax law more neutral by reducing or eliminating differences in overall tax burdens across types of entities, owners and income; (iii) reducing or eliminating differences in the taxation of debt and equity. Reform options are broken into five main categories: (i) taxation of different types of income and entities, (ii) corporate finance decisions, (iii) compensation, (iv) financial products and (v) other. We discuss the first and second categories, which are most likely to be of interest to non-U.S. investors.

Options for Reform of the Taxation of Business Entities

The options described for reform of the taxation of business entities are many. Some are far-reaching while others are more modest. For each proposal, the option paper includes a reference to an article or legislative proposal advocating the change and providing additional detail.

The first option discussed is to maintain two levels of tax on the earnings of C corporations while taxing capital gains, dividends and ordinary income at the same rate. Other potential options include taxing only dividends as ordinary income or narrowing the difference between ordinary income rates and capital gains and dividend rates.

The second option discussed is to fully integrate the corporate and individual income taxes. Under an integrated tax system, businesses income is taxed at the same rate whether it is earned by a C corporation or a pass-through entity. Various approaches are discussed to achieve an integrated tax system. The possibilities include: (i) taxing dividends as ordinary income and providing shareholders with a tax credit for corporate income taxes paid (an imputation credit), (ii) taxing dividends as ordinary income and allowing corporations to deduct dividends paid to the extent earnings are taxed at the corporate level (a dividends paid deduction), (iii) excluding dividends from the income of shareholders to the extent the dividend is paid from previously-taxed corporate earnings, (iv) eliminating deduction for interest and dividends for all businesses and allowing investors to exclude interest and dividends from their taxable income (a comprehensive business income tax), (v) permitting corporations to deduct a portion of the amount raised in the corporate equity markets (an allowance for corporate equity), and (vi) treating all business entities as pass-through entities.

The paper does not offer any detail on the many practical and technical issues raised by these various approaches. One key issue is how to tax non-U.S. shareholders should the United States move to one of these systems. This would need to be addressed both by domestic law and U.S. income tax treaties.

The third option discussed is to only partially integrate the corporate and individual income taxes. Possibilities include: (i) taxing dividends as ordinary income and allowing a partial imputation credit or dividends paid deduction, (ii) adjusting corporate and individual tax rates so that the combined tax rate on corporate income and dividends received is closer to the rate of tax on business income earned through a pass-through entity, and (iii) taxing capital gains as ordinary income rates (except those from the sale of stock in a C corporation).

A fourth option would be to "redraw the line" between pass-through entities (i.e., partnerships and S corporations) and C corporations. The options discussed in this section of the paper include: (i) requiring more or all publicly-traded partnerships to pay tax as C corporations, (ii) requiring larger pass through businesses to pay tax as C corporations, (iii) allowing or requiring more businesses to pay tax on a pass-through basis, and (iv) modifying the rules regarding taxation of regulated investment companies (RICs) and real estate investment trusts (REITs), e.g., reducing the types of activities that may be conducted by a RIC.

Other options discussed include conforming the rules for S corporations and partnerships, harmonizing different tax rates on capital gains and equalizing the tax treatment of corporate and pass-through entities with respect to certain government incentives.

Options for Reform of Corporate Finance Decisions

The options for reform of corporate finance decisions are grouped into four categories. The first option is to expand the current thin capitalization rules, for example, to disallow interest expense in excess of a certain percentage of adjusted taxable income (such as is done by Germany today). Another option is to further limit deductions associated with tax-exempt or tax-deferred income. For example, the Obama administration has proposed deferring the interest deduction associated with un-repatriated foreign earnings. The third option would be to create greater parity between debt and equity financing for C corporations.  This could be done by generally reducing the amount of interest deductible by C corporations or by disallowing a deduction for interest paid on debt used to redeem corporate equity. The final option is to create greater parity between retaining and distributing earnings for C corporations. This would reduce the "lock-in incentive," i.e., the incentive to retain corporate earnings in C corporations rather than to distribute those earnings to shareholders and subject them to additional level of federal income tax. This could be achieved by various means including applying a lower tax rate to dividends and capital gains on C corporation stock or strengthening the accumulated earnings tax.

Chairman Camp Weighs Linking Tax Reform to Raising the Debt Ceiling

There has been discussion in the press that Republican members of Congress would not agree to an increase in the federal debt ceiling without a commitment to tax reform by the Obama administration. For example, in May House Republicans met to discuss concessions to seek from the White House in return for agreeing to raise the federal debt ceiling.  Tax reform was mentioned as one of those concessions. Linking tax reform to an increase in the debt ceiling would enhance the odds for tax reform in the near term.

Currently, the federal debt ceiling is not expected to be reached until October. At that time Congress will have to pass a law to increase the federal government's borrowing capacity to avoid the federal government defaulting on its debts. In general, Republicans are loathe to do so, and they are looking for concessions from the Obama administration in exchange for agreeing to an increase. Sen. Baucus and the Secretary of the Treasury, Jacob J. Lew have insisted, however, that the debt ceiling should be raised through a “clean bill,” i.e., one without any linkage to tax reform.

To date, there has been no explicit linkage between an increase in the debt ceiling and tax reform on the part of Republicans. However it is clearly on the minds of some. The chairman of the House Ways and Means Committee, Rep. Dave Camp said in June that he would wait until after Congress’s August recess to decide whether to advocate such a linkage.

His decision will probably be influenced, at least in part, by his counterpart in the Senate, Sen. Baucus. The two are holding informal lunch meetings during the summer to discuss tax reform. Both men have a keen interest in seeing progress on tax reform in the near future, as each relinquishes his chairmanship at the end of the term. Sen. Baucus will retire from the Senate, and Rep. Camp will remain in Congress, but he must relinquish his chairmanship of the Ways and Means Committee under the rules of the House.

[1] The letter is available at: http://www.finance.senate.gov/imo/media/doc/06272013%20Call%20for%20Input%20on%20Tax%20Reform1.pdf.

[2] Types of Income and Business Entities, http://www.finance.senate.gov/issue/?id=0fb586fb-ba29-46ea-a194-df488e41b1bd.