There is a mounting interest in Congress, the business community and the Administration to revise the corporate income tax. The marginal rate is the highest in the world and international competition is driving the possibility of an update. In addition, policy makers are searching for any and all ways to help the lagging economy. However, the issue is very complicated and unlike the individual tax side, the choices are diverse.
Three broad areas have emerged to form a triangle of reform. The first is the reduction of the corporate income tax rate. In conjunction with lowering the tax rate, the second leg how to minimize the loss of revenue to the government by examining the makeup of income and the associated reduction or eliminating “tax expenditures”. Reduction of such expenditures is also seen as promoting tax simplification and reducing the importance of tax considerations in business decision-making. Lastly, as the third side of the triangle, there is the basis on which the United States taxes multinational corporations.
By way of background, C corporations are taxed at statutory rates ranging from 15 percent to 35 percent.
Certain domestic production activities are effectively taxed at lower rates by virtue of a deduction equal to a percentage of the income from such activities. The deduction is equal to nine percent of the income from manufacturing, construction, and certain other activities specified by statute Thus, generally the maximum tax rate for a C corporation on its domestic production activities income is effectively 31.85 percent.
The United States employs a worldwide tax system, meaning that American companies are taxed on their U.S. profits, taxed abroad on their foreign profits, and then taxed again when those foreign profits are brought back home. By contrast, virtually all foreign companies are taxed under a territorial system in which they pay taxes on their home country profits in their home country and on their foreign profits in the foreign country. Foreign profits are not taxed a second time when they are brought back home. Thus, the double taxation of foreign profits is avoided.
To offset the advantage of a territorial tax system and to help level the playing field between American worldwide companies and their foreign competitors, the U.S. government employs a system of tax credits and tax deferral. Deferral, which has been in the Internal Revenue Code in various forms since the 1960’s, allows U.S. companies to delay paying tax on foreign earnings until that income is repatriated.
Link as follows: http://waysandmeans.house.gov/taxreform/
The centerpiece is a reduction of the highest marginal rate to 25 %. The provision maintains the present law 15-percent corporate tax rate for taxable income not in excess of $50,000. For a corporation with taxable income in excess of $100,000, the benefit of the 15-percent rate is eventually recaptured.
This rate reduction would be accomplished without increasing the deficit by broadening the tax base. In typical Washington fashion, the necessary base-broadening provisions are not included in the discussion draft.
In addition the discussion draft specifics a number of changes in international taxes as follows:
- A deduction equal to 95% of foreign-source dividends received by a 10% U.S. corporate shareholder from a controlled foreign corporation (CFC). In addition, 95% of capital gains from the sale of shares in a CFC by a 10% corporate shareholder would be excluded from income, as long as a one-year holding period requirement is met and at least 70% of the assets in the CFC are used in the active conduct of a trade or business.
- Initiate a transition rule that would apply a 5.25% tax to all existing foreign earnings currently held offshore, whether or not such earnings are repatriated. Taxpayers could use a ratable portion of their foreign tax credit carryovers to further reduce the 5.25% tax. In addition, they could elect to pay this tax in up to eight annual installments. Once paid, such earnings would benefit from the 95% exemption if brought back to the United States as a dividend.
In essence the proposals shifts from a worldwide system of taxation to a territorial-based system because as explained above the current high U.S. rates have the effect of penalizing those U.S. corporations that bring their foreign profits back. These changes are designed to free up existing overseas earnings in order to facilitate reinvestment domestically after they are taxed at a low rate
In contrast to Chairman Camp’s outline, the Department of Treasury and the White House released in February a “framework“ of proposals to reform the corporate tax system. The details are not complete but there are a few good suggestions. The centerpiece is a cut in the top corporate rate - now at 35 percent to 28 percent. The proposal suggests broadening the income base, also a good suggestion and, sensitive to the fact budget deficits have been more than $1 trillion a year, the plan crows it will not "add a dime to the deficit."
A Link to the plan is as follows: http://www.treasury.gov/resource-center/tax-policy/Documents/The-Presidents-Framework-for-Business-Tax-Reform-02-22-2012.pdf
The proposal provides special tax treatment for manufacturing - cutting that tax rate to 25 percent - and a minimum tax on profits earned in abroad.
The plan calls for the elimination dozens of business tax preference and tax expenditures starting with “a presumption (to)..eliminate(s) all tax expenditures for specific industries, with the few exceptions that are critical to broader growth or fairness.”
Here are the examples of specific reductions in tax expenditures and loophole closers:
- Eliminate “last in first out” accounting
- Eliminate oil and gas tax preferences
- Reform treatment of insurance industry and products-
- Taxing carried (profits) interests as ordinary income for financial managers (not a corporate issue)
- Eliminate special depreciation rules for corporate purchases of aircraft
While details are incomplete, the framework also focuses on manufacturing, however that is defined, by giving a preferential tax rate, pouring more subsidies for research and development and the production of clean energy. This would seem to be in direct conflict with the stated principals stated in the framework of “eliminating significant distortions that can result in a less efficient allocation of capital, reducing the productive capacity of the economy and U.S. living standards.”
Finally, the framework goes after multinational corporations. No doubt, the taxation of these behemoths deserves review. As stated, the current U.S. tax system subjects foreign subsidiaries of U.S.-based multinationals to taxes on their overseas income offset by foreign tax credits. However, corporations are not required to pay taxes in the United States on that income until repatriated back to the U.S., a principal called a deferral (since it defers taxation of the income). Under the President’s proposal, income earned abroad would be subject to a minimum rate of tax and the benefits of deferral curtailed, if not eliminated.
The approach conflicts with many business leaders, economists and House Ways and Means Chairman Dave Camp that favor revamping the system from a worldwide tax system to a territorial one. The Administration opposes any shift to a territorial based system and this issue will be strongly debated and contested.
There are other items of interest such as a proposal to deny deductibility of interest, the differing treatment of debt and equity and the use of depreciation.
Corporate income taxes are only the third largest source of revenue for the government. Increasingly businesses have been organizing into pass-through entities such as partnerships Limited Liability Companies (LLC) and Subchapter S. Even so in corporate tax reform, the stakes are very high; the impact enormous, will be hotly contested and will have a huge financial impact on many organizations.
The current focus on taxes is the year-end expiring tax provisions, affectionately referred to in a lump fashion as the “fiscal cliff”. While there are provisions effecting corporations, the bulk involves individual taxation and rates and there will not be any fundamental changes in the tax structure in the short term. Until the situation clears up it is unlikely corporate tax reform will proceed in any meaningful fashion. Because of the complexity and different approaches of the Republican controlled House and the Administration and the Senate, it is difficult to see individual and the corporate taxes being linked into one giant revision. However, it is also clear that anything is possible given the state of the economy and the political landscape.