The Obama Administration Moves on Business Tax Changes
The topic of tax reform made the news on Monday as the Obama Administration simultaneously took regulatory steps to further limit corporate inversions and released an update to its 2012 Framework for Business Tax Reform. The inversion regulations make it more difficult for companies to move their headquarters abroad, while the tax proposal offers the Administration's views on an area that has potential for bipartisan compromise.
For companies with a tax residence in the United States, the federal government currently taxes the active income they earn abroad when it is repatriated to the U.S., and taxes passive (financial income) in the year it is earned. An inversion involves a large U.S. company acquiring a smaller foreign company and then moving its tax residence abroad to avoid taxation. Current anti-inversion rules consider a business a U.S. company for tax purposes if at least 80 percent of it is owned by U.S. shareholders, thus when inverting, companies will work to ensure that there is at least 20 percent foreign ownership in the resulting company. Rules issued by the Obama Administration in 2014 and last year limit the ability of companies to game the 80 percent threshold and limit the ability of inverted companies to repatriate income tax-free.
The rules released this week take additional steps to discourage inversions. The first rule restricts a foreign company from gaming the 80 percent shareholder rule by acquiring multiple U.S. companies in quick succession; specifically, the rule disregards a foreign company's acquisition of any U.S. stock in the past three years from the threshold calculation. Presumably, this rule targets recently inverted companies that use their increasingly larger size to quickly invert larger U.S. companies.
The second rule addresses "earnings stripping," a technique inverted companies use to lower federal tax obligations by having the U.S. company borrow from a related foreign company and pay tax-deductible interest payments to the related company. The rules related to earnings stripping would consider any debt-related distribution to the foreign company non-deductible stock, as long as the debt is not associated with actual business investment in the U.S. The rule would also allow the IRS to treat a debt instrument as part-debt and part-equity if appropriate.
The accompanying Framework for Business Tax Reform notes that current tax regulations are inadequate to wholly address the issue of inversions, and the President's budget proposes further policies to lower the U.S. shareholder threshold to 50 percent as well as limit interest deductions. The Framework also acknowledges other issues with business taxation beyond inversions like the high statutory tax rate; distortions among industries, debt and equity, and types of business organizations; a narrow tax base; and complexity.
The new Framework includes much of the same discussion and analysis as the 2012 Framework but incorporates new policies that the President has since proposed (particularly the fleshing out of international tax changes) and other new developments. The President's budget already includes several changes to the international tax system, including a 19 percent minimum tax on foreign income, and the elimination of several business tax expenditures to finance other business tax breaks and raise $460 billion of revenue according to the Congressional Budget Office. It also includes a 14 percent "deemed repatriation" tax on all foreign-held income that would be used to fund the Highway Trust Fund.
|Budgetary Effect of Policies in President's Budget/Framework|
|Policy||Ten-Year Savings/Cost (-)|
|International tax changes||$432 billion|
|Small business tax breaks||-$62 billion|
|Manufacturing, research, and clean energy tax breaks||-$96 billion|
|Regional growth tax breaks||-$12 billion|
|Infrastructure tax breaks||-$14 billion|
|Fossil fuel tax preference eliminations||$41 billion|
|Financial and insurance tax changes||$29 billion|
|LIFO elimination||$107 billion|
|Other changes||$35 billion|
|Total, Revenue From Business Tax Reform||$460 billion|
|14% deemed repatriation tax||$195 billion|
|Total, President's Budget Policies||$655 billion|
|Additional Framework Policies|
|Reduce corporate tax rate to 28%||-$700 billion|
|Lengthen depreciation schedules||Unknown|
|Reduce interest deductions||Unknown|
Sources: Joint Committee on Taxation, Congressional Budget Office
In addition to these policies, the Framework proposes to lower the corporate tax rate from 35 to 28 percent and finance it by lengthening depreciation schedules and reducing interest deductions (perhaps by "haircutting" them). Lowering the corporate tax rate would cost about $700 billion over ten years, and the Framework states that it would target revenue increases to pay for last year's tax deal so presumably the depreciation and interest changes would be large enough to offset the rate cut; in the 2010 Wyden-Gregg tax reform bill, for example, depreciation and interest changes raised $730 billion.
The Framework also discusses innovation boxes, which would tax income from patents or other intellectual property at a lower rate to encourage companies to keep IP in the country. This policy has attracted the attention of the congressional tax-writing committees and has been seen as a potential area for action. However, the Administration criticizes that policy as providing a costly windfall to already-existing IP, not being particularly effective in promoting innovation, and adding complexity and chances for gaming. It sees the R&E credit, made permanent last year, and the budget's international tax changes as better solutions.
The inversion regulations take on a narrow part of our tax system, while the Framework provides a broader look at what is needed to improve business taxation. Whether lawmakers can find common ground this year on taxes remains to be seen, but it is important that they do. As CRFB president Maya MacGuineas has said, "The best way to stop inversions is to enact comprehensive tax reform."