Republicans will have to show accomplishments when wooing constituents as they gear up for fall elections in 2018, so something on the tax front must happen. However, any radical reform of the tax system is increasingly unlikely, and the US may remain a jurisdiction with one of the highest corporate tax rates.
Kathleen Dale, principal, Washington National Tax, explained to NeuGroup’s Treasurers’ Group of Thirty (T30), meeting in New York in mid-May, that from a procedural standpoint, Congress must introduce a major reform bill by August, when members vacate Capitol Hill. Otherwise, the legislation will be competing with other issues, including ACA repeal and the budget resolution, and unless the legislation becomes law by the end of first quarter 2018, it will likely fall off the priority list as members of the House of Representatives and Senate gear up for elections.
“So the question becomes: Is it better to do something small or hold out for something bigger,” Ms. Dale said.
Ms. Dale added that “small” could mean components of the exploratory paper published by House Speaker Paul Ryan (R-WI) and Congressman Kevin Brady (R-TX), known as the “House Blueprint” which on the business side aims to increase competitiveness. The measures it proposes include reducing the corporate tax rate to 20%, capping the tax on active business income of owners of pass through entities at 25%, eliminating the deduction for net interest expenses and carrying these deductions forward indefinitely to offset future interest income, repealing the corporate AMT, and eliminating various unspecified “special interest” deductions.
On the international front, the Blueprint, which has not yet been submitted as legislation, would move to a destination-based and territorial tax system, with a 100% exemption for dividends received from foreign subsidiaries.
The Trump administration’s proposal drops the corporate rate even further, to 15%, but mentions few other measures, although it does support moving to a territorial system and taxing foreign earnings accumulated under the old tax system, at a rate to be determined with Congress. The Blueprint would require repatriation of foreign earnings under the old system by paying a tax of 8.75% on cash or cash-equivalent holdings and 3.5% otherwise, payable in installments over eight years.
The Blueprint would fundamentally revamp the current corporate and individual tax systems, eliminating the corporate income tax completely and instituting a destination-based cash flow tax, in the form of a “border adjustable tax” (BAT). It would tax imports and leave exports of US companies untaxed. The BAT is intended to pay for a proposed corporate rate reduction to 20% from the current 35% rate.
The BAT has faced significant resistance from larger importers, since they would be fully taxable on their sales income without being able to deduct any of the cost, and the Senate has suggested it won’t include a BAT in its bill.
Nevertheless, the initial fear of BAT may subside as companies think through the implications for the broader economy, Ms. Dale said, adding that big importers are already rethinking how they could restructure their businesses to accommodate this change.
Republicans will most likely seek to pass the bill in the budget reconciliation process, where only 51 votes are needed instead of the 60 to overcome an almost certain Democratic filibuster. To do so, however, the law must be revenue neutral, or it will expire in 10 years. Some House members have been supportive of that approach, essentially taking the chance that the law’s impact will have been positive enough to warrant voting on a more permanent version.
Another controversial component of the House Bueprint is the elimination of interest expense, given the impact it would have on corporate funding. Both measures each raise approximately $1 trillion in revenue and are necessary to lower the corporate rate to 20% while remaining revenue neutral.
If Congress decides to pursue the revenue neutral path but is unable to find sufficient lawmaker support for the BAT, more traditional tax reform may be in the offing, such as less extreme versions of the rate cut and the elimination of various preference items. Ms. Dale said corporates are applying significant pressure to repatriate stranded cash, making that measure a very likely component of any tax reform. Territoriality is also key, to make companies more competitive with foreign competitors and to avoid the cycle of companies building up cash overseas to wait for another repatriation amnesty.
Eliminating the interest deduction has also aroused opposition, given many business strategies are based on leverage, as is much of Wall Street’s revenue. Ms. Dale noted that the interest-expense component, like Section 385 inversion rules issued last year, are designed to neutralize the decision companies make when choosing debt or equity, by eliminating debt as a tax-favored form of financing.
“So the question is, to what extent would eliminating interest expense impact how your company funds itself, and what would your financing structure look like,” Ms. Dale said.