White House Releases Skinny Budget and Postpones Tax Proposals
The White House released its fiscal 2018 skinny budget on March 16, 2017, which contained discretionary budget proposals but no tax proposals. A more complete budget that will address mandatory spending and tax policy is expected to be released in May. House Republicans have also delayed release of legislative language for their Blueprint for tax reform (Blueprint). A reduction in tax rates for business income is a cornerstone of both the Trump and House Republican plans, but the offsets that could be used to broaden the tax base remain uncertain. While businesses continue to wait for key details to emerge, Republicans have shifted their focus to the repeal and replacement of Obamacare. The American Health Care Act (AHCA) would repeal most (but not all) of the taxes imposed under Obamacare. The AHCA was approved by the House Ways and Means Committee on March 9th and the House Budget Committee on March 16th, but faces significant political and procedural hurdles in moving forward.
Proposal to Repeal Obamacare Taxes
If enacted, the AHCA would repeal the 3.8% net investment income tax, the 0.9% surcharge on wages above $250,000, the Sec. 162(m) limitations on executive compensation for health insurers, and the medical device tax for taxable years beginning in 2018. Some expected that these taxes would be repealed retroactively to the beginning of 2017. The inclusion of a 2018 effective date in this proposal indicates that a retroactive repeal of the taxes for 2017 is unlikely. Obamacare limitations on contributions to tax-preferred savings accounts and restrictions on a deduction for major medical expenses would also be repealed. The onset of the Cadillac tax on pricey health insurance plans would not be repealed, but would be further delayed until 2025. The penalty for failure to have health insurance would be repealed immediately and retroactively with respect to the 2016 penalty.
Lower Tax Rates for Business, But at What Cost?
President Trump has called for a top tax rate on business income of 15%, whether in corporate or pass-through form. The Blueprint provided for a top rate of 20% for corporations and 25% for active pass-through business income. Reasonable compensation of individuals would be subject to a top individual rate of 33%. Divergence of the top tax rates may be necessary because of the revenue cost of lowering top individual rates to match top business rates, but it creates many complexities. Crafting workable definitions of active pass-through business income and reasonable compensation is no small task. Will passive investors be taxed at individual or business rates? Is professional services income treated as business income or compensation? Many questions are being raised with respect to the pass-through business income proposal as well as the revenue raising provisions that might be part of tax reform.
The Blueprint modifies business income taxes to be border-adjustable, similar to the operation of a value-added tax (VAT). The border adjustment purports to address base erosion by imposing tax at the point of destination rather than based on the source of income. Products, services and intangibles that are exported will not be subject to U.S. tax (the income from exports is exempted), while those that are imported will be subject to U.S. tax regardless of where they are produced (the cost of imports is not deductible). Retailers and other net-importers have raised concerns that the border adjustment would result in price increases for consumers. Academic economists have suggested that currency values or prices would adjust to offset these effects. What are the ancillary consequences of either a 20-30% increase in the value of the dollar and/or price increases on consumers? Would net exporters who generate a tax loss under the cash flow tax receive a refundable tax credit or a credit against other taxes paid? Would a border adjustment curb aggressive tax planning by multinationals and promote jobs in America, or would it merely set the stage for new tax planning techniques? Trump indicated that border adjustments may be too complex, but he has not come out either for or against.
Deemed Repatriation Tax
The Blueprint includes a territorial tax system with a one-time deemed repatriation of previously untaxed foreign income at a tax rate of 8.75% for cash and 3.5% for other profits. Like the Blueprint, Trump proposed a one-time deemed repatriation tax (at a 10% discounted rate) and to end the deferral regime on corporate income earned abroad, but he has not voiced support for a territorial tax system.
Capital Expensing and the Deductibility of Net Interest Expense
The House Republican Blueprint shifts the taxation of business income to a consumption-based approach focused on business cash flow. A key element is to allow the cost of capital investment to be immediately expensed, but to couple expensing with a complete disallowance of a deduction for net interest expense (interest expense less interest income). Consumption-based taxes are widely regarded by economists as more pro-growth than income-based tax systems. This shift would dramatically impact the way most businesses are taxed, whether highly leveraged, capital-intensive, or both. Trump proposed to allow manufacturers to elect to immediately expense new business investments (and if elected, lose the deductibility of interest expense) but has not embraced the shift to a consumption-based approach in the Blueprint.
What are the Alternatives?
While Trump is firmly for lower tax rates, his position on offsetting revenue generating measures remains unclear. If he is not in favor of territorial, would he support a minimum tax for foreign earnings, similar to former President Obama’s proposal? Senate Republicans are largely reserving judgment on the Blueprint and some House Republicans may be wavering. A proposal akin to that made by former Ways and Means Committee Chairman Camp could be revived - it comes with legislative language that could be updated with relative ease. However, House Republicans made a deliberate move away from Camp’s proposal (stronger anti-base-erosion measures, longer cost recovery periods, continuing deductibility of net interest) in part because of weak economic growth estimates. Will the Blueprint fare better once official estimates are released? It appears that the wait will continue until more details are released in May.
Despite many obstacles, enactment of business tax reform is still at the top of the Republican agenda for 2017. Although details are scarce, businesses should take proactive measures to plan and prepare for likely changes, including lower tax rates and a deemed repatriation tax. Deferral of taxable income into a later period when a lower tax rate is in effect provides taxpayers with an opportunity to generate a permanent tax savings for items that typically would result only in a benefit via the time value of money. Business should consider implementing accounting method changes or elections that would defer income and accelerate deductions. Multinational business should also prepare for the imposition of a deemed repatriation tax. An earnings and profits (E&P) study should be considered for taxpayers who do not already have an accurate computation of foreign E&P. Changes in methods of accounting can also be made for purposes of a foreign corporation’s E&P and may reduce E&P subject to the deemed repatriation tax.