United States: As Election Season Looms, Congress Sets Stage For Future Tax Reforms

Congress is working on a handful of significant tax issues that could prove very important for tax reform in 2017 and 2018.

Following the passage of the Bipartisan Budget Act of 2015, which reformed partnership audit procedures, and the Protecting Americans from Tax Hikes (PATH) Act of 2015, which made permanent nearly two dozen otherwise temporary tax provisions, Congress has continued its efforts to enact meaningful tax reform.

Tax writers in both the House Ways and Means Committee and the Senate Finance Committee have held hearings and introduced proposals on various aspects of reform, including corporate integration, a business equivalency rate, value-added and consumption taxes, and an intellectual property (IP) box, as well as modifications to how financial products and instruments are taxed and how depreciation should be calculated.

Given the presidential election in November and ongoing re-election campaigns, there is little hope for any type of reform in the 2016 calendar year. Congress still must reauthorize aviation taxes by July 15 and has discussed extending the alternative energy incentives left off of last year's PATH Act. Ways and Means Committee Chair Kevin Brady, R-Texas, has also discussed trying to move a package of noncontroversial bills by regular order, but little other tax legislation is expected.

However, ideas discussed today are likely to serve as a basis for future legislative action. One of the most significant potential proposals could come in the form of a tax reform blueprint from Brady and the Ways and Means Committee. House Speaker Paul Ryan, R-Wis., assigned the blueprint as part of a series of task forces. The task forces are supposed to issue reports before the Republican convention. So far, Brady has offered few hints at what his blueprint will include.

The outcome of the presidential election will also have significantly affect what happens in tax legislation next year. See our side-by-side comparison of the tax platforms of the presidential candidates for a full analysis.

Corporate integration
Senate Finance Committee Chair Orrin Hatch, R-Utah, is working on a proposal to integrate taxes on corporate earnings. The goal is to remove the double tax on earnings distributed as dividends and create parity between debt and equity financing.

The proposal is expected to allow corporations to deduct dividends paid to shareholders against their corporate tax. In exchange, a 35% nonrefundable withholding tax would be imposed not only on dividends, but also on interest payments on corporate debt.

The proposal would end the separate imposition of taxes at both the entity and investor level, but it is raising objections from tax-exempt investors like pension funds and higher education endowments. Tax-exempt organizations generally pay no tax on dividend income, so corporate earnings distributed to them already face only a single layer of tax at the entity level. In addition, interest is already deductible at the corporate level and is tax-free for tax-exempt investors, so the new 35% nonrefundable withholding represents a tax increase on the bond income of tax-exempt shareholders. Tax-exempt organizations are also arguing that treating taxable and tax-exempt shareholders the same will undermine incentives for investing through tax-free retirement accounts.

So far, Democrats appear to be backing tax-exempt investors and are not expected to embrace the Hatch proposal. Hatch said preliminary estimates show that the proposal will raise revenue, and he pledged to tweak it to address objections. The proposal is expected in June. House Republicans have been quiet on the issue, and are instead focused on crafting their own tax reform blueprint.

Equal rates for all businesses
Comprehensive tax reform to lower individual tax rates along with corporate tax rates appears unlikely so long as Democrats hold a check on the balance of power in the presidency. The repeal of the Bush-era tax cuts in 2013, which pushed the highest marginal rate on individual income to 39.6%, was a legislative victory for President Obama and congressional Democrats. Returning to a lower rate appears difficult, if not impossible, while Democrats hold the presidency or can successfully filibuster such legislation in the Senate.

An alternative efforts to lower corporate tax rates has been unable to overcome the concerns of pass-through businesses. Pass-throughs are concerned that a corporate rate cut, combined with base-broadening provisions that would eliminate existing tax benefits for all businesses, would result in a tax increase for their businesses, exacerbating an existing rate disparity.

Grant Thornton LLP has long advocated for a business equivalency rate (BER) that would allow owners of pass-through businesses to apply the lower, corporate tax rate to qualified active business income, so that business income would be taxed at equivalent rates, no matter the form of the business itself. In May, Rep. Vern Buchanan, R-Fla., introduced the Main Street Fairness Act, which would help to close the existing rate gap between corporations and pass-throughs, and which could expand if Congress lowers corporate tax rates.

If Congress cannot come to agreement on comprehensive tax reform, a BER may very well be a mechanism to provide equal treatment to pass-through businesses in the event of tax reform that lowers the corporate tax rate.

VATs and consumption taxes
Value-added taxes (VATs) and other types of consumption tax have long been anathema to lawmakers on both sides of the aisle. Republicans have derided such taxes as a means to both expand the size of government and raise taxes through increased revenue collection, and Democrats have criticized them as being over regressive. Nonetheless, a significant reduction in the top corporate tax rate would be costly, and a VAT, or more likely a business transfer tax that would resemble a VAT, could offset the loss in revenue, according to some lawmakers.

Senate tax writer Benjamin L. Cardin, D-Md., has long advocated for a VAT, arguing that a 10% consumption tax could keep revenue levels the same, while achieving the goal of lower, more competitive business tax rates. Sen. Ted Cruz, R-Texas, ran for the Republican nomination for president on a platform of repealing the corporate income tax and replacing it with a 16% flat tax on net business sales, which many characterized as having the same effect as a VAT.

A VAT and other consumption taxes, such as a carbon tax, have been offered up as tax reform proposals by various members of Congress, but support will likely not come easily, especially from House and Senate leadership. Such taxes remain politically controversial. Yet, for a Congress seeking to lower business tax rates while keeping the deficit in check, a VAT or some other type of consumption tax is likely to continue to play a role in the debate.

IP box and international tax reform
The tax-writing committees have examined the idea of international-only reform over the past two years as the prospects for business tax reform dwindled. The general plan would be to pair a territorial tax system with a one-time transition tax on unrepatriated earnings, and reduce the rate on intellectual property income as a stand-in for a broader rate cut.

Republicans and Democrats discussed tying international reform to transportation spending, but ultimately couldn't get a deal done. Legislation is unlikely this year, but corporate inversions and the base erosion and profit shifting (BEPS) initiative continue to make international reform a hot topic. Republicans on the Ways and Means Committee remain interested and have discussed releasing an international-only discussion draft.

Rep. Charles Boustany, R-La., is one of the leaders in this effort, and his innovation box discussion draft from last year (with Rep. Richard Neal, D-Mass.) remains the most current proposal. That bill would allow a 71% deduction on innovation box profits, which would include profits from the sale of any property using qualifying IP, and qualifying IP would be defined broadly to include patents, inventions, formulas, processes, designs, patterns, know-how, computer software, movies and video.

Innovation box profits would be reduced by the ratio of domestic research and development expenses to all expenses over the past five years (other than cost of sales, interest and taxes). It represents a sharp break from Boustany's earlier proposals. The previous version applied only to income associated with patents, required the patent to contribute a substantial portion of the value and reduced the qualified profits based on a "routine return." The new version applies to such a broad definition of IP that almost any product would qualify, but it does not extend the benefit to service income and pass-throughs, and is sharply limited based on research expenses.

The new version was not well-received by the business community, and Boustany is refining it. He has acknowledged, however, that the international reform effort is taking a backseat to the tax reform blueprint the Ways and Means Committee is working on, and he said it's possible an IP box won't be needed if corporate rates can be addressed directly.

Pooling of depreciation
Senate Finance Committee ranking minority member Ron Wyden, D-Ore., has unveiled a proposal that would replace current depreciation rules with a very different, pooled asset, approach. The proposal was released as a discussion draft and follows the same general approach that former Senate Finance Committee Chair Max Baucus, D-Mont., used in a 2013 tax reform proposal. Unlike Baucus' draft, which was designed to raise revenue for tax reform, Wyden's proposal is revenue neutral.

The Wyden draft would replace the modified accelerated cost recovery system (MACRS) with a new pooling recovery system. Taxpayers would no longer track depreciation schedules on an asset-by-asset basis. Instead, they would pool property into six separate categories and deduct a designated percentage of the total amount in each pool annually. The percentages are designed to be revenue neutral and produce a depreciation deduction with a current value roughly equivalent to current MACRS depreciation:

  • 3-year property: 49%
  • 5-year property: 34%
  • 7-year property: 25%
  • 10-year property: 18%
  • 15-year property: 11%
  • 20-year property: 8%

The pool balance would be calculated by adding the cost basis of any new assets to the beginning balance and subtracting any sale proceeds. Taxpayers would then deduct the designated percentage of the pool balance and carry over the remainder. For more details, see Tax Hot Topics.

Wyden says he hopes the pooled approach can provide a simpler calculation and eliminate the need for the midyear convention and asset-by-asset tracking. But the transition could be disruptive, and taxpayers who already track assets on an individual basis for financial accounting would no longer simply adjust these figures for tax purposes. The draft is meant to be considered as part of possible tax reform in the next Congress and will become more important if Democrats retake the Senate in November.

Financial products taxation
Wyden has also released a discussion draft that would require taxpayers to mark-to-market derivatives. The proposal builds on a discussion draft released in 2013 by former Ways and Means Committee Chair Dave Camp, R-Mich., but with several changes intended to address issues raised by the Camp draft.

At its heart, Wyden's bill would generally require derivatives, and their underlying investments, to be reported on a mark-to-market basis annually, with all resulting mark-to-market gain or loss ordinary. In effect, it would expand the mark-to-market treatment under Sections 475 and 1256 to nearly all derivatives, while denying the 60-40 split of capital gains and losses available for Section 1256 contracts. Taxpayers would be allowed to rely on book valuations of derivatives for tax purposes. As in Camp's version, the definition of derivatives under the proposal is intended to be broad and would cover any contract, futures contract, short position, swap or similar instrument.

Wyden's draft adds several new carve-outs and would create a new regime to cover the hedging of capital assets. See Tax Hot Topics for more detailed information. Like Wyden's draft on depreciation, this proposal is meant to set the table for potential tax reform next year and will be more meaningful if Democrats retake the Senate. But the proposal on derivatives could also gain traction outside of tax reform. The Joint Committee on Taxation estimated the bill would raise $16.5 billion over 10 years, making it an attractive revenue raiser with support in both parties. The original version was proposed by a Republican lawmaker, and the president has supported the idea in his last several budget requests.

IRS budget and operations
The ongoing political battle over the IRS's funding and leadership will likely continue so long as Republicans control Congress. The IRS has been under continual fire from House and Senate Republicans over the revelations in 2013 that the agency's Tax-Exempt and Government Entities Division singled out for additional scrutiny certain conservative groups seeking Section 501(c)(4) exemptions.

Congress has held numerous hearings on the subject and has demanded emails and other documents related to the scandal. IRS Commissioner John Koskinen has been a target of lawmakers, who have argued that he misled Congress during the discovery process. House Oversight and Government Reform Committee Chair Jason Chaffetz, R-Utah, introduced a resolution to impeach Koskinen, an unprecedented measure that signals Republicans' distaste for the agency and its head.

Meanwhile, Congress has repeatedly cut the IRS's budget, which has gone from approximately $13.4 billion in 2010 to $10.9 billion in 2015. Such cuts have created challenges for both taxpayer services and tax administration in an era in which the IRS has been tasked with implementing major initiatives, including the Affordable Care Act. The IRS is unlikely to see a significant budget increase while the government remains divided.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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