Ryan Kenny, Associate Member, University of Cincinnati Law Review
On June 24, 2016, House Speaker Paul Ryan (R-WIS) and Kevin Brady (R-TX), Chairman of the Ways and Means Committee, released a Blueprint outlining their proposed tax reform. The Blueprint is titled A Better Way: Our Vision for a Confident America (Blueprint).[1] The Blueprint details proposed reforms to the tax system, for individual taxation, pass-through entity taxation (such as partnerships and LLCs), and corporate taxation.[2] The individual and pass-through entity tax reform proposal consist primarily of reductions in the top marginal tax rates, and the reduction of the current seven-tax-bracket system for individual taxation, into a three-tax-bracket system.[3] Pass-through entities would have a top marginal rate of 25%.[4] Furthermore, the capital gains tax rate will match ordinary income rates, rather than the current special rates in the Internal Revenue Code (Code) §1(h).[5] However, the changes to corporate taxation are the most seismic. Not only are the top marginal rates reduced for corporations, but the underlying theories on U.S. jurisdiction to tax corporate incomes is set to change dramatically under the proposed reform. It is important to understand how corporations are currently taxed in the United States under federal income tax law. Then, the changes proposed in the Blueprint will be explained to show the changes. Any possible economic repercussions are beyond the scope of this analysis. This analysis will only cover corporations that are incorporated under state law in the United States, not foreign resident and nonresident corporations.
I. The Blueprint Will Significantly Change Corporate Income Taxation, Capital Expenditure Depreciation, and U.S. Taxation of Foreign-Earned Income.
There are three main areas of corporate taxation that are getting an overhaul in the Blueprint: top marginal rates, capital expenditure deductions, and foreign-sourced income.[6] A comparison of the current tax regime and the proposed changes in the Blueprint demonstrates the significance of Ryan’s and Brady’s tax reform.
A. The Blueprint Will Lower and Simplify the Current Corporate Taxation Paradigm.
Currently, there are four tax brackets imposed on corporations based upon the size of the individual corporation’s taxable income.[7] Taxable income is gross income less any above-the-line deductions, such as Internal Revenue Code (Code) §162 trade or business expenses.[8] The first $50,000 of taxable income is taxed at a rate of 15%; taxable income between $50,000 and $75,000 is taxed at 25%; taxable income between $75,000 and $10 million is taxed at 34%; and any income over $10 million is taxed at 35%.[9] Additionally, Code §11 states that for income above $100,000, the tax liability is increased by the lesser of the following: 5% of the amount over $100,000, or a flat amount of $11,750; for income above $15 million, the amount is increased by the lesser of the following: 3% of the amount over $15 million, or a flat amount of $100,000.[10]
The Blueprint aims to streamline this process significantly by imposing a flat 20% tax on all corporate income.[11] Across the board, this would be the largest tax cut for corporations in United States history.[12] More importantly, it reflects a long-held goal of the Republicans to simplify the corporate tax code. This simplification is also evident in the individual tax reform in the Blueprint, with the goal of making an individual “postcard” tax filing.[13] Not only would this pose significant tax savings for corporations, but would also reduce compliance costs. The IRS estimates that a business’s tax returns will cost about $420 each, an estimate compliance cost of $4.4 billion.[14] The IRS estimate only includes the cost of filing, and excludes other compliance costs, such as audits and legal research.[15] In 2016, the estimated total cost of business income tax was about $234.4 billion in economic loss.[16] While any estimates on the Blueprint’s compliance savings are simply speculation, if implemented into law, the compliance savings for corporations could be significant.
B. Corporations Would be able to Fully Deduct Capital Expenditures, Rather than Depreciate Over Time.
A capital expenditure is any tangible property that a corporation purchases that it will use in the carrying-on of its trade or business or for the production of income that is subject to wear and tear.[17] Additionally, a capital expenditure is limited to new buildings or permanent improvements that increase the value of property on which it is located.[18] These types of expenditures cannot be fully deducted in the year in which they are purchased, but rather must be deducted over a period of time, known as depreciation.[19] The underlying policy behind this tax treatment is that these types of assets provide benefits over the course of several years, and therefore are not simply an up-front cost.[20]
For example, Corporation A has gross income of $100, and bought a piece of qualified technological equipment for $70, which has a 5-year recovery period Under current tax law, Corporation A’s yearly deductions would be as follows: Year 1, $14; Year 2, $22.40; Year 3, $13.44; Year 4, $8.06; Year 5, $8,06; Year 6, $4.03.[21] Thus, for year 1, Corporation A’s tax liability would be $86.
Unlike capital expenditure deductions, most trade or business expenses are fully deductible in the year the expense was incurred under Code §162. This is because, unlike capital expenditures, the value of these expenses rarely extend beyond a short time period, and more importantly, are not property or tangible expenses. Rather, they can include expenses from interest paid on a loan,[22] or compensation paid to its employees.[23]
The Blueprint would essentially treat capital expenditure depreciation no differently than any other trade or business expense. First, the cost associated with calculating and filing Form 4562 for deductions is about $46 billion.[24] The Blueprint would greatly reduce, or possibly completely eradicate, this compliance cost. Second, the total tax liability for corporations under the proposed changes could be dramatically reduced for the years a corporation buys a capital expenditure. This would be especially true for industries with significant capital expenditures, such as the construction and manufacturing sectors. Going back to Corporation A above, under the proposed rules in the Blueprint, Corporation A’s Year 1 tax liability would be $30, and no subsequent deductions would be available on the same property in any following year. Therefore, the tax savings for corporations that have high equipment costs could be significantly reduced under the proposed changes in the Blueprint.
C. The Destination-Based Jurisdiction in the Blueprint Would Only Tax Corporations if the Place-of-Purchase is in the Territorial United States.
There are several international law theories that explain different forms of tax jurisdiction for nations: nationality, domicile or residence, presence or doing business in the country, and property or transactions within the country.[25] The United States uses a nationality standard for taxation of international transactions.[26] The general theory is that a U.S. national reaps the benefits of being a U.S. national, no matter where they are located or where their dealings take place.[27] This effectively establishes a worldwide-tax jurisdiction that taxes U.S. nationals on their total worldwide income, regardless of where the income was actually earned.[28] This same rationale is applied to U.S. corporations. A U.S. corporation is any corporation which is organized under the laws of the United States, any individual state, or the District of Columbia.[29] So a corporation that is organized in Delaware will owe taxes on income earned both in any territory of the United States, and any other nation in the world.[30]
The Blueprint would essentially change the taxing jurisdiction on corporate income that has been in place since the Civil War.[31] The Blueprint would shift the United States closer to a territorial tax system. Under a territorial tax regime, a country will only tax transactions that occur within its borders.[32] Therefore, if Corporation A is organized under the laws of Country A, it will pay tax on any transactions within Country A, but would not pay tax on profits earned in Country B, even after those profits are repatriated into Country A. In the Blueprint, this means that U.S. corporations with operations overseas will no longer have any tax liability for those profits, a dramatic shift in the current tax regime which has been in place for over one hundred and fifty years. Additionally, the Blueprint will have a border adjustment with the tax. For example, if Corporation A makes widgets at a production cost of $5 per widget, and then sells the widgets overseas for $10, Corporation A will not pay tax on the $5 of gain on the sale of the widgets, but will also be able to deduct the $5 production cost to offset U.S.-based income.[33] However, if Corporation A is a retailer who imports clothes from overseas at a cost of $100, Corporation A will not be able to deduct the cost of the clothes, but will also have to pay tax on the sale of those clothes here in the United States.[34] This embodies the principle of a destination-based cash flow tax: “that the tax is levied based on where the good ends up (destination), rather than where it was produced (origin).”[35] Thus, the destination-based cash flow tax in the Blueprint can be understood as a consumption tax, where the tax is levied where the final product or services is actually consumed, rather than where the producing or selling corporation resides.[36]
II. Conclusion.
The changes posed in Paul Ryan’s and Kevin Brady’s tax reform Blueprint are significant indeed but face challenges before enactment. First, most calculations show the plan will significantly reduce government revenues over the next decade by as much as $2.4 trillion.[37] Therefore, the implementation of the Blueprint must be coupled with significant reductions in government expenses. A plan to reduce government expenses will likely cause a significant political battle on the Hill, which is already plagued with partisan intransigence.
Second, there is legitimate concern that the border adjustment portion of the Blueprint will violate World Trade Organization (WTO) rules. The WTO “has never allowed a direct tax to be border adjustable . . . .”[38] Net importers impacted by the non-deduction on imports and taxation on income will argue that they are unfairly burdened for U.S. tax revenue over net exporters. Moreover, foreign entities may feel that the Blueprint disadvantages foreign competitors in the United States, while giving American firms an unfair advantage when doing business in other nations.
Finally, there is likely going to be significant political opposition in Congress and in the White House. The corporate tax breaks and subsequent loss of revenues is unlikely to gain support from Democrats in Congress, and President Donald Trump has also expressed skepticism for the Blueprint for being “too complicated.”[39]
[1] Paul Ryan and Kevin Brady, A Better Way: Our Vision for a Confident America, (June 24, 2016) (http://abetterway.speaker.gov/_assets/pdf/ABetterWay-Tax-PolicyPaper.pdf).
[2] Id.
[3] Id. at 17; the plan combines the 10% and 15% brackets into a spectrum of 0% to 12% bracket (depending on the available credits), the 25% and 28% will be combined into a single 25% tax bracket, and the 33%, 35%, and 39.6% brackets are combined into a single 33% bracket.
[4] Id. at 23
[5] Id. at 18; the rates on these forms of income are also reduced to three brackets of 6%, 12.5%, and 16.5%
[6] Id. at 23 – 27.
[7] I.R.C. §11
[8] What is Taxable Income?, Internal Revenue Service (https://www.irs.com/articles/what-is-taxable-income-2).
[9] I.R.C. §11(b)(1).
[10] I.R.C. §11(b).
[11] Ryan and Brady, 25.
[12] Id.
[13] Id. at 18.
[14] Joshua D. McCaherty, The Cost of Tax Compliance, Tax Foundation (Sept. 11, 2014) (https://taxfoundation.org/cost-tax-compliance)
[15] Id.
[16] Demian Brady, Tax Complexity 2016: The Increasing Compliance Burdens of the Tax Code, National Taxpayers Union Foundation (Apr. 6, 2016) (http://www.ntu.org/foundation/detail/tax-complexity-2016-the-increasing-compliance-burdens-of-the-tax-code).
[17] I.R.C. §167(a).
[18] I.R.C. §263(a)(1)
[19] I.R.C. §168
[20] Internal Revenue Service, Pub. 946, 2015 WL 10322099.
[21] I.R.C. §§168(e)(3)(B)(iv), (c); Revenue Procedure 87-57 1987-2 C.B. 687, Table 1.
[22] I.R.C. §163.
[23] I.R.C. §162(a)(1).
[24] Scott A. Hodge, The Compliance Costs of IRS Regulations, Tax Foundation (June 15, 2016) (https://taxfoundation.org/compliance-costs-irs-regulations)
[25] Gustafson, Peroni, and Pugh, Taxation of International Transactions, 16-17 (4th ed. 2011).
[26] See generally Cook v. Tait, 265 U.S. 47 (1924).
[27] Id.
[28] Supra Note 24.
[29] I.R.C. §7701(a)(4).
[30] There is a Foreign Income Tax Credit under I.R.C. §901 that matches dollar-for-dollar the taxes already paid to a foreign government.
[31] Ryan and Brady, 15.
[32] Philip Dittmer, A Global Perspective on Territorial Taxation, Tax Foundation (Aug. 10, 2012) (https://taxfoundation.org/global-perspective-territorial-taxation).
[33] Kyle Pomerleau and Stephen J. Entin, The House GOP’s Destination-Based Cash Flow Tax Explained, Tax Foundation (June 30, 2016) (https://taxfoundation.org/house-gop-s-destination-based-cash-flow-tax-explained/).
[34] Id.
[35] Id.
[36] Len Burman and William G. Gale, The Pros and Cons of a Consumption Tax, Brookings Institute (Mar. 3, 2005) (https://www.brookings.edu/on-the-record/the-pros-and-cons-of-a-consumption-tax/).
[37] Kyle Pomerleau, Details and Analysis of the 2016 House Republican Tax Reform Plan, Tax Foundation Fiscal Fact No. 516 (July, 2016) (https://files.taxfoundation.org/legacy/docs/TaxFoundation_FF516.pdf).
[38] Brian Garst, Political and Economic Risks of a Destination-Based Cash Flow Tax, Center for Freedom and Prosperity (Jan. 2017) (http://freedomandprosperity.org/2017/publications/political-and-economic-risks-of-a-destination-based-cash-flow-tax/).
[39] Richard Rubin and Peter Nicholas, Donald Trump Warns on House Republican Tax Plan, The Wall Street Journal (Jan. 16, 2017) (http://www.wsj.com/articles/trump-warns-on-house-republican-tax-plan-1484613766).
