By Paul Tadros and Marc Schwartz
The below is meant to be an apolitical analysis of the first items that jumped out at us – ignoring commentary on the Affordable Care Act impact.
Overview. Well folks, Congress has done it again. Smoke and mirrors. Talking a big game about tax reform with many areas materially unchanged. Unclear policy objectives. And where did those deficit hawks go? To be fair, there is some good, such as moving to a partial territorial system, but we’re not convinced the legislation as a whole will yield the economic growth to offset the expected increase of $1.5 trillion in the deficit. While we are not economists, the economy would need to exceed a 4% growth rate, resulting in potential overheating causing an asset bubble bust.
Job Repatriation? We also believe it highly unlikely there will be a significant “repatriation of jobs”. There are two (2) issues: (1) Does anyone think that supply chains which took years to establish will be dismantled? And (2) While the statutory federal rate is reduced and state income taxes are still (partially) deductible, the combined rates are still higher than some of the other developed countries. One need only look north of the border. If one compares the combined federal/provincial tax rates in the four (4) most industrialized and populous provinces in Canada (Alberta, British Columbia, Ontario, and Quebec) with the combined federal/state rates in California, Massachusetts, New Jersey, New York, and Pennsylvania, the combined rates in California, Massachusetts, New Jersey, and Pennsylvania are higher than those of the aforementioned provinces. New York is marginally less (0.7%). Note: Canada does not allow a deduction for provincial income taxes. When one throws in Ireland or the UK into the mix, good luck in “repatriating jobs”.
Job Creation? Another important question: How many corporations will use repatriated funds to expand operations (create jobs)? History has shown that the majority use the funds for share buyback. After all, increasing EPS is in the interest of the CEO to enhance stock compensation. Will investors use the funds from the share buyback to create jobs?
Let’s face it, most people just look at the statutory tax rate. Those truly thinking about the proposed law [are there (m)any in Congress?] focus on the effective rate. Despite recently announced stock buybacks by certain large companies, we’re not convinced corporate America’s net effective tax rate automatically decreases, and certainly not by the 14% margin (today’s 35% down to 21%) Congress is touting. Here’s just a quick rundown.
Dividends received deduction (“DRD”). We’re looking at the domestic side for now. We call this strategy let’s play with the math and hope the American people aren’t thinking. The current 70% DRD is reduced to a 50% DRD which, in essence, leaves the effective tax rate the same as under today’s law, regardless of the statutory rate decreasing from 35% to 21%; (b) the 80% DRD is reduced to 65% which, in essence, increases the effective rate from 7% to 7.35%. Yet, we allow Congress to pat itself on the back and claim, We just cut corporate taxes! Really!?
For you numbers folks, you’ve probably already realized that the exact same tax will apply at the 70% DRD. How?
- Current Law [assume a 35% tax rate]: Suppose a 100 gross dividend with a 70% DRD. The 30 taxable dividend results in 10.5 tax.
- Proposed Law: Reducing the DRD to 50% means a 50 taxable dividend taxed at 21% which yields, wait for it. . . a 10.5 tax.
Even our kids know there needs to be substance to their arguments when they come to us for permission to do something. Is this smoke and mirrors or other trickery, or has Congress been public about the DRD effective rate not changing, or are we simply being too cynical?
Alternative Minimum Tax (“AMT”) repeal. This is fantastic news, right? In concept, yes, and we applaud the concept. Well, doesn’t the proposal’s net operating loss (“NOL”) carryforwards being limited to 80% of taxable income before NOLs, the prohibition of NOL carrybacks and the limitations on interest deductions mean the AMT still exists, in essence? Our clients would fire us if we tried to get away with something like this. For non-capital intensive industries, the 100% write-off of machinery and equipment becomes irrelevant.
International. High level overview — On the international side there’s a number of measures, some confusing, some good and some clearly designed to generate revenue for the fisc. For instance, there is a critical sourcing rule change that would provide sales income from inventory produced in the US and sold outside the US to be 100% US source (passage of title ignored), resulting in a lower foreign tax credit limitation. Current law apportions income 50/50 to US/foreign source. The 30-day holding period for Subpart F purposes would be repealed meaning that if a foreign corporation is a controlled foreign corporation (“CFC”) on day 1, Subpart F income inclusion begins.
The proposal would also expand the attribution rules making it easier to reach CFC and US Shareholder status, among other items –making it more likely you’ll pay additional US tax; at the very least, information reporting burdens for many of our clients will increase. It would also expand the US Shareholder definition to include 10% or more of the total value of all shares (previously was 10% of voting stock). Section 956 was not repealed. While we applaud (yes, a standing ovation, seriously) the 100% DRD equivalent for certain foreign dividends, the DRD does not apply to hybrid instruments (debt in the foreign country/equity in the US). The US has, basically, adopted one of the OECD’s BEPS (“Base Erosion and Profit Shifting”) action plans. Also, the temporary Subpart F look-through rules are not made permanent nor extended by the proposal.
There is some good news but it’s not enough to offset the smoke and mirrors and other oddities. For small “C” Corps the uniform capitalization rules (section 263A) will not apply if average gross receipts for the previous 3 years is $25 million or less (current law is $10 million). That will save headaches for some.
Patent-box(ish). One of the items in the package was a “patent-box”-like provision, i.e., taxing income from intangible property at a lower rate; however, the measure in the reform is via a deduction in determining taxable income (in essence, exempting a portion of the income). While several European countries have a patent box regime, the income is not exempted, just taxed at a lower rate. It is that subtle difference which causes the US system to run directly into, for example, one of Germany’s anti-abuse provisions: If a Germany taxpayer pays a royalty to the US, that taxpayer may be denied a deduction for the royalty because income is exempt in whole or in part. Note: Germany does not have a patent-box regime and she does not provide any significant R&D benefits. She was always against the patent-box regimes and to prevent R&D activities moving to another EU member state, it brought in the non-deductibility measure. As an aside: North American companies always push for tax breaks in order to be competitive; yet, the top 5 R&D countries have higher effective rates and rank above all others in innovation in all sectors. In order, they are: South Korea; Sweden; Germany; Switzerland; and Finland. The US comes in at 9th (after Singapore, Japan, and Denmark) while Ireland with a 12.5% tax rate comes in at 16th. (Source: Bloomberg 2017 Innovation Index). One item to note: While the US has the highest per capita R&D spending, innovation is relatively low (young people think Apple “creates” and “innovates”).
Partnerships. The key items impacting many of our clients include a statutory overturn of Grecian Magnesite Mining: Sale of a partnership interest will be effectively connected income (“ECI”) and therefore taxable (effective date – dispositions on or after November 27, 2017). The transferee (buyer) will withhold 10% of the amount realized. In addition, the automatic termination rule of section 708(b)(1)(B) would be repealed.
Individuals (Other than rate changes):
- Did we mention rate changes in the parenthetical above? Doubling the standard deduction, capping state/local tax deductions, eliminating exemptions. . . .we’re not convinced the effective tax rate for most middle-income individuals / families will significantly change.
- AMT not repealed. Ugh! But it’s such a revenue driver Congress couldn’t eliminate it without finding savings elsewhere. There is a higher exemption amount which hopefully helps.
- Electing small business trust (“ESBT”): An ESBT could be the shareholder of a “S” Corp. as long as the beneficiaries of the ESBT would have been qualifying shareholders of the “S”. Although full details are “scant”, the “S” status will not be lost if one of the beneficiaries of the ESBT is a foreign person.
The estate tax exemption was also increased significantly.
Two (2) closing items: (1) Compliance costs significantly increase for taxpayers due to increased complexity; and (2) In most cases, until Treasury issues regulations, clarity will be lacking. We’d much prefer a simplified tax code. America deserves better.