TRUMP and a Changing Tax Landscape

 
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With the election of Donald J. Trump as the 45th President of The United States of America on November 8th along with GOP control of both the House of Representatives and the Senate, our country is now in a position with an aligned party to eliminate gridlock (possibly?).  While tax reform has been a major goal for politicians over the past decade, government gridlock has left us with mere “extenders” agreed upon late in each year.

When the 115th Congress convenes in January 2017, the House Republicans Blueprint for Tax Reform, (“Blueprint”) released on June 24, 2016 can be expected to be the starting point for future House Republican tax reform efforts.  The Blueprint proposes to reduce tax rates for individuals and businesses and to move the U.S. tax system to a system similar to a consumption-based tax system through revisions to the income tax rules (without providing a value added tax or national sales tax).  The Blueprint is the most recent proposal of several proposals released as part of House Speaker Paul Ryan’s “A Better Way” initiative, which overlaps with Trump’s tax reform plan.

Summary of the Blueprint’s Proposals

Individuals
Proposed changes applicable to individuals include measures to:

  • Replace the current seven tax brackets for individuals with three brackets of 12%, 25%, and 33% (each indexed for inflation), lowering the top individual income tax rate to 33%.  
  • Deduct half of individual’s net capital gains, dividends, and interest income (leading to  rates of 6%, 12.5%, and 16.5% on such income depending on the applicable rate bracket)
  • Repeal the individual alternative minimum tax (“AMT”).
  • Provide a larger standard deduction and an enhanced child and dependent tax credit by consolidating the current standard deduction, additional deduction, and personal exemption for a taxpayer, spouse, children and dependents, and child tax credit.
  • Eliminate all itemized deductions, except the mortgage interest and the charitable contribution.
  • Repeal the estate and generation-skipping transfer taxes.
  • Simplify and consolidate current tax benefits relating to education.
  • Continues existing tax incentives for retirement savings, and explores the creation of more savings vehicles.

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*As described in the Tax Reform Blueprint, the new standard deduction is larger than the current-law standard deduction and personal exemptions combined.          This in effect, creates a larger 0% bracket.  As a result, it is anticipated that taxpayers who are currently in the 10% bracket are likely to pay lower taxes than under current law.  Additionally, the Blueprint will create a new business tax rate for small businesses that are organized as sole proprietorships or pass-through entities, which means that small business income will no longer be subject to the top individual tax rate, likely leading to a maximum tax rate of 25% on small business income.  

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*As described in the Tax Reform Blueprint, these proposed changes will simplify tax filings for families.  The Tax Reform Blueprint aims to reduce the number of taxpayers who itemize their deductions from approximately 33%  under current law to approximately 5% under the proposed simpler and fairer tax system.

Large Businesses

Today, businesses operated through C corporations are subject to corporate tax at a statutory rate of 35 percent.  This stands in stark contrast to what our major trading partners have done over the past 30 years, whereby the average statutory rate has dropped to 24.8 percent.  Additionally, the income earned through a C corporation today is subject to double taxation, with a second layer of tax imposed on such income at the shareholder level through the individual tax on dividends and capital gains recognized on disposition of corporate shares.  Finally, corporations today face the added burden of the corporate AMT.

The U.S. tax system arguably places U.S. multinationals at a competitive disadvantage with foreign-based multinationals with income from low-tax countries because U.S. companies must pay the difference between the U.S. tax rate and foreign tax rates when they repatriate profits from their foreign affiliates.  In contrast, most foreign countries  have exemption systems that allow their resident multinationals to pay only the foreign-tax rate on their overseas profits.  Additionally,  the U.S. controlled foreign corporation (“CFC”) rules tax some forms of foreign-source income of U.S. multinationals as it accrues in their foreign subsidiaries.  Consequently, the current Code encourages businesses to move overseas because it imposes one of the highest corporate tax rates in the world.  

Congress has proposed a variety of serious ideas for pro-growth tax reform with the Tax Reform Blueprint being the most recent proposal.

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Businesses
Proposed changes applicable to businesses include measures to:

  • Lower the corporate tax rate to a flat rate of 20% from the current maximum rate of 35%.
  • Repeal the corporate AMT.
  • Fully and immediately expense the cost of investments in tangible property (such as equipment and buildings) and intangible assets (such as intellectual property), but not land.
  • Deduct interest expense against interest income, with any net interest expense not being deductible being carried forward indefinitely to use against future net interest income (with special rules for financial services companies).
  • Allow net operating losses (“NOLs”) to be carried forward indefinitely (with no carryback) and to be increased by an interest factor that compensates for inflation and a real return on capital.
  • NOL carryforwards would be limited to 90% of the net taxable income for the year.
  • Preserve the last-in-first-out (LIFO) method of accounting and a credit to encourage research and development (R&D), and make  both  more effective.
  • Eliminate special-interest deductions and credits that are designed to encourage particular business activities (such as the Sec. 199 domestic manufacturing deduction).
  • Transform the current U.S. international tax system by moving the U.S. towards a destination-based tax system, where the taxing jurisdiction would be based on the location of consumption (i.e., where goods are sold or services are performed) rather than the location of production.

Territorial Tax System for Businesses with International Operations

  • Shifts from the current worldwide system, which permits deferral of the U.S. tax on foreign active business earnings until  earnings are repatriated, to a “territorial” system.
  • Exempts foreign active business income by providing a 100% exemption for dividends received from foreign subsidiaries.
  • Repeals most of the current  “subpart F” regime that subjects certain income of CFCs to current U.S. taxation, but retains the “foreign personal holding company” rules, (e.g.,  dividends, interest, rents  and royalties) to discourage U.S. based multinational corporations from conducting certain passive activities outside the U.S.
  • Imposes a one-time tax of 8.75% on accumulated foreign earnings held in cash or cash equivalents and a 3.5% tax on all other accumulated foreign earnings; repatriation tax payable over an eight-year period. 

Treatment of Cross-border Sales, Services, and Intangibles for Businesses with International Operations

  • The move toward a consumption-based tax approach would make the U.S. cross-border system more “indirect” and  allow the U.S. to counter the current imbalance .by including border adjustments in a new system that is consistent with World Trade Organization (“WTO”) rules. 
  • The  intended result is that products, services, and intangibles that are exported outside the U.S. are intended to be exempt from U.S. income tax, while products, services, and intangibles that are imported into the U.S. would be subject to U.S. tax, regardless where they are produced.

Pass-through Business

  • The tax rate applicable to “active business income” from sole proprietorships and pass-through entities would be capped at 25%, except to the extent of an owner’s “reasonable” compensation for services.
  • Does not address the treatment of profits interests in partnerships (i.e., carried interest). 

Besides the WTO compliance concerns, the following important questions are also raised: 

  • Whether the Blueprint would replace the current income tax with a consumption tax, or if it would retain an income tax, but make modifications to mimic the economics of a consumption tax.
  • Whether there could be consequences for current U.S. income tax treaties, if there is a move from an income tax to a consumption tax to effectively void the current network of U.S. treaties.
  • Whether certain income tax treaty provisions may be overridden, if inconsistent with the destination-based approach of taxation (e.g.,  permanent establishment (“PE”) provisions  that  prohibit the U.S. from taxing a foreign business on U.S. sales, unless those sales are attributable to a U.S. PE of the foreign business).
  • Whether the treatment of expenses in the proposed system made by U.S. taxpayers to foreign counterparties, such as royalties, would be “border-adjusted.”

It remains to be seen if the tax reform plans achieve revenue neutrality and attract support from any Democrats next year.  Republicans may turn to the budget reconciliation process to circumvent the 60-vote filibuster threshold in the Senate, if sufficient support from Democrats is not garnered. 

The chances for the enactment of comprehensive tax reform however, are perhaps greater than at any time over the past decade.  A unified Republican Government makes the process of achieving significant tax reform much more manageable next year.  Furthermore, a great deal of work has already been completed on tax reform in the Congress. What had been lacking in the past was the political dynamic and leadership needed to make reform a reality, which is no longer the case.

Overall, the economic realities of these potential changes will remain unknown for some time.  While some of the proposals may be viewed as catering to “the one-percenters,” others, such as lowering the individual income tax rates and increasing the standard deduction may be viewed as governing for the lower and middle class of our society.

As we delve into a new administration and updates occur, True Partners will continue to keep you apprised of further developments.  

Contacts:

Alexis Bergman, Director - International Tax

Bob Gordon, Managing Director and Assistance General Counsel

Jim Hedderman, Managing Director - Federal Tax

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