Yesterday’s letter from Treasury Secretary Jack Lew on inversions is just the latest headline on an issue that has dominated the tax discussion ever since Pfizer proposed to merge with AstraZeneca back in May. As the chart below notes, the number of companies moving their headquarters overseas is accelerating and it’s sending a strong signal that something is very wrong with our tax code.
The motivation for inverting is simple – it allows companies to avoid paying US taxes on foreign earnings. This is a uniquely American problem. Most major economies have territorial tax systems that only collect tax on income earned within the home country’s borders. The US, on the other hand, has a modified worldwide system that imposes US tax on all income regardless of where it is earned. The US system is “modified” in that it includes two significant exceptions to the worldwide approach:
- US taxpayers get a credit for any foreign taxes paid on their income; and
- US tax only applies to income that is repatriated (paid as a dividend) back the parent corporation.
As other countries have reformed their corporate tax codes and lowered their tax rates, the incentive for US companies to invert has grown.
Adding to their motivation is the policy risk that the US tax system will become even more punitive in coming years. High profile Democrats, including President Obama, have run on platforms that include “ending tax breaks that send jobs overseas” – i.e. ending or curbing a company’s ability to defer paying US tax on foreign earnings. No country, not even those few that still have worldwide tax systems, has ever adopted this approach. These proposals have never been seriously considered by Congress but they do expose the large gulf in vision on tax reform and serve as a potent reminder that action taken by Congress may not be business friendly.
So get out while you can.
The best way to address inversions is to reform the tax code to encourage more companies to organize here in the United States. The “fix it with comprehensive tax reform” response has been adopted by many tax writers in Congress, but how long can they stick with this refrain when nobody believes thoughtful tax reform is possible under this administration?
On the other hand, it is highly unlikely that Congress sits back and passively watches while all our best companies invert. Inversions may have limited real economic effects – most inversions are a legal exercise, not an economic one – but it looks bad and something must be done.
Secretary Lew argues for a two-step approach. First, enact legislation that raises the barrier to inverting in order to slow the tide of companies moving their incorporation papers overseas. Second, enact comprehensive tax reform that would make the US more attractive. It is hard to argue with step two here – and we’re glad to see the Administration support the concept of comprehensive reform – but step one is sure to prove ineffective. US companies are already structuring spin-offs that would get around the proposed, tougher anti-inversion rules.
We have a better idea that also involves two steps.
Why not officially adopt a territorial system now, and then move comprehensive tax reform later? After all, what’s the difference between Congress enacting a territorial system through a statute and companies acting organically to accomplish the same end through deferral and inversions? You end up in the same place. Moreover, how much could a shift to a statutory territorial system cost the US Treasury if we already have a de facto territorial system in practice? It can’t be much, so just make it official and remove the incentive for US companies to jump through all these legal hoops in order to invert.
Then the discussion could shift to the real issues confronting the tax code, including the excessive tax rates we impose on individuals, pass-through businesses, and US corporations alike. The corporate community is right to argue that high US taxes are driving investment and jobs overseas. These excessive rates are not limited to corporations – they include even higher rates on individuals and pass-through businesses – and, unlike inversions, excessive tax rates have a tangible and negative effect on our economy. That’s the real challenge with our current tax code and that’s what real tax reform needs to address.
The pending debate over highway spending has tax implications and the pass-through business community should pay attention.
The Highway Trust Fund will run out of money in the next couple weeks and both the Senate and the House are planning a two-step response — a short-term patch that will keep highway projects funded into next year and then longer bills that would establish highway policy for the next couple years.
How to allocate all those dollars for roads and bridges is always a complicated and politically charged affair. So is how to pay for it. Finance and Ways and Means both are expected to hold markups tomorrow on their respective plans. Here are the offsets for each:
- Ways and Means: $11 billion in offsets from pension smoothing ($6.4 billion), customs user fees ($3.5 billion), and transferring funds from the Leaking Underground Storage Tank fund ($1 billion)
- Finance: No final deal yet, but it looks like they are shooting for $10 billion in offsets including mortgage reporting ($2.2 billion), extending the statute of limitations on overstatement of basis ($1.3 billion), and a host of other items.
Considering the alternatives — gas tax hike, tolls on interstate highways — this set seems pretty tame. That said, the debate over the highway bill should serve notice to the business community that while tax reform may be on hold, Congress will continue to look to tax policy to offset some of its other priorities, so we need to be vigilant.
Meanwhile, action on extenders and related items continues at a low level. This week, the House will take up a permanent 50 percent bonus depreciation bill. While bonus depreciation is not really an “extender,” it does keep the focus on all those expired provisions, and it’s not bad policy either. Coupled with the higher Section 179 limits, the bill goes a long way towards moving the tax treatment of business investment towards general expensing, something many economists have argued is good for the economy. As the Tax Foundation noted:
We find that permanently extending this provision would boost GDP by over 1 percent, wages be 1 percent, and create 212,000 new jobs due to its effects on the cost of capital. It would also increase federal tax revenues by $23 billion after taking into account the increases wages and incomes caused by making bonus expensing permanent.
Extending R&E, Section 179, and built-in gains — either permanently or for several years — would be good for the economy too. These provisions already expired at the end of last year (2013), so every day Congress waits is a day of benefit lost. When Congress does act, it will make the extension effective back to January 1st, but it will be hard to argue that business investment increased in 2014 because of higher Section 179 limits that weren’t retroactively extended until this December, won’t it? The behavioral effect will be lost.
Moreover, any extension that is less than two years (2014 and 2015) would require Congress to come back next year and perform the exercise all over again. How Congress expects businesses to use these provisions to their advantage when they keep expiring is beyond our ability to explain, and one of the best arguments behind Chairman Camp’s push to make them permanent.
Despite the strong case for action now, any meaningful movement prior to the elections would be shocking. There’s only seven or eight weeks of session left before Congress recesses for the elections, and with the extenders already expired, we can’t see a real catalyst out there that would compel the House and Senate to come together on a package.
That’s too bad, and is just one more reason why both the tax code and the policy making process that creates it appear wholly dysfunctional.
It’s a big day for S corporations! Earlier today, the House voted to adopt HR 4453, the S Corporation Permanent Relief Act of 2014, by a count of 263 to 155. The bill, sponsored by Representatives Dave Reichert (R-WA) and Ron Kind (D-WI) makes permanent the five year built-in gains holding period, and contains a basis adjustment fix for charitable contributions made by S corporations.
These S corporation provisions received strong bipartisan support. All but two Republicans supported the measure, while forty-two Democrats parted with their leadership and the Administration and voted yes. Ways and Means Committee Chairman Dave Camp kicked off the day by offering these remarks on the House floor:
The bill we have before us today is the right step forward to level the playing field between the small businesses on Main Street and big businesses. If a small business chooses to operate as an S corporation for tax purposes, we should ensure that they have the ability to access certain capital without tax penalties.
…This is a bipartisan, commonsense bill that will give small businesses some much needed relief from the burdens of the tax code, and allow them to make new investments and create new jobs.
Washington State Congressman and S-Corp ally Dave Reichert had this to say:
The BIG tax is a double tax on S corporations who want to sell their assets after converting from C corporation status.
…As we’ve heard from Jim Redpath…who testified before one of our Ways and Means hearings…the BIG tax causes S corporations to hold onto unproductive or old assets that should be replaced. He gave the example of a road contractor which is holding onto old equipment that is sitting in the junkyard…because if he sold them, they would be subject to the BIG, double tax.
Instead of selling the assets and using the proceeds to hire new workers or invest in new equipment, the business owners sit on the sidelines. This is a perfect example of the tax code influencing business decisions and needs to stop.
Opposition focused on the fact that the legislation included no offset. The Joint Committee on Taxation estimated the bill would cost $2.1 billion over ten years. The Democrats offered a motion to recommit – also lacking an offset – that would have extended the two provisions for two years only. This “no offset” argument also was at the heart of the veto threat articulated by the White House yesterday.
We strongly disagree with these concerns. JCT may score tax legislation on a current law basis but taxpayers, including business owners, live in a current policy world. Offsetting the cost of extending tax rules these businesses already use, and have used for years, makes little sense. Moreover, as the motion to recommit demonstrates, many of those opposed to making these provisions permanent were willing to incur the revenue loss of extending them temporarily. What is the difference between voting once to extend these items without an offset, and doing so repeatedly every year or two?
As far as next steps, the tax world now shifts it gaze to the Senate side, where new Finance Committee Chair Ron Wyden (D-OR) and Majority Leader Harry Reid (D-NV) are working out how to best move forward on their extenders package, which includes two year extensions of these to S corporation provisions. Our best guess is we will have to wait until after the November elections before we see further movement on these items, but that doesn’t detract from the success of the day and it certainly won’t prevent us from continuing to press these issues when we’re up on the Senate side!