U.S. Tax Reform Update Presented at TEI - Detroit Chapter International Tax Seminar April 26, 2017

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1 U.S. Tax Reform Update Presented at TEI - Detroit Chapter International Tax Seminar April 26, 2017 Adam S. Halpern Fenwick & West LLP (650) ahalpern@fenwick.com I. House Republican Blueprint. A. The House Republican Tax Reform Task Force released its tax reform Blueprint June 24, Styled, A Better Way: Our Vision for a Confident America, the Blueprint proposes some radical changes the U.S. corporate and international income tax systems, including a border adjustability feature. House Ways and Means Chairman Kevin Brady (R-Tex.) and House Speaker Paul Ryan (R-Wis.) have spent considerable effort promoting the plan in recent weeks and months. B. The Blueprint would reduce the corporate tax rate to 20% and repeal the corporate AMT. Double taxation of corporate earnings would remain in place, though both the corporate rate and individual rates would be reduced. (The maximum individual rate for dividends and capital gains would be 16.5%) C. The Blueprint also proposes immediate expensing of all business investments. The resulting corporate income tax would then resemble a cash-flow tax. The immediate recovery of investments would apply to both tangible and intangible assets, including buildings, equipment, and intellectual property, but not land. D. Net interest expense would no longer be deductible. Interest expense could be deducted only to the extent of interest income. Net interest expense could be carried forward indefinitely and deducted against a future year s net interest income, much like capital losses under our current system. Special rules would be developed for financial service companies such as banks, insurance companies, and leasing companies. E. The Blueprint states that the elimination of deductions for net interest would help to equalize the treatment of different types of financing (i.e., debt vs. equity) and would reduce tax-induced distortions in investment financing decisions. It also

2 expresses the concern that allowing both immediate expensing and interest deductions would result in a subsidy for debt-financed investment. F. Net operating losses would carry forward indefinitely, and would be increased by an interest factor to account for inflation. NOL carrybacks would not be allowed. NOL carryforwards could be deducted up to a limit of 90% of taxable income before NOLs (as under the current corporate AMT). The Blueprint does not discuss whether the current limitation under Section 382 (or some similar limitation) would be continued. G. The NOL provisions would take on increased importance under the Blueprint s international provisions, discussed below. Under those provisions, exporters could be expected to incur substantial losses year after year. H. The foregoing aspects of the Blueprint appear to be loosely based on the American Business Competitiveness Act of 2015, H.R (114th Cong.), introduced in the House in December 2015 by Rep. Devin Nunes (R-Calif.) and 26 others. The Nunes bill is somewhat skeletal; the cash-flow tax (including transition rules) is described in a mere 25 pages of bill text. Compare the 979-page Camp proposal from I. LIFO inventory would be preserved. The R&D credit would be preserved in a similar form. The 199 deduction would be repealed, as would a host of other special interest deductions and credits. J. Internationally, the Blueprint proposes moving from our current residence-based tax system to a destination-based system, with a border adjustability feature similar to a VAT. In describing the destination-based tax, the Blueprint states: This means that products, services and intangibles that are exported outside the United States will not be subject to U.S. tax regardless of where they are produced. It also means that products, services and intangibles that are imported into the United States will be subject to U.S. tax regardless of where they are produced. K. The Blueprint thus refers to the new tax as a destination based cash flow tax, reflecting full expensing for business investment (within the United States, at least) and the imposition of the tax only on sales to U.S. customers. L. The Blueprint also would replace the current, worldwide taxation of U.S. companies with a territorial system allowing for a 100% exemption for dividends 2

3 from foreign subsidiaries. Foreign earnings accumulated under the current system could be brought back to the United States at an 8.75% tax rate for cash and cash equivalents, and otherwise at a 3.5% rate, and the tax liability could be paid over eight years. These proposals are closely aligned with the territorial system as set forth in Rep. Camp s 2014 tax reform proposal. M. Subpart F rules would be scaled back only the foreign personal holding company income rules would be retained. Presumably the foreign tax credit would be repealed. N. As the House plan would create significant winners (exporters) and losers (importers), lobbying efforts have been intense. Bloomberg/BNA Daily Report reported Feb. 16 that the CEOs of several major retailers, including Target, J.C. Penney, and Gap met with President Trump to express their opposition to the plan. O. Exporters such as Boeing and Caterpillar have organized the Made in America Coalition to support the House plan. The coalition sent a letter to congressional leaders Feb. 21 expressing that support, and in particular endorsing the border adjustability feature of the plan TNT P. If the cost of imported goods were nondeductible under the plan, retailers would pay the 20% corporate tax on gross receipts from the sale of those goods less operating expenses, with no offset for COGS. For a typical retailer, this tax could be substantially greater than their current profit margins. Q. Proponents of the House plan have argued that these effects would be offset by a strengthening of the U.S. dollar, making imports cheaper. A recent article in Bloomberg/BNA Daily Tax Report cites currency traders as stating that a full offset is not a credible assumption, since the currency exchange market is notoriously unpredictable and since U.S. trade flows make up only a small proportion of total volume of the worldwide trade in U.S. dollars. R. On the other hand, if the currency offset were complete, as the bill s proponents suggest, U.S. exporters would then receive lower U.S. dollar prices for their exports, and would appear to require full monetization of their U.S. tax losses to compensate. Consider the following (greatly oversimplified) example: 3

4 1. Assume ImCo, a U.S. importer, buys goods from China and resells them in the U.S. ImCo s P&L statement for its most recently completed year is as follows: Revenues 100 COGS (75) Gross Profit 25 Opex (20) Net Profit 5 2. Under current law, ImCo s U.S. federal income tax is 1.75, and its profit after tax is Under the Blueprint, ImCo s COGS of 75 would be nondeductible. Thus, its taxable cash flow after border adjustment would be 80, and its U.S. tax (at the reduced 20% corporate rate) would be 16. After tax, it would have a net loss of If the U.S. dollar strengthened by 20% (or 25%, depending on which way you look at exchange rates) as against the Chinese RMB, ImCo would essentially be restored to its previous position. Its COGS would be reduced from 75 to 60. Its net profit before tax would be 20. Its U.S. tax would still be 16, leaving it with profit after tax of 4. That s the same profit it would have under current law if the corporate rate were reduced to 20% with no other law or currency changes. 5. But consider the effect of the U.S. dollar s strengthening on ExCo, a U.S. exporter to Europe. Assume ExCo s P&L statement before taking into account the currency effects of the Blueprint is the same as ImCo s: Revenues 100 COGS (75) Gross Profit 25 Opex (20) Net Profit 5 6. Assuming the U.S. dollar also strengthened by 20% (or 25%) against the euro, ExCo s revenues would be reduced from 100 to 80, as it presumably would not be able to increase the euro price of its goods in its European markets. It would incur a net loss before tax of 15, and a taxable loss of 95 (zero taxable revenue less 95 deductible costs). 4

5 7. If tax losses were refundable, similar to an export VAT, ExCo could seek a refund from the U.S. government of 19 (20% of 95), which would restore it to an after-tax profit of 4 the same after-tax profit it would have under current law with a 20% corporate tax rate and no other law or currency changes. But the Blueprint does not propose to offer VAT-like refunds to exporters. It only proposes to allow unlimited NOL carryovers, with an interest component. Thus, ExCo would need to seek market relief, by selling its NOLs to ImCo, for example. S. Several Senate Republicans have expressed concerns over the House plan. Finance Committee Chairman Orrin Hatch (R-Utah) stated that the Senate would hold hearings once the House plan is released in the form of a bill. Sen. Lindsey Graham (R-S.C.) was quoted as saying the plan won t get 10 votes in the Senate TNT T. Numerous practitioners, reporters, economists and others have commented on the Blueprint. Several commentators have noted that under the House plan, exporters would likely generate net operating losses year after year, as their export gross receipts would be non-taxable but their U.S. costs of producing those goods would be deductible. This raises the question whether NOL carryforwards could be transferred to other taxpayers (importers, for example). U. More recently, the House leadership has stated that it would hold hearings on the Blueprint, presumably to avoid another debacle as occurred with the ACA repeal bill, which was not circulated even to House Republicans until it was in near-final form. Ways and Means Committee Chairman Brady stated in an interview that the committee would begin announcing hearings the week of April 24th. Senate Republican staff are also beginning to work on a parallel tax reform process on the Senate side TNT 74-1 (Apr. 19, 2017). V. Four of President Trump s former campaign advisers argued in an April 19th New York Times op-ed in favor of breaking tax reform into several smaller bills, rather than attempting to tackle the entire tax code all at once. The authors Steve Forbes, Arthur Laffer, Larry Kudlow, and Stephen Moore suggested tackling corporate and business tax reform first, including a reduced corporate tax rate and low-tax repatriation. They also recommended scrapping the border adjustability feature outlined in the House Blueprint. One commentator criticized the proposal as the all-candy option TNT 75-2 (Apr. 20, 2017). 5

6 II. Corporate Integration. A. Senate Finance Committee Chairman Hatch has been working on a corporate integration proposal for over a year. While that proposal has been largely eclipsed in the press by the House proposal, Senate Finance Committee Chief Tax Counsel Mark Prater recently stated that the proposal is still very much alive. Prater explained that while the Senate plan is self-contained, it could be introduced in conjunction with a larger tax reform plan TNT B. The corporate integration plan has not yet been released in the form of a bill. Its major elements appear to be a dividends paid deduction, so that corporate income is taxed only once, and (possibly) a nonrefundable 35% withholding tax on both interest and dividends. At Finance Committee hearings, ranking member Ron Wyden (D-Ore.) expressed concern that the withholding tax could impose substantial burdens on tax-exempt investors such as retirement plans. III. Enzi 2012 Proposal. A. Senate Finance Committee staff have also indicated that the Senate may be looking at previous reform proposals, such as the one introduced in 2012 by Sen. Mike Enzi (R-Wyo.), the United States Job Creation and International Tax Reform Act of 2012, S (112th Cong.). B. The Enzi bill would have instituted a partial participation exemption for foreign earnings, accomplished through a 95% DRD on the qualified foreign source portion of any dividend received by a U.S. corporation from a CFC. A 1-year holding period requirement would apply. No foreign tax credit would be allowed with respect to any portion of the dividend. An election would allow similar treatment for a 10/50 company. C. Perhaps foreshadowing BEPS, the Enzi bill would have denied the DRD in the case of hybrid dividends, i.e., dividends for which the paying CFC would receive a deduction under its home country laws. D. Gains on the sale of CFC stock would only be partially exempt. To the extent the gain were recharacterized as a dividend, it would be eligible for the 95% DRD, whether the sale were made by the U.S. parent or a higher-tier CFC. On the other hand, gain representing appreciation over and above E&P would be taxed at regular U.S. rates. Losses on sales of CFC stock would not be allowed as deductions, and (in the case of a CFC seller) would not reduce E&P. 6

7 E. The Enzi bill would also significantly strengthen Subpart F, by adding a new category of Subpart F income. So-called low-taxed income would mean the entire gross income of a CFC unless the taxpayer could establish that the income was subject to an effective foreign tax rate of at least half the U.S. rate. Effective foreign rates would be determined based on the same rules as the current-law Subpart F high-tax exception of 954(b), i.e., based on the effective rate in the CFC s relevant 902 pools. F. A limited exception would be provided for qualified business income, which would be carved out of low-taxed income and exempted from Subpart F treatment. Qualified business income would mean income derived by the CFC in a foreign country that is attributable to the active conduct of a trade or business in that country with a certain threshold of activity required, but only if the income were not intangible income. Intangible income would be broadly defined to include essentially all forms of income to the extent properly attributable to intangible property (as defined in 936(h)(3)(B)). G. The bill would also provide a new deduction for 50% of the foreign intangible income attributable to a trade or business conducted in the United States by a domestic corporation. The domestic corporation would be required to have developed the intangible property, or acquired it and added substantial value to it through the active conduct of its U.S. trade or business. H. The bill would also provide for an elective deemed repatriation of all previously accumulated CFC earnings at a 10.5% tax rate. If elected, all non-previously taxed CFC E&P would be added to Subpart F income but the U.S. parent would receive a deduction equal to 70% of the E&P. No foreign tax credit would be allowed with respect to the 70% or 30% portions, resulting in a 10.5% effective U.S. tax rate. The tax could be paid over 8 years. I. For taxpayers that did not elect deemed repatriation, the bill would have provided an important FIFO ordering rule for CFC distributions: pre-transition earnings of CFCs subject to full tax rates and foreign tax credits would have been deemed to be paid before post-transition earnings subject to the 95% DRD. J. The foreign base company sales and services income rules would have been repealed, though the new low-taxed income category would, for many taxpayers, more than offset any potential benefit of this change. Section 960 would have been modified to apply on a year-by-year, item-by-item basis. 7

8 K. Two other provisions are tucked away at the very end of the bill: The repeal, solely for foreign tax credit purposes, of the title passage rule for the source of income from sales of inventory property, and the acceleration of the long-deferred (and, 13 years later, still not effective) election to allocate interest expense on a worldwide basis ( 864(f)). These rules presumably would be of lesser importance, as foreign tax credits would only be relevant with respect to Subpart F income. 8