Comments of. The National Association of Manufacturers. On the Tax Reform Act of Submitted to the House Ways and Means Committee.

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1 Comments of The National Association of Manufacturers On the Tax Reform Act of 2014 Submitted to the House Ways and Means Committee August 2014 l. Introduction The National Association of Manufacturers (NAM) welcomes the opportunity to comment on the Tax Reform Act of 2014 Discussion Draft (the discussion draft), released by House Ways and Means Committee Chair Dave Camp (R-MI) in February The NAM is the largest manufacturing association in the United States, representing manufacturers of all sizes in every industrial sector and in all 50 states. Manufacturing employs nearly 12 million men and women, contributes more than $1.8 trillion to the U.S. economy annually, has the largest economic impact of any major sector and accounts for two-thirds of private-sector research and development. NAM members know firsthand that our current tax system is fundamentally flawed and discourages economic growth and U.S. competitiveness. As a result of manufacturing s critical importance to our nation s economy, any effort to rewrite the federal tax code should result in a balanced, fiscally responsible plan that allows manufacturers in the United States to prosper, grow and create jobs and also enhances their global competitiveness. As outlined in the NAM s A Growth Agenda: Four Goals for a Manufacturing Resurgence in America, a key objective for the association is to create a national tax climate that enhances the global competitiveness of manufacturers in the United States and avoids policy changes that would increase the tax burden on the manufacturing sector. To achieve these goals, we need a comprehensive tax reform plan that both reduces the corporate tax rate to 25 percent or lower and includes lower rates for the nearly two-thirds of manufacturers organized as flow-through entities. We also believe that comprehensive tax reform must include a shift from the current worldwide system of taxation to a modern and competitive international tax system, a permanent and strengthened research and experimentation (R&E) incentive and a strong capital cost-recovery system. The following comments, which focus on specific provisions in the discussion draft, reflect NAM Board-approved policy on tax reform and are not intended to provide a comprehensive assessment of the entire plan. In addition, the comments are based on the premise that any changes would be part of a comprehensive tax reform plan. The NAM recognizes that the discussion draft plays an important role in the current tax reform debate and supports a number of provisions in the draft. At the same time, the NAM believes that other provisions in the discussion draft need to be modified and in some instances eliminated to achieve a progrowth-pro-manufacturing tax code. 1

2 l. Individual Tax Reform and Small and Medium Manufacturers a. Overview Nearly two-thirds of manufacturers generally small and medium-sized businesses are organized as pass-through entities and pay taxes at individual rates. Moving forward, any discussion about reforming the tax code must ensure that the new plan does not disadvantage these manufacturers that play a critical role in the supply chain and broader economy. For more than 60 years, manufacturers and other business owners have chosen to organize as subchapter S-corporations or other pass-through entities to benefit from comprehensive liability protection and a single level of federal taxation. According to IRS data, between 1980 and 2008, the total number of pass-through businesses more than tripled to nearly 31 million, employing an estimated 54 percent of the entire private-sector workforce. 1 Manufacturing is a capital-intensive industry and, in smaller companies, the capital to grow and expand operations, increase product lines and hire additional workers most often comes directly from the owners. Clearly the tax treatment of pass-through businesses in tax reform will impact the decisions and ability of small and medium-sized manufacturers to hire and retain workers and reinvest in their companies. Indeed, in a March 2012 NAM/IndustryWeek Survey of Manufacturers, 2 56 percent of respondents said that the individual tax rate increases slated to take effect in January 2013 would negatively impact business investment and job retention/ creation plans. Consequentially, Congress must consider the unique impact that individual tax rates and specific types of base broadening could have on these smaller manufacturers and ensure that the changes do not increase the tax burden on these companies to pay for other tax reform measures. Additionally, it is important to point out that while many small and medium-sized manufacturers will benefit from the enhanced Section 179 proposal discussed later in these comments, passthrough companies, like their corporate peers, need thoughtful tax reform that includes both a lower tax rate and a strong capital cost-recovery system. It is essential for the committee to consider the impact of all the tax changes in the draft on the ability of these small and mediumsized manufacturers to compete, invest and grow. Manufacturers are concerned that, despite the reduction in the top rate, the draft as a whole will increase taxes on many flow-through companies. b. Definition of QDMI While NAM members appreciate that the draft recognizes some manufacturers unique position as pass-through entities by including a proposal to lower tax rates for qualified domestic manufacturing income (QDMI), we do have some concerns about the proposed construction of QDMI, including its definition and the interactions with the proposed changes to the selfemployment tax. 1 Robert Carroll and Gerald Prante, The Flow-Through Business Sector and Tax Reform: The Economic Footprint of the Flow- Through Sector and the Potential Impact of Tax Reform, (April 2011) aspx. 2

3 In particular, the NAM is concerned that the definition of QDMI excludes computer software, similar to the proposed definition of qualified expenses for the research and development tax credit. Manufacturers believe the creation of software is a form of manufacturing. Under most definitions, manufacturing means producing, assembling, building, constructing, inventing and/or fabricating. All of these terms can be applied to the manufacture of hardware and software. Indeed, the creation of software requires intensive labor application in the formulation and creation of the product, which is intended to be both incorporated into other products and sold as a finished product. While software generally is treated separately from other forms of manufacturing that require heavy machinery or result in a physical output, the information sector, including the creation of software, is an important industrial sector, as represented by Department of Commerce economic statistics. Indeed, many products now integrate software in order to operate, and the line is blurring even on production. For example, 3-D printing enables the "manufacture" of increasingly more complex products and is heavily software driven. By excluding software from QDMI, the draft is effectively writing off a growing contributor to our economy and underappreciating the role of software in our economy. Indeed, information industries comprised 4.9 percent of GDP in the first quarter of 2014, with the sector contributing $828.2 billion in value-added to the economy. That is up from an average of $701.5 billion in For comparison, durable and nondurable goods contributed 6.5 percent and 5.8 percent respectively, to the GDP in the 1 st quarter. Software and software creation are major parts of modern manufacturing, and software is a key component of many finished products. As such, software should be included in QDMI. c. Determination of Net Earnings from Self-Employment Manufacturers also have a number of concerns with the proposed expansion of the definition of net earnings from self-employment. The draft states that the distinction between net earnings from self-employment and other income not subject to the Self-Employment Contributions Act (SECA) reflects the fact that over the past several decades, the portion of gross domestic product attributable to labor has remained remarkably constant at approximately 70 percent, while the portion of GDP attributable to capital has held steady at roughly 30 percent. 3 As noted above, unlike many other sectors of the economy, manufacturing requires significant and continuing investment in capital equipment. Thus, for many active business owners who are manufacturers, the 70 percent is grossly overstated as a share of income derived from their own labor and understates the return on the capital investment they made in their own firms. Moreover, for pass-through manufacturers, investment is largely driven by business owners reinvesting earnings back into the company. As the committee highlighted during the months leading up to the expiration of the tax cuts, tax increases on pass-through manufacturers would harm the economy. In this instance, the tax increases are likely to come through the expansion of SECA taxes. According to the committee materials accompanying the draft, this proposed change reflects compliance problems and ongoing abuse of the current rules. For more than 35 years, manufacturers have been complying with the current rules that penalize business owners who pay themselves less than reasonable compensation. The expansion assumes that passthrough owners have been sheltering earnings from SECA taxes by paying them as a distribution rather than as income. This proposal penalizes manufacturers who have been 3 Tax Reform Act of 2014 Section by Section, p. 33 3

4 playing by the rules and represents a significant departure from current law. Any abuse should not be addressed with a one-size-fits-all policy that increases taxes on small and mediumsized manufacturers. Increasing taxes on these owners will reduce the amount of capital available to reinvest, grow and create jobs. d. Partnership Issues The discussion draft also includes several provisions on partnerships that raise concerns for the NAM. i. Mandatory Adjustment to Basis of Partnership Property Current rules for determining initial basis and basis adjustments in partnership property generally result in parity between inside basis (the partnership s basis in partnership assets) and aggregate outside basis (a partner s basis in the partnership interest). Transfers of partnership interests and partnership distributions, however, can create disparity between outside and inside basis. In general, when there is a disparity, the partnership s inside basis is adjusted to correct this disparity if (1) the partnership has a Section 754 election in effect; or (2) the partnership has a substantial built-in loss or a substantial basis reduction. The NAM has concerns with the provisions that would require partnerships to adjust inside basis of partnership property upon any transfer of a partnership interest. This would require partnerships to (1) adjust inside basis of partnership property upon any partnership distribution; and (2) make such adjustments so that each remaining partner s share of net gain or loss from the sale of all partnership properties immediately after the distribution is the same as it would have been immediately prior to the distribution. Manufacturers believe that current law is adequate to prevent taxpayers from achieving inappropriate loss transfers among partners or other abuses. Indeed, mandating positive basis adjustments would generally produce a tax benefit for partners, at the cost of substantial complexity. In addition to mandating taxpayer-friendly positive partnership basis adjustments, the proposal also changes the method of determining the amount of any basis adjustment. The proposed method could result in mandated adjustments even for a property distribution that does not create any disparity between inside and outside basis. Other partnership tax rules already prevent inappropriate results from failing to make Section 754 adjustments. The present law anti-mixing bowl rules, for example, prevent taxpayers from using partnerships to shift built-in loss on contributed property to other partners. Similarly, failing to make a Section 754 election is subject to the general partnership anti-abuse rule. In addition, mandated basis adjustments and expanding the scope of situations requiring a basis adjustment would create unnecessary complexity. When Congress amended the partnership rules in 2004, only material downward basis adjustments were mandated. Congress correctly decided then that preserving the simplification aspects of the current partnership rules for transactions involving smaller amounts was appropriate. In contrast, under the proposals in the discussion draft, each time a partnership interest is transferred or a partnership distribution is made, partnerships would be required to value every asset, allocate the adjustment and track it to compute partnership income. Moreover, under the new proposed method of determining basis adjustments in connection with a distribution, valuation would be necessary to determine whether or not there is a basis adjustment to make. 4

5 These unnecessarily complex proposals run counter to one of the paramount objectives of tax reform: simplification. Manufacturers are concerned that these proposals will increase the administrative burden and add costs that may discourage future partnerships from forming despite other benefits the partnership may yield. ii. Repeal of Time Limitation on Taxing Pre-contribution Gain Under current law, the anti-mixing bowl rules are generally designed to prevent the use of partnership contributions and distributions to inappropriately defer or avoid recognition of gain or loss in property where gain or loss would otherwise be recognized. An anti-mixing bowl rule requires the contributing partner to recognize any remaining built-in gain or loss if the contributed property is distributed to another partner within seven years of the contribution. The discussion draft however, proposes to eliminate the seven-year time limitation on the recognition of pre-contribution built-in gain. The proposal would require a partner that contributes property to recognize pre-contribution built-in gain or loss when the partnership distributes the contributed property, regardless of when or to whom the distribution occurs. In other words, the proposal would make the seven-year lock-in permanent. Manufacturers are concerned that this would create unnecessary difficulties for an indefinite period of time for taxpayers to efficiently unwind a legitimate joint venture conducted through a partnership. The proposal would place permanent impediments to efficiently unwinding joint ventures when the partners decide it is in their economic interests to do so. Such impediments would undermine the intent of the partnership tax regime by creating significant inflexibility that would prevent efficient capital allocation and could discourage some joint ventures. Furthermore, with respect to depreciable tangible property such as machinery and equipment used in most manufacturing, any remaining pre-contribution built-in gain will have been largely, if not fully, eliminated under Section 704(c) by the end of seven years. In addition, the draft would create a harsher rule for partnerships than joint ventures conducted in corporate form. Manufacturers believe that present law limitations are sufficient to protect against inappropriate deferral or avoidance of gain recognition through the use of partnerships. II. The Corporate Tax Rate Since April 1, 2012, the United States has had the highest corporate tax rate among developed economies. While the top U.S. corporate tax rate has remained at 35 percent for almost 25 years, other major developed countries have realized that lower corporate tax rates encourage economic growth and have significantly reduced their statutory tax rates. As a result, the United States is at a significant disadvantage in the global economy. Manufacturers in particular feel the brunt of our high tax rates. Excluding the cost of labor, it is 20 percent more expensive to manufacture in the United States than in our major trading partners countries, according to a study by the Manufacturing Institute and the Manufacturers Alliance for Productivity and Innovation (MAPI). Corporate tax rates are one of the greatest factors contributing to this cost differential. As noted above, a key objective for the NAM is to create a national tax climate that enhances the global competitiveness of manufacturers in the United States. An important step to achieving this goal is to adopt a federal statutory corporate tax rate of 25 percent or lower, 5

6 which will put us more in line with our major competitors. A lower corporate tax rate will make it easier for manufacturers in the United States to compete in the global marketplace, encourage greater investment in the United States and promote U.S. job creation and overall growth. Thus, the NAM supports the 25 percent corporate tax rate included in the discussion draft. III. Capital Cost Recovery a. Overview In addition to lower tax rates for businesses of all sizes, one of the most effective ways to spur business investment and make U.S. manufacturing more competitive is through a strong capital-cost recovery system. An ideal system would allow companies to expense capital equipment in the tax year purchased. The positive economic impact of expensing capital equipment is well recognized. A basic premise of economic theory is that investment is a positive function of an increase in demand and a negative function of cost. The cost of capital to a firm includes three components: the price of capital equipment, the cost of financing the equipment and the tax treatment of investment. Expensing lowers the after-tax cost of capital and increases the number of profitable projects a firm can undertake, helping spur the growth in business investment. The enhanced Section 179 and bonus depreciation provisions enacted in recent years have temporarily moved us toward an expensing system. Manufacturers believe that, where possible, these policies should be expanded and made a permanent part of any pro-growth tax reform. Moreover, the fact that increased investment leads to job creation cannot be overemphasized. Indeed, cost recovery is not merely timing. Manufacturers of all sizes take into account the tax impact of cost recovery mechanisms on project cash flows in making investment decisions. For manufacturers large and small, cash flows are carefully managed to support key growth objectives and, especially for small and medium-sized manufacturers, cash flow is critical when access to credit is difficult. The NAM is concerned that the long-term impact of some of the proposed changes in the discussion draft may negatively affect domestic investment. According to the Joint Committee on Taxation, 4 [O]verall, the proposal is expected to increase the cost of capital for domestic firms, thus reducing the incentive for investment in domestic capital stock. This is of particular importance as recent data 5 released by the Bureau of Economic Analysis underscores manufacturing s central role in the economic well-being of our nation. Indeed the BEA s release of new quarterly statistics of GDP by industry reinforces the role that a healthy manufacturing sector plays in the health of the nation s economy. Manufacturing in the United States is poised for a comeback, but for the nation to fully reap the benefit of this resurgence, manufacturers need tax policies that allow them to compete in today s global economy and do not tip the scales against investment. Manufacturers recognize the important role a favorable tax climate plays in attracting high-value jobs and investment to the United States and improving competitiveness. Consequently, we urge policy makers to advance reforms that encourage investment and job creation in the United States rather than penalize companies struggling to compete in a global economy. While we appreciate that the draft has no general limitation on interest expense, it is important to 4 JCT Macroeconomic Analysis, JCX 22 14, Bureau of Economic Analysis, U.S. Department of Commerce, April 25,

7 maintain full deductibility for interest given the role it plays in funding new investments and business operations. Clearly, making the cost of capital more expensive will not serve to achieve these goals. b. Alternative Depreciation System (ADS) In the capital-intensive sector of manufacturing, an effective approach to cost-recovery beyond Section 179 is vital to ensuring that comprehensive tax reform allows manufacturers to remain globally competitive. Indeed, the tax treatment of tangible assets influences investment decisions by both small and large manufacturers. The accelerated depreciation regime in effect today reduces the after-tax cost of investment and promotes economic growth by stimulating investment, which has a multiplier effect throughout the economy. The current system, which includes 189 specific categories, attempts to match productive lives to asset type and the high productivity in early years of asset ownership with the higher costs of operating equipment in later years. In contrast, the draft proposal would shift to straight line depreciation under the Alternative Depreciation System (ADS). For many manufacturers, this shift would greatly increase the time for a company to write off the cost of the investment. Further, for some capital assets this shift will require calculating a useful life for a piece of equipment that does not reflect the actual useful life for the company due to the rapid pace of technological advancement in 21 st century manufacturing. In short, useful life does not always equal optimal productive life in modern manufacturing. While we appreciate the draft s proposal to include an option for an inflation adjustment and delay the shift to ADS until after 2016, manufacturers still are concerned about a move away from accelerated depreciation and the impact it would have on cash flow and in altering the fundamentals of long-term investment decisions. Additionally, the inflation factor is a variable that may be difficult to predict. It would add a level of uncertainty to the projections and could be cumbersome, especially for small and medium sized businesses. Although the needs of the various manufacturing sectors vary widely, manufacturing typically requires a significant investment in productive assets. By spreading depreciation deductions over a longer period of time, the proposal in the discussion draft could make investment in productive assets more expensive and thus discourage it. This change could lead to slower future investment in additional equipment and the job growth often associated with such investment until anticipated tax savings are recouped. c. Sec. 179 Expensing NAM members strongly support the enhanced Section 179 provisions that have been enacted in recent years. Thus, manufacturers were pleased that the discussion draft includes an enhanced Section 179 that would make this pro-investment policy permanent and indexed to the levels of inflation. Additionally, manufacturers support the expanded definition of qualifying property under the proposal, which would benefit many companies and their customers. At the same time, since manufacturing is a capital-intensive industry, NAM members would prefer a permanent expensing provision at higher levels, such as those proposed in H.R. 4457, America s Small Business Tax Relief Act of 2014, approved by a bipartisan majority of the House of Representatives on June 12. As you know, that bill would reinstate permanently the now expired Section 179 at the 2013 limits of $500,000 expensing threshold with a $2 million phase-out. 7

8 Additionally, as noted above, while enacting the proposal would help many small and mediumsized manufacturers, these companies, like their larger peers, need thoughtful tax reform that includes a lower tax rate and a strong capital cost-recovery system. d. Natural Resources One key area where the draft maintains a pro-investment posture is the current provision that allows operators or working interest owners to expense (in full or in part) intangible drilling costs (IDCs) relating to oil and gas investments. Under longstanding tax policy rules, these costs are correctly treated as ordinary and necessary business expenses. For manufacturers and other energy consumers, the development of shale natural gas in the United States has been a game changer in terms of reduced energy costs, increased access to secure energy supplies and availability of a low-cost raw material. The chemical industry alone has generated billions of dollars of new investment thanks to this innovation. IDCs cover about 70 to 80 percent of the cost of a shale gas well. Manufacturers, both energy producers and energy consumers, support policies that will help advance domestic energy production. In contrast, the NAM has concerns with the proposed elimination of the percentage depletion deduction beginning after This long-standing deduction is vitally important to domestic companies producing natural resources including mineral, coal and aggregates and independent oil and gas producers. Percentage depletion allows taxpayers producing from mines, wells and other natural deposits to claim a deduction for a percentage of the gross income from these properties, recognizing the unique nature of these investments, which require significant financial commitments to longterm projects to deliver a competitive product at a low margin. The percentage depletion provision also reflects the large risk inherent in these activities and the fact that the value of a mine or well declines as production progresses. Congress created percentage depletion because the otherwise available cost depletion rules resulted in a cost of capital too high to permit producing from important mineral resources. It is important to note also that even with the percentage depletion tax deduction, the U.S. tax burden on mining and other American resources operations puts them at a significant competitive disadvantage. IV. Other Business Deductions and Exclusions a. Overview While NAM members recognize that broadening the income tax base will be part of the debate over lowering tax rates, policy makers must also consider the negative impact of expanding the tax base on economic growth and the competitiveness of capital-intensive industries like manufacturing. Indeed, even though the discussion draft reduces the U.S. rate to the average OECD rate, proposed base-broadening would subject more income to tax in the United States than in other countries, with the potential to severely impact companies core activities, such as R&D and inventory expansion. 8

9 In contrast, some current tax rules are key to a strong manufacturing sector, and the benefits of these provisions should be maintained in a new system. For every $1.00 spent in manufacturing, another $1.32 is added to the economy, the highest multiplier effect of any economic sector. Indeed, a new system should not result in a net increase in manufacturers U.S. tax burden a change that would undoubtedly derail efforts to enhance U.S. economic growth, investment and jobs. a. Net Operating Losses NAM members believe that a new tax system should provide fair and equitable treatment for taxpayers that have generated substantial attributes based on current law. Thus, the NAM is concerned about proposed changes to current rules on net operating losses (NOLs), in particular the 10 percent haircut on NOL carryovers and carrybacks. Manufacturing is a cyclical industry and manufacturers of all sizes and in all industry sectors fall into an NOL position when expenses exceed income. The U.S. tax code has long recognized that business cycles include natural fluctuations in a company s loss and profits from year to year. In contrast, the proposal arbitrarily caps the use of NOLs to 90 percent of a company s taxable income. This limitation unfairly burdens companies already in a loss position that are most in need of additional cash and sets a dangerous precedent for limiting existing tax attributes. Manufacturers believe that a new tax plan should allow future timely utilization of tax attributes, like net operating losses, that have been generated but not yet utilized under the current tax code. b. Amortizing Advertising Expenses Advertising plays a critical role in the competitiveness of manufacturers and the success of their products and plays a central role in driving market growth and innovation, which benefits both the manufacturer and the consumer. In doing so, advertising also helps drive prices down by spurring competition. The Internal Revenue Service (IRS) has long recognized that advertising expenses represent a normal cost of doing business and are deductible. 6 Thus, the proposal requiring capitalization of advertising expenditures is at odds with the IRS s longstanding view that such costs constitute normal business expenses deductible under Section 162. While the NAM remains opposed to the proposed change in the tax treatment of advertising expenses, in the event that taxpayers are required to capitalize a portion of their advertising expenses, the proposed 10-year amortization period should be no longer than two years. As with the proposal to shift to ADS, the proposal to place advertising expenses that are currently considered an ordinary and necessary cost of doing business on a longer recovery period will impact the cash flow of advertising-heavy manufacturers. Additionally, while manufacturers have strong concerns with this proposal, we recommend that at a minimum, the committee consider, as an alternative to the 2015 effective date in the draft, a 6 In Rev. Rul , the IRS announced that The [U.S. Supreme Court s] Indopco decision does not affect the treatment of advertising costs as business expenses which are generally deductible under section 162 of the code. (Emphasis added.) 9

10 longer transition period to allow for business planning adjustments aimed at mitigating negative impacts. c. The Domestic Manufacturing Deduction Section 199 or the Domestic Manufacturing Deduction (DMD) effectively reduces the federal tax rate on income from domestic manufacturing activities and helps mitigate the tax burden for all domestic manufacturers. By reducing the tax burden on income from U.S. manufacturing activities, the DMD encourages more manufacturing in this country and helps attract needed capital to spur new investment. This deduction creates a financial incentive to keep production in the United States and influences decisions on where corporations build new production facilities. Since the DMD is directly linked to domestic production, the loss of the DMD would result in higher effective tax rates for many domestic manufacturers, which could outweigh the overarching goal of lower tax rates. d. Like-kind Exchange Rules The NAM also opposes the proposed repeal of the like-kind exchange (LKE) rules that allow taxpayers to replace property with like property, without immediately recognizing gain. Historically, Congress has recognized the fact that, from an economic perspective, taxpayers are in essentially the same position after the property exchange, making the recognition of gain inappropriate. Moreover, the taxpayer is not taking any profit from this type of transaction but rather investing it back into the business. LKE rules are a powerful economic engine that promote capital investment, improve business productivity and create jobs. Indeed, tax-deferred exchanges are one of the few incentives available to, and used by, taxpayers of all sizes in all sectors of the economy, including manufacturers. For example, by deferring the tax consequences associated with replacing outdated equipment, LKE helps businesses invest in newer, more efficient and more environmentally friendly machinery. Repealing the LKE rules will affect a wide array of taxpayers. It will negatively impact manufacturers because their customers will no longer be able to replace their equipment without immediate negative tax consequences and thus may slow their purchases of replacement equipment, reducing demand that would ripple throughout the supply chain and the greater economy due to manufacturing s substantial economic multiplier effect. Repeal would also harm manufacturers with captive finance arms that facilitate and support sales and leasing transactions with their customers and, in some cases, enable sales where financing might otherwise be difficult to obtain. Since the LKE rules also apply to real property, repeal could make upgrading facilities more costly for manufacturers, impacting real estate prices and restricting manufacturers growth. Repeal of LKEs could also make it more difficult for companies to better align real properties to current business needs. e. Last-in, First-out (LIFO) Method 10

11 For more than 70 years, companies have been using the last-in first-out (LIFO) accounting method to determine financial statement earnings and tax liability. It allows taxpayers to match current sales revenues with current inventory replacement costs. By taking into account the greater cost of replacing inventory, LIFO results in a more conservative measure of the financial condition of the business and the economic income subject to tax. The LIFO method is the predominant method of accounting for industries that carry inventories of goods, including manufacturing, mining and energy production. The NAM opposes the LIFO repeal proposal in the discussion draft, which would impact hundreds of thousands of U.S. businesses of all sizes in all industry sectors. Companies currently using the LIFO method would be subject to a one-time tax on their LIFO reserves and higher future tax bills on the appreciation in value of their inventory. The retroactive nature of this tax, coupled with the inability to use the LIFO method prospectively, would cost manufacturers billions of dollars in immediate and future taxes. For some LIFO companies, this burden would not necessarily match up with a revenue-generating event to provide the cash to pay the tax bill. For companies that do have cash on hand, this retroactive tax would take capital away from other growth priorities and put these companies at a competitive disadvantage vis-àvis peer firms, foreign or domestic, that do not face this additional tax burden. These additional costs and their impact on working capital will make it more difficult for manufacturers to expand their businesses and hire new workers. In some cases, the additional tax burden would exceed the company s annual capital expenditure budgets, impairing manufacturers borrowing ability. f. Research and Development i. Overview The NAM believes it is critical for any tax reform plan to recognize the important role of research and technology investment in the growth of U.S. jobs and innovation. The United States has been a leader in promoting R&D for more than 30 years, but more and more countries have provided greater certainty for businesses in recent years by enacting permanent R&D incentives. A top priority of NAM members is to ensure that manufacturers in the United States are the world s leading innovators. The tax treatment of R&D, including the current deduction for R&D expenses and a strengthened and permanent R&D incentive, is critical to achieving this goal. ii. R&D Expenses Maintaining the current tax treatment of R&D expenses along with a strong and permanent R&D incentive will allow the United States to remain competitive in the global race for R&D investment dollars, particularly as countries with more generous and stable R&D tax incentives and lower corporate tax rates court manufacturers. While manufacturers very much appreciate current efforts by Chairman Camp and the committee to advance pro-growth tax reforms that include a permanent R&D incentive, we do have concerns with the R&D provisions in the discussion draft that would require R&D expenditures to be amortized over five years and make modifications to the R&D credit. Under the discussion draft, manufacturers would no longer be able to immediately deduct research and experimentation expenses, as currently allowed under Section 174 of the tax code. Instead, taxpayers would be required to amortize R&D expenditures over five years. 11

12 Removing the ability to immediately deduct R&D expenditures would make the United States an outlier in terms of global incentives for innovation. Indeed, the proposal would act as a disincentive to research investment and make the United States even less competitive in the global race for R&D investment dollars. Section 174 was added to the tax code to both encourage R&D and remove the uncertainty in its tax accounting treatment. Previous rules required taxpayers to capitalize R&D expenses and suspend them until it was determined whether the research was successful, which is not always apparent at the time the expenses are incurred. Congress acted to remove this uncertainty by allowing R&D expenses to be deducted in the year incurred. Unfortunately, the discussion draft would revert back to a complex and difficult system of tax accounting that does not reflect the true nature of engaging in R&D and the fact that these investments do not always result in a successful outcome. Moreover, the inability to currently deduct R&D expenses would raise taxes significantly for companies engaged in R&D. According to the Joint Committee on Taxation, changing the tax treatment of R&D expenditures would raise some $192 billion, a significant tax increase on companies that perform R&D. Given that the inherently uncertain outcomes of experimental research, manufacturers need to be able to write off the costs associated with these investments when they are incurred. The NAM recommends that the current tax treatment of R&D expenses be retained. Indeed, given the critical importance of R&D and innovation to the U.S. economy, this is the time to enhance, not cut back, R&D incentives. The NAM, therefore, supports both the continuation of the R&D deduction in its current form and an enhanced permanent R&D credit. iii. R&D Credit First enacted more than 30 years ago, the R&D credit is a proven incentive for spurring privatesector investment in R&D and creating domestic, high-wage jobs. R&D fuels innovation that translates into new product development and increased productivity two key factors necessary for growth in manufacturing. The R&D credit is a true U.S. jobs credit 70 percent of credit dollars go toward the salaries of high-skilled R&D workers. Studies have shown that strengthening the R&D incentive and making it permanent would significantly increase employment, by as much as 510,000 jobs in the next decade. 7 Strengthening and making the R&D credit permanent would also restore U.S. leadership in global innovation. The United States was once the leader among developed countries in providing the best R&D incentives. Unfortunately, according to a recent Organisation for Economic Co-operation and Development study, the United States now ranks at 22nd 8 among industrialized countries, as many have created more robust and permanent R&D incentives. While the discussion draft takes the critical step of making the R&D credit permanent, it also is important that the incentive to invest be enhanced so that the United States can regain its position at the top of global innovators. 7 Milken Institute, Jobs for America: Investments and Policies for Economic Growth and Competitiveness, (January 2010). 8 Organisation for Economic Co-operation and Development, Science, Technology and Industry Scoreboard, December 2013, p

13 To compete successfully with other countries for R&D dollars, the alternative simplified credit (ASC) formula currently 14 percent needs to be increased to 20 percent. The ASC makes it easier for companies of all sizes to use the R&D credit. The NAM and the broader R&D Credit Coalition have supported legislation (H.R. 4438) introduced by Reps. Kevin Brady (R-TX) and John Larson (D-CT) to boost the ASC to 20 percent while allowing the regular credit to expire. Under this proposal, many manufacturers that currently use the regular credit would be able to switch to the ASC without losing incentive value. The Brady-Larson bill was approved by a bipartisan vote in the House, illustrating the strong bipartisan support in Congress for strengthening the R&D credit with a 20 percent ASC and making the incentive permanent. Unfortunately, the discussion draft would only increase the ASC to 15 percent and eliminate the regular credit. For those companies using the regular credit, the proposal to eliminate the regular credit while only increasing the ASC by one percent would not make up for the elimination of the regular 20 percent credit, particularly if R&D expenses cannot be deducted in the year incurred. The NAM recommends the ASC be enhanced to 20 percent to make the United States more competitive with other countries offering far more generous R&D incentives. The NAM has long advocated for a strengthened R&D incentive to boost growth and global competiveness. Manufacturers are concerned that the proposed narrowing of the credit in the discussion draft, which eliminates amounts paid for supplies or computer software from the definition of qualified research expenses, would be a step backward in promoting U.S. innovation. Since many manufacturers engage in R&D, requiring the use of both supplies and computer software, the NAM strongly supports a permanent extension of the R&D credit that maintains the current definition for qualified research expenses. Manufacturers claim the most R&D credit amounts of any industrial sector. After wages, supplies account for the highest use of credit dollars for manufacturers, in many cases making up one-third of the total credit value. NAM members need equipment, raw materials and instruments to conduct research and test new technologies. The inability to claim the credit for supplies used in conducting research would significantly reduce the credit s incentive value. While the discussion draft suggests that removing supplies would reduce controversy with the IRS, manufacturers have found that recent IRS guidance has helped clarify the prior uncertainties regarding the treatment of supplies. The NAM recommends that supplies continue to be considered a qualified research expense eligible for the R&D credit. Moreover, eliminating supplies from the definition of qualifying expenses for the credit would increase costs for private sector R&D, with manufacturers bearing the brunt of these additional expenses. The NAM is also concerned that the discussion draft would further weaken the credit by eliminating computer software from the definition of qualified research. Manufacturers spend billions of dollars annually on computer expenses in the course of research and experimentation, in undertaking the creation of new software products and in developing software to facilitate innovative manufacturing processes. These activities contribute to economic growth and help to employ millions of highly skilled workers here in the United States. Since no other country specifically denies credit eligibility for all software costs, removing computer software from being considered for the R&D credit will reduce its incentive value and push research activities involving software, and the jobs they create, overseas to countries that do not have such restrictions. The NAM recommends that computer software be retained and considered a qualified research expense eligible for the R&D credit. 13

14 Given the global nature of the 21 st century economy, any proposal to limit U.S. R&D expensing and tax credits would further weaken the incentive to innovate domestically. In addition to offering more robust and permanent R&D credits, many countries have offered non-tax incentives to locate R&D activities within their borders, such as a skilled workforce educated in technical and scientific fields and dedicated research centers. In this very competitive global environment, U.S. companies are already under strong pressure to take advantage of these opportunities. The discussion draft would further increase this pressure. Clearly, private-sector research and development are critical to our nation s ability to innovate and compete. Manufacturers account for the lion s share of R&D in the United States, and its tax treatment plays an important factor in their ability to perform R&D. NAM urges the committee to consider a permanent R&D incentive that retains the current year deduction for R&D expenses, boosts the ASC to 20 percent, and retains supplies and software expenses as qualifying for the credit. V. International Tax Rules b. Overview To make manufacturers in the United States more competitive, the NAM supports moving from our current worldwide approach to a modern, competitive international tax system similar to those found in most industrial countries and structured to enhance U.S. competitiveness, not raise additional revenue. To that end, the international tax provisions in the discussion draft represent an important step in the right direction. At the same time, NAM members also feel strongly that some issues raised by the discussion draft need to be addressed to achieve an international tax system that will operate in the manner intended. c. Participation Exemption System By moving to a dividend exemption system, the legislative changes proposed by the discussion draft would fundamentally alter the way the United States taxes foreign income. Under the proposal, U.S. corporate taxpayers would receive a 95 percent dividends-received deduction (DRD) for foreign source dividends from foreign corporations in which they have a 10 percent or more interest. The NAM believes that this approach is a very important step in creating a pro-manufacturing tax climate that will enhance U.S. competitiveness, not raise revenue. Adopting a modern international tax system like those used by other industrialized countries will allow U.S.-based companies to compete on a more level playing field. In particular, a modern, competitive system would allow for the free flow of capital from foreign operations back to the United States for reinvestment in the domestic economy. The current high corporate tax rate of 35 percent even though partially offset by foreign tax credits at lower tax rates imposed outside the United States often results in a high residual U.S. tax charge on the repatriation of earnings from foreign subsidiaries. This additional charge causes what is often referred to as a lockout of earnings, preventing them from being repatriated to the United States without a significant cost. The proposed corporate tax rate of 25 percent coupled with the 95 percent DRD would reduce this disincentive to repatriate foreign earnings, freeing up resources for investment in the United States. 14

15 Territorial systems similar to the one proposed by the discussion draft are now the international norm. The vast majority of our trading partners employ a territorial system of taxing foreign income. In recent years, Japan and the United Kingdom two of the world s largest economies abandoned worldwide taxation systems in favor of a territorial approach. Adopting a tax system that is not more burdensome than those that apply to foreign manufacturing companies is critical to the ability of U.S. manufacturers to compete in the global marketplace. A competitive tax system will impact jobs at U.S. headquarters, increase exports from U.S. manufacturers and improve the efficiency of their supply chains. Finally, the enactment of a modern international tax system would simplify U.S. tax law by eliminating several complex tax rules. For example, the discussion draft would significantly reduce the importance of the foreign tax credit. Eliminating the use of the foreign tax credit system as the primary means of preventing international double taxation will reduce the possibility of double taxation currently experienced by U.S. multinationals. For example, the rules for allocating and apportioning interest expense have long been criticized for overallocating interest expense to foreign source income, resulting in double taxation of foreign source income. 9 By limiting the importance of the foreign tax credit rules, this and other inequities in the rules are minimized. Under the discussion draft, the foreign tax credit would be relevant primarily to Subpart F income and withholding taxes on interest and royalties earned from foreign loans and licenses. Taxpayers would be required to compute only one foreign tax credit limitation, rather than separate limitations for separate baskets. In addition, only directly allocable expenses would reduce the limitation. The NAM believes these proposed changes are important steps toward eliminating the complexity of the U.S. tax system and addressing the policy issues of double taxation. The NAM generally supports the partial exemption approach taken by the discussion draft, which would continue to tax five percent of the dividends from controlled foreign corporations (CFCs). While the NAM would prefer the approach taken by many of our trading partners, including the United Kingdom, Spain, Denmark, Finland, Austria and Netherlands, which provides a 100 percent participation exemption, we realize that the taxation of five percent of CFC dividends presumably obviates the need to allocate costs such as administrative expenses and research and development that support U.S. multinationals global operations. These expenses cover activities that generate high-paying U.S. headquarters jobs that might not otherwise be located in the United States. The NAM also supports maintaining the current tax treatment of branches, as provided in the discussion draft. Earlier proposals, which would treat certain foreign branches of domestic corporations like CFCs for all purposes of the code, would be unworkable and penalize companies with existing branches. Manufacturers are concerned that the new system could make it difficult for companies with excess foreign tax credits (generally U.S. headquartered multinationals that incurred U.S. losses in the past) to use their excess credits before they expire. Thus, the NAM recommends that current domestic source loss recapture rules be amended so that the 100 percent of domestic source income could be characterized to the extent of prior year domestic source losses. While 9 See, e.g., H.R. Rep. No , at (2004), setting forth the committee s reasons for adopting what became code Section 864(f). 15