Tax policy and tax reform in an uncertain world: What is driving the tax legislative and tax reform agenda, and how to prepare for change 5 December 2011
Disclaimer Any US tax advice contained herein was not intended or written to be used, and cannot be used, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Page 1
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Presenter Gary Gasper Washington Council Ernst & Young, Ernst & Young LLP 1001 Pennsylvania Avenue, NW, Suite 601, North Concourse Washington, DC 20004 +1 202 467 4302 gary.gasper@wc.ey.com Page 3
Agenda Congressional landscape and deficits Congressional agenda: jobs, extenders Supercommittee Tax reform 01 02 03 04 Page 4
Current and future deficits and federal debt $1.3 trillion FY2011 deficit $3.5 trillion FY2012 2021 deficit under current law Current policies Extending Bush tax cuts beyond 2012 AMT patch beyond 2011 Other tax provisions (e.g., payroll tax cut) Tax extenders beyond 2011 (e.g., R&D credit) Medicare payment rates for physicians services beyond 2011 $8.5 trillion FY2012 2021 deficit under current policies Federal debt, 2011: $14.8 trillion Debt projection, 2021: $21.3 trillion Page 5
Despite changes in the mix of federal revenue, total federal revenue has remained relatively constant over time Composition of federal spending as a percent of GDP: 1970 to 2010 50 Percent of GDP 45 40 35 30 25 20 15 18.0% historical revenue level, 1970 2010 Discretionary and other mandatory spending Net interest Social Security outlays Medicare and Medicaid 10 5 Federal revenues 0 1970 1980 1990 2000 2010 2020 2030 2040 2050 Sources: Congressional Budget Office, Long-Run Budget Outlook Alternative Fiscal Spending Scenario (June 2010); Monthly Treasury Statement (September 2010), for FY 2010 only. Page 6
Congressional landscape and deficits Congressional agenda: jobs, extenders Supercommittee Tax reform 01 02 03 04 Page 7
Issues for consideration by Congress in remainder of 2011 1 2 3 4 5 Job creation Deficit reduction Tax reform Extenders Repeal of 3% withholding for government contractors; hiring credits done Supercommittee seeking agreement on at least $1.2 trillion in savings by November 23 Extenders, Medicare physicians payment rate (doc fix) Payroll tax relief; unemployment insurance (UI) 100% expensing Infrastructure spending; repeal of regulations Repatriation proposals for temporary lower tax rate for repatriated foreign earnings President s plan; $3 trillion in deficit reduction, half of which is from tax increases Now what? House Ways and Means Chairman Camp (R-MI) October 26 released discussion draft on international reform, move to territorial Base broadening to lower rates Treasury white paper? Appropriations: FY2012 funding, highway spending Page 8
Obama American Jobs Act of 2011 1. Payroll tax relief: Reduce employee payroll taxes to 3.1% for 2012 Employers payroll taxes cut to 3.1% (limited to first $5m in wages), eliminated for increases in wages (limited to $50m increase in wages) 2. Delay 3% withholding on government contractors 3. Increase jobs credit Up to $9,600 for hiring certain longterm unemployed veterans Up to $4,000 for hiring long-term unemployed 4. 100% expensing extended through 2012 5. Extend UI benefits for long-term unemployed 1. Limit to 28% the benefit of certain individual itemized deductions and income exclusions for individuals earning more than $200,000 (joint filers > $250,000) 2. Corporate jet depreciation lengthened to 7 years from 5 3. Tax carried interest as ordinary income 4. Repeal many oil and gas industry preferences Page 9
Senate Democrats breaking up President s job plan, with millionaires surtax as offset S. 1660, The American Jobs Act (President s plan minus original offsets) rejected 50-49, October 11 S. 1723, The Teachers and First Responders Back to Work Act rejected 50-50, October 20 S. 1769, Rebuild America Jobs Act (infrastructure investment) rejected 51-49, November 3 Incentives to hire veterans Offset with surtax on taxpayers with adjusted gross income over $1 million Page 10
Tax proposals of interest to tax-exempt entities President Obama s budget, jobs, deficit plans Limit on itemized deduction to 28% Payroll tax relief: Employee side reduce to 3.1% Employer side reduce to 3.1% Worker classification changes Congressional and other proposals and activities Limit on itemized deduction to a certain percent of adjusted gross income (AGI) 3% Eliminate and/or reduce the exclusion for employer-provided health care Tax reform Potential hearings in tax-writing committees Page 11
Tax extenders; doc fix More than 60 tax provisions expire Dec. 31, 2011 the tax extenders that are normally extended as a package. A one-year extension of business and individual provisions costs more than $30 billion. A one-year AMT patch adds another $70 billion +. Doc fix costs $12 billion for one year. Precedent has been set for the provisions expiring, then seamlessly extended. Page 12
Scheduled 2013 individual tax rates Description Current rates Scheduled rates for 2013 Other additions Individual income tax rates Qualified dividends 0%, 15% 10%, 25%, 28%, 33%, 35% 15%, 28%, 31%, 36%, 39.6% Reinstate personal exemption phase-out (PEP) and Pease limitation on itemized deductions Individual income tax rate, with top rate of 39.6% Individuals with income over $250,000 (joint) or $200,000 (individual) face tax increases of both: 0.9% on wages (on amounts exceeding threshold) 3.8% on investment income (e.g., interest, dividends, capital gains) if AGI exceeds threshold Long-term capital gains 0%, 15% 20% Estate tax 35% top rate, $5 million exemption 55% top rate, $1 million exemption Page 13
Repatriation Group of multinationals pushing for lower tax rate on repatriated foreign earnings Sen. Carl Levin s PSI report released October;11 questioned economic benefit of 2004 AJCA provision. April 2011 JCT estimate projected reinstatement of Sec. 965 to cost approximately $80 billion. H.R. 1834 Reps. Kevin Brady (R-TX) and Jim Matheson (D-UT) repatriate foreign earnings at 5.25% tax rate, with penalty for companies that repatriate and subsequently reduce US employment S. 1671 October 6 Sens. Kay Hagan (D-NC) and John McCain (R-AZ) repatriate foreign earnings at 8.25% tax rate, or 5.25% for companies that expand payroll by 10% in 2012; penalty for reducing employment after distribution Page 14
Congressional landscape and deficits Congressional agenda: jobs, extenders Supercommittee Tax reform 01 02 03 04 Page 15
Budget Control Act of 2011 deficit reduction compromise Republicans No tax increases as part of deficit reduction proposals Focus on spending cuts Democrats Deficit reduction proposals should reflect a shared sacrifice by increasing taxes on the wealthy No cuts to entitlement programs Agreed to Budget Control Act with: 1. Caps on discretionary spending, $900 billion debt limit hike 2. Supercommittee to agree on at $1.2 trillion in deficit reduction (failed) or $1.2 trillion in automatic cuts starting January 2013 3. Now automatic cuts (sequestration) start in 2013 with $600 billion from domestic and $600 billion from defense Page 16
Supercommittee members Supercommittee members Rep. Jeb Hensarling (R-TX), co-chair Rep. Dave Camp (R-MI) Rep. Fred Upton (R-MI) Sen. Jon Kyl (R-AZ) Sen. Rob Portman (R-OH) Sen. Pat Toomey (R-PA) Sen. Patty Murray (D-WA), co-chair Sen. Max Baucus (D-MT) Sen. John Kerry (D-MA) Rep. Xavier Becerra (D-CA) Rep. James Clyburn (D-SC) Rep. Chris Van Hollen (D-MD) Page 17
President Obama's recommendations to Supercommittee President Obama s deficit reduction plan Living within our means and investing in the future: the President s plan for economic growth and deficit reduction Interest savings $430 billion Mandatory spending cuts: $577 billion Medicare: $248 billion Medicaid: $72 billion Other: $257 billion Winding down wars in Iraq, Afghanistan $500 billion Tax changes $1.5 trillion 2001/2003 tax cuts expire for high incomes $866 billion 28% benefit limit on itemized deductions and exclusions Closing $410 billion loopholes and eliminating special interest tax breaks. $300 billion Page 18
President Obama's tax increase proposals American Jobs Act offsets International tax Revenue proposals in September 19 White House report Repeal LIFO Repeal lower-of-cost-or-market inventory accounting method Eliminate coal preferences Insurance proposals (life insurance contracts, dividends-received deduction, expand pro rata interest expense disallowance) Reinstate Superfund taxes Make unemployment insurance (UI) surtax permanent Worker classification Financial Crisis Responsibility Fee Defer deduction of interest expense related to deferred income Determine foreign tax credit on a pooling basis Tax excess returns associated with transfers of intangibles offshore currently Limit shifting of income through intangible property transfers Limit earnings stripping by expatriated entities Tax carried interest as ordinary income Repeal many oil and gas preferences Limit to 28% certain individual itemized deductions and exclusions for individuals earning more than $200,000 (joint filers more than $250,000) Lengthen corporate jet depreciation to 7 years from 5 years Modify rules for dual capacity taxpayers $ raised/10yrs $52 billion $8 billion $2 billion $12 billion $19 billion $15 billion $8 billion $30 billion $36 billion $53 billion $19 billion $1 billion $4 billion $13 billion $41 billion $410 billion $5 billion $10 billion Page 19
Congressional landscape and deficits Congressional agenda: jobs, extenders Supercommittee Tax reform 01 02 03 04 Page 20
Major issues in tax reform Income or consumption tax? Experts from both parties have recommended a value-added tax (VAT) or other consumption tax. Some argue a consumption tax is necessary to raise money necessary to fund entitlements. Democratic Senators (Conrad, Cardin, etc.) have shown particular interest in a VAT. Worldwide or territorial? The current worldwide system taxes domestic companies foreign-earned profits. US is the only major country with a worldwide system; Japan, UK recently went to territorial. Consensus is that worldwide system makes US an unattractive place to invest; territorial is preferable. Corporate or comprehensive? There is concern that corporate reform will repeal provisions beneficial to pass-through entities without lowering rates applicable to them. Consensus is that business rather than corporate reform should be pursued. Administration is considering $50 million gross receipts threshold above which certain passthrough entities would be taxed as corporation. How low of a corporate rate? Rate would have to dip into 20s to be effective in making US attractive for investment. Every percentage point reduction in rates costs $100 billion over 10 years. Congressional Republicans set 25% top rate as target. Page 21
President Obama s tax reform principles Comprehensive tax reform must: 1. Lower tax rates 2. Cut loopholes and tax breaks 3. Reduce the deficit by $1.5 trillion 4. Boost job creation and growth 5. Adhere to the Buffett Rule, a new principle requiring that those making more than $1 million per year should not pay a smaller share of their income in taxes than middle-class families Page 22
Corporate tax rates in the OECD, 2011 Percent 45 40 35 30 25 GDP-weighted Average (excluding US) 29.9% Simple Average (excluding US) 25.1% 20 15 10 5 0 Note: Includes both national and sub-national statutory corporate tax rates. Source: Organisation for Economic Co-Development, International Monetary Fund Page 23
Every percentage point reduction in rates costs $100 billion over 10 years $100 billion over 10 years = cost of reducing corporate tax rate by 1% Eliminating all corporate tax expenditures could reduce rate from 35% to 27% or 28% Page 24
Highlights of JCT estimates on repeal of corporate tax expenditures memo to Cong. Levin (D-MI) October 27 Provision to be repealed Repeal MACRS/apply ADS Expensing of R&D expenditures Domestic production activities deduction LIFO Low-income housing tax credit Deferral of gain on like-kind exchanges Completed contract rules method Percentage depletion for oil and natural gas wells/coal Exclusion of interest on private activity bonds $ raised/10 years* $507 billion $152 billion $127 billion $63 billion $33 billion $16 billion $14 billion $10 billion $9 billion * Portion of revenue attributable to C corps Page 25
Overview of Camp tax reform discussion draft High-level overview Move toward territorial intended to be revenue-neutral Corporate rate reduced to 25% Corporate base broadening/individual tax changes forthcoming 95% dividend exemption for foreign source active income of controlled foreign corporations (CFCs) Foreign branches treated as CFCs Transition rule: 5.25% mandatory tax on pre-effective date foreign earnings, which can be spread over a period of up to eight years Page 26
House Ways and Means Chairman Camp s tax reform discussion draft key elements Tax rate Dividends received deduction Transition rules CFC rules Subpart F Base-erosion rules 25% maximum corporate rate (no offsets specified) Stated intent for 25% individual top rate as part of broad reform 95% deduction for the foreign-source portion of dividends received from controlled foreign corporations 5% subject to tax (1.25% effective rate) No regime for allocating US incurred expenses to foreign exempt earnings 95% deduction for gain on disposition of stock in certain active CFCs (no deduction for losses) 5.25% mandatory tax on pre-effective date foreign earnings, which can be spread over a period of up to eight years (with interest) Actual distribution of these same earnings would be subject to an additional 1.25% tax Treat foreign branches as CFCs Treat foreign corporations that are not CFCs but have 10% US corporate shareholders (10/50 corps) as CFCs Retains the framework of Subpart F but repeals: The current inclusion rule for investment of earnings in US property The income exclusion for previously taxed earnings Thin cap rule would limit deductibility of net interest expense if a US company that is a member of a worldwide group fails a two-part test In addition, three proposed options: Treat excess income from transfers of intangible property as Subpart F income Include a new category of Subpart F income for lowtaxed cross-border income Tax all of a CFC s foreign intangibles income as Subpart F income subject to a 15% tax rate Page 27
Camp tax reform discussion draft thin cap Thin capitalization rule: would disallow portion of net interest expense if US company fails two-pronged test: US group is overleveraged relative to the worldwide group US company s net interest expense exceeds an unspecified percentage of adjusted taxable income Page 28
Camp tax reform discussion draft base erosion options Three alternative base erosion options: Treasury s excess returns proposal Low-taxed (10%) cross-border foreign income treated as Subpart F income (similar to Japanese regime) Foreign intangible income taxed at 15% when earned directly by US corporation or as Subpart F income of CFC Exclusion from Subpart F if taxed at more than a prescribed rate (the draft suggests 13.5%) Page 29
Conclusion Page 30