Spring is in the air, as is tax reform. Just as many of us filed our individual income tax returns April 18, the hype began on an upcoming announcement by the Trump administration on tax reform. The press conference April 26 announced a high-level outline without any significant discussion of details.
Changes in the United States tax code have been a long time coming. The U.S. tax code has been criticized in recent years by many as being anti-competitive when compared to the tax regimes of U.S. trading partners. This criticism may have some merit when comparing the current U.S. corporate tax rate to our trading partners, such as the United Kingdom, Canada, Germany and China. The current U.S. corporate (combined federal and state) tax rate is nearly 40 percent and is significantly in excess of the tax rate in the trading partners mentioned above. The proposal of a 15 percent U.S. federal corporate tax rate will change the playing field for many multinational companies in the country. State taxation also may be impacted by any federal tax reform.
The last reduction in the U.S federal corporate tax rate was the rate reduction (from 46 percent to 34 percent) included in the Tax Reform Act of 1986. At that time, the U.S. had the lowest corporate tax rate among most of its trading partners. The reduction in the top line tax rate was offset by expanding the tax base, including limiting certain deductions and the reduction or elimination of certain tax credits. In the 30-plus years since, there have been many adjustments and changes to tax rates, tax deductions and tax credits. In addition, the individual tax rates have increased since the reduction in the rates enacted back in 1986. Over the years, the top federal marginal individual tax rate has changed from 28 percent to the current tax rate of 39.6 percent (before the net investment income tax of 3.8 percent). There also have been changes in deductions, items of taxable income and tax credits during this time.
The individual tax rate and tax base changes have impacted business taxation, as many small- and medium-sized businesses in the U.S. operate as flow-through or pass-through entities (such as sole proprietorships, partnerships — including limited liability companies or LLCs — and S corporations). The flow-through business income is taxed on the owner’s individual income tax return. The announcement of the proposal of a 15 percent rate on earnings of flow-through entities April 26 also garnered keen interest among business owners. How the actual interplay of entity and individual taxation will work ultimately will impact the effective tax rate paid by the entities and by the owners of the flow-through businesses.
To many, the announcement April 26 was encouraging. Lower corporate and business tax rates, lower individual tax rates, and the repeal of the alternative minimum tax and the estate tax are popular proposals. However, there wasn’t much detail provided with respect to the timing, the transition, and what, if any, offsets there may be in order to accomplish major tax reform.
For those businesses with overseas operations with cash that has not been repatriated, the April 26 announcement indicated a reduction in the taxes on repatriating such foreign earnings to the U.S. As we have commented in the past, the U.S. is one of a few countries that still taxes its corporations on a worldwide basis. Under the U.S. system, the U.S. taxes business earnings earned in foreign subsidiaries when the earnings are distributed or deemed distributed to its U.S. owner. Most other countries provide for a dividends received deduction, a participation exemption, or utilize a territorial tax system that effectively exempts or taxes at a very nominal rate the earnings of foreign subsidiaries. Such countries as Canada, Germany, France and the United Kingdom have such a tax regime.
All of the countries mentioned also have some form of a value added tax (VAT) system in addition to their corporate and individual income tax regimes. The VAT regimes are similar to a sales tax regime but typically assessed at a higher rate and a more broad tax base. In recent months, we have seen some tax reform discussion, including the possibility of a border adjustment tax (BAT) that would reward export activity and tax import activity. Many have raised a number of issues with respect to whether a BAT would be compliant with current trade and treaty agreements.
The BAT proposals have had mixed reaction by businesses. Often, the reaction is based, in part, on whether such a change helps or hurts their current tax position. In addition, many of our trading partners have serious concerns on the implementation of any BAT or similar tax. There has been some analysis of the negative impacts of a BAT by our major trading partner Canada. Any U.S. tax changes that involve a BAT or VAT could have significant impact on businesses, consumers and tax compliance in the U.S.
The current and upcoming debate on tax reform has allowed me to take a step back and recall 1986 when I was early in my career in public accounting. Reflecting back to 1986, the reduction in corporate and individual tax rates also was accompanied by changes in the tax base. Certain itemized deductions were limited. The investment tax credit for equipment purchases was eliminated. In addition, losses from passive activities were limited, and the alternative minimum tax as we know it today was retooled with new adjustments and preferences in its calculation. Also, long-term captial gains and ordinary income were taxed at the same marginal tax rate. There were many transition rules to allow a smooth transition from the former rules to the new rules.
The unanswered question with tax reform in 2017 is, “What exactly will it look like?” The various proposals have given some insight into what reform may include. The challenge for taxpayers is to be able to make decisions regarding capital purchases, hiring and repatriation of earnings, as these types of decisions are impacted by what tax reform brings. Effective dates and transition rules will impact the timing of when any tax reform provisions will take hold.
Patience may be required as tax reform comes together. The ability to react and make quick decisions may prove invaluable, as timing could be everything in taking full advantage of various provisions that may be included in any tax reform package. Understanding the proposals early and their impact on one’s situation will greatly aid in taking advantage of the impending change.
William F. Roth is a tax partner with the local office of international accounting firm BDO USA LLP. The views expressed above are the author’s and not necessarily those of BDO. The comments are general and not to be considered specific tax or accounting advice or relied upon for the purpose of avoiding penalties. Readers are urged to consult their professional advisers.