An Experiment in Reforming the Tax System
A Summary and Analysis of the Report of the President’s Advisory Panel on Federal Tax Reform

By Larry Witner, Kathleen Simons, Tim Krumwiede, Andrew Duxbury, and Michael C. Plaia

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Prologue

FEBRUARY 2006 - In January 2005, President Bush appointed a nine-member advisory Panel to make recommendations for reforming federal tax laws. A review of the Panel’s interim work was described in the October 2005 CPA Journal (“Federal Tax Reform,” page 20).

The Report of the President’s Advisory Panel on Federal Tax Reform, titled “Simple, Fair, and Pro-Growth,” was issued November 1, 2005.

The report’s recommendations are described here as follows:

  • Taxation of Households (page 45);
  • Savings and Retirement Plans, Capital Income (Dividends, Interest, Capital Gains) (page 49);
  • Taxation of Business (page 52);
  • Taxation of International Transactions (page 55); and
  • Epilogue (page 59).

This prologue contains preliminary remarks, and it comments on factors that may have influenced the Panel’s work and conclusions.

The Panel and Its Charge

Some critics have claimed that the selection of the Panel’s members and staff preordained the outcome. The authors leave it to others to affirm or refute this allegation. The authors believe that the members made a valiant effort, produced results that will shape the upcoming debate, and deserve the nation’s appreciation. The following factors, rather than the composition of the Panel itself, may better explain what influenced the Panel’s work.

The President’s charge. In his charge to the Panel, President Bush instructed it to make recommendations that promote simplicity, fairness, and economic growth, encompassing—

  • reducing costs of compliance;
  • recognizing the importance of home ownership and charity;
  • increasing saving and investment; and
  • strengthening U.S. competitiveness in the global marketplace.

In addition, President Bush instructed the Panel to—

  • base at least one of its recommendations on the current tax system;
  • make recommendations that are “appropriately progressive”; and
  • make recommendations that are revenue neutral (i.e., that collect the same amount of taxes as current projections).

Some critics have claimed that this charge stacked the deck for or against certain reform measures. This criticism has merit. For example, there are legitimate arguments both for and against the home mortgage interest deduction. By emphasizing the importance of home ownership, the President weighed in on one side of the debate and may have predetermined the Panel’s final recommendation. The Panel did not comment on the appropriateness of the President’s charge and what effect, if any, it had on simplification and fairness.

Self-imposed constraint: progressivity. The Panel imposed on itself a constraint to keep the distribution of the tax burden (i.e., level of progressivity) relatively the same as under the current tax system. (While the tax burden may be the same at the federal level under the Panel’s proposals, it may increase at the state level; see “Taxation of Households,” below.) The Panel reasoned that decisions about progressivity are best left to elected officials. There were no official minority reports to the Panel’s recommendations, but at the conclusion of the Panel’s work, Panel member Elizabeth Garrett expressed her personal concerns about poverty, growing income inequality, and inadequate government revenues:

Although I believe legislators should use this panel’s report as a roadmap for reform, they should use the structure we have provided to increase the progressivity of the tax system and to raise sufficient revenue to responsibly meet the country’s short- and long-term obligations. (2005 TNT 211-24)

Simplicity trumps other goals. The Panel recognized that simplicity may be at odds with differing notions of fairness and strategies for economic growth. For instance, it may be fair to target tax benefits toward low-income taxpayers and away from high-income taxpayers. It may be fair, but it will not be simple if it involves phase-outs, caps, floors, and the alternative minimum tax. The Panel decided to make simplicity a priority. Thus, when simplicity conflicted with other goals, more often than not simplicity won out.

Lack of consensus on alternatives. The Panel worked by consensus. Due to lack of agreement among the nine members on the feasibility or desirability of alternatives to the income tax system that were presented to them, they did not recommend a consumed-income tax, a national retail sales tax (NRST), or a value-added tax (VAT).

Two Integrated Packages

After 10 months of hearings and deliberations, the Panel formed a consensus around two recommendations: the Simplified Income Tax Plan (SIT) and the Growth and Investment Tax Plan (GIT). These plans are similar in their treatment of households (individuals), but they differ in their treatment of capital income (dividends, interest, and capital gains) and businesses.

The Panel viewed the provisions of each plan as integral, inseparable parts of the larger whole:

In isolation, some of the recommended pieces may be controversial, but, taken as a whole, they [the plans] accomplish the panel’s objectives [simplicity, fairness, economic growth]. Each plan is designed to be comprehensive and should be viewed as an integrated package.

Note on the Tables and Text

For several reasons, the reader may want to pay close attention to Form 1 on page 45, (a new Form 1040 based on the Simplified Income Tax Plan) and Form 2 on page 50, (a new Form 1040 based on the Growth and Investment Tax Plan). They reveal the Panel’s efforts to simplify the filing process, and the tables summarize, in a familiar visual format, much of the verbiage contained in the text.

The authors have attempted to be objective in their analysis, but despite their good intentions, some biases (liberal or conservative) may slip through. Please excuse the authors for this shortcoming, and feel free to correct or contradict them.

The expressions “currently” and “current law” are used to refer to tax law in effect in 2005. Citations are kept to a minimum; the source material, unless otherwise indicated, is the Panel’s 272-page report, which can be downloaded from www.taxreformpanel.gov.

Taxation of Households

By Larry Witner

The Report of the President’s Advisory Panel on Federal Tax Reform recommends two options: the Simplified Income Tax Plan (SIT) and the Growth and Investment Tax Plan (GIT). These plans are almost identical in their treatment of households (i.e., individuals), so there is no need to distinguish between the plans.

The Alternative Minimum Tax (AMT)

Currently, there are two methods for individuals to calculate their tax liability: the regular method and the AMT method. The AMT is a separate and parallel tax system with its own definitions, exclusions, deductions, credits, and tax rates. According to the Panel, the AMT is “the most vivid example of the wasteful complexity that has been built into our system to limit the availability of some tax benefits.”

The Panel noted that the AMT was passed in 1969 after it was found that a few hundred wealthy families had not paid any income taxes. The individual AMT’s function is “to ensure that no taxpayer with substantial economic income can avoid significant tax liability by using exclusions, deductions, and credits. … [I]t is inherently unfair for high-income individuals … to pay little or no tax due to their ability to utilize various tax preferences” (Senate Finance Committee Report, H.R. 3838, p. 518, U.S. Government Printing Office, May 29, 1986).

The AMT is not indexed for inflation, so, as time has passed since it became law, more and more middle-income individuals have become subject to the AMT. Unless something is done, in 2006 21 million taxpayers will be affected, and in 2015 52 million taxpayers will be affected.

For the sake of simplicity, and because the original intent of the AMT—limited application—has been foiled, the Panel recommends repealing the AMT. In the process, however, the U.S. Treasury would lose $1.2 trillion in projected tax revenues over the next 10 years. In this era of deficits, hurricanes, wars, baby-boomer retirements, prescription drug entitlements, inadequate healthcare, and so forth, the United States cannot afford to lose $1.2 trillion. The Panel was charged with making recommendations that were revenue-neutral, but it could not address government spending priorities or reductions that would potentially fund tax cuts. In the author’s opinion, once the Panel decided to repeal the AMT, that tax revenue had to be made up somewhere else. This need for additional revenue partially explains 1) the Panel’s efforts to broaden the tax base, 2) the Panel’s reduction of the home mortgage interest deduction and elimination of the state and local tax deduction, and 3) the Panel’s modest reduction in the tax rates, all of which are discussed below, and discussed in the accompanying article “Panel Discussion” on page 32.

Increasing Use of Credits

For several reasons, the Panel favors increasing the use of tax credits. To illustrate, the Panel uses the standard-deduction-versus-itemized-deduction scenario of the current tax system. Currently, 35% of individuals itemize deductions and 65% take the standard deduction. Thus, with regard to certain tax benefits available only to taxpayers that itemize, the 65% that take the standard deduction are “losers.” For those who do itemize, deductions are more beneficial to high-income individuals than to low-income individuals. For example, consider a hypothetical deductible expenditure of $1,000. Non-itemizers cannot take advantage of it. For itemizers, those in the 35% tax bracket save $350 in taxes ($1,000 x 35%), but those in the 15% tax bracket save only $150 in taxes ($1,000 x 15%).

Credits, on the other hand, do not play favorites. Reconsider the hypothetical expenditure of $1,000, and assume it qualifies as a credit, instead of as an itemized deduction. Regardless of whether the taxpayer is an itemizer or a non-itemizer, in the 35% bracket or the 15% bracket, a $1,000 credit saves taxes of $1,000. For this reason, the Panel favors increasing the use of credits, with its Family Credit, Work Credit, and Home Credit. It did, however, still recommend using deductions for charitable contributions, health insurance contributions, and Social Security benefits.

A New ’Family Credit’

Currently, in general, individuals may choose between itemizing deductions and taking the standard deduction ($10,000 for married couples; $5,000 for singles; $7,300 for heads of households). Certain itemized deductions phase out as income rises. Individuals can deduct a personal exemption ($3,200) for each member of their household, which likewise phases out as income rises. Individuals are also allowed a credit for child and dependent care for expenses incurred to enable individuals to work or seek employment, which phases out as income rises.

The Panel recommends doing away with the choice of itemizing deductions or taking the standard deduction. With no itemized deductions as we now know them, there would be no deduction for medical expenses and casualty losses.

The Panel recommends using a Family Credit to replace the standard deduction, the personal exemption, the credit for child and dependent care, head of household filing status, and the 10% tax bracket. The Family Credit would consist of the following:

  • A $3,300 credit for a married couple, a $2,800 credit for an unmarried person with a child, or a $1,650 credit for an unmarried person;
  • A $1,150 credit for someone who is a dependent of another;
  • An additional $1,500 credit for each child; and
  • An additional $500 credit for each other dependent.

The Family Credit would exempt most lower-income households from income tax. According to the Panel, the amount of income not subject to federal income tax under the Family Credit would be similar to the amount not subject to tax under current law.

A New ‘Work Credit’

Currently, there is an earned income tax credit (EITC) designed to encourage work by low-income individuals. The maximum credit for a working family is $2,747 with one child and $4,536 with two or more children. This benefit phases out as income exceeds certain levels. In addition, households are entitled to a child tax credit of $1,000 for each child under age 17. In certain cases, the credit is refundable. This benefit also phases out as income exceeds certain levels.

Some of these current provisions duplicate and overlap those discussed in the section above. The eligibility rules and the lengthy computations make it difficult for low-income individuals to claim the EITC without the help of a tax professional. More than 70% of EITC recipients use a paid preparer. Nevertheless, the error rates for individuals who claim the EITC and the refundable child tax credit are substantial. The Panel reveals that the EITC overclaim rate was 27% in 1999. At the same time, between 15% and 25% of eligible individuals did not claim the EITC.

Eligibility rules that vary by provision add complexity to the Tax Code. For example, the maximum ages for children under the child tax credit, the dependent exemption, and the EITC, are 16, 18, and 23, respectively. Numerous filing errors occur because taxpayers are required to determine their eligibility for each provision under different sets of rules.

The Panel recommends replacing the EITC and the refundable child tax credit with a Work Credit. The maximum Work Credit for a working family would be $3,570 for one child and $5,800 for two or more children. The Panel recommends setting the maximum age for children for both the Family Credit and the Work Credit at 18 (20 for full-time students). According to the Panel, the Work Credit provides about the same maximum credit as the combined amount of the current-law EITC and the refundable child tax credit.

Phase-outs. As with the current credits and deductions discussed above, many tax benefits phase out as income rises. Phase-outs are a source of complexity because, among other things, they phase out at different income levels, and they require lengthy worksheets to compute. Phase-outs are essentially backdoor tax increases (or stealth taxes) that enable lawmakers to avoid raising other taxes. For the sake of simplicity, with the exception of its Work Credit and Saver’s Credit, the Panel recommends repealing all phase-outs.

The Marriage Penalty

Currently, in some circumstances, two people will pay less tax if they file as two unmarried individuals rather than as a married couple. This is called the “marriage penalty.”

The Panel recommends reducing penalties for marriage by making the tax brackets and other tax provisions for married couples equal to twice the amount for unmarried individuals.

Home Ownership

Currently, for a primary and secondary home, an individual can deduct the interest on mortgages of up to $1 million for “acquisition debt” and $100,000 for “home equity debt.” Because the home mortgage interest deduction is available only to itemizers, merely 54% of homeowners who pay mortgage interest receive a tax benefit. Besides deducting mortgage interest, homeowners can deduct state and local property taxes, and when they sell, they can exclude a gain of up to $500,000 ($250,000 if single).

According to the Panel, taken together, these benefits provide a generous tax subsidy for individuals to invest in housing. According to statistics in the Panel’s report, the economy-wide tax rate on housing investments is close to zero, whereas the tax rate on business investments is about 22%. This may result in too much investment in housing and too little investment in business. According to the Panel:

While the housing industry does produce jobs and may have other positive effects on the overall economy, it is not clear that it should enjoy such disproportionately favorable treatment under the tax code.

According to the Panel, the original intent of the home mortgage interest deduction was to support the American dream of home ownership for everyone. The Panel believes that current law, with its arguably lavish provisions (multiple homes and million-dollar mortgages) that provide tax benefits disproportionately to high-income itemizers, may have strayed from the original intent. The Panel compared the incidence of homeownership to that in other countries. The Panel studied other countries that do not allow a home mortgage interest deduction (Canada, the United Kingdom, Australia), and found no correlation to homeownership (69% of U.S. households).

The Panel recommends replacing the home mortgage interest deduction with a Home Credit equal to 15% of the mortgage interest paid on acquisition debt. There would be no tax benefit (deduction or credit) for interest paid on second homes or home equity debt. Because it would be a credit, it would be available to all homeowners, not just itemizers as under the current system.

So as not to encourage overinvestment in housing, the Panel recommends limiting the amount of the Home Credit. The Panel believes that interest eligible for the credit should be limited to 130% of the average regional price of housing; in today’s market, this ranges from $227,000 to $412,000. According to comments made in the press by Connie Mack, chair of the Panel, fewer than 5% of mortgages in the United States exceed this proposed cap (“Panel Takes Aim at Treasured Tax Deduction,” Associated Press, www.msnbc.msn.com/id/9927167).

Current homeowners would have five years before they have to use the new credit. During this transition period, homeowners could still take a home mortgage interest deduction, but the size of the mortgage, the interest on which is deductible, would gradually decline. At the end of five years, everyone would use the Home Credit.

As readers might expect, this recommendation is controversial, especially for taxpayers in expensive real estate markets. The National Association of Realtors claims that if this recommendation becomes law, housing prices will fall by 15%. The Home Credit may not help homeowners in regions of the country where housing prices have skyrocketed, such as New York and California. Homeowners that itemize and that are in a tax bracket higher than 15% will see their tax benefits shrink. In response to these criticisms, the Panel would probably point to the benefits for non-itemizers and would ask itemizers to consider the package as a whole and not to pass judgment based on isolated provisions.

Under current law, upon sale, homeowners can exclude from income gain of up to $500,000 ($250,000 if single). The Panel recommends that the exclusion should be increased to $600,000 ($300,000 if single), and that it should be indexed for inflation. The Panel believes that the prerequisite for this benefit—the period of personal use and ownership—should be increased from two out of five years to three out of five years.

Charitable Contributions

Currently, itemizers (35% of taxpayers) can deduct their charitable contributions to the extent of, in general, 50% of their adjusted gross income. Non-itemizers (65% of taxpayers) do not receive a tax benefit for their donations to charity.

To extend the tax benefit, the Panel recommends that all taxpayers, whether or not they itemize, be allowed to deduct their charitable contributions to the extent the contributions exceed 1% of adjusted gross income. Under the recommendations, then, a 50% cap is replaced with a 1% floor. In this case, the Panel prefers a deduction over a credit, even though a deduction provides greater benefits to high-income donors, because the Panel believes this incremental incentive is an important source of charitable donations. (For a lengthier discussion of deductions versus credits, see the accompanying article “The SET Tax,” on page 14.)

The Panel wants a reporting requirement for charities. Specifically, the Panel recommends that charities be required to report large gifts ($600 or higher) directly to the IRS and to the taxpayer. Although some commentators believe that this could improve compliance, others wonder about the additional administrative burden.

Under current law, when an individual sells appreciated property and gives the sales proceeds to charity, two things happen: the taxpayer pays tax on the gain, and the (itemizing) taxpayer deducts the cash contribution. The Panel recommends that taxpayers be allowed to sell property without recognizing gain and receive a full charitable deduction, provided the entire sales proceeds are donated to charity within 60 days of the sale. The sale would provide an objective measure of the market value of the property, and it would reduce the charity’s administrative costs and the burden of selling the property. If property, rather than cash, is contributed, issues arise about the contribution’s value. The Panel recommends that the standards for appraisal be improved.

Health Insurance

Employer-sponsored health insurance is the primary source of health insurance for many Americans. Under current law, employees may exclude from income all of the premiums paid on their behalf by employers.

To level the playing field between workers that have access to employer-provided health insurance and those that do not, the Panel recommends that all individuals be allowed a deduction for health insurance premiums, regardless of the source. Furthermore, the Panel recommends capping this benefit at $5,000 for individuals and $11,500 for families, which is equal to the national average expected to be spent on premiums in 2006 (this cap would be indexed for inflation). The cap would be the maximum amount that employers could exclude from employee income, and similarly, it would be the maximum amount that individuals who buy their own health insurance could deduct from their income. The Panel estimates that the new deduction will reduce the number of uninsured Americans by one to two million people. This recommendation is controversial, and it represents a significant change from current practice.

State and Local Taxation

Currently, itemizers can deduct state and local income and property taxes. The Panel recommends repealing this deduction, using the following logic:

This deduction provides a federal tax subsidy for public services provided by state and local governments. Taxpayers who claim the state and local tax deduction pay for these services with tax-free dollars. These services, which are determined through the political process, represent a substantial personal benefit to the state or local residents who receive them …. The panel concluded that these expenditures should be treated like any other nondeductible personal expense, such as food or clothing, and that the cost of those services should be borne by those who want them—not by every taxpayer in the country.

This recommendation has been controversial in states with higher tax rates. For a fuller discussion of this provision, and a general discussion of the impact of the Panel’s proposed changes across states, please see the accompaying article “Panel Discussion” on page 32.

Education

Under current law, there are a number of duplicative and overlapping tax benefits for higher-education costs, including the Hope credit, the lifetime learning credit, the deduction of interest on student loans, and the tuition deduction. The differing definitions, allowable amounts, eligibility rules, and phase-outs for these various provisions increase complexity and taxpayer confusion. It is estimated that more than one-fourth of eligible taxpayers fail to claim one of these benefits.

The Panel recommends that tax preferences for education be simplified by replacing the current hodgepodge of deductions and credits through the new full Family Credit allowance of $1,500 for families with full-time students age 20 and under. The Panel also recommends that families be allowed to save tax-free for future education expenses. (See the section below dealing with savings and retirement plans.)

Fringe Benefits

Current law allows employees to exclude the value of fringe benefits received from employers. Besides the significant exclusion for health insurance (discussed above), these fringe benefits include educational assistance, childcare benefits, group term life insurance, and long-term care insurance.

According to the Panel, the favorable tax treatment of fringe benefits results in an uneven distribution of the tax burden, because workers that receive the same amount of total compensation may pay different amounts of tax depending on the mix of cash wages and fringe benefits. The Panel recommends putting all taxpayers on a level playing field by eliminating tax-free fringe benefits except for certain in-kind benefits provided to all employees. For example, the Panel recommends that meals at a company cafeteria remain untaxed, as under current law, but only if provided to all employees.

Social Security Benefits

Currently, there is a complicated three-tier structure whereby, based on the amount of outside income, retirees either 1) exclude all benefits, 2) include benefits based on a 50% test, or 3) include benefits based on an 85% test. There is a marriage penalty, and because the numbers are not adjusted for inflation, recipients are subject to “bracket creep” (i.e., taxes rise due to inflation).

The Panel recommends replacing the three-tier system of taxing Social Security income with a simple deduction. Married couples with income of less than $44,000 ($22,000 if single) would pay no tax on Social Security benefits. This recommendation eliminates the marriage penalty and indexes brackets for inflation. If retiree income exceeds these thresholds, Social Security benefits are included in income to the extent of the lesser of:

  • 50% of the amount by which income exceeds the threshold, or
  • 85% of benefits received.

Example. Assume a retired married couple has income of $50,000 ($40,000 in outside income and $10,000 in Social Security benefits), or $6,000 ($50,000 – $44,000) in excess of the threshold. They would include $3,000 in income, because this is the lesser of $3,000 (50% x $6,000) or $8,500 (85% x $10,000).

Tax Rates

An individual’s tax liability is calculated by multiplying the tax base (i.e., taxable income) by the tax rate. For derivation of the tax base, see Form 1 and Form 2. Currently, there are six tax rates for individuals: 10%, 15%, 25%, 28%, 33%, and 35%. The Panel’s proposal would reduce the number of tax rates to four in the case of the SIT, and to three in the case of the GIT (see Exhibit 1).

The Tax Reform Act of 1986 was successful because it broadened the tax base and reduced the rates. The Panel’s recommendations broaden the base, but reduce the tax rates only moderately. As mentioned in the Epilogue, below, if dynamic scoring is used to calculate the effects of tax cuts on government revenues, tax rates may be reduced further when Congress eventually drafts legislation.

The Impetus for Change

Analyses conducted by the Treasury Department that appear in the Panel’s report indicate that, on average, most taxpayers would not see a change in their tax burden under these proposals. What, then, is the driving reason behind these reforms? The Panel’s official answer is simplicity, fairness, and economic growth. It also believes that “a simpler and more transparent tax system would be less susceptible to tax avoidance.” Finally, according to the Panel, the new system would—

  • reduce time spent on filing returns and keeping records;
  • reduce out-of-pocket costs for paid preparers;
  • enable more taxpayers to prepare their own returns;
  • enable more taxpayers to understand how taxes are computed;
  • ensure that more taxpayers can correctly compute their tax liability without overlooking anything; and
  • engender in taxpayers more confidence in the tax system and the belief that other taxpayers have paid their fair share.

Larry Witner, LLM, CPA, is an associate professor at Bryant University, Smithfield, R.I.


Savings and Retirement Plans, Capital Income (Dividends, Interest, Capital Gains)

By Kathleen Simons and Larry Witner

As mentioned above, the Panel recommends two options: the Simplified Income Tax Plan (SIT) and the Growth and Investment Tax Plan (GIT). They are almost identical with regard to savings and retirement plans. With regard to capital income (dividends, interest, capital gains), the two differ significantly. References below to the Panel’s recommendations will apply to both SIT and GIT unless otherwise noted.

Household saving is crucial not only for families but also for the economy. Families need to save for retirement, education, healthcare, and housing. The economy relies on savings from households because such savings flow into investment; investment increases productivity. Increased productivity means increased business profits and improved standards of living. The Panel’s report reveals that, over the last three decades, the net U.S. savings rate—household savings plus business retained earnings plus government surplus/deficit—has fallen from 9% of gross domestic income to 2% of gross domestic income.

Currently, there are tax incentives to promote savings for retirement, education, and healthcare. Each of these follows a basic strategy. First, a special savings vehicle for certain approved purposes is created, where funds can be deposited. Second, those dollars are permitted to grow tax-free until withdrawn. Third, those funds are classified as taxable or nontaxable when withdrawn. In the case of a traditional individual retirement account (IRA), deposits are deductible and withdrawals are taxable. But in the case of a Roth IRA, deposits are not deductible, and qualified withdrawals are not taxable. In the case of a health savings account, deposits are deductible and withdrawals to pay healthcare expenses are not taxable, but other withdrawals are. The Panel believes this lack of uniformity is a source of complexity.

Reasons for Reform: Complexity, Confusion, Fairness

The Panel believes the current tax system is too complex with regard to savings and retirement plans. The numerous tax-favored options have different eligibility rules, contribution limits, and permissible withdrawals. In the area of saving for education, there are numerous tax-favored options, each with its own different set of rules. In the area of saving for healthcare, there are medical savings accounts (MSA), health savings accounts (HSA), and flexible spending arrangements (FSA), each with its own set of rules. The Panel sees no reason to have so many savings and retirement plans.

The complexity of employer-sponsored retirement plans leads to employee confusion, among other adverse consequences. For example, the Panel notes, because of the elaborate rules when changing jobs, it is not uncommon for a worker to have multiple, modestly sized 401(k) accounts spread out among past employers. Studies indicate that a sizable majority of workers who receive a lump-sum distribution of $5,000 or less from their former employer do not roll it over into another qualified plan or IRA. Rather, they pay tax and penalties, and they spend the rest. Such results adversely affect a worker’s ability to save for retirement.

Over 90 million workers use some type of tax-favored retirement plan at work. As the report relates, in part due to high administrative costs, only about 53% of private employers, and only about 25% of small employers, offer retirement plans. The panel found this current situation unfair.

General Recommendations

The Panel did not recommend any changes to defined-benefit plans. The panel recommends the following for defined-contribution plans:

  • Replace the current hodgepodge with three new plans: Save at Work, Save for Retirement, and Save for Family;
  • Reduce the administrative burden on employers, including an AutoSave provision; and
  • Modify the Saver’s Credit for low-income taxpayers.

The Panel recommends eliminating exclusions that allow some individuals to save an unlimited amount tax-free through annuities, life insurance, and deferred compensation. The Panel recommends a more consistent treatment of savings (capital income) outside of tax-favored accounts. According to the Panel, these measures would encourage saving in a manner that is fair, efficient, flexible, convenient, and straightforward.

New ‘Save at Work’ Plans

The employer-provided Save at Work retirement plan would combine the following: 401(k), Simple 401(k), Thrift 403(b), governmental 457(b), SARSEP, and Simple IRA. The single plan would follow the contribution limits and rules of existing 401(k) plans, but the plan qualification rules would be much simpler.

Costs to administer Save at Work plans would be reduced in three ways. First, there would be a single set of administration rules. Second, there would be an AutoSave provision, as discussed below. And third, the discrimination-testing rules would be simplified. Specifically, there would be a single test to ensure that employee contributions were not tilted in favor of highly compensated employees. In addition, there would be a safe harbor for any plan designed to provide consistent employer contributions to each plan participant, regardless of compensation.

The Save at Work plan contains features beneficial to small businesses. Employers with 10 or fewer employees could set up a Save at Work plan that resembles the current Simple IRA. The accounts would be controlled by employees, the employer would not have to file annual returns, and the employer would not have the legal liability associated with larger plans.

SIT and GIT propose different Save at Work plans. Under SIT, Save at Work contributions would be deductible, and withdrawals would be taxable, like a traditional IRA. Under GIT, Save at Work contributions would not be deductible, but withdrawals would not be taxable, like a Roth IRA. Under GIT, existing traditional IRAs could remain intact, or taxpayers could pay taxes and transfer their funds.

AutoSave. The Panel wants workers to be pointed in the direction of sound saving and investing decisions. Businesses would be permitted, but not required, to include AutoSave as part of their retirement plan. AutoSave would have four features:

  • Automatic enrollment in Save at Work, unless the employee chooses not to participate;
  • The employee’s contribution percentage would increase automatically over time, unless the employee chooses
    otherwise;
  • Employee contributions would be invested automatically in a balanced, diversified portfolio with low fees, unless the employee chooses different investment alternatives; and
  • When leaving a job, unless the employee chooses otherwise, the account balance could be automatically retained in the existing plan, transferred to a Save at Work account with a new employer, or rolled over into a Save for Retirement account.

While each of these features would be voluntary, the report argues in favor of a default approach, because studies show that employees tend to adopt default rules for enrollment, contributions, and disbursements. The Panel recommends that liability protection against investment losses be extended to employers who incorporate AutoSave into their Save at Work plans. The Panel suggests that less-stringent discrimination testing be used on retirement plans that include AutoSave.

New ‘Save for Retirement’ Accounts

Save for Retirement accounts would supplement Save at Work plans by allowing workers to save the lesser of $10,000 or their earnings. Like Roth IRAs, contributions to the account would not be deductible, earnings would accumulate tax-free, and withdrawals would be taxable. Save for Retirement accounts would replace traditional IRAs, Roth IRAs, deferred compensation plans, and the tax-free inside build-up of cash surrender value of annuities and life insurance.

Unlike current-law plans, there would be no income limitations. Distributions (which would have no minimum amount) would be restricted until after age 58, unless there is a disability or death. Early distributions would be subject to tax plus a 10% penalty. Under current law, early withdrawals are permitted for education, first-time home purchase expenses, and medical expenses. These exceptions would no longer be necessary because Save for Family accounts, discussed below, would include such provisions.

Existing Roth IRAs could be converted to Save for Retirement accounts. Traditional IRAs could also be converted upon paying the tax. Under GIT, Save at Work accounts would be “after-tax,” like a Roth IRA. Existing IRAs could be held outside the Save for Retirement plan, but no new contributions could be made to them.

New ‘Save for Family’ Accounts

Every taxpayer could contribute up to $10,000 to a Save for Family account. Contributions to the account would not be deductible, and earnings would accumulate tax-free. Save for Family accounts would replace existing education and medical accounts, such as HSAs, MSAs, and FSAs.

Tax-free withdrawals from a Save for Family account could be used for retirement, healthcare, education and training, or a home down payment. Up to $1,000 could be withdrawn each year for any reason, without penalty. Unqualified withdrawals beyond that would be subject to tax plus a 10% penalty. As with the Save for Retirement account, funds could be withdrawn penalty-free by taxpayers 58 or older, and there would be no minimum distribution rules.

Refundable saver’s credit. To encourage low-income taxpayers to save, the Panel recommends a refundable saver’s credit, which would replace an older, less inclusive version that is scheduled to expire after 2006. The new refundable saver’s credit equals 25% of the first $2,000 contributed to a Save for Retirement or a Save for Family account. Thus, the maximum refundable saver’s credit is $500 ($2,000 x 25%). The credit phases out as income exceeds $30,000 ($15,000 for unmarried taxpayers).

Other Savings

The Panel wants a more neutral treatment of financial income earned outside of the plans above. Currently, there are no limits on the tax benefits for increases in the cash surrender value of annuities and life insurance, and certain deferred compensation. The Panel wants to treat these arrangements like other investments.

The Panel recommends that, in general, the annual increase in the cash surrender value (the inside build-up) of annuities and life insurance be treated as current income, with two exceptions: The inside build-up would not be subject to current taxation 1) for life insurance that cannot be cashed out, and 2) for annuities that provide regular, periodic payouts of substantially equal amounts until the death of the holder.

The Panel recommends eliminating the ability of some taxpayers to save tax-free through deferred compensation plans. Specifically, the Panel wants all amounts deferred under nonqualified deferred compensation plans to be included in income to the extent these amounts are not subject to a substantial risk of forfeiture and were not previously included in income.

Annuities, life insurance, and deferred compensation plans that are now in existence would continue to be taxed under current rules.

Capital Income

Within Save at Work plans, Save for Retirement accounts, and Save for Family accounts, capital income (dividends, interest, capital gains) accumulates tax-free. In general (except Save at Work accounts under SIT), capital income is taxed as ordinary income when funds are distributed from these arrangements. What are the tax consequences for individuals who generate dividends, interest, and capital gains outside of these arrangements?

Exhibit 2 summarizes the treatment of capital income under current law, SIT, and GIT. Under SIT, when stock in U.S. corporations is sold, 75% of long-term capital gain is excluded from income, and the other 25% is included in income and taxed at ordinary income rates. Thus, under SIT, the tax rates for the sale of stock held long term are 3.75% (25% x 15%), 6.25% (25% x 25%), 7.50% (25% x 30%), and 8.25% (25% x 33%).

Currently, corporate earnings are taxed twice: once when a corporation earns profits, and again when profits are distributed as dividends, and realized from the sale of stock. To reduce the double tax on corporate earnings, SIT excludes from income 100% of dividends received from U.S. corporations that are paid out of domestic earnings, and 75% of long-term capital gain from the sale of stock in U.S. corporations. The Panel believes that this would increase investment in corporate equity and promote economic growth.

Under SIT, long-term capital gains, other than those from the sale of stock in U.S. corporations, would be taxed at ordinary income rates (15%, 25%, 30%, 33%). This would raise the tax rate on some capital gains for higher-income individuals, but it would lower the tax rate for all investors in corporate stock. According to the Panel, besides reducing the double tax on corporate earnings, this treatment would simplify the reporting of capital gains. In addition, it would eliminate the need for a host of complex rules for recapturing tax on the sale of assets by small businesses that take advantage of the new simplified and expanded expensing rules described below, in “Taxation of Business.”

Also, as discussed below, GIT would move the tax system closer to a consumption tax and would impose a reduced flat rate tax, 15%, on capital income received by individuals.

Comments on Saving

The authors wonder if Americans want to sacrifice a complex system that allows them to invest in a retirement vehicle with pre-tax dollars (traditional IRA) in favor of a simpler one using after-tax dollars (Roth IRA). The Panel’s reforms are based on the assumption that simplicity will be a greater incentive than the ability to invest before-tax dollars in a more complicated array of choices. A taxpayer in the 30% bracket can currently put $1,000 into an IRA and save $300 in taxes. Under GIT, the same taxpayer would need to earn $1,429 in order to invest $1,000 ($1,429 x 70%) in a Save at Work account.

According to the American Society of Pension Professionals and Actuaries (ASPPA):

[T]hese accounts would allow a couple owning a small business to save $40,000 [$10,000 x 4] for retirement on a tax preferred basis (compared to $10,000 under current law). Many small business owners will forego adopting a workplace retirement plan [e.g., Save at Work] if they can save that much on their own on a tax preferred basis. [2005 TNT 211-20]

If employer-sponsored retirement plans disappear, evidence indicates workers will save less. According to ASPPA:

Employer-sponsored retirement plans have been the most efficient and effective way for workers to save. … [A]lmost 50% of American households owning mutual funds held those funds through employer-sponsored retirement plans. However, when deprived of the discipline and structure of a workplace plan, the vast majority of American workers simply do not save. According to the Employee Benefit Research Institute, low- to moderate-income workers are 20 times more likely to save when they participate in a workplace retirement plan. [2005 TNT 211-20]

There are probably many factors that account for why Americans do not save as much as they could or should. The authors wonder if the reforms suggested by the Panel will change this.

Kathleen Simons, DBA, CPA, is a professor, and Larry Witner, LLM, CPA, is an associate professor, both at Bryant University, Smithfield, R.I.


Taxation of Business

By Tim Krumwiede and Larry Witner

The Panel recommends two options: the Simplified Income Tax Plan (SIT) and the Growth and Investment Tax Plan (GIT). With regard to the taxation of business, the two options have some similarities and many differences, which will be discussed below. Unless otherwise indicated, to be consistent with the Panel’s terminology here the term “corporation” refers to regular, C corporations; S corporations are referred to as such or as “pass-through entities.”

A ‘Cleaner‘ Tax Base

The Panel strives for a “clean” tax base, one devoid of special tax breaks (preferences) for certain industries and business activities. According to the Panel, these special tax preferences require complex rules and regulations for taxpayers to determine eligibility and the IRS to enforce. These preferences also have the effect of raising the tax rates for all businesses.

To generate a cleaner tax base, the Panel recommends eliminating over 40 special provisions, including the research and experimentation credit, the rehabilitation investment credit, and the deduction for domestic production. A cleaner tax base would allow the business tax rate to be reduced. Under SIT, the tax rate on large businesses would be reduced from 35% to 31.5%—a 10% reduction.

Repealing the Corporate AMT

Currently, many corporations are subject to two systems of taxation: a regular tax and an alternative minimum tax (AMT). Like the individual AMT, the corporate AMT is a second, parallel tax system designed to ensure that all corporations pay a certain share of tax.

Both SIT and GIT would repeal the corporate AMT. The Panel believes it is too complex because it forces many corporations to keep two different sets of books and to calculate their tax liability under two different sets of rules.

Because SIT and GIT provide a clean tax base devoid of special breaks, there is no need for a second, parallel AMT system.

According to the Panel, eliminating numerous tax breaks and the corporate AMT would simplify the tax system. A more level playing field for all businesses would be created by eliminating tax breaks that apply to only a limited number of companies. Finally, removing tax considerations as much as possible from investment and business decisions would result in allocating resources more efficiently.

‘Double Taxation’

Currently, corporate earnings are taxed twice: once when a corporation earns profits, and again when profits are distributed as dividends or realized from the sale of stock. The Panel believes this “double taxation” may discourage investment in corporations.

Corporations may raise funds by issuing either debt or equity (stock). Currently, corporations can deduct the interest paid on their debt, but they cannot deduct the dividends paid on their stock. This may encourage corporations to use debt financing rather than equity financing. During economic downturns, this increases the risk of bankruptcies. The Panel worries that tax considerations, rather than economic considerations, may unduly affect corporate decisions regarding the retention and distribution of profits.

The Panel claims there is a tax bias against the corporate form of business organization. To illustrate this point, the Panel cites the rapid rise in the number of pass-through entities. For instance, between 1980 and the present, S corporations have grown from 528,100 to 3,612,000, while C corporations have hardly grown at all, from 2,115,000 to 2,190,000. The report reveals that total business net income from pass-through entities recently exceeded total business net income from C corporations.

The Panel wants to remove the bias against investing in corporations by providing a more neutral tax treatment among various forms of business organization. In addition, the Panel wants to level the playing field between debt and equity financing.

SIT: Taxation of Earnings

To reduce the double tax on corporate earnings, SIT would exclude from shareholder income: 1) 100% of dividends received from U.S. corporations that are paid out of domestic earnings, and 2) 75% of long-term capital gain from the sale of stock in U.S. corporations.

Currently, individuals report on their individual tax returns their share of earnings from sole proprietorships, partnerships (including limited liability companies), and S corporations. Although these three separate regimes are designed to provide a single level of tax, there are enough differences among them to unnecessarily complicate the choice of business form as well as tax compliance. The Panel recommends more uniformity among pass-through entities with regard to contributions, allocations of income, distributions, and liquidations. These changes would eliminate confusion and simplify the choice of business entity.

SIT Would Classify Businesses

Under SIT, business entities would be classified as small, medium, or large on the basis of their gross receipts, as shown in Exhibit 3. The Panel suggests using, for purposes of classification, the average of gross receipts over the prior three years.

Small businesses under SIT. Currently, there are 22 million small businesses, as defined by SIT, accounting for 95% of all U.S. businesses. According to the Panel, under current law, small businesses must use complex accounting rules to keep their books and records. The Panel recommends that small businesses be entitled to use a simplified cash method of accounting. Under this method, taxable income would equal cash receipts less cash payments (except for purchases of buildings and land). In essence, small businesses could use just their checking accounts to prepare their tax returns.

The primary feature of this system is that cash paid for most assets would be deducted as paid, instead of being capitalized and recovered through depreciation and amortization. Thus, cash paid for inventory, tools, software, intangibles, and equipment would be deducted as paid. The only exceptions would be for the purchase of buildings (capitalized and depreciated) and land (capitalized). (For a discussion of depreciation, see “Depreciation under SIT,” below.)

Small-business taxable income would be subject to individual tax rates (15%, 25%, 30%, 33%), unless, as discussed below, the small business chose to be treated as a corporation.

Medium-sized businesses under SIT. Under SIT, medium-sized businesses could use the same simplified cash method of accounting as small businesses, with two exceptions. First, purchases of equipment would be capitalized and depreciated. (For a discussion of depreciation, see “Depreciation Under SIT,” below.) Second, medium-sized businesses in inventory-intensive industries (e.g., manufacturing) would use inventory methods.

To improve recordkeeping and compliance, the Panel suggests that small and medium-sized businesses use designated business bank accounts to deposit all business receipts and make all business payments. In these segregated bank accounts, businesses could not commingle personal and business funds. Banks maintaining the segregated accounts would provide an annual summary of cash inflows and outflows both to the businesses and to the IRS. Issuers of debit and credit cards would report the purchases made by their cardholders to the businesses and to the IRS.

Medium-sized business’ taxable income would pass through to owners and be subject to individual tax rates (15%, 25%, 30%, 33%), unless, as discussed below, the entity chose to be treated as a corporation.

Large businesses under SIT. Under SIT, large businesses would be taxed as corporations, and they would be subject to an entity-level flat tax rate of 31.5%. In addition, small and medium-sized businesses could choose to be taxed as corporations, whereupon their shareholders would be eligible for the dividends-received exclusion (100%) and the long-term capital gains exclusion (75%).

If partnerships, limited liability companies, and S corporations are “large,” they are subject to the entity-level flat tax rate of 31.5%. According to the Panel, treating pass-through entities this way—

  • lessens opportunities for tax shelters and loopholes, most of which have been facilitated by pass-through entities; and
  • levels the playing field among various forms of business organization.

Under SIT, regulated investment companies (RIC) and real estate investment trusts (REIT) would continue to be taxed as under current law, meaning they avoid the entity-level tax if they distribute most of their earnings. Furthermore, the report suggests that owners of RICs and REITs would benefit from the new rules applicable to the dividends-received exclusion (100%) and the long-term capital gains exclusion (75%).

Under SIT, large businesses would be denied the deduction for state and local income and property taxes. According to the Panel, because individuals and small businesses cannot deduct these taxes, large businesses should not be able to deduct them either. (See the discussion above, “Taxation of Households.”)

Other SIT Provisions

Depreciation under SIT. Currently, businesses are required to maintain detailed schedules and records related to the cost and depreciation (cost recovery) of long-term assets. For the most part, these records are maintained on an asset-by-asset basis. Current law provides options in determining how much of an expenditure should be immediately expensed and how much should be capitalized and deducted over time. For instance, IRC section 179 provides that a limited amount of capital expenditures ($105,000 for 2005) can be expensed in lieu of depreciation. According to the Panel, current law, by requiring detailed records and numerous cost recovery options, places a burden on taxpayers. SIT would alleviate some of these burdens.

As mentioned above, under SIT, small businesses would depreciate buildings, and medium-sized and large businesses would depreciate buildings as well as equipment. The current depreciation system uses eight different asset class lives (3, 5, 7, 10, 15, 20, 27.5, and 39 years), different recovery methods (accelerated, straight-line, and alternative depreciation system), and three different conventions for the year an asset is placed in service (mid-year, mid-month, and mid-quarter).

The Panel recommends a simplified depreciation system that would collapse the number of asset classes and cost recovery methods. The Panel suggests four asset categories, as shown in Exhibit 4.

The Panel suggests that this simplified depreciation system would provide about the same cost recovery deductions as current law but would greatly simplify the depreciation process, including eliminating much of the recordkeeping burden.

Financial accounting net income. Currently, financial accounting rules dictate the preparation of income statements and the calculation of net income, whereas the IRC dictates the preparation of tax returns and the calculation of taxable income. The Panel recommends for further study the idea that large businesses be taxed on net income, thus avoiding a separate calculation of taxable income.

GIT: Toward a Consumption Tax

According to the Panel, GIT would move the U.S. tax system closer to a consumption tax. Of all the Panel’s recommendations, this fact is best illustrated by the taxation of business. The key difference between an income tax and a consumption tax is the relative burden placed on capital income (dividends, interest, capital gains).

Under GIT, no business would include capital income in gross income (with a special exception for financial services companies, which would include interest income and deduct interest expense). The Panel claims that GIT would be pro-growth; by not taxing capital income, savings, investment, and productivity would increase, growing the economy. GIT is not a pure consumption tax, however, because individuals would still pay a flat tax rate of 15% on all capital income.

GIT taxes business cash flow. Under GIT, businesses would pay tax on their “business cash flow,” defined as follows:

Sales (excluding capital income) – Purchases (of materials, labor, and assets).

Sales would exclude capital income (dividends, interest, capital gains). Purchases would be deductible only if made from businesses subject to U.S. taxation. Purchases from foreigners not subject to U.S. taxation would not be deductible. (For a further discussion, see “Comments,” below.)

By focusing on cash flow, the Panel believes, complicated accounting rules dealing with matching revenue and expense could be avoided. The report suggests that the GIT tax on business cash flow resembles a subtraction-method value-added tax (VAT; discussed in “Federal Tax Reform,” The CPA Journal, October 2005).

The Panel recommends that sole proprietorships simply report net cash flow on the income tax return of the owner, who would pay tax at the graduated individual rates (15%, 25%, 30%, 33%). All other businesses would pay a flat tax rate of 30%. Because this would equal the top rate for individuals, the Panel believes it would reduce tax planning efforts to shift income between businesses and individuals.

GIT would resolve the issues of double taxation of corporate earnings and tax bias against the corporate form in a curious way. GIT would impose the same flat tax rate of 30% on all business entities, regardless of their legal form. Under GIT, then, there would be no pass-through entities (partnerships, including limited liability companies, and S corporations). According to the Panel, owners of pass-through entities would compute their tax on a separate schedule, which would be filed along with their individual return.

GIT expenses capital expenditures. Under GIT, all businesses would immediately deduct the cost of capital expenditures, including those for equipment, building, and land. Thus, there would be no need for complex rules for the capitalization and cost recovery of long-term assets.

The Panel justifies this recommendation on many grounds. First, the current depreciation system is an imperfect mechanism for measuring the actual decline in value of an asset. Second, the current system fails to take inflation into account. Third, eliminating complex rules for capitalization and cost recovery would simplify the tax system and reduce compliance costs. And fourth, the current system is inefficient, because depreciation and other tax-related considerations may distort investment decisions. The Panel states: “Moving from depreciation allowances to expensing would lower the tax burden on the returns to new investment and would level the playing field across different types of business assets.”

Other GIT Provisions

Interest on NOL carryforwards. The Panel recommends that net operating losses (NOL) not be carried back. The Panel recommends that NOLs be carried forward indefinitely and not be sold or otherwise transferred from one entity to another. GIT would allow interest on NOL carryforwards. For example, assume an interest rate of 10% and an NOL of $1 million in Year 1. In Year 2, as an offset against other income, the business in question could claim a loss of $1.1 million [$1 million + ($1 million x 10%)]. If the loss offset were not used in Year 2, it would be carried forward to Year 3 and increased to $1.21 million [$1.1 million + ($1.1 million x 10%)].

Debt versus equity financing. Under current law, businesses that raise funds by issuing debt can deduct the interest paid on that debt. On the other hand, businesses that raise funds by issuing equity (stock) cannot deduct the dividends paid on that stock. The Panel believes this distorts financing decisions and disadvantages the corporate form.

The Panel recommends eliminating the corporate deduction for interest. Thus, under GIT, neither dividends paid nor interest paid would be tax-deductible.

Transition Rules

For existing assets, the Panel suggests a transition period to GIT. In the first year, assets placed in service prior to GIT would be eligible for 80% of the depreciation. In the second, third, and fourth years, the percentages would be 60%, 40%, and 20%, respectively. The Panel suggests a similar phase-out timetable for both interest deductions and interest income. The Panel recognizes that transition rules would be needed in other areas, such as the treatment of NOL carryforwards, tax credits, and inventory holdings, but did not provide specifics.

Comments

Some large businesses may believe that the current tax system, with its research and experimentation credit, among other things, may be better than the Panel’s recommendations. Some predict a fierce battle over eliminating business’ ability to deduct interest payments. Opposition to fundamental tax reform may come from the business community as well as individuals (2005 TNT 209-2).

Special-interest groups, including the National Retail Federation (NRF), are weighing in on the Panel’s proposals. The NRF has decried the “new import tax” (2005 TNT 211-17). Under GIT, the business cash flow tax permits a deduction for purchases of goods and materials only if the seller is subject to U.S. taxation. According to the NRF, a majority of consumer products (e.g., clothing, gas, toys) sold in U.S. stores are made overseas. If the foreign suppliers of these consumer goods are not subject to U.S. taxation, the U.S. retailer cannot deduct the cost of imports. According to NRF, this lack of deductibility would amount to a tax on imports that would drive up the price of consumer goods by nearly one-third. If proved correct, this could reduce consumer spending and adversely affect the economy.

Tim Krumwiede, PhD, CPA, is an associate professor, and Larry Witner, LLM, CPA, is an associate professor, both at Bryant University, Smithfield, R.I.


Taxation of International Transactions

By Andrew Duxbury, Michael C. Plaia, and Larry Witner

With regard to international taxation, currently, the United States uses a worldwide system. Under the Simplified Income Tax (SIT), the Panel recommends changing to a territorial system. Under the Growth and Investment Tax Plan (GIT), the Panel recommends changing to a destination-basis, border-adjusted tax system. The expression “U.S. multinational corporation” is used to refer to a U.S.-based entity that owns foreign subsidiaries.

One journalist summarized the problems with the current U.S. international tax system as follows:

[The current worldwide or extraterritorial system] seeks to tax U.S. taxpayers on their worldwide income on a current basis, regardless of where the income is earned. Foreign-source earnings of foreign subsidiaries are not taxed until those profits are repatriated to U.S. parent companies in the form of inbound dividends. Because repatriation is elective, taxation is rendered elective, leading to a system in which massive amounts of profits are held offshore for as long as possible. According to the Panel, [this] creates a disincentive to reinvest those funds domestically. (2005 TNT 211-4)

According to the Panel, the current system has other disadvantages, such as making filing complex for businesses, putting U.S. companies at a disadvantage against international competitors, and embroiling the U.S. in controversies before the World Trade Organization.

Current System

While the United States does not tax the earnings of a non-U.S. owned, non-U.S. entity (unless the non-U.S. entity does business in the United States), it does tax the U.S. owner when a controlled foreign corporation (CFC) pays a dividend to the U.S. corporate owner. To avoid double taxation, U.S. companies may offset this tax through a foreign tax credit (FTC). (Note that this article and the examples in it will ignore the fact that treaties between the U.S. and other countries may alter tax consequences.)

Example 1. A U.S. multinational corporation and a Dutch multinational corporation each have subsidiaries in the United Kingdom. Assume the U.K. tax rate is 20% and the U.S. tax rate is 35%. The U.S. multinational corporation is subject to a worldwide tax system, and the Dutch multinational corporation is subject to a territorial tax system. Assume the subsidiaries each earn $100 in the United Kingdom and immediately send the profits home as a dividend. The U.S. subsidiary and the Dutch subsidiary each pay $20 ($100 x 20%) of tax to the U.K., and a dividend of $80 ($100 – $20) to the parent company.

With regard to the dividend, the U.S. multinational corporation, but not the Dutch multinational corporation, pays a repatriation tax. Specifically, in its income, the U.S. multinational corporation will include $100, consisting of $80 as dividend income and $20 as a “section 78 gross-up.” The U.S. multinational corporation is subject to a tax rate of 35%, which will be offset by a foreign tax credit for the $20 paid to the U.K. The U.S. multinational corporation, then, pays tax of $35: $15 ($35 – $20) to the U.S. and $20 to the United Kingdom. The Dutch multinational corporation, however, pays tax of only $20.

Example 1 reveals several things. In elemental terms, it differentiates between a worldwide system and a territorial system. The FTC rules are more complicated than the above example. There are detailed regulations regarding source of income and allocation and apportionment of expenses. These rules are necessary to ensure that multinational corporations do not offset tax on U.S. source income with FTCs. Essentially, these sourcing rules divide a multinational company’s taxable income between U.S. source and foreign source. Only the tax on foreign source income (which is divided into categories) may be offset by FTCs (of the same category).

Another important rule in the current tax system is Subpart F income, which is divided into the following two basic categories:

  • Foreign personal holding company income (FPHCI) is income from dividends, interest, rents, and royalties. This type of passive income, or “mobile” income, when earned by a CFC, is not eligible for U.S tax deferral and is taxed to the U.S. shareholder in the year it is earned by the CFC.
  • Foreign-based company sales income (FBCSI) is income earned by a CFC on resale of property purchased and sold outside of its country of incorporation when a related party is involved in the product flow. (The foreign-based company service income rules are similar, but less common.)

Example 2. A U.S. multinational corporation manufactures property in the United States. The U.S. multinational sells the property to its CFC European distributor in the Netherlands, which warehouses it. The CFC ultimately sells the property to a third party in Italy. The income in question is FBSCI, and as such, it is taxed to the U.S. multinational when sold to the third party in Italy. The theory for currently taxing net income on this type of transaction is that the Dutch company adds no value to the transaction—a debatable point.

Example 3. A U.S. multinational corporation manufactures property in the United States. The U.S. multinational sells the property to its Cayman Islands CFC. The Cayman Islands CFC, without adding value to the property, sells it to a third party in Italy.

Examples 2 and 3 are similar, except that the Netherlands tax rate is 30.5%, and the Cayman Islands tax rate is zero. Therefore, absent the Subpart F rules, the U.S. multinational would have a tax incentive to earn profits through the Cayman Islands CFC.

While the Subpart F rules are potent, they do not extend to many types of foreign source income earned by CFCs. Consequently, U.S. parent coporations benefit when they shift income to, or away from, their foreign subsidiaries that operate in low-tax, or high-tax, jurisdictions.

Example 4. A U.S. multinational corporation manufactures an appliance for sale in the United States (35% tax rate) and in a foreign jurisdiction (20% tax rate). Foreign sales are made by a wholly owned foreign subsidiary. The appliance costs $150 to manufacture, and sells for $250 abroad. If the transfer price between the U.S. parent and the foreign subsidiary is set low, much of the profit is shifted to the low-tax foreign jurisdiction. For example, if the transfer price is $150, there will be zero U.S. tax [($150 – $150) x 35%] and tax of $20 [($250 – $150) x 20%] in the foreign jurisdiction. But if the transfer price is set high, at $250, there will be tax of $35 [($250 – $150) x 35%] in the U.S. and tax of zero [($250 – $250) x 20%] in the foreign jurisdiction. In this simplified example, there is a significant tax savings ($15) to be had if the profit is shifted to the foreign jurisdiction.

IRC section 482 gives the IRS the authority to allocate gross income, deductions, or credits between related parties to correct any perceived distortion resulting from unrealistic transfer pricing. In this area of tax law, there is much ambiguity, complexity, and conflict between taxpayers and governments.

Currently, companies outside of the United States are subject to a value-added tax (VAT), levied at each stage of production on the value added by each party. The value added is the difference between sales and purchases of inputs. VAT is collected by each entity at every stage of production. A company calculates its VAT liability into its prices, so it fully shifts the VAT liability to the buyer. There are several ways to calculate the tax. Under a credit VAT, a company calculates its VAT liability as follows: VAT on sales (VAT rate x sales) – VAT on inputs.

Foreign companies are believed to have a competitive advantage over U.S. companies because VAT is refunded on exports. Thus, foreign goods appear cheaper by the time they reach retail shelves in foreign markets. U.S. exporters, however, do not receive the same preferential treatment, because U.S. income taxes cannot be refunded on exports without violating international trade rules. The following Examples 5, 6, and 7, focus on VAT, and ignore income-tax-related concepts.

Example 5. Consider a farmer, a miller, and a baker involved in turning wheat into bread. The farmer grows wheat and sells it to the miller, who grinds the wheat into flour and sells it to the baker, who turns the flour into bread and sells it to the public. The VAT rate is 10%. The farmer sells the wheat to the miller for $1,100, consisting of $1,000 for the wheat and $100 for VAT. The farmer forwards $100 to the government. The miller sells the flour to the baker for $3,300, consisting of $3,000 for the flour and $300 for VAT. The miller forwards $200 ($300 VAT on sales – $100 VAT on purchases) to the government.

Example 6. Assume the same facts from Example 5, but assume that the farmer and the miller are in different jurisdictions. When the farmer sells to the miller, he is not charged VAT, making the cost to the miller $1,000, not $1,100.

Example 7. Assume the same facts from Examples 5 and 6 above, except the farmer is a U.S. farmer who sells wheat to the miller for $1,100, consisting of $1,000 for the wheat and $100 for U.S. income tax. The U.S. farmer does not receive a $100 refund for income taxes paid. Thus, in Example 6 (foreign producer), the miller has a cost of $1,000, but here, in Example 7 (domestic producer), the miller has a cost of $1,100. The foreign exporter has an advantage over the domestic exporter.

SIT: Territorial System

Under SIT, the Panel recommends replacing the current worldwide taxation system with a territorial system. Under a territorial system, a government taxes only the income earned within its borders; thus, the foreign source income of U.S. companies would be exempt from U.S. taxation. The Panel defines foreign business income (FBI) as income earned in the active conduct of a trade or business outside of the United States. This income could be earned by either a CFC or a foreign branch of a U.S. corporation.

The much-criticized, complex Subpart F rules would be retained. As mentioned previously, Subpart F taxes certain types of passive (mobile) income earned by CFCs. As under the current system, an FTC would be allowed to offset U.S. tax.

The Panel’s recommendation contains new rules that disallow expenses related to earning tax-exempt foreign income. These expenses, including interest expense and general and administrative expenses, would be allocated and apportioned using sourcing rules similar to the current tax system. Research and experimental expenses would be apportioned only to foreign mobile income and U.S. income.

The taxability of dividends to U.S. shareholders of multinational corporations would change. Corporations would be required to track their income between foreign exempt income and U.S. taxable income. U.S. multinational corporations would be required to disclose to shareholders the percentage relating to FBI. Shareholders would be required to include that percentage as taxable on their tax returns.

Many U.S. companies have established foreign holding companies (e.g., in Bermuda) in order to escape U.S. tax. Under the Panel’s recommendation, if a U.S. company met certain control tests, the holding companies would be taxed as if they were incorporated in the U.S.

While the change to a territorial system would appear to represent a major shift, the tax rules themselves would not change dramatically. U.S. multinational corporations would still need to track and report not only Subpart F income but also the earnings and taxes of CFCs. In addition, because FTCs would still be allowed to offset tax on “mobile” income, FTC limitation calculations would still apply, as would expense apportionment rules. Because these rules are some of the more complicated rules in U.S. international taxation, the Panel’s recommendation under SIT would not significantly simplify our current international tax system.

The Panel would broaden U.S. residency rules. Currently, corporations are residents of the country in which they are organized, where they file their articles of incorporation. The Panel’s report reveals that this rule enables inversions, whereby U.S. corporations can change their residency simply by incorporating abroad. The American Jobs Creation Act of 2004 created certain ownership tests. If, after changing residency, there is a little (80% test) or a modest (60% test) change in ownership, the inverted U.S. corporation would still be taxed, to differing degrees, as a domestic corporation. The law does not prevent newly organized entities from taking advantage of the rules.

The Panel proposes a two-part residency test. An organization would be considered to be a U.S. resident for tax purposes if it were organized in the United States, or if its place of primary management and control were in the United States. The Panel believes this would curtail corporate inversions. While the authors support the Panel’s goal to curtail inversions, they question whether this two-part residency test will have that effect. Creative U.S. companies may be able to manipulate their place of primary management and control to their tax advantage. The Panel leaves unanswered questions relating to what rules would apply to the common situation where U.S. companies own between 10% and 50% of foreign entities.

The territorial system would put U.S. companies on a more equal footing with their international competitors, most of which operate under such a system. Although such a system would remove a barrier to repatriation of earnings, the Panel’s SIT recommendation would do little to simplify international taxation.

GIT: Destination-Basis, Border-Adjusted System

Under GIT, the Panel recommends changing from the worldwide system to a destination-basis, border-adjusted system.

Under the destination-basis concept, tax would be imposed at the point of purchase, not the point of production. As a result, U.S citizens would pay the same price no matter the origin (domestic or foreign) of the goods. According to the Panel, a domestic exporter would still sell its goods in a foreign country at the same price as without the tax. Goods sold in the United States by a foreign producer would be subject to the U.S. tax. As a result, the foreign importer would compete in the U.S. on the same level as domestic sellers. Under a border-adjusted system, there would be a refund of tax on exports. The Panel believes that imposing a destination-basis tax would not affect the country’s balance of trade.

Example 8. Assume the same facts as Examples 5, 6, and 7, where a farmer sold wheat to a miller. Under a border-adjusted system, the U.S. farmer receives a $100 refund of domestically imposed taxes, and the U.S. farmer’s price for wheat on the international market would be $1,000, not $1,100. Thus, whether the miller bought the wheat from a U.S. farmer or a foreign farmer, the miller would pay the same price, $1,000.

Under GIT, exports would be excluded from the tax base, and imports would be included in the tax base. Purchases from abroad (i.e., imports) would be taxed either by making them nondeductible to the importing business or by imposing an import tax.

Under a destination-basis tax, transfer prices do not affect the computation of tax liability. Border adjustments make the tax base domestic consumption, which, at the business level, equals domestic sales minus domestic purchases. As a result, there would be no opportunity to use transfer prices to minimize tax liability.

Example 9. Assume the same facts as Example 4 above, where the setting of a transfer price (between $150 and $250) for an appliance determined how taxes were shifted between jurisdictions. Under a destination-basis, border-adjusted system, the tax base, at the business level, is equal to domestic sales minus domestic purchases. If the U.S. multinational has domestic sales of $1,000 and domestic purchases of $600, it has profit of $400 and tax of $140 ($400 x 35%). Sales in the foreign jurisdiction do not affect the multinational’s U.S. tax liability. As a result, transfer pricing schemes cannot affect U.S. tax liability.

According to the Panel, under GIT—

  • the United States would be attractive to foreign investors because capital expenditures (equipment, building, and land) would be expensed;
  • there would be no tax incentive for U.S. companies to move production overseas because tax liability would depend entirely on U.S. sales; and
  • tax compliance and administration would be simplified because there would be fewer complex cross-border tax-planning activities.

Comments

Under GIT, all cash outlays for purchases of both tangible and intangible goods from outside the United States would not be deductible in computing a company’s taxable cash flow. This is why transfer pricing becomes unimportant: none of the purchase price would be deductible. Given the proposed 30% tax rate on net business cash flow, this provision would impose an effective 30% tax rate on all imports of consumer goods, raw materials, and energy. Presumably, this 30% tax would be in addition to any duties already imposed on these imports. This would amount to a substantial increase in taxes that may adversely affect the U.S. economy. While the idea may be good, the tax rate may be too high. Any reduced tax rate for international transactions would have to comport with economic studies, equity, government revenue requirements, and World Trade Organization requirements.

Under GIT, the new system would be beneficial to net exporters of technology and other intellectual property, because all royalty income from licenses to use the licensed property outside the U.S. would be tax-free. Presumably, the current rules for sourcing income contained in IRC section 862 would still apply.

The GIT proposal raises many questions. What would happen to the CFC provisions of current law? Would the income-based Subpart F provisions be retained or jettisoned? What would happen to the FTC regime? How would this new tax be treated under current tax treaties? Would our tax treaties have to be renegotiated? How would earnings repatriated from foreign subsidiaries be taxed, if at all? What would happen to the U.S. withholding tax system under section 1441?

Would the Panel’s new international tax system really be simpler—and, if so, at what price? A repeal of the Subpart F regime would certainly be a simplification. But some corporate attributes, such as earnings and profits, might still have to be tracked, depending upon how repatriated earnings are taxed. If the FTC system no longer existed, the complex calculations of net foreign-source income and the related determinations of which foreign taxes are creditable would disappear, at least in the corporate context.

If and when Congress takes up the Panel’s proposal, all of these questions will be answered. But the deliberations will bear close watching to make sure that the goal of tax simplification is achieved.

Andrew Duxbury is a manager, international taxes, at Textron, Inc., Providence, R.I., and an adjunct professor at Bryant University, Smithfield, R.I. Michael C. Plaia is a manager, international taxes, at Hasbro Corporation, Pawtucket, R.I. Larry Witner, LLM, CPA, is an associate professor at Bryant University, Smithfield, R.I. The views expressed by the authors are their own and not that of their employers.

Epilogue

Scoring: Static Versus Dynamic

There are two ways to “score” the effects of a tax cut. To illustrate, assume the government cuts taxes by $1,000. Under static scoring, the government loses revenue of $1,000, and the analysis stops there. Under dynamic scoring, however, the analysis continues, and secondary revenue effects are considered. That is, if a tax cut promotes economic growth, there is an increase in the tax base and thus in government tax receipts. Some would argue that the estimated cost of a tax cut should be offset by subsequent tax receipts. If, in the example, the $1,000 tax cut promotes economic growth that generates additional government tax receipts of, say, $300, the cost of the tax cut would be $700 ($1,000 – $300), not $1,000. Some contend that subsequent government tax receipts could more than offset the initial tax cut, thus it would “pay for itself.”

The Panel scored both plans using the traditional static method. In a controversial move, the Panel recommended that Congress use dynamic scoring in its work. The Panel states that if it had used dynamic scoring, it could have reduced tax rates even more. Proponents of further tax reductions are waiting for the action to shift to Congress, where the dynamic scoring of reform proposals will be possible.

Lukewarm Reactions

The Panel’s recommendations have received a mostly lukewarm reaction from the public and the media because, for many taxpayers, the recommendations are controversial. For some, the recommendations do not go far enough, because they would not tear out the old tax system by its roots and replace it with something new. To critics of the current system, the Panel’s recommendations merely trim the branches. For some other critics, the recommendations go too far and represent a shift of the tax burden from wealth (upper class) to work (middle class).

Prospects for Major Tax Reform

According to Panel member Bill Frenzel (2005 TNT 211-23), taxpayers were more irritated with the Tax Code in 1986 than they are now. As a result, tax-reform legislation may be that much harder to sell. Major tax reform, like the 1986 Tax Reform Act, may be a mid-term, rather than a short-term, project. At present, Congress is preoccupied with hurricanes, wars, and budget deficits. 2006 is an election year, and politicians may be reluctant to tackle a controversial topic such as major tax reform. Over the last 11 years, the Republican-controlled Congress has not moved toward major tax reform, and there is little indication it will move in that direction now. To be successful, President Bush needs the support of moderate Republicans and Democrats, and to get this support, tax reform proposals probably cannot be too radical.

In spite of the above, some kind of change is probably inevitable, because of the near-term implications of the creeping AMT and the sunset provisions enacted in recent tax legislation. Each year, Congress has to tweak the AMT, with its non-indexed brackets, so that it does not swallow up the middle class. Certain recently enacted tax cut provisions expire in 2008 (dividends and long-term capital gains) and in 2010 (estate tax repeal), so action will have to be taken before then. Addressing the AMT and the expiring tax provisions will provide an impetus for major tax legislation, and reform proposals will likely influence the path of eventual legislation.

The Panel’s recommendations will likely shape the debate over tax reform in the years ahead, but its specific provisions are not likely to become law soon.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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