Posted tagged ‘tax reform’

Tax Foundation: Rethinking U.S. Taxation of Overseas Operations

December 1, 2011

By Jonathan Prokup

Our in-house and private-practice corporate readers will likely enjoy one of the Tax Foundation’s newest reports: Rethinking U.S. Taxation of Overseas Operations. As the abstract describes:

The United States produces a third of the world’s wealth but contains less than 5 percent of the world’s population. This disparity pushes many U.S. businesses and entrepreneurs to embrace globalization to improve productiv­ity and expand market reach. Large and small businesses alike are increasingly using the tools of faster information, cheaper transporta­tion, and overseas workforces that blur the traditional notions of taxes and services based on geographic lines.

The U.S. government can effectively pro­mote this dynamism and growth with a tax system that taxes profits earned in the United States but leaves taxation on activity occurring in other countries to those other countries. Instead of pursuing this economic concept of neutrality, however, the U.S. government seeks to tax the profits of U.S. corporations wherever in the world they are earned. This worldwide tax system differs from most other countries, where only activity within the country’s borders is taxed (territoriality).

U.S. corporations operating overseas there­fore face a unique combination of burdens not borne by their international competitors: taxes owed to the United States, taxes owed to the country where the operating activity takes place, and a complex tax system that attempts to reduce the resultant economic harm but involves an array of credits and definitions (primarily the Internal Revenue Code’s Sub­part F).

Many of the report’s “key findings” won’t come as news to our corporate readership.  For example, one of the findings is that “Under Subpart F, ‘active’ income can be deferred from U.S. tax until repatriated home, while ‘passive’ income (royalties, interest, dividends) is generally subject to immediate U.S. taxation.”

Nevertheless, the report makes a number of interesting criticisms of the Subpart F regime – e.g., that the regime is based on an outdated model of corporate operations. The solution, according to the report, is to move to a territorial tax system, an idea that has drawn recent support from the House Ways and Means Committee as well as GOP presidential candidates. As the report acknowledges, however, ““[F]rom a tax collection standpoint, it could be said that a worldwide tax system is better than a territorial taxation system as a tax revenue source.” (citation omitted)  Given the federal government’s yawning budget deficits, the interests of the “tax collection standpoint” may well prove paramount.

The complete report is available here.

The Moment of Truth: Is Tax Reform Coming?

December 2, 2010

By Jonathan Prokup

Recalling one of our first blawg posts, the topic of tax reform could be described in much the same terms as the codification of economic substance (prior to its codification, anyway): “a cousin of Bigfoot and the Loch Ness Monster – often spotted, but never confirmed.”  Reform commissions come and go with nearly every presidential administration, and the current one is no exception.

The National Commission on Fiscal Responsibility and Reform has released its much-anticipated report proposing reforms intended to closing the yawning federal budget deficit.  The report, titled “The Moment of Truth,” a copy of which is available here, makes a variety of proposals, including a number of reforms to individual and corporate tax provisions.

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Say That Again: A Summary of AJACTLA

June 1, 2010

By David Shakow

If you haven’t memorized the 433 pages of the latest version of the American Jobs and Closing Tax Loopholes Act of 2010 (undoubtedly named to allow for the euphonious acronym, AJACTLA), you are denying yourself a unique treat.  (To get the true flavor, don’t forget the fifteen pages of amendments included with the House passage of the bill on May 28.)  We will allow others to give you a full rundown of the 206 sections of the bill and content ourselves with a summary of the highlights.

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More on Wyden-Gregg’s Interest Disallowance Rule

April 28, 2010

By Jonathan Prokup and David Shakow

You might recall our prior post on the Wyden-Gregg tax reform proposal in which we discussed the proposed limitation on corporate interest deductions.  To summarize, the legislation would limit the deductibility of payments on corporate debt to the amount of the interest in excess of the annual rate of inflation, thereby discouraging the use debt to finance corporate operations.

We previously asked: “Why use inflation as the index for disallowing interest deductions, rather than simply disallowing, say, a fixed portion of the interest deduction?”  Thanks to the efforts of Greg Hillson, an enterprising 3L at UVA, we are now able to answer that question.  Mr. Hillson contacted an economist from the Senate Budget Committee who directed him to the 1984 Treasury proposal on which the interest-disallowance provision was based.  (You can find that proposal, and Treasury’s explanation, here.)  Fortunately, Treasury’s explanation of its original proposal gives a sensible explanation of why the portion of interest payments that is attributable to inflation should not be deductible.

As our readers know, neither the making of a loan nor the repayment of principal is generally considered to be a taxable event.  Generally, only the payment or receipt of interest on the loan is deductible or taxable, as the case may be (putting aside the satisfaction of a debt for less than the principal amount).

Yet, from an economic perspective, the payment of interest can actually represent, in part, the repayment of principal.  Consider that the nominal interest rate on a loan reflects a variety of components–e.g., a credit-risk component that compensates the lender for the risk that the loan might not be repaid, so that a less credit-worthy borrower pays a credit-risk premium relative to a more credit-worthy borrower.  Of primary importance here is the inflation component, which (to quote the 1984 Treasury explanation) “compensates the lender for the anticipated reduction in the real value of an obligation of a fixed dollar amount [due to inflation].”  Thus, “the inflation component of nominal interest payments is, in effect, a repayment of principal.”

Stated differently, there are two ways to account for the impact of inflation on the principal amount of a loan—(i) include an inflation component in the interest rate, or (ii) index the principal balance to inflation.  In theory, either mechanism should produce similar economic results of protecting the real value of the lender’s interest in the principal loaned to the borrower.  (Of course, in practice, the outcomes are much messier; but that is beyond the scope of this post.)  Thus, as noted above, the payment of the inflation component of interest is economically equivalent to the repayment of an inflated principal amount.

In sum, there is a principled basis for suggesting that the portion of interest payments that is attributable to inflation should be disallowed as a deduction.  Nevertheless, two further questions are raised:

(1)    By the same theory, recipients of interest (i.e., lenders) should be permitted to exclude from their gross income the same inflation component for which no deduction would be allowed to the payers of such interest (i.e., borrowers).  that was part of the 1984 Treasury proposal.  Query why it has been omitted from the Wyden-Gregg bill.

(2)    How should periods of deflation be handled?  If, during periods of inflation, interest deductions should be limited because the payment of interest reflects, in part, the repayment of principal; during periods of deflation, interest deductions should be extended above the amount of interest paid under the same reasoning.

The Wyden-Gregg Tax Reform Bill – Part I (cont’d)

March 8, 2010

By Jonathan Prokup and David Shakow

We previously discussed how the Wyden-Gregg bill proposes reducing interest deductions to the extent the interest simply compensates for inflation.  Inflation affects tax calculations in two ways.  First, it affects the dollar figures in the Code so that, for example, when your wages keep up with inflation, but you are pushed into a higher tax bracket, the resulting “bracket creep” is caused by inflation.  Second, when the value of your investment simply keeps pace with inflation and does no better, you still recognize a “gain” when you sell it.  Here, the measurement of real income has been distorted by inflation.

Many “bracket creep” issues are taken care of through section 1(f) of the Code, which adjusts dollar amounts in the Code to account for inflation.  But the Code has not generally corrected for the effects of inflation on the measurement of income.  A proposal made by the Treasury after the 1984 election would have broadly attacked the effects of inflation on income measurement.

To see an example illustrating the two ways inflation affects tax calculations as well as further discussion of the 1984 Treasury proposals, keep reading.

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