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By lowering the corporate tax rate, can the United States regain a competitive edge?
Lori Calabro, CFO Magazine
January 1, 2008
The race is on to cut corporate tax rates around the world. Last year, eight countries, including Germany and the Netherlands, cut their corporate tax rates. The year before, five countries did the same. Now the question is: Will the United States join the competition — and if so, when?
"Right now the U.S. has the second-highest marginal tax rate," says Mark A. Weinberger, Americas vice chairman–tax services at Ernst & Young LLP. That needs to be reevaluated, he argues, "if we are looking to keep jobs and businesses here."
According to the Treasury Department, the top corporate tax rate in the United States, including state taxes, is 39 percent. The average for other industrialized countries? Only 31 percent. Because "our current system for taxing businesses and multinational corporations has developed in a patchwork fashion spanning decades," the agency wrote in a 52-page report prepared for a July conference on the matter, the result is "a web of tax rules that can harm the competitiveness of U.S. companies."
To address the issue head-on, in October Rep. Charles Rangel (D–N.Y.), chairman of the House Ways and Means Committee, introduced the Tax Reduction and Reform Act of 2007. The main feature of the legislation is a drop in the corporate tax rate to 30.5 percent. But the proposal comes with a laundry list of offsets (see "Wrangling Over Rangel" at the end of this article), including the permanent repeal of the deduction for domestic production activities and the last-in, first-out (LIFO) inventory accounting method. It contains so many offsets, in fact, that Financial Executives International (FEI) has indicated concern over "the impact some of the revenue offsets in this bill could have on the global competitiveness of U.S. companies."
Obtaining both a lower rate and limited offsets in a "pay-as-you-go" legislative environment, which requires that any new spending be offset by new sources of revenue or cuts, will not be easy. Getting Corporate America to back a single proposal may be next to impossible. Finance chiefs and tax directors, after all, care more about their effective tax rates than the official rate. And they have been very adept at using the myriad allowances and deductions in the tax code to their advantage — achieving a 24 percent effective rate on average. Any tax overhaul that waters down or eliminates precious deductions will have a tough time garnering universal corporate support. In fact, says Mark Prysock, FEI's general counsel, the only thing it guarantees is that there will be "winners and losers."
No Easy Fix
The last round of real tax reform dates back to the Reagan era, when the Tax Reform Act of 1986 slashed the top corporate tax rate from 46 percent to 34 percent. By 1993, however, that rate had crept back up to 35 percent. Adding state taxes to the mix pushes it to the current 39 percent.
How much the rate deters international business from coming into the United States is subject to debate. But there is a growing sense that rate creep has fueled the lowering of rates elsewhere — which in turn attracts U.S. dollars overseas. A recent study by Michael Devereux and Ben Lockwood of the University of Warwick found that when an EU country cuts its corporate tax rate by 10 percent, it can expect a 60 percent increase in investment by U.S. multinationals — at least in the short term.
That trend caught the attention and ire of Treasury Secretary Henry M. Paulson Jr., whose summer powwow — The Treasury Conference on Business Taxation and Global Competitiveness — drew everyone from former Federal Reserve chairman Alan Greenspan to FedEx chairman Frederick Smith. And the ensuing dialogue hinted that at least some business leaders might trade in special-interest deductions for a lower rate and simplification. "I would trade it in a minute for a simpler, lower rate," said Oracle president and CFO Safra Catz of the R&D tax credit.
Which deductions meet which fate is another matter entirely. But there is agreement that preserving the current system is both exhausting and expensive. Says Hank Gutman, a principal in KPMG's Washington National Tax practice, "There are more than 30 provisions, including the R&D tax credit, that affect corporations and that are not permanent in the tax code." Just patching the alternative minimum tax (AMT), says Marc J. Gerson, a partner with Miller and Chevalier, requires "a $50 billion fix to keep current law."
At least the Rangel bill, says Gutman, offers "a baseline for discussion." It also offers a sneak preview of where the battle lines will be drawn. "Different corporate sectors affect different parts of the economy in different ways," he explains. This is legislation that will be felt on "a company-by-company basis. And I don't know that you can get everyone on the same page."
Keeping What's Mine
Certain provisions could pit U.S. multinationals against purely domestic firms. Rangel's bill, for example, makes expenses related to foreign-source income nondeductible until earnings are repatriated and taxed in the United States. This essentially will "gut deferral," says FEI's Prysock, and create a serious disadvantage to U.S.-based multinationals, such as General Electric and Merck, which have amassed large foreign profits.
Companies operating just in the United States, on the other hand, will have to evaluate whether a lower rate makes up for losing the deduction for domestic production activities. Oil and gas companies will have to make similar assessments about the elimination of LIFO, as will large wholesalers. And S-corporations will lose their manufacturing tax break without being entitled to the lower corporate tax rate. "There are a lot of oxen being gored here," says Eli J. Dicker, chief tax counsel for the Tax Executives Institute (TEI), which is currently "challenging its members" to model the business impact of the different provisions.
Splitting the Difference
In fact, the numerous offsets have led Republicans to dub the Rangel bill "the mother of all tax hikes." But one silver lining, says Prysock, is that the bill does manage to "bifurcate individual reform and corporate reform." The fear was that "individual reform would be paid for by corporate tax reform," he says, adding that FEI's Committee on Taxation plans to analyze and respond to the Rangel bill in the coming months.
For their part, finance chiefs and tax directors are only beginning to discuss details of a tax overhaul. But most are in agreement that the current system is untenable. "Tax complexity adds compliance costs that are not readily evident in the tax rates," says George Herrmann, executive vice president for Right Management. Moreover, says Richard Skeen, tax director at HealthTronics, "anything that saves me time and expense is worth evaluating."
Still, if there is to be substantial overhaul of the tax code, don't look for it in 2008. Much of what will happen then will depend on what was resolved by the end of 2007 — issues still pending as CFO went to press. Whether the AMT gets extended for another year and how it is paid for (raising taxes on hedge funds and private-equity partnerships was one possible solution) captured most of Congress's attention in December and promised to carry over to the new year if not resolved.
The Presidential election also promises that no major change will gain traction until a new Administration is in place. But most tax observers expect hearings and discussions to be held in 2008, setting the stage for real reform in 2009 or 2010. "History tells us that business taxation is not the first order of voter [concern]," says Gutman. But whoever is elected, he adds, will have to embrace some type of reform.
At this point, the Rangel bill is the one alternative on the table. Secretary Paulson is expected to unveil the Administration's take on tax reform sometime this year; one component is expected to be a lower corporate tax rate. Still, no one is holding his breath for some miraculous solution — just one that is acceptable to all involved. Pointing to numerous tax proposals dating back to the 1960s, Gutman says, "The wheel does not have to be reinvented here."
Whether a lower rate ultimately guarantees a global edge, however, "is a multilayered question," says TEI's Dicker. "What you want to do, at least, is create a level playing field."
Lori Calabro is a deputy editor of CFO.
Wrangling Over Rangel
Whether the bill sponsored by Rep. Charles Rangel (D–N.Y.) has a chance of passing in its current form remains unclear. But the proposal has framed the debate over lowering the corporate tax rate. Here are some of the key corporate provisions contained in Rangel's Tax Reduction and Reform Act of 2007 that executives — and their lobbyists — will likely debate in the months ahead:
Reduction of the corporate tax rate. The bill cuts the top corporate marginal tax rate from 35 percent to 30.5 percent. (Estimated cost over 10 years: $364 billion.)
Repeal of the deduction for domestic production activities. The tax break, says Rangel, benefits only a few corporations, providing a 3.15 percent rate cut on domestic manufacturing income. (Estimated to raise over 10 years: $115 billion.)
Allocations of expenses and taxes for repatriated income. The provision would require U.S.-based companies that defer income through controlled foreign corporations to also defer the associated deductions. Currently, corporations are allowed to take deferred deductions and account for them on a current basis. (Estimated to raise over 10 years: $106 billion.)
Repeal of worldwide allocation of interest. Current law, which has yet to take effect, allows U.S. corporations to elect special-interest allocation rules that reduce the amount of interest expense allocated to foreign assets. (Estimated to raise over 10 years: $26 billion.)
Limitations on treaty benefit for deductible payments. The bill would prevent foreign multinationals that are incorporated in tax-haven countries from avoiding tax on income earned in the United States. The provision addresses multinationals that route income through structures that allow a U.S. subsidiary to make a deductible payment to a country that has a tax treaty with the United States. Usually, the company repatriates the earnings in the tax-haven country after the deduction is taken. (Estimated to raise over 10 years: $6 billion.)
Repeal of the LIFO inventory accounting method. Any income recorded as a result of the proposed repeal of the last-in, first-out accounting method for booking inventory would be taxed over eight years. (Estimated to raise over 10 years: $107 billion.)
Repeal of the inventory valuation choice method. The bill would require corporations to value inventories at cost, eliminating the opportunity to choose between the lower of cost and market value. (Estimated to raise over 10 years: $7 billion.)
Elimination of the special service-provider rule. The provision would prevent larger corporations (defined as C-corporations in the tax rules) that use the accrual method of accounting from taking advantage of the special rule pertaining to service providers. The current rule allows C-corps to not account for amounts that will go uncollected based on the history of the service provider. (Estimated to raise over 10 years: $225 million.)
Permanent extension of enhanced small-business expensing. The bill would extend the current threshold amounts that small businesses can count as a tax-deductible expense. The rule is scheduled to expire in 2010, but the proposal would allow businesses to continue at current levels — that is, $125,000 (indexed for inflation) with a phase-out threshold of $500,000 (also indexed for inflation). After 2010, if the law is not changed, small businesses would be able to expense only $125,000, with a $500,000 phase-out threshold, and neither expense mark would be indexed for inflation. (Estimated cost over 10 years: $21 billion.)
Increase in the amortization period for intangible assets. The bill would increase the current 15-year amortization period for intangibles to 20 years. (Estimated to raise over 10 years: $21 billion.)
Clarification of the economic-substance doctrine. In any transaction in which economic -substance analysis is required, the doctrine would be satisfied only if: (1) the transaction changes — in a meaningful way — the corporation's economic position (apart from federal income tax consequences); and (2) the corporation has a substantial non-federal tax purpose for entering into the transaction. The provision also imposes a 20 percent penalty on understatements that stem from a transaction lacking economic substance. The fine rises to 40 percent if relevant facts are not adequately disclosed. (Estimated to raise over 10 years: $4 billion.)
Decrease in the deductions allowed for dividends received. For a 20 percent–owned corporation, the deduction would drop from 80 percent to 70 percent. For dividends currently eligible for a 70 percent reduction, the tax break would fall to 60 percent. (Estimated to raise over 10 years: $5 billion.) — Marie Leone
Taxed to the Max
The 10 highest global tax rates
39.3%: United States
33.0%: New Zealand
Source: The Tax Foundation