Last week, at a U.S. Chamber of Commerce event, Senate Finance Committee chairman Orrin Hatch (R-UT) signaled that the Senate would take its own path to tax reform, saying “a major concern on tax reform is producing a bill that can get through the Senate, and that is likely going to require a separate Senate tax reform process, which will almost surely end up looking different from what passes in the House.”
With only a 52-vote Republican majority, Hatch will need to craft bipartisan legislation or (if the filibuster-proof budget reconciliation process is used) wrangle support from all but two of his Republican colleagues in the Senate to pass a tax reform bill. Assuming the Senate does move away from the destination-based cash flow tax (or DBCFT) being considered in the House, it will have an array of options. In this post, we explore various possibilities for what may emerge from Congress’ upper house.
Consumption Tax by a Different Name. Hatch has suggested that a handful of Republican Senators have “serious reservations” about the House Republican DBCFT. Although Senators may be hesitating over the DBCFT, the Senate’s “different approach” may still center around a shift toward a consumption tax. The Senate has embraced consumption tax-based systems in the past. For example, the 2015 Business Income Bipartisan Tax Working Group Report (drafted by Senators Benjamin Cardin (D-MD) and John Thune (R-SD)) discussed a move toward consumption tax at length, underscoring the ability of such a system to address current law disincentives to save and invest.
Past Proposals. Since 2014, three different consumption tax plans have been proposed.
- Senator Jerry Moran (R-KS)’s FAIR Tax Act of 2015 would have replaced much of the existing U.S. tax system with a 23% retail sales tax on use or consumption in the U.S. of taxable property and services.
- Senator Cardin’s Progressive Consumption Tax Act of 2014 would have coupled a new 10% credit-invoice VAT with a 17% ongoing corporate income tax rate.
- Senator Marco Rubio (R-FL) and Senator Mike Lee (R-UT)’s Economic Growth and Family Fairness Tax Plan would have paired a 25% corporate tax rate with immediate expensing and a denial of interest deductions.
As noted in our recent post, a consumption tax much like the DBCFT was also proposed by the Bush Administration Advisory Panel’s 2005 Growth and Incentive Tax Plan.
If the Senate does pass a bill based on a consumption tax model, it may be easier for the House and Senate to forge a compromise in conference committee.
Enzi Plan – Territoriality (Mostly). Senator Mike Enzi (R-WY)’s 2012 proposal (and technical explanation) is another example of a Senate proposal that could be dusted off this year. As we noted last week, Enzi’s bill called for a shift toward territoriality by permitting U.S. shareholders to deduct 95% of qualified foreign-source dividends (very generally, active foreign-source income) paid by a CFC, including sales proceeds recharacterized as dividends under Section 1248, that are attributable to earnings generated after the effective date. Enzi’s draft preserves a U.S. corporation’s ability to deduct amounts attributable to investments in foreign subsidiaries. The proposal’s continued taxation of 5% of qualified foreign-source dividends is intended to offset this continued deduction (in lieu of a more complex deduction allocation system for disallowing the portion of deductions allocable to foreign income). A 95% exemption is equivalent to taxing active offshore profits at a maximum tax rate of 1.75% (35% of five percent).
Enzi’s proposal retained a modified subpart F regime, taxing passive income on a current basis. Enzi’s proposal denied foreign tax credits on dividends subject to the 95% exemption (including on the 5% taxed), but allowed foreign tax credits on subpart F income. Like the House Blueprint and former House Ways and Means Committee Chairman Dave Camp’s (R-MI) discussion draft, Enzi’s proposal provides for a lower tax rate (10.5%) on offshore earnings accumulated prior to the effective date of the proposal. However, unlike the Blueprint and Camp proposals, repatriation of such earnings would be optional. Camp’s proposal, presented most recently in 2014, contains more detail than Enzi’s proposal but is similar in many ways.
Trump Outline – Modified Worldwide System. The Senate’s consideration of tax reform proposals could also provide an opening for the Trump Administration to advocate for a modified world-wide system. Like the Blueprint and Camp’s discussion draft, Trump’s outline calls for a one-time deemed repatriation of accumulated offshore earnings, taxed at a 10% rate. Trump’s plan is unlikely to be adopted without rate adjustments (commentators who analyzed the proposal found that it would substantially increase the deficit absent other spending cuts). However, aspects of Trump’s outline (in particular, an end to deferral and the choice between immediate expensing and deductibility of net interest expense), may well appear in the Senate draft. During President Obama’s final year in office, a joint report by the White House and the Department of the Treasury likewise espoused ending deferral of tax on foreign earnings.
Corporate Integration. The Utahan Senator long ago hatched a plan to mitigate the harshness of double taxation of corporate earnings by providing for “corporate integration.” Puns aside, Senator Hatch announced in January of 2016 that he was drafting a corporate integration proposal and held a hearing on the idea in May (available here). Corporate integration proposals are not new, of course. Since 1975, bills to achieve some form of corporate integration have been proposed (but never enacted) at least 12 times.
The Basics. Under the current system, corporate income is taxed first when earned by the corporation and again upon distribution (via dividend) to shareholders. Hatch’s proposal would permit corporations to deduct dividends paid to shareholders, thereby eliminating the second layer of tax. As we noted last week, some commentators have observed (for example, here and here) that corporate integration could be a “simple” way to reduce the effective tax rates of U.S. companies as reported for GAAP purposes, permit U.S. companies to repatriate cash trapped abroad on a tax-free basis to pay dividends and reduce the pressure to enact legislation that would effect a switch from a worldwide system of taxation to a territorial one. Corporate integration would also equalize the treatment of debt and equity and reduce the incentive to organize as a pass-through. Corporate integration is also seen as promoting progressivity, as corporate earnings would be taxed in the hands of individual shareholders at their individual (progressive) tax rates. Hatch’s proposal, which he has refrained from formally introducing in light of the broader Republican push for comprehensive tax reform, also has been scored positively by the Joint Committee on Taxation.
Fly in the Ointment. The biggest question left unanswered by Hatch’s plan thus far is how to ensure that corporate earnings are taxed at least once when paid to foreigners and tax-exempt entities that do not themselves pay U.S. income tax. His plan suggested coupling the corporate dividend deduction with a withholding tax on dividends paid by U.S. corporations that taxable U.S. shareholders can credit against their U.S. income tax liability. Tax-exempt shareholders might be concerned that they would bear more tax than taxable shareholders under such a system (although this is not necessarily the case). Moreover, it is unclear how a new corporate integration withholding tax would correspond with the existing 30% withholding tax imposed on dividends to foreign investors under the FDAP regime (and the network of tax treaties that modify this rate).
Other Options? In a recent post, we discussed other options for reform that center on a shift toward territoriality, aside from the DBCFT. Finding consensus within the Republican ranks and common ground with Senate Democrats likely will be necessary to achieve any reform of the tax code. If reform as comprehensive (and as radical) as that proposed in the House Blueprint is not embraced by the Senate, more incremental reform that reduces and simplifies the rate structure for individuals and corporations, effects a deemed repatriation tax on earnings trapped overseas and ends deferral, may be on the table.