Two weeks ago, we previewed the destination based cash-flow tax (or DBCFT), the centerpiece of the House Republicans’ Blueprint for tax reform. In this post, we focus on one aspect of that proposal—the immediate deduction for capital expenditures—and how transition to immediate expensing might be implemented.
Policy choices for transition rules must take into account short-term and long-term effects on businesses, revenue effects and political considerations. Pro-growth rationales for tax reform tend not to favor prolonged phasing-in of expensing, but generous transition rules for the “losers” in tax reform may need to be offset, to some extent, by the phasing-in of expensing to achieve revenue neutrality.
Current Law – Amortization and Depreciation. Under current law, ordinary and necessary business expenses are deductible in the current year. The cost of acquiring or creating business assets, and other expenses that give rise to assets that have a useful life beyond the current tax year, must be capitalized, i.e., added to the cost basis of the asset to which such expenses relate. Once capitalized, a taxpayer is entitled to “recover” the capitalized basis over time through annual depreciation or amortization deductions, on a fixed schedule prescribed by the Internal Revenue Code and regulations promulgated thereunder.
Expensing under DBCFT – Phased-In or Immediately Effective? Concepts such as depreciation and amortization (and, for that matter, capitalization, basis and realization) presumably would no longer be relevant in a DBCFT system. However, it is unclear at this point how or whether tax writers plan to phase in the introduction of immediate expensing. It is conceivable that the change would be immediately applicable to all new expenditures and investments.
Alternatives for Treatment of Existing Basis. A key transition issue is how pre-enactment investments with remaining undepreciated or unamortized basis will be treated. For this, lawmakers have some options. The most taxpayer-friendly option would be to permit an immediate deduction for remaining depreciable or amortizable basis in existing investments. Alternatively, lawmakers could simply permit immediate (or phased-in) expensing for new investments, with no relief for existing investments. Other options include retaining the present system for existing investments alongside the DBCFT, with anti-churning rules to police the line between new and existing investments. Lawmakers could also permit transition period write-offs on a new, uniform schedule (i.e. depreciation or amortization of remaining depreciable or amortizable basis over a fixed number of years for all assets, regardless of the remaining recovery period under current law).
Lessons from the Past –Transition to MACRS. Congress has been faced with the question of how and when to transition between cost recovery systems before. As part of the Tax Reform Act of 1986, congress enacted the modified accelerated cost recovery system (MACRS), which increased recovery periods for many asset classes, while permitting accelerated write-offs in certain cases and immediate deductibility in others. The new MACRS system applied only to property placed in service beginning January 1, 1987, except that certain enumerated classes of property were subject to staggered effective dates and other enumerated classes were wholly exempted (e.g., certain media and public utility property). The Act also added anti-churning rules to prevent taxpayers from bringing certain property placed in service in the six years preceding the Act under MACRS.
Other Options – Transition under the 2005 GIT Proposal. Another interesting data point is the transition plan outlined in the Growth Investment Tax (GIT) Plan, one of the two tax reform proposals included in the November 2005 report of the President’s Advisory Panel on Federal Tax Reform. The GIT plan included a DBCFT very similar to the DBCFT proposed by the Blueprint (with immediate expensing of new investments). The GIT Plan proposed phasing out the existing cost recovery system over a five-year period following enactment. In the year of enactment, taxpayers would be entitled to claim a deduction for 80% of the annual depreciation or amortization allowance they would have been entitled to receive under the pre-existing system, reduced by 20% down to zero for each successive year.