President Donald J. Trump campaigned on a platform of large tax cuts for businesses. With President Trump in the White House and Republicans controlling both the House of Representatives and Senate, does it mean businesses can count on tax cuts? If so, should they expect simple tax cuts or wholesale changes to the U.S. tax system? How does the recent failure to repeal the Affordable Care Act (ACA) impact tax reform? When can we expect to see any changes? This article describes the current state of play as to tax proposals affecting businesses.

The four tax proposals likely to have the most significant impact on U.S. business are discussed, as is the process by which we can expect to have the tax changes enacted:[1] In addition to tax rate cuts, we focus on immediate expensing, border adjustment, and eliminating the interest deduction. Each of these changes, if enacted, would represent a drastic change to the U.S. tax system, likely to have sweeping consequences. For a discussion of the individual tax proposal, the repeal of the alternative minimum tax, infrastructure tax proposals, move to territorial taxation rather than worldwide income, and other business proposals we encourage you to read see our earlier publication "An Analysis of Tax Law Proposals of the President-Elect and the House."

1. Immediate Expensing

Under current law, a taxpayer can deduct the cost of property used in business over the useful life of property. The depreciation deduction represents an annual allowance for the wear and tear, deterioration, or obsolescence of the property, and helps accurately measure income. Both plans would change this.  

House Plan: Businesses may immediately deduct, expense or "write-off" the cost of business investments in tangible property (such as equipment and buildings) and intangible assets (such as intellectual property). As under current law, land may not be immediately expensed. 

Trump Plan: "Firms" (presumably meaning business in all forms in which it is conducted, including corporations, partnerships, and sole proprietorships) engaged in manufacturing in the United States may elect to expense "capital investment" and lose the deductibility of "net corporate interest."

Observations:

  • Dramatic change to U.S. tax system. Immediate expensing would mean that a taxpayer could earn a return of its entire cost of capital before it would be required to pay any income tax. Note that income can be viewed as arising from three primary sources—wages, capital-financed investment, and debt-financed investment. Viewed through this lens, this proposal represents a dramatic decrease in the income derived from capital. This, along with border adjustment, is considered to be the most significant change to the current U.S. tax system.  
  • Eligible assets. Will the purchase of inventory be currently deductible? Will any "capital investment" (including, for example, in stock of a subsidiary) be eligible for expensing? If one looks to current law for guidance, one would expect expensing to extend to the types of assets that are currently deductible, which would not include inventory or stock. The cost of inventory likely would continue to be deducted from revenue, upon sale as a component of cost of goods sold. That being said, the answer to this is not yet clear.
  • Old versus new capital. Most established businesses have their infrastructure in place. Thus, a business that has already invested its capital will have a significantly lesser preference for this than a business planning substantial capital investment.
  • Financial industry. Manufacturers would clearly benefit from the enactment of this rule. It is not as clear that the rule would benefit businesses in other fields. For example, businesses in the financial services industry do not usually invest in depreciable property. They invest in financial assets such as portfolio stocks or various financial derivate positions. Under the House Plan, unspecified special rules would apply to financial services companies that will take into account the role of interest income and interest expense in their business models.
  • Unusable losses? Some businesses will not have enough income to absorb their immediate expense deduction. Until the point in time such a business has sufficient income, the losses would not result in a benefit.[2] An alternate rule that would have been more taxpayer friendly would have been to allow taxpayers to use excess losses to immediately obtain a tax refund. To date, there has been no indication that either President Trump or the House Plan would incorporate such a proposal. 
  • Tax planning for M&A and to monetize losses. If immediate expensing becomes law, there likely will be significant changes to tax planning for M&A transactions. For example, sellers may be able to command a higher purchase price to take into account any immediate tax benefit resulting to a buyer from a structure that allows for the characterization of an asset purchase. In addition, there may be increased focus on tax rules meant to prevent trafficking in losses. It is also possible that there would be a significant push to allow losses to be monetized in some way. 
2. Border Adjustment

This proposal goes hand in hand with the immediate expensing proposal, and in fact serves as a rationale for the current expensing proposal.

The House Plan’s border adjustment proposal has two key rules: 

  • No deduction would be allowed for assets purchased from outside the United States. So, if an asset whose cost would otherwise be immediately deductible is purchased from a foreign person, the immediate deduction would be lost.
  • Taxable proceeds from the sale of any goods and services to foreign persons would be excluded from taxable income, while deductions for producing or acquiring the property would still be available. Thus, generally, exporters would get immediate tax benefits.

The Trump Plan has no provisions comparable to the border adjustment proposal. President Trump has, however, talked repeatedly about tariffs. 

Observations:

  • One of the most controversial proposals. The border adjustment tax provision is the biggest point of difference between the House Plan and the Trump Plan. President Trump has waffled on whether he supports it—sometimes calling it too complicated, but at other times praising its potential for raising extra cash. A few Republican senators are reportedly also opposed to this proposal. As a result, many predict that it will not be included in a final tax reform bill.
  • Significant base broadeners. The border adjustment proposal is one of the three biggest base broadeners (the other two being the elimination of most itemized tax deductions for individuals and the elimination of the net interest deduction). It is estimated to generate $940 billion over 10 years. Without the inclusion of this in any overall tax reform effort, it is hard to see how such tax reform effort would come even close to being revenue neutral.  
  • Significant opposition. Retailers are strongly opposed to the proposal. If enacted, the border adjustment tax would significantly harm retailers and others that purchase inventory or component parts outside the United States.
  • Broad impact on more than just retailers. It is estimated that nearly 60% of imports are intermediate goods used by U.S. businesses in the manufacture or production of goods or services. Thus, the border adjustment proposal would potentially affect not only retailers that sell to the public, but businesses that sell products to other businesses, real estate developers, and more. Further, it is unclear that it would be easy to separate the domestic and imported components of products.
  • Illegal under WTO? The United States is a member of the World Trade Organization (WTO), an intergovernmental organization that regulates trade worldwide. Many question whether the border adjustment tax would comply with WTO rules. One way for the tax to comply with WTO rules would be for it to be a value-added tax (VAT). However, for the border adjustment tax to be more like a VAT, the tax deduction available under current law for wages would have to be eliminated. This, however, is not popular, nor being suggested by anyone.
  • Unusable losses. The border adjustment is likely to result in significant net operating losses for exporters, as generally, their revenue from sales will not be includable in income, but they'll still be able to deduct the costs of producing or acquiring income. See discussion above relating to "Unusable losses."

3. Eliminate Interest Deduction

Under current law, business interest is deductible. Both Plans affect this. 

House Plan: While interest could be deductible against interest income, the deduction for net interest expense would be eliminated.

Trump Plan: A business must elect whether to claim a net interest deduction or to expense interest. 

Observations:

  • Significant change to U.S. tax system. Right after immediate expensing and the border adjustment tax, eliminating the deductibility of net interest expense likely would be one of the most impactful changes to the U.S. tax system. For years, U.S. taxpayers have been encouraged by existing tax rules to leverage their investments (since the interest deduction lowers the cost of the capital they obtain). If the proposal is enacted, this would change. The enactment of the proposal would also affect many existing U.S. tax rules—including those distinguishing debt and equity, earnings-stripping, and inversion-related rules.
  • Either interest deductibility or immediate expensing. Note that few, if any, support capital expensing while also allowing an interest deduction. If both are allowed, the deductions would distort economics, and cause taxpayers to borrow even where it would not make economic sense.
  • Recharacterizing other revenue as interest income. Interest expense can be deducted against interest income. Accordingly, if this proposal becomes law, there would be incentive for taxpayers to characterize income as interest income, which can at least be offset by interest expense, rather than another type of income which cannot be offset by interest expense. For example, recharacterizing taxable sales revenue as interest income would allow interest expense to reduce taxable income. 
  • Real estate, private equity, and financial services industries affected. Real estate developers have expressed a strong desire not to lose the deductibility of interest, as they worry that it would mean less investment in real estate. Similarly, private equity firms, which typically use significant debt to buy out companies, have expressed a strong desire to not lose the deductibility of interest. In addition, financial services companies would be significantly disadvantaged, as they tend to borrow money to make their investments. 
  • Significant base broadener. Similar to the border adjustment tax, the elimination of net interest expenses is a significant base broadener, estimated to raise $1.2 trillion over the next decade. Again, it is difficult to see how this proposal could be eliminated if some of the proposed tax rate cuts, and immediate expensing are to be implemented.

4. Tax Rate Cuts

Corporations: Under current law, the top federal tax rate on corporate taxable income is 35%. 

The House Plan would reduce the corporate tax rate of 20%. The Trump Plan would reduce it even further, to 15%.

Pass-through entities: Since owners of pass-through entities pay tax on pass-through income at their applicable rates, the reduction in corporate and individual tax rates (with the top rate on ordinary income decreasing from 39.6% to 33%) would mean that all owners pay a lower tax rate on pass-through income. In addition, both Plans suggest special lower tax rates applicable in certain circumstances to pass-through business income. The individual tax rates and taxation of income from pass-through entities are discussed in greater detail in “An Analysis of Tax Law Proposals of the President-Elect and the House,” available here.

Observation:

  • Rate cuts without revenue generating proposals. Even if revenue neutrality is not a goal of tax reform, tax rate cuts are likely to have broader support if the base broadeners are part of the reform enacted. Two of the most significant base broadeners are business tax proposals— the limitation on the deductibility of net interest, and the border adjustment tax. Unless these are both enacted, tax rate reduction of the magnitude described under the House Plan or the Trump Plan may be difficult to achieve. There are those that have put forth that it may be more realistic to expect a corporate tax rate cut to 25% or 28% rather than 15% or 20% put forth by the Trump and House Plans.

For a greater discussion of individual taxes, the repeal of the alternative minimum tax, infrastructure tax proposals, and move to territorial taxation rather than worldwide income, we encourage you to read our earlier publication "An Analysis of Tax Law Proposals of the President-Elect and the House."  

The Process for Achieving Tax Changes

One of the most important questions that must be answered prior to achieving tax reform is whether tax changes will be sought to be brought about via comprehensive tax reform, or a budgetary procedure called reconciliation. The answer to this question significantly impacts what tax changes we can expect and when we can expect them.

Observations:

  • Comprehensive tax reform: Comprehensive tax reform was famously successfully undertaken in 1986 when the U.S. Internal Revenue Code was overhauled. This took more than five years and had bipartisan support. The advantage of using comprehensive tax reform as the political process to enact legislation would be that it could conceivably include all the proposals discussed above. It also would not have to revenue neutral, though as a practical matter, in order to achieve bipartisan support, some attempt at revenue neutrality may be required. The disadvantage associated with this process is that it would require the support of at least 60 senators, which would include, of course, Democrats. This is because Senate rules require a three-fifths majority to end debate on legislation and move to a vote. Without a successful cloture vote, a minority party with control of at least two-fifths or 40 votes can filibuster a bill and prevent it from passing. As of the writing of this article, not even all of the 52 Republican senators have indicated they are in favor of the House Plan. Obtaining the support of 60 senators currently seems to be a monumental task.
  • Reconciliation. Reconciliation is a process for enacting parts of a budget resolution into law that enables the Senate to get around potential filibuster. It allows legislation to be passed with a simple majority of Senate votes rather than three-fifths. However, constraints on the use of reconciliation limit the extent of the tax changes that can be enacted using this process. These include: 
    • Legislation may not increase the federal deficit outside of a 10-year window.  This is why the Bush tax cuts, which were passed via reconciliation, were set to expire after a 10-year period.
    • Generally, only one reconciliation bill is considered per fiscal year. See below for discussion of whether window for Fiscal Year 2017 remains open. 
  • Impact of reconciliation on timing of tax changes. Congress cannot use reconciliation whenever it chooses. The passing of a budget resolution by the House and Senate is a prerequisite for using the reconciliation process. The budget resolution contains specific reconciliation directives. Specifically, to enact tax laws, the reconciliation directives must allow desired tax legislation. A budget resolution was passed for Fiscal Year 2017 (which ends at the end of September 2017). The resolution laid the procedural groundwork for the repeal of portions of the ACA through the reconciliation process. The resolution for the Fiscal Year 2017 did not contain directives allowing enactment of tax reform through the reconciliation process.[3] This means that if tax reform is to be enacted through the budget reconciliation process, then either there has to be a new budget resolution passed for Fiscal Year 2017 specifically containing directives as to tax reform (which seems unlikely given the time remaining until the end of Fiscal Year 2017), or tax reform has to be considered in the budget resolution for Fiscal Year 2018. It is important to note that an agreed-to budget resolution for Fiscal Year 2018 would wipe out Fiscal Year 2017 budget resolution's reconciliation instructions—so that effectively, it would be absolutely clear that the repeal of the ACA could not be done via reconciliation relating to the Fiscal Year 2017 budget. So, when will the budget resolution for Fiscal Year 2018 be passed? It is hard to know, but probably only after it is certain that Republicans will not be seeking to effectuate the repeal of the ACA through the reconciliation process for Fiscal Year 2017.
  • Why the status of repeal of ACA is so relevant to tax reform. The repeal of the ACA would have meant that the revenue baseline that tax legislation would have had to meet in reconciliation would have been significantly lower than without the repeal of the ACA. The revenue baseline for tax reform is estimated to have been $500 billion to $900 billion lower if the ACA had been repealed. Whether or not the reconciliation process is used, and whether technical revenue neutrality is an absolute goal, it seems likely that legislation that contributes to a smaller deficit would have broader support and thus be easier to enact that legislation that contributes to a significant deficit.

Where does this leave us? Nothing is set in stone. However, at the moment, the most likely path for tax legislation to be enacted seems to be via the Fiscal Year 2018 budget reconciliation process. This would mean that we would not have wholesale tax reform that radically changes the U.S. tax system. However, it is quite possible that we may have significant tax rate cuts (though not to corporate tax rates as low as 15% or even 20%), combined with some aspects of immediate expensing (or accelerated depreciation) and deemed repatriation of foreign deferred earnings (since that generates short term revenue). However, we caution that accurate prediction is particularly difficult given the current political climate. 

Ballard Spahr's Tax Group will continue to monitor tax reform efforts and keep you apprised of key developments.


[1] The changes are included in either the tax plan outlined by President Trump during his campaign (Trump Plan), the Blueprint released by House Republicans (Blueprint), or both (Plans). While it is possible that the Senate may produce its own plan, currently, the House Plan is the Republican plan that seems likely to serve as the starting point for tax legislation—in part because there are not currently other detailed Republican plans in circulation.

[2] Under the House Plan, net operating losses (NOLs) would be allowed to be carried forward indefinitely and would be increased by an interest factor that compensates for inflation and "a real return on capital to maintain the value of amounts that are carried forward." The carryback of NOLs would not be permitted. But there would be a limit on the use of NOLs—they would be deducted against a limit of 90% of the net taxable income for a tax year.

[3] Technically, the instructions did not mention repeal of the ACA, but rather directed the Senate Finance Committee and the Senate Health, Education, Labor, and Pensions Committee to each submit to the Senate Budget Committee legislation to reduce the deficit by at least $1 billion over the Fiscal Year 2017 - Fiscal Year 2026 period. However, given that tax reform will not reduce the deficit by at least $1 billion— but may well increase it by at least that much—this direction does not leave much room to enact tax reform through it.


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