Everyone Who Calls for Repealing the Corporate Tax Is Wrong

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Every now and then something happens — a Senate investigation into Apple’s tax dodging, Burger King’s plan to become Canadian — that demonstrates that our corporate income tax is very ill. Every time, pundits debate how to cure this disease, offering various tax reform proposals. And every time, a few suggest we shoot the patient, that is, repeal the corporate income tax, which is expected to raise $4.6 trillion over the coming decade.

The idea of repealing the corporate tax seems to have just one virtue, which is that it’s simplistic enough to fit into a blog post or op-ed. In every other way this idea is terrible.

The argument made is usually some variation of the idea that corporate profits are eventually paid out as stock dividends to shareholders who pay personal income taxes on them, so there is no need to also subject these profits to a corporate income tax. But in real life that’s not how things usually work.

CTJ published a fact sheet last summer that explained three very important reasons why we need the federal corporate income tax.

First, a corporation can hold onto its profits for years before paying them to shareholders. This means that if the personal income tax is the only tax on these profits, tax could be deferred indefinitely. It also means that people with large salaries could probably create shell corporations that would sell their services. Their income would then be transformed into corporate income and any tax would be deferred until they decide to spend the money, which could be decades later, if ever.

Second, even when corporate profits are paid out as stock dividends to shareholders, under our current system about two-thirds of those stock dividends are paid to tax-exempt entitles, such as pensions and university endowments which are not subject to the personal income tax. In other words, a lot of corporate profits would never be taxed if there was no corporate income tax.

Third, our tax system overall is just barely progressive and it would be a lot less progressive if the corporate income tax were repealed. The corporate income tax is a progressive tax because it is mostly paid by the owners of capital — people who own corporate stocks (which pay smaller dividends because of the tax) and other business assets.

Some have tried to argue that the corporate tax is mostly borne by labor because it chases investment out of the United States, leaving working people with fewer jobs and/or lower wages. But corporate investment is not perfectly mobile and, as a result, the Treasury Department has concluded that 82 percent of the corporate income tax is paid by owners of capital, and consequently, 58 percent of the tax is paid by the richest 5 percent of Americans and 43 percent is paid by the richest one percent of Americans. Congress’s Joint Committee on Taxation has reached similar conclusions.

There are various ways Congress could conceivably repeal the corporate income tax and get around these problems but each presents so many complications and uncertainties that one wonders what could possibly be gained in the effort. One proposal that has received attention would partly offset the cost of repealing the corporate income tax by taxing dividends and capital gains as ordinary income (repealing the lower rates for those types of income) and taxing the gains on corporate stocks each year rather than only when they are realized when the stocks are sold. Those are all fine ideas in themselves, but they don’t make up the revenue loss from repealing the corporate income tax. The net effect of the proposal, as its proponents acknowledge, would be to lose about half the revenue raised by the corporate income tax.

Congress could make additional changes, for example, ending the tax-exempt status of those pensions and university endowments that receive so many stock dividends without paying any tax on them, but that seems politically unrealistic to say the least.

Moreover, repealing the corporate tax could create worrisome problems of tax compliance. For example, Jared Bernstein has noted that we do, of course, have many businesses structured as “pass-through” entities whose profits are subject only to the personal income tax and not the corporate income tax, but these businesses are linked to even greater tax compliance problems.

“One study found that the tax gap — the share of taxes owed but not collected — was 17 percent for corporations and 43 percent for business income reported by individuals. That research is over a decade old, but more recent tax gap research found that business income taxed at the individual level was the single largest source of the gap, and that sole proprietors report less than half of their income to the I.R.S.”

The bottom line is that repealing the corporate income tax is a seemingly simple answer that would create far more problems than it would solve and would almost surely result in less revenue, a more regressive tax system, and even more complexity and compliance problems than we have now.

Tax Policy and the Race for the Governor’s Mansion: Texas Edition

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Voters in 36 states will be choosing governors this November. Over the next several months, the Tax Justice Blog will be highlighting 2014 gubernatorial races where taxes are proving to be a key issue. Today’s post is about the race for Governor in Texas.

texas.jpgTexans will choose a new governor this November. State Attorney General Greg Abbott (R) will face state Senator Wendy Davis (D-Fort Worth). So far, taxes have played a minor role in the campaign, taking a back seat to social issues such as abortion, education funding, and veterans.

Abbott is widely seen as Perry’s heir apparent, and promises to maintain Texas’s low-tax, low-service model of government. In July, Abbott proposed an exemption from the business franchise tax and business registration fees for veteran-owned companies in their first five years of operation. The proposal is designed to encourage veteran entrepreneurship. Abbott also proposed an optional commercial property tax cut – to be applied by local jurisdictions – for businesses that hire veterans, where the business owner would receive a $15,000 reduction in the assessed taxable value of their property for every veteran hired.

At a recent campaign event, Abbott raised the idea of repealing the business franchise tax altogether, saying “Texas is known as having no income tax. Think how many more jobs we could attract to Texas if we also had no business franchise tax.” Texas lawmakers created the franchise tax in 2006 to help pay for a cut in property taxes, though there have been many efforts to reform or kill it since. Currently, the tax exempts all businesses with less than $1 million in revenue each year, and accounted for 4.8 percent of state revenues in 2013.

Davis has insisted that new taxes are not needed, and that the state can better spend the money it already collects; she says she would ask the state legislature to close some of the over $43 billion in tax loopholes to fund needed improvements in education and other areas. In an interview with the Texas Tribune last year, she vowed to veto any increase in sales or property taxes; Texas is one of nine states that does not levy a personal income tax. 

Texas voters will also decide on a proposed constitutional amendment this Fall that could change the way the state funds its roads. Proposition 1 would amend the state constitution to divert 37.5 percent of the severance tax on gas and oil extraction to the State Highway Fund. The move would add $1.7 billion in road funding in the first year alone. Both Davis and Abbott are on record as supporting the proposition. A better solution would be raising the state gas tax, something Texas has not done in over 22 years

One statewide race where taxes have played a bigger role is the campaign for state comptroller, where a proposal to replace property taxes with sales taxes has drawn attention. State Senator Glenn Hegar (R) supports the proposal, while businessman Mike Collier has slammed the idea as a massive, regressive tax increase. If the proposal is passed, poor school districts may end up looking wealthier on paper because of their stronger sales tax bases, affecting the distribution of state and local education funding. 

Cumulative Impact of Ohio Tax Changes Revealed

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Since 2004, Ohio lawmakers – from those living in the Governor’s mansion to those elected to the legislature – have pushed through numerous changes to the Buckeye state’s tax code. Since being elected in 2010, Gov. John Kasich has championed his own series of tax cuts including accelerating already scheduled income tax rate reductions and creating a special new tax break for “pass through” businesses, while providing much smaller tax breaks to low- and middle-income families.  Now that Governor Kasich is running for reelection, informed voters ought to be asking, “What’s the cumulative impact of these changes?” After all, voters should know the impact of the tax-cut path their elected leaders have led them down.

Thanks to a new report from Policy Matters Ohio (which includes analyses from ITEP) we know the answer.  The findings in the report are pretty staggering.

The tax changes combined are costing the state $3 billion and are currently reducing tax bills for the state’s most affluent 1 percent of taxpayers by more than $20,000 on average, while the bottom three-fifths of state taxpayers as a group are actually paying more taxes now, on average, than they would if these tax changes had not been enacted. It’s worth noting that the average benefit from these tax changes by the top 1 percent of Ohioans is actually greater than the income of the poorest twenty-percent of Ohioans.

In its editorial about the Policy Matters Ohio report, the Toledo Blade makes the case that “Ohioans needs a new tax policy that works for everyone, not just the wealthiest. It needs a tax system that is fairly based on ability to pay, not one that favors the already favored.” For more on the Ohio tax debate over the years, check out our Ohio page on the Tax Justice Blog

Will Congress Let Burger King’s Shareholders Have It Their Way?

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Burger King’s statement that its planned merger with the Canadian donut and coffee chain Tim Hortons is not about avoiding taxes might be one of the biggest whoppers we’ve heard about corporate inversions.

The merger will allow Burger King to claim for tax purposes that it is owned and controlled by a smaller Canada-based company. We’ve heard this song before — several times in the last three months (Medtronic, Mylan, Walgreen and Pfizer) and 13 so far this year. Corporate bosses and their lobbyists continue to claim that they are doing nothing wrong. Gaping loopholes in the law allow them to do this, and without action from Congress or the administration, there is no incentive for corporations to stop exploiting those loopholes. 

Corporate inversions have made so many headlines lately that even people outside the tax world know how big businesses are using the practice to game the system: Buy a smaller foreign corporation, maintain the same executives, continue managing the firm from an office in the United States, maintain most of the same shareholders, but file a bit of paperwork and claim the company is based in a foreign county. In the case of Burger King, that country is Canada. The most likely motivation for this sleight of hand is tax avoidance.

Inversions are confusing partly because corporations pursue them for different reasons. For example, some corporations invert to avoid paying U.S. taxes on the profits they have already earned (or claimed to have earned) offshore. After inverting, corporations can get this offshore cash to their shareholders without paying the U.S. tax that would normally be due. This may not be relevant for Burger King, which has little offshore cash compared to other corporations.

But another reason corporations invert is to avoid paying U.S. taxes on profits earned in America in the future, and this is relevant for a company like Walgreen’s (which was considering inversion until recently) or Burger King. This can be accomplished through earnings stripping, a practice that effectively shifts profits earned in the United States to another country where they will be taxed less. So for Burger King, this means it could continue to earn profits off the burgers and fries its sells to Americans yet use accounting tricks to shift those profits to Canada so they will not be subject to U.S. taxes.

Looking past the technical details, the bottom line is this: It’s insulting that the company intends to continue profiting by selling a quintessentially American product to U.S. consumers but then pretend to be Canadian when the time comes to pay taxes.

Of course, the real insult is that a majority of our elected members of Congress have so far not closed the loopholes in our tax laws that allow this nonsense to continue. Several proposals, which have been described by Citizens for Tax Justice, would accomplish this.

Sadly, our lawmakers’ motto regarding big, powerful corporations seems to be “Have it their way.”

Kinder Morgan Doesn’t Want to Be a Limited Partnership Anymore–But They’re One of the Few

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Last week the energy giant Kinder Morgan Energy Partners announced that it will restructure itself into a traditional C corporation, moving away from the “master limited partnership” (MLP) structure it helped to popularize almost a quarter century ago. While C corporations pay corporate income tax on their profits, the income of MLP’s is passed through to its individual partners and taxed (at least in theory) under personal income tax rules, so these companies can bypass the corporate income tax entirely.

Unlike most partnerships, MLP’s are publicly traded. Soon after the first MLP was created in the early 1980s, Congress clamped down on the use of this form: a 1987 law treats most publicly-traded partnerships as corporations for tax purposes. But lobbyists for the extractive industries got an exception for energy companies, including those engaged in exploration, refining and even “fracking.” IRS private letter rulings have gradually expanded the scope of the energy-related activities that MLP’s can engage in, and as a result the number and value of these tax-exempt entities has grown dramatically

Kinder Morgan appears to be swimming against this tide. By all accounts, the company’s sheer size is making the MLP form too unwieldly, and may even be hindering the correct valuation of their assets: Kinder Morgan actually forecasts that moving to the C form will constitute a smart tax move, apparently because they expect many of their depreciable assets to be given a sharply higher valuation after the deal goes through. Or maybe there’s more that we don’t know. Perhaps the merger to a corporate form will be followed by an inversion transaction or just more aggressive offshore profit-shifting.

Kinder Morgan’s announcement came on the same day that a Treasury Department spokesperson signaled Treasury’s concern about the growing number of MLP’s and its effect on future federal tax revenues. The Obama administration’s concern about MLP’s is understandable: earlier this year, a General Accounting Office (GAO) report found that, because of the complexity of partnerships, the Internal Revenue Service simply doesn’t have the resources to audit these business structures, even when they suspect them of wrongdoing.

Treasury seems to be considering halting the gradual expansion in the scope of these partnerships. Maybe it’s time for Congress to shut them down altogether. For every Kinder Morgan abandoning the MLP form as too complicated, there are dozens of others lining up to take advantage of this hole in the tax system. Companies, particularly large publicly-traded ones, shouldn’t be able to just restructure to take advantage of the tax-dodge flavor of the day. At a time when the corporate tax is under siege from companies seeking to invert to tax havens, spinning off REITs, or just agressively shifting profits offshore, the MLP invasion is a clear example of a tax break that Congress could stop in its tracks.


New CTJ Report: Proposals to Resolve the Crisis of Corporate Inversions

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The ongoing wave of American corporations inverting, or reincorporating as offshore companies to avoid U.S. taxes, has resulted in a bewildering variety of solutions being debated in Washington and in the editorial pages. A new report from Citizens for Tax Justice explains how these proposals differ and which are most effective.

The proposals vary in several ways. Some target inversion by stopping the IRS from recognizing the “foreign” status of a corporation that has not actually moved abroad except on paper, while others target the tax dodging practices that inversion facilitates and which provide its true motivation.

Contrary to corporate lobbyists’ claims, corporations do not seek to become foreign for tax purposes simply because other countries have lower statutory corporate tax rates. They do it because inversion makes it easier to use accounting tricks to dodge U.S. taxes. For example, an inverted company can strip earnings out of the American business by making large interest payments to the ostensible foreign company that owns it, and it can use accounting tricks to move offshore profits into the U.S. without triggering the tax normally due when U.S. companies repatriate offshore profits.

An American corporation can accomplish these feats after it creates, through inversion, the pretense that it’s owned by a foreign company, even if this change exists only on paper. So, in addition to changing the basic rules about when an American corporation will be recognized as having become a foreign one (the basic proposal to crack down on inversions), many people in Washington are also thinking about ending these two tax dodges to eliminate the incentives to invert.

Another difference between the proposals being debated is that one approach would do this through legislation while another would accomplish this through regulatory changes under existing law. The regulatory route is important in case Congress fails to provide a legislative solution — which seems increasingly likely given some of the impossible conditions key lawmakers have placed on approving any legislative solution.

There is nothing inevitable about corporate inversions. There is no fundamental reason why corporations that are American in every sense and that benefit from taxpayer-funded services should be allowed to pretend they are foreign when it comes time to pay taxes. Congress and the White House have the tools to solve this problem, and simply need to choose the right ones.

Proposals to Resolve the Crisis of Corporate Inversions

August 21, 2014 01:38 PM | | Bookmark and Share

Read this report in PDF.

Several proposals have been offered to address the crisis of American corporations “inverting.” These companies reincorporate as offshore companies to avoid U.S. taxes even as they continue to operate and be managed in the U.S. and benefit from the public investments that American taxpayers support. This report describes these proposals and explains why some are much stronger and more effective than others.

The Basics
The Inversion Crisis Consists of Three Problems which Require Separate Solutions

The inversion crisis actually consists of three related problems which each call for specific solutions. First, loopholes in our tax law allow American corporations to pretend they are based abroad. Second, those corporations claiming to be based abroad (and corporations that really are based abroad) are able to use “earnings stripping” techniques to make profits earned in the U.S. appear to be earned in countries where they will be taxed more lightly or not at all. Third, the profits that American corporations earn offshore are supposed to be taxed by the U.S. when they are brought to the U.S., but after inverting corporations are able to use accounting tricks to escape that rule.

The first problem is simply the absurdity that American corporations can pretend to be foreign corporations, while the second and third problems are the benefits they obtain by doing so. As Edward Kleinbard, former director of the Joint Committee on Taxation (JCT) argues, these benefits, rather than any attempt to enhance “competitiveness,” are the true goals of inversions.[1]

A powerful response would be to address all three problems by taxing “inverted” corporations as American corporations and removing the ability of such companies to earnings strip or access their previously accumulated offshore profits without triggering U.S. taxes.

It is possible that Congress will only address the first problem, by enacting the anti-inversion proposal from President Barack Obama’s recent budget plan and introduced as legislation by Rep. Sander Levin and Senator Carl Levin to tighten the rules around which corporations are treated as American for tax purposes.[2] Or, Congress could instead enact legislation that would address the other two problems — i.e., addressing the motivation for most inversions. The most obvious way to accomplish this would be the enactment of the new legislation that Rep. Sander Levin is reportedly working on to address these problems.

Yet another possibility is that Congress will fail to act and the Obama administration will act on its own to issue regulations authorized under existing law. There is no obvious way that a regulatory change could address the first problem (the loopholes allowing American corporations to pretend to be foreign) but former Treasury official Stephen Shay argues that the administration does have authority to issue regulations that would partially address the other two problems (the motivations for many inversions) which would alleviate the crisis to a large extent.[3] [4]

Loopholes allowing inversions must be closed.

The first problem is that loopholes in our tax law simply allow American corporations to invert. That is, loopholes allow American corporations to pretend, for tax purposes, that they have restructured themselves as foreign companies even though this restructuring exists only on paper. Before 2004, an American corporation might set up a shell corporation in a tax haven like Bermuda and then, as a technical matter, become a subsidiary of that tax haven corporation. Bipartisan legislation enacted in 2004 treats such a company as an American corporation for tax purposes if the former shareholders of the American corporation own more then 80 percent of the newly merged company and there is no substantial business activity in the foreign country.[5]

But American corporations have recently responded by merging with real foreign corporations — albeit smaller ones — to provide the sheen of legitimacy that the 2004 rules require. The arrangements still do not include any actual move of managers or other personnel or any significant change in the business operations, but result in corporations that can pretend to be foreign for tax purposes. The straightforward solution is to treat the company that results from this arrangement as American if the majority of it is owned by the former shareholders of the American company, and to treat is as American if it is managed in the U.S. This is what the Obama-Levin-Levin proposal would do.

Earnings stripping must be stopped.

The second problem is that once a corporation has inverted, it has opportunities to use “earnings stripping” to make profits earned in the U.S. appear to be earned in other countries where they will be taxed more lightly or not at all. In theory, any profits earned in the U.S. are subject to U.S. taxes, whether they are earned by an American-owned company or a foreign-owned company (which an inverted corporation is, technically). But earnings are stripped out of the U.S. when a U.S. corporation (which after inversion is technically the subsidiary of a foreign parent corporation) borrows money from its foreign parent corporation, to which it makes large interest payments that wipe out U.S. income for tax purposes. The loan is really an accounting gimmick, since all the related corporations involved are really one company that is simply shifting money from one part to the other. The interest payments made by the American corporation in effect shift the profits that are really earned in the U.S. to the foreign country for tax purposes.

Restrictions on earnings stripping can take several forms, any of which can be weak or strong depending on how strict the limits are. One approach is to limit the amount of interest that can be deducted for tax purposes to some percentage of income or revenue. Another approach is to limit the deductions to the extent that the American subsidiary’s ratio of debt to equity (loans taken to stock issued) exceeds some set limit. The current (very weak) rule uses these approaches, and some reform proposals would simply lower the percentage of income or revenue that the deductable interest cannot exceed. Another approach would be to limit the interest deductions to the extent that the American subsidiary’s indebtedness is disproportionate relative to the rest of the corporate group (the group of corporations owned by the same foreign parent company). This is the approach taken in the earnings stripping proposal in President Obama’s most recent budget plan, which may be the strongest proposal to stop earnings stripping.

American corporations must not be allowed to avoid the U.S. tax normally due on offshore profits upon repatriation to the U.S.

The third problem is that the profits that American corporations earn offshore are supposed to be taxed by the U.S. when they are officially brought to the U.S. But after inverting, corporations are able to use accounting tricks to escape this rule.

The U.S. theoretically taxes all the profits of American corporations, including the profits earned by offshore subsidiaries. (The U.S. corporate income tax is reduced by whatever corporate income tax has been paid on these profits to foreign governments.) But U.S. corporations are allowed to defer paying U.S. tax until these profits are officially brought to the U.S., which may never happen. As a result, one of the key questions is what will become of the offshore profits that American corporations’ subsidiaries have accumulated offshore (at least officially, since these profits are often in the U.S. in a real economic sense).

In theory, if the U.S. corporation inverts and becomes the subsidiary of a foreign corporation, the profits accumulated by the offshore subsidiaries of the U.S. corporation are still subject to U.S. tax whenever they are repatriated (officially brought to the U.S.) But inverted corporations can easily get around this rule. Money is fungible. The subsidiaries of the U.S. company can loan the money they have accumulated offshore to the foreign company that ostensibly owns the U.S. corporation after inversion, or to another foreign company in the corporate group that is not a subsidiary of the U.S. company. That money can then be used to expand business in the U.S. or buy back stock from the shareholders of the U.S. company. If the offshore accumulated profits of the subsidiaries were directly used for these purposes, that would constitute a repatriation and would trigger U.S. tax. But the inversion allows for the use of loans (as an accounting gimmick) to move the money into the U.S. for that purpose while avoiding the tax.

Proposed solutions generally would enhance the effectiveness of section 956 of the tax code, which is designed to prevent corporations from avoiding the U.S. tax that is due upon repatriation of offshore profits. Before section 956 was enacted in the 1960s, an American corporation could get around the tax by having an offshore subsidiary make an investment in its American operations that was not actually a dividend payment to the American parent company, and thus not considered a taxable repatriation. Section 956 was enacted to treat such investments as repatriations, and to impose U.S. tax at that point. But section 956 applies to investments made by the offshore subsidiaries directly in related American companies. It does not apply when the offshore subsidiaries hopscotch over their American parent company, investing or lending the money to other foreign companies within the corporate group (foreign companies that are not subsidiaries of the American company), which can then use that money for the same purpose without triggering U.S. tax.

Proposals to address this loophole would make section 956 apply when such investments are made by the subsidiaries of the American corporation to other foreign companies in the corporate group in certain situations.

More Details
The Three Problems and Specific Proposals to Address Them

1. Corporations Using Paperwork to Claim to Be Foreign Companies

Problem: Corporations use restructuring that exists only on paper to claim “foreign” status to avoid U.S. taxes.

Solution: Amend the tax laws to refuse to recognize foreign status that exists only on paper.

Proposal: The basic anti-inversion proposal included in President Obama’s most recent budget and then incorporated into the Stop Corporate Inversions Act, provides this solution. The proposal would treat an entity that results from a U.S.-foreign corporate merger as an American corporation if the majority (as opposed to the current threshold of 80 percent) of voting stock is held by the shareholders of the former American corporation. It would also treat the entity resulting from the merger as an American corporation if it is managed and controlled in the U.S. and has significant business activities in the U.S. (Significant business is defined as 25 percent of the corporate group’s employees, payroll, assets or income.)

This proposal would raise $19.5 billion from 2014 through 2014 according to Congress’s official revenue estimator, the Joint Committee on Taxation (JCT). 

Some lawmakers have taken issue with the provision concerning inverted corporations managed in the U.S. They claim that this could encourage corporations to literally and physically move their headquarters, including management and supporting personnel, to a foreign country in order to reduce their tax bill. This seems extremely unlikely. So far there is no evidence of any inverting corporations moving managers offshore. In fact, Ireland, where many inverted corporations claim to be based, appears not to be benefiting from the inversion wave precisely because nothing real is actually moving to Ireland, which consequently does not enjoy any revenue or economic gain.[6] In other words, the danger that corporations might respond to a change in the law by moving management offshore is at best speculative, while the danger of corporate inversions causing a loss of revenue is very real and unfolding before our eyes.

Even if there was any reason to fear that some American corporations would do whatever necessary to be considered “foreign,” even if that means moving management abroad, the answer would be to enact additional provisions that remove the incentives a corporation currently obtains by virtue of being foreign (which are discussed in the following sections) and make these provisions apply to all corporations. Under this approach, even if an American corporation was willing to be acquired in a true, economic sense and was willing to move management offshore, there would be little or no incentive to do so because becoming “foreign” would no longer provide significant benefits.

2. Earnings Stripping by Inverted Corporations

Problem: American corporations that invert to claim foreign status often then engage in “earnings stripping,” the practice of multinational corporations earning profits in the United States reducing or eliminating their U.S. profits for tax purposes by making large interest payments to their foreign affiliates.

Solution: Enact tighter limits on debt taken on by the U.S. part of a multinational corporation (tighten restrictions against earnings stripping).


a) Obama’s fiscal 2015 budget plan

The strongest anti-earnings stripping proposal is the one included in President Obama’s most recent budget plan. It would, with good reason, apply to all corporations, not just those that have inverted. It would allow a multinational corporation doing business in the U.S. to take deductions for interest payments to its foreign affiliates only to the extent that the U.S. entity’s share of the interest expenses of the entire corporate group (the entire group of corporations owned by the same parent corporation) is proportionate to its share of the corporate group’s earnings (calculated by adding back interest deductions and certain other deductible items). A corporation doing business in the U.S. could choose instead to be subject to a different rule, limiting deductions for interest payments to ten percent of “adjusted taxable income” (which is taxable income plus several amounts that are usually deducted for tax purposes).

This proposal would raise $41 billion from 2015 through 2024 according to JCT.

b) Rep. Levin’s discussion draft legislation

A different approach is taken by a proposal in legislation being drafted by Rep. Sander Levin, the ranking member of the House Ways and Means Committee.

It would bar the American corporation (which is technically a subsidiary of a foreign company after an inversion) from taking deductions for interest payments to a foreign parent company in excess of 25 percent of its “adjusted taxable income,” which is defined as taxable income plus certain significant deductions that corporations are allowed to take. The current rule (under section 163(j) of the tax code) sets the limit at 50 percent of adjusted taxable income.

This proposal would eliminate the rule that waives that limit if the corporation’s debt does not exceed 150 percent of its equity.

This proposal would also repeal the rule allowing corporations to carry forward any excess limitation (the amount by which the limit on interest deduction exceeds the interest expenses deducted in a given year) to increase their limit in future years.

It would also bar corporations from carrying forward any disallowed interest deductions to more than five years into the future. (The current rules allow disallowed interest payments to be carried forward indefinitely, to be used in any year in which the company has income to deduct from and is not otherwise subject to the limits on interest deductions.)

There is not yet any estimate of the revenue that would be saved under this proposal. It therefore difficult to determine whether it is more effective or less effective than the earnings stripping proposal in the President’s most recent budget plan, which was described above.

c) President Obama’s previous budget plans

The earnings stripping proposal included in the President’s previous budget plans is the template for the proposed change to section 163(j) in Rep. Levin’s discussion draft (described above). But the proposal from the President’s previous budgets was much weaker because it would apply only to companies that are considered inverted under the existing rules, whereas Rep. Levin’s earnings stripping proposal would apply to all corporations.[7]

Limiting this proposal to inverted companies makes it much weaker, as demonstrated by its relatively small estimated revenue impact. This proposal would raise just 2.7 billion from 2014 through 2023 according to JCT, which suggests that it would have little effect.

This should be a warning to lawmakers. If, during the process of legislative negotiations, they are tempted to scale back Rep. Levin’s proposal so that it only applies to inverted corporations (as President Obama had earlier proposed) the policy will likely have very little impact.

d) Camp tax reform plan

The tax reform plan proposed by House Ways and Means chairman Dave Camp also includes an anti-earnings stripping proposal that would amend section 163(j) and is also based on the proposal in President Obama’s older budget plans. Rep. Camp’s proposal is broader in the sense that it would apply to all corporations (not just inverted corporations) but also narrower in the sense that the limits would not be as strict as those proposed by the President.

Rep. Camp’s proposal would bar an American subsidiary company from taking deductions for interest payments to a foreign parent company in excess of 40 percent of its “adjusted taxable income,” which is defined as taxable income plus certain significant deductions that corporations are allowed to take. (As explained, the current rule sets the limit at 50 percent of adjusted taxable income, while President Obama would set it at 25 percent for inverted companies.)

Another difference is that Rep. Camp’s proposal would not change the rule that waives the limit if the corporation’s debt does not exceed 150 percent of its equity.

Like Levin and Obama, Camp would also repeal the current rule allowing corporations to carry forward to future years any excess limitation. But, unlike the other two, Camp would not change the rule allowing disallowed interest payments to be carried forward to be deducted in future years.

In other words, Rep. Camp’s proposal is less strict in these ways, but also applies to all corporations. The result is that Camp’s proposal has roughly the same revenue impact as President Obama’s old proposal. Rep. Camp’s proposal would raise $2.9 billion from 2015 through 2024 according to JCT.

The revenue impact would be somewhat larger than that if this proposal was enacted on its own. The revenue estimate assumes that it is enacted as part of Rep. Camp’s larger tax reform plan, which also gradually reduces the corporate tax rate to 25 percent. Enacting this earnings stripping proposal on its own, without the reduction in the corporate tax rate, would raise somewhat more.

e) Possible administrative action

Former Treasury official Stephen Shay has proposed that if necessary, the Treasury Department could issue regulations under section 385 of the tax code that would limit earnings stripping for inverted corporations.[8] That section of the law essentially allows Treasury to issue regulations to determine whether an interest in a corporation is treated as debt or equity (stock). Regulations could, Shay explains, reclassify excessive debt taken on by an inverted American company from its (ostensible) foreign parent company as equity. This would mean that any interest payments made by the inverted American corporation would be reclassified as dividends paid on stock, which, unlike interest payments made on debt, are not deductable.

There are probably several ways that Treasury could define the excess indebtedness that would be reclassified as equity. Shay proposes that Treasury provide two calculations, and whichever amount is less would apply.

The first would be any debt that exceeds 110 percent of the debt that the inverted U.S. corporation would have if its debt-to-equity ratio was the same as that of the rest of the corporate group (the rest of the group of corporations owned by the same parent company). (This rule borrows from another provision of Camp’s tax reform plan.)

The second would be the amount of debt for which the interest would exceed 25 percent of the American corporation’s adjusted taxable income (again, income plus certain expenses usually deducted) averaged over the previous three years.

There is no estimate of how much revenue this proposal would save.

3. Inverted Corporations Avoiding the U.S. Tax Due on Accumulated Offshore Profits Upon Repatriation to the U.S.

Problem: Inverted corporations are able to avoid the rule that requires U.S. taxation when an American company repatriates (officially brings to the U.S.) profits of its offshore subsidiaries.

Solution: Strengthen section 956 of the tax code, the provision that is designed to prevent corporations from circumventing the rule that requires U.S. tax paid on offshore subsidiary profits when they are repatriated.


a) Rep. Levin’s discussion draft legislation

Rep. Levin’s discussion draft legislation would strengthen section 956 to impose U.S. tax on certain investments made by offshore subsidiaries of the American company to its ostensible foreign parent company or to other companies within the corporate group when such investments are really ways to indirectly move offshore profits into the U.S. without technically making a taxable repatriation.

Section 956 currently applies when the offshore subsidiaries of an American company invest directly in the U.S. company in some way that is really a repatriation of offshore profits by another name. For example, the offshore subsidiary could lend money to, or guarantee a loan to, its American parent company in a way that has the same effect as paying a dividend to the American parent company. Section 956 treats such investments as repatriation and imposes U.S. tax on them. The reform proposed by Levin would do the same when the investment is done indirectly, routed through a foreign parent company after an inversion or through one of the other companies that is owned by the foreign parent company.

There is currently no revenue estimate for this proposal.

The arcane nature of this reform belies the significance of the problem it addresses. American corporations officially hold, through their offshore subsidiaries, $2 trillion in foreign profits that they have declared to be “permanently reinvested” abroad. In many cases, these profits are really earned in the U.S. or another country with a normal tax system but manipulated through accounting gimmicks to appear to be earned in countries like Bermuda or the Cayman Islands that do not tax corporate profits. Almost none of these profits can be described as “earned,” in a real economic sense, in these tax haven countries, which do not provide nearly enough business opportunities to justify the amount of profits reported there.[9]

In fact, several corporations have acknowledged that if they repatriate these offshore profits, they would pay almost the full U.S. tax rate of 35 percent on them, which indicates that a large portion of these profits have not been taxed by any government, a clear sign that they are largely reported in tax havens.[10]

These corporations would like to access their offshore subsidiaries’ profits (to increase domestic investment or, more likely, to enrich shareholders with dividends or stock buybacks). This would be considered a repatriation of offshore profits, and U.S. taxes would come due — at or near the full 35 percent rate when tax haven profits are repatriated. Naturally, the corporations would like to avoid this tax. Allowing them to do so would essentially reward their offshore tax avoidance.

Section 956 as currently written blocks American corporations from getting around the U.S. tax that is due upon repatriation, but fails when these companies invert and become part of foreign-controlled corporate group. Rep. Levin’s proposal would address this problem.

b) Possible administrative action

Former Treasury official Stephen Shay has argued that this problem (along with earnings stripping) can be resolved through administrative action if Congress fails to act. He cites several sections of the tax code, including 956(e) which says the “Secretary shall prescribe such regulations as may be necessary to carry out the purposes of this section, including regulations to prevent the avoidance of the provisions of this section through reorganizations or otherwise.” The mergers that corporations use in inversions to claim to be restructured as foreign companies would seem to be such “reorganizations.”

Another section of the law cited by Shay is even more straightforward in providing this authority to the President. Section 7701(1), provides that the “Secretary may prescribe regulations recharacterizing any multiple-party financing transaction as a transaction directly among any 2 or more of such parties where the Secretary determines that such recharacterization is appropriate to prevent avoidance of any tax imposed by this title.”

The techniques used by inverted companies to access their offshore cash (having their offshore subsidiaries lend to or guarantee loans to a foreign parent company or one of its foreign subsidiaries which then finances the American company) would seem to be the sort of “multiple-party financing transaction” mentioned in the provision quoted above.

There is currently no revenue estimate for this proposal.

Shay cites other provisions that seem to grant such authority, so that the question left is not a legal one but a political one. If Congress fails to act and the administration addresses the crisis with regulations, there is no doubt that some members of Congress will accuse it of overstepping its authority, even if that is factually not true. Does the administration have the will to act despite that inevitable backlash? A lot may depend on how that question is answered.



[1] Edward D. Kleinbard, “’Competitiveness’ Has Nothing to Do with It,” August 5, 2014. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2476453

[2] H.R. 4679, “Stop Corporate Inversions Act of 2014.” http://democrats.waysandmeans.house.gov/bill/hr4679-stop-corporate-inversions-act-2014

[3] Stephen E. Shay, “Mr. Secretary, Take the Tax Juice Out of Corporate Inversions,” Tax Notes, July 28, 2014.

[4] Other prominent tax law experts agree with Shay that current law allows the Treasury Department to do this. See Victor Fleischer, “How Obama Can Stop Corporate Expatriations, for Now,” New York Times, August 7, 2014. http://dealbook.nytimes.com/2014/08/07/how-obama-can-stop-corporate-expatriations-for-now/?_php=true&_type=blogs&_r=0; Steven Rosenthal, “Can Obama Slow Corporate Inversions? Yes He Can,” August 15, 2014. Tax Vox, Tax Policy Center. http://taxvox.taxpolicycenter.org/2014/08/15/can-obama-slow-corporate-inversions-yes-can/

[5] I.R.C. sec. 7874.

[6] Maureen Farrell, “Ireland: U.S. Tax Inversions Aren’t Helping Us Much Either,” Wall Street Journal, July 8, 2014. http://blogs.wsj.com/moneybeat/2014/07/08/ireland-u-s-tax-inversions-arent-helping-us-much-either/

[7] One additional difference is relatively minor: The proposal from the President’s previous budget plans would allow companies to carry forward disallowed interest expenses for ten years, as opposed to the five year limit proposed in Rep. Levin’s discussion draft.

[8] Stephen E. Shay, “Mr. Secretary, Take the Tax Juice Out of Corporate Inversions,” Tax Notes, July 28, 2014.

[9] Citizens for Tax Justice, “American Corporations Tell IRS the Majority of Their Offshore Profits Are in 12 Tax Havens,” May 27, 2014. http://ctj.org/ctjreports/2014/05/american_corporations_tell_irs_the_majority_of_their_offshore_profits_are_in_12_tax_havens.php

[10] Citizens for Tax Justice, “Dozens of Companies Admit Using Tax Havens,” May 19, 2014. http://ctj.org/ctjreports/2014/05/dozens_of_companies_admit_using_tax_havens.php


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Tax Policy and the Race for the Governor’s Mansion: Pennsylvania Edition

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Voters in 36 states will be choosing governors this November. Over the next several months, the Tax Justice Blog will be highlighting 2014 gubernatorial races where taxes are proving to be a key issue. Today’s post is about the race for Governor in Pennsylvania.

Pennsylvania.jpgPennsylvania Gov. Tom Corbett (R) is fighting for his political life in the Keystone State, where he has trailed his challenger, businessman Tom Wolf (D), by double digits for much of his reelection campaign. With election only months away, Corbett has sought to portray Wolf as a tax-and-spend hypocrite – eliciting a sharp response from Wolf and pushing tax issues to the forefront of the race.

There are many competing theories for Corbett’s unpopularity with voters, from the fallout over the Penn State abuse controversy to his overly conservative views on social issues, but his tax and spending policies have alienated liberals and conservatives alike. Progressives expressed outraged when he cut more than $1billion from education budgets at the beginning of his term – disproportionately harming districts with large numbers of low-income students – while anti-tax conservatives were equally dismayed by his transportation plan, which raised the gas tax and motorists fees to fund roads and bridges. Wolf has also assailed Corbett’s gas tax increase (though critics point out Wolf has also praised the bipartisan transportation plan of which the tax is a key component.)

Earlier this month, Wolf released the vague outlines of his plan to make the state’s tax system more progressive, while still providing middle-class Pennsylvanians a tax break. Pennsylvania has a flat income tax rate of 3.07 percent and the Pennsylvania Supreme Court has ruled that the constitution bars the adoption of a graduated income tax. Wolf’s plan would raise the income tax rate but exempt income below a certain level. In an interview, Wolf gave a hypothetical scenario with a 5 percent income tax rate and a uniform exemption of the first $30,000 of income. An individual making $40,000 could expect a tax break of $421, while an individual making $250,000 would pay an additional $4,825. Wolf plans to use the extra revenue generated by his tax reform to increase the level of state aid to public schools and provide Pennsylvanians with property tax relief. It is uncertain if his plan will survive legal and financial scrutiny.

Because of the regressive nature of the state income tax, Pennsylvanians have one of the highest property tax rates in the nation. Wolf wants to see the state’s share of local education spending increase to 50 percent — currently, the state foots a third of the bill for schools, while property taxes cover 40 percent. Corbett argues that local jurisdictions have raised property taxes to cover the increasing cost of pensions rather than the schools themselves, and that an increase in the income tax is not necessary. Corbett has also accused Wolf of scheming in increase taxes on the middle class, rather than lower them.

Another flashpoint between the two candidates is a potential severance tax on the extraction of oil and natural gas – a potent issue in Pennsylvania, where the economy has been buttressed in recent years by hydraulic fracking along the Marcellus Shale. Wolf has campaigned on a 5 percent severance tax to fund education, arguing that the tax would be passed onto consumers in other states, rather than Pennsylvania residents. Corbett has refused to endorse a severance tax, despite calls for such a tax from some members of his own party. In 2012, Corbett enacted an impact fee on oil and gas companies that has since raised $630 million, which critics allege is much less revenue than a severance tax would raise. Recently, Corbett has backed off of his staunch opposition to a severance tax, given the state’s $1 billion budget shortfall, though he insists that any new taxes be tied to efforts to reduce the cost of pensions for educators and state employees.


Tax Policy and the Race for the Governor’s Mansion: Maryland Edition

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Voters in 36 states will be choosing governors this November. Over the next several months, the Tax Justice Digest will be highlighting 2014 gubernatorial races where taxes are proving to be a key issue. Today’s post is about the race for Governor in Maryland.

Brown---Hogan.jpgMaryland’s gubernatorial election pits current Lt. Gov. Anthony Brown (D) against former state official and businessman Larry Hogan (R). Current governor (and possible presidential candidate) Martin O’Malley (D) is not on the ballot, but the election is widely seen as a referendum on his stewardship, most notably the tax increases passed during his tenure.

Like Brown’s primary challenger Doug Gansler, Hogan has sought to make tax increases a campaign issue. Change Maryland, an organization founded by Hogan in 2011, claims that the O’Malley-Brown administration passed 40 separate tax and fee increases that will cost Marylanders an additional $20 billion by 2018. Hogan further argues that the tax increases have made Maryland’s business climate less competitive, and forced wealthier residents to flee the state. To back up his claims, Hogan cites a recent Gallup poll that that found 47 percent of Marylanders would move to another state if they could, and the loss of 10 out of 13 of the state’s Fortune 500 companies. Hogan has pledged to reverse as many of O’Malley’s tax increases as possible, particularly personal and corporate income taxes, as well as cut more than a billion dollars in wasteful spending.

Polling suggests Hogan’s anti-tax message has failed to gain traction – Brown leads him 50 percent to 37 percent. Many Marylanders believe the tax increases were necessary to make or maintain investments in transportation, education and other priorities, and they credit O’Malley for his balanced approach of spending cuts and revenue increases during tough economic times.

Furthermore, many of Hogan’s claims have been called into question. The Maryland Center on Economic Policy asserts that studies showing Maryland losing billions of dollars in income due to out-migration use inflated numbers that don’t account for new income generated by other Maryland residents taking the jobs and businesses left behind. In fact, about 97 percent of households leaving Maryland between 1993 and 2011 were replaced by households moving in from other states. The organization also notes that anti-tax critics attribute out-migration to tax policy, when in reality residents have myriad reasons for moving – and taxes rank far below family, friends and even weather when making moving decisions.

Hogan’s claim that the state lost 10 out of 13 Fortune 500 companies during O’Malley’s tenure doesn’t hold up to scrutiny. In 2006, the year O’Malley was elected, Maryland had 5 Fortune 500 companies and 12 Fortune 1000 companies – not 13 Fortune 500 companies, as Hogan alleges. A cursory search of Fortune 500 lists between 2006 and 2013 shows that the number of Fortune 500 companies based in Maryland has been remarkably steady, between 4 and 6 each year; results for Fortune 1000 companies are similar, between 11 and 13. The Fortune 500 companies that left the state – Black and Decker, Constellation Energy, and Coventry Health Care – were acquired by other companies (Black and Decker maintains a headquarters in Towson.)

Brown, for his part, has kept a low profile on tax issues. He has pledged to create a new commission to study comprehensive tax reform within his first 100 days in office, and says he does not foresee the need for any new taxes in the future. His campaign has also pushed back against Hogan’s association with former Governor Bob Ehrlich’s (R) administration, claiming that Ehrlich oversaw one of the largest expansions of government, taxes and fees in state history (Hogan served at Ehrlich’s appointment secretary).

Both candidates support an exemption for veteran’s pensions from the state personal income tax, with Brown’s endorsement of the proposal coming a day after Hogan’s. Both candidates have been cautious on the recent change to Maryland’s estate tax law, which will raise the estate tax threshold from $1 million to $5.34 million. When asked about the estate earlier this year, Brown demurred, saying that any tax reform should be comprehensive, while Hogan has made no public statement on the bill. 

Congress Wants to Give Businesses a $276 Billion Tax Break That CEOs say Doesn’t Spur Investment

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All is quiet in the streets of the nation’s capital as members of Congress have fled to their home districts for their annual August recess. But as is the case every August in recent years, our elected officials left a lot of unfinished business.

Among this incomplete work is the future of “bonus depreciation,” which is as contradictory as it sounds. This huge tax break allows companies to accelerate tax write offs for equipment and other infrastructure investment. First enacted to address the recession during the George W. Bush administration, it has been repeatedly re-enacted, expanded during the most recent economic collapse and finally expired at the end of 2013.

Defenders of bonus depreciation argue that this special tax break gives businesses a needed incentive to engage in risky infrastructure investments. But, as we noted previously, the Congressional Research Service published a report last month concluding that bonus depreciation doesn’t appear to have a meaningful impact on corporate investment decisions. In fact, the CRS argued, the only thing bonus depreciation is less good at than encouraging short-term investment is encouraging long-term investment.

Just when it seems the case for bonus depreciation cannot get any weaker, now business leaders have admitted that it has no effect on investment. A new survey from Bloomberg BNA confirms the CRS’s finding that the expiration of bonus depreciation is hardly ruffling a feather among most Fortune 500 corporations. BNA surveyed 100 leaders at large U.S. businesses to find out how, if at all, changes in bonus depreciation and related tax rules are affecting their decisions on capital expenditures, and found that 83 percent of these business leaders believed the expiration of these tax breaks has not affected their capital expenditures in 2014.

Nonetheless, the House of Representatives voted in July to make bonus depreciation permanent (at which point the term “bonus” would apparently no longer describe this break) at a projected cost of $276 billion over a decade.

While CEOs say this break doesn’t spur investment, this doesn’t mean that the business community is indifferent about the fate of bonus depreciation, of course.  Even if businesses aren’t basing their decisions on these tax breaks, they certainly would welcome their extension. As former Treasury Secretary Paul O’Neill put it, “I never made an investment decision based on the tax code…If you are giving money away I will take it. If you want to give me inducements for something I am going to do anyway, I will take it. But good business people do not do things because of inducements.” 

And, Washington being Washington, some lawmakers are quite interested not just in extending bonus depreciation but in broadening its scope. California Rep. Jeff Denham is renewing his call to make bonus depreciation a permanent feature of the tax code—and to extend this tax break to businesses investing in “fruit- and nut-bearing trees and vines,” presumably to benefit almond growers in his district. The bill passed by the U.S. House of Representatives last month would do both of these things.

The Senate has taken a different approach. The Senate Finance Committee approved a bill that would extend bonus depreciation, along with a package of additional tax breaks that mostly benefit businesses, for just two years. While the House has voted to make certain tax breaks (including bonus depreciation and several others) permanent, the Senate seems content to stick with Congress’s traditional, but very problematic, practice of extending such tax breaks (the infamous tax extenders) for a couple of years at a time. The nation would be better served if bonus depreciation, along with the rest of these tax breaks, were allowed to die.