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Earlier today, House Ways and Means Committee Chairman Dave Camp released his long-awaited and highly anticipated proposal for tax reform. The proposal promised to present the most thorough, sweeping changes to the law since the 1986 Act, and it didn’t disappoint.

Before we begin our analysis of the plan let me start by saying that while I clearly admire Chairman Camp for his tireless push to simplify the industry in which I ply my trade, I’d be remiss if I didn’t point out the irony that in the tax world, even a proposal for “simplification” stretches to nearly 1,000 pages.

Because there’s so much to take in, we’ll be separating our analysis into two parts

Part 1: Proposal for individual tax reform

Part II: Proposal for business tax reform

Let’s get to it with Part 1, Chairman Camp’s proposal for individual tax reform.

Streamlining of Individual Income Tax Rates

Current Law

Effective January 1, 2013, we now have seven income tax rates that are applied against so-called “ordinary income,” (i.e. income from wages, business income, interest, etc…): 10%, 15%, 25%, 28%, 33%, 35%, and a top rate of 39.6%. If you’ve ever wondered how efficient this type of structure is, consider that in 2013, the 35% rate was only applied on single taxpayers with incomes in excess of $398,351 but less than $400,000. Yes, we had a tax bracket that was $1,649 wide.

Because our tax system is a progressive one, taxpayers don’t pay a flat rate of tax on all earned income; rather, as income increases, so does the tax rate applied to the income. Thus, when someone proclaims that they are in the “39.6% bracket,” that does not mean they paid 39.6% on all of their income; rather, it means they paid 39.6% on their last dollar of income. It also means that they are likely insufferable.

No matter how you slice it, a system with seven brackets – and a high of nearly 40% — is far from ideal.

Camp Solution

Camp’s proposal would consolidate the current seven brackets into three, consisting of 10%, 25%, and 35% rates. Generally, the new 10% rate would replace the old 10% and 15% brackets, meaning it would cover all income earned up to approximately $73,800 if married, $36,900 if single (for simplicy’s sake, from this point on I will refer to married versus single thresholds or limitations like so: $73,800/$36,900).

The new 25% bracket would replace the former 25%, 28%, 33% and 35% brackets, meaning single taxpayers with taxable income between $36,900 and $400,000 would pay a 25% rate on that income, while married taxpayers with taxable income between $73,800 and $450,000 would pay a 25% rate on that income.

If you happen to earn taxable income in excess of $450,000/$400,000, then you will pay a rate of 35% on the excess, as opposed to 39.6% under current law.

Excluded from this top rate of 35% — meaning it would be taxed at a top rate of 25% — would be any income earned from “domestic manufacturing activities,” which is defined as “any lease, rental, license, sale, exchange, or other disposition of tangible personal property that is manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the United States, or (2) construction of real property in the United States as part of the active conduct of a construction trade or business.”

Click here to read the rest on Forbes

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Last week, in our reactions to President Obama’s proposal for corporate tax reform, we took special note of the president’s continued push towards a  “worldwide” international tax system; one  that greatly expands the reach of the U.S. in taxing non-U.S. sourced income earned by foreign subsidiaries.

Most notably, we highlighted just how dramatically the president’s proposal deviates from those posited by the leading Republican candidates, who favor the “territorial” systems adopted by much of the developed world.

But what do “worldwide” and “territorial” international systems really mean? How do they compare to our current system? And more importantly, how would they change the way the U.S. currently taxes the icnome earned by foreign subsidiaries of domestic corporations?

To illustrate, let’s take a simple fact pattern:

X Co. is a U.S. corporation. X Co. owns 100% of Foreign Co., a foreign corporation that generates no revenue from U.S. sources.

How is Foreign Co.’s income taxed by the U.S. under either:

1) The current “deferral” international tax system?

2) The “territorial” tax system proposed by Mitt Romney and Newt Gingrich?

3) A more expansive “worldwide” tax system as proposed by President Obama.

Current  “Deferral” Tax System

Under the current system, there is generally no U.S. tax imposed upon the earnings of Foreign Co. until the earnings are repatriated to the U.S through a distribution to X Co. At that point, X Co. will pay U.S. tax on the dividend received from Foreign Co., subject to any tax treaty between X Co. and Foreign Co.’s resident nation.

Upon receiving the dividend, X Co. is permitted to utilize a foreign tax credit to reduce the U.S. tax applied to the dividend, preventing the same income from being taxed twice: once when earned by Foreign Co. and a second time when distributed to X Co.

Pros:

  • The current “foreign tax credit” system ensures that even where Foreign Co. enjoys a lower tax rate in its home nation, tax will ultimately be imposed on the earnings of Foreign Co. at the U.S. corporate rate;
  • U.S. tax is not imposed upon income earned by F Co. until the earnings are repatriated to the U.S.

 Cons:

  •  An administrative nightmare;
  • Encourages X Co. to leave Foreign Co.’s profits offshore to avoid the imposition of U.S. taxes upon repatriation;
  • Gives birth to a wide variety of accounting tricks and sophisticated tax planning measures employed to minimize the U.S. tax burden, which ultimately reduce U.S. tax revenue.

Territorial Tax System

Under a territorial tax system, U.S tax would never be imposed on income earned by Foreign Co. from non-U.S. sources. The U.S. would simply allow Foreign Co.’s home country to tax its earnings. When Foreign Co.’s earnings are subsequently repatriated to X Co., the dividends would not be subject to U.S taxation.  

Pros:

  • Greatly reduces the complexity of international taxation;
  • Eases the administrative burden on multinational corporations;
  • By eliminating the U.S. tax on repatriated foreign earnings, U.S. companies will no longer have to pay to bring overseas income “home,” thus encouraging investment in the U.S.

Cons:

  • Encourages U.S. corporations to shift activities to jurisdictions with lower corporate tax rates, taking jobs and revenue along with them and eroding the U.S. tax base.
  • Transition concerns; What do you do with the foreign income that was previously earned but not yet repatriated to the U.S.?  

A More Expansive Worldwide Tax System

President Obama is proposing a sea change in the way the U.S. taxes international operations; one which embodies the opposite characteristics of the system proposed by his Republican counterparts. The president would eliminate the current laws that permit domestic corporations to defer U.S. tax on Foreign Co.’s earnings until they are repatriated by instituting a worldwide minimum tax. This tax would be imposed on Foreign Co.’s income when earned, regardless of whether it was U.S. sourced or when it is repatriated.

Pros:

  • More tax revenue for us!
  • Does not distort the decision of where to invest.
  • Eliminates incentive to game the system, since the U.S. will tax Foreign Co.’s earnings, wherever they may be.

 Cons:

  • Makes the existing administrative nightmare even worse;
  • I’m not sure if this is a pro or con, but it is the opposite system that much of the developed world is adopting, potentially putting us at a competitive disadvantage.
  • Is sure to be highly opposed by powerful corporations that have successfully shifted much of their earnings overseas under the current regime.

Which system is the best? It’s nearly impossible to say at this point, because under no scenario would the U.S. adopt a pure territorial or worldwide international tax system. Any territorial system would have to adopt elements of a worldwide system to curb abuses, and vice versa. As indicated above, there are advantages and disadvantages to each of the options, and ultimately, the devil will be in the details.

This much is clear, however; the chasm that exists between the proposals fronted by President Obama and the Republican candidates is material and meaningful, and stands to garner more attention as November nears.

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