The time is ripe for US tax reform. The public and many members of Congress believe that the current US tax regime is out of date, uncompetitive and results in what some consider to be ’undesirable’ tax-driven behaviours. The US corporate rate is the highest of the G20 countries and the system is arguably one of the most burdensome in the world. The federal rate is 35% and many local states and cities impose additional levies that can vary between 4 and 12%.

Moreover, unlike other countries, the US has not moved to a territorial system and still taxes all of its resident multinationals on a worldwide basis - with deferral - paired with a foreign tax credit mechanism applied when offshore earnings are repatriated.

Other world nations are also swiftly making changes to their respective tax rules as a result of the OECD's Base Erosion and Profit Shifting (BEPS) initiatives and EU state aid cases, which combine to provide an extremely powerful external force that would seem to necessitate US reform.

As noted, the US tax and accounting systems permit a deferral of tax on accumulated foreign earnings if US multinationals designate them as being permanently invested overseas.

This has contributed to the fact that many US multinationals have been able to manage their effective tax rate through tax planning and keeping their foreign profits offshore, something that has been criticized as discouraging reinvestment into the US economy and impeding economic growth. 

The US tax and accounting systems permit a deferral of tax on accumulated foreign earnings if US multinationals designate them as being permanently invested overseas

An estimate a year ago suggested that offshore profits of US multinationals amounted to $2.6 trillion and that the number was growing. Some believe that the high corporate tax rate coupled with the worldwide system have caused an exodus of numerous US- parented groups to lower tax jurisdictions, either through domicile shifting (inversion) transactions or more traditional acquisitions of these firms by foreign entities.

These transactions have potentially allowed US companies to achieve a permanent reduction in their effective tax rate – an outcome viewed as inherently more attractive than the combination of a lower current rate and a potential tax rate spike on any repatriation event.

The response by the US Treasury has been to address key perceived abuses via targeted regulation projects aimed at limiting inversions and tightening debt-equity rules. There has been significant debate, often on political party lines, over whether to tackle issues such as these through regulations and incremental changes to the tax code or through a fundamental reform of the tax system.

Repairing the system

The groundwork for a comprehensive tax reform goes back to 2011 when then-House Ways and Means Committee Chairman Dave Camp released international tax proposals, which he followed up with his comprehensive Tax Reform Act of 2014.

His proposals to lower corporate and individual tax rates, simplify the tax code and move to a territorial tax system got a mixed reaction and never received a vote before he retired from Congress two years ago. Since then there have been other proposals with varying degrees of specificity drafted both in Congress and by the Obama administration.

However, no substantive progress has been made with Democrats controlling the White House and Republicans controlling the House and Senate. Now that the balance of power in Washington has shifted with the Republicans in charge of the White House and both chambers of Congress beginning in 2017, there is an expectation that a comprehensive tax reform will be near the top of the Republicans’ to do list. 

Desire for reform

During the presidential campaign, Trump made comprehensive tax reform a part of his economic growth plan, most notably in a speech at the Detroit Economic Club in August, and in remarks at the Economic Club of New York in September.

Although his proposals in many cases lack technical details, Trump’s positions appear to align in many ways with the tax reform blueprint released by House Republicans earlier this summer, although there are some differences between the two plans. 

There also appears to be a general consensus between President-elect Trump and congressional Republicans to move ahead with tax reform as soon as possible. House Ways and Means Committee Chairman Kevin Brady has stated that committee staff is turning the blueprint into legislative language and that he intends to move tax reform legislation through the chamber in 2017. Trump for his part has pledged to work with House Republicans. 

Corporate tax proposals - business reforms

Trump and the House Republicans seem to broadly agree on the substance of the business reforms. Both of their plans propose to reduce tax rates and broaden the tax base through eliminating or limiting various business deductions, tax credits and incentives.

President-elect Trump would reduce the top corporate rate to 15%, while House Republicans propose a top rate of 20%. The proposals similarly change the income tax rate on pass-through entities like partnerships and LLCs, and propose changes to carried interest.

Trump’s plan generally calls for a rate of 15% while the House Republican blueprint proposes a pass-through rate of 25%. Although these proposals currently lack detail, there are indications that earnings from pass-through entities would be subject to tax at an entity level and then possibly again at the shareholder level, putting them on a more comparable footing to corporation tax.

Both plans make a move toward full expensing of capital investment.  Under the House Republican blueprint, full expensing would be mandatory for all businesses. Under Trump’s proposal, however, full expensing would be voluntary and would apply only to the manufacturing sector.

Both plans would eliminate the deduction for net business interest expense for companies that move to expensing (whether by force or by choice). These proposed changes are significant and would, among other things, go far beyond the controversial debt-equity regulations under Section 385 issued earlier this year.

Both the Trump and House Republican plans also would repeal the Alternative Minimum Tax regime.

International tax proposals

Both Trump and the House Republicans propose substantial reforms to international tax provisions.  The House Republican blueprint would move the US to a strictly territorial system. Trump’s proposals are a bit less specific.

In 2015, he proposed to maintain the worldwide tax system and eliminate deferral, though he was more circumspect on this issue later in the campaign, leading to questions as to whether he was willing to adopt an international tax framework more along the lines of what is being proposed by House Republicans.

Both plans propose a mandatory one-time tax on un-repatriated foreign earnings. The House Republican blueprint proposes to tax cash earnings at 8.75% and all other earnings at 3.5% payable over 8 years.  Under Trump’s plan, accumulated foreign earnings would be taxed at 10% irrespective of their character. 

Interestingly, the House Republican blueprint includes special provisions for a destination-based cash flow tax. While details are scant, it appears this tax would be based on the place of consumption rather than the place of production. Companies would not be taxed on export sales but would be denied deductions for costs incurred to import goods. (The exact mechanism is undefined, but it could operate as a denial of the deduction for the cost of goods sold).

It appears that the House Republicans believe that the combination of low corporate rates and the destination-based cash flow tax should discourage US multinationals from moving their domicile, production and assets (such as IP) overseas. Likewise, many believe this would result in increased US inbound foreign direct investment in US production facilities and other activities, though the proposal is sure to attract strong opposition from retailers and other import-dependent businesses.

Personal income tax proposals

Both Trump and the House Republicans would condense the individual tax rates to three brackets of 12, 25 and 33% (from the current-law seven brackets with a top rate of 39.6 percent). They both propose to repeal the AMT, the 3.8% Net Investment Income tax, and the estate and gift tax (though Trump would impose a tax at death on some highly appreciated capital gains). 

His proposals would retain the top 20% tax rate on capital gains and dividends.  House Republicans would tax capital gains and dividends (as well as interest, which is currently taxed as ordinary income) at ordinary rates with a 50% exclusion, for an effective top tax rate of 16.5%.

Future legislation

The high level expectation for tax reform may come from the belief that the Republican administration and the Republican controlled House and Senate should be able move the tax bill through Congress with relative ease. After years of partisan gridlock, Republicans will be keen to demonstrate they can govern effectively. But the legislative process is never as simple as it sometimes seems.

Trump’s agenda includes high profile priorities such as infrastructure spending, repeal and replacement of the Affordable Care Act (often referred to as Obamacare), and immigration reform, and it is appropriate to question whether this Congress has the band width to implement all these changes, particularly given divisions – even among Republicans – on some of these questions.

The generality of many of Trump’s proposals over the course of the campaign also means that he enters office with a mandate for change but not for many specific policy outcomes.

Passing tax reform

There are procedural hurdles as well. Tax reform legislation could potentially stall in the Senate because most major legislation can be blocked by a determined minority that forces the majority to clear multiple 60-vote hurdles, and Senate Republicans will have at most 52 seats next year. (They currently hold 51 and are strongly favoured to win a run-off Senate race in Louisiana in December). 

This means that to pass tax reform legislation Republicans may need to make some compromises to win cooperation from Senate Democrats, and likely from some of the non-loyalists within their own party. It is unknown whether Senate Democrats will want to help pass tax reform or will be more incentivised to provide effective opposition.

While some Senate Democrats, notably including Charles Schumer (the incoming Democratic leader) and Ron Wyden (the senior Democrat on the tax-writing Finance Committee), have been interested in at least some aspects of tax reform, their caucus is not unified on the issue. Most Senate Democrats have been opposed to cutting the top individual tax rates and generally believe in a more progressive tax code designed to deal with perceived income inequalities.

Facing the prospect of a Senate minority that may be determined to block tax reform, Republicans are keeping open the option of pursuing tax reform through a procedural mechanism known as reconciliation, which would allow it to pass with only 51 votes in the Senate.

At the same time, however, reconciliation presents substantive and political challenges that many Republicans would prefer to avoid. House Ways and Means Committee chairman Kevin Brady is among those who have recently expressed a preference for finding common ground so that tax reform can proceed on a bipartisan basis.

Although the level of optimism is high, tax reform supporters must hope that key leaders in Washington have sufficient desire to overhaul the tax code and will be able to generate the momentum necessary to achieve a goal that has proved to be elusive for would-be reformers in the past. 

About the authors

Jeff Wehner is tax partner at Deloitte.

Jon Traub is managing principal of tax policy at Deloitte Tax LLP

Natalia Mityaeva is associate director at Deloitte.