In short, the New Year’s Day fiscal cliff deal lacked any significant tax reform. The American Taxpayer Relief Act of 2012 (H.R.8) focused on personal income tax rates and permanently extending the AMT patch. The deal left the corporate income tax rate at 35% and did not include any meaningful tax reform or simplification. For most corporate taxpayers, the legislation was a typical year-end extension of existing tax incentives, which included the R&D tax credit, credits for renewable energy, the active financing exception to Subpart F, and the look-through rule for related-party payments under Section 954(c)(6) of the Internal Revenue Code of 1986, as amended. Perhaps this is the last year we refer to the 1986 Code, and the 113th Congress will enact a new Code. A complete overhaul may be in order because the 157 pages of legislation failed to address the budget deficit, the debt ceiling, and entitlement reform. Moreover, it postponed the sequestration cuts for another two months, kicking the can down the road.
In the words of one commentator, we have sailed off the fiscal cliff but hit a ledge on the way down. The 3.8% Medicare Tax goes into effect this year, a hangover from the last Congress, and the Foreign Account Tax Compliance Act (“FATCA”) goes into effect next year. However, the former is the only tax likely to raise any significant revenue because FATCA is intended to ensure compliance with existing law. The President has announced his willingness to lower the corporate income tax rate to 28% in exchange for corporate tax reform. The Administration’s view of tax reform includes raising taxes on the oil and gas industry and on US-based multinationals doing business abroad. Newly-appointed Secretary of State John Kerry proposed ending the deferral of US taxation of foreign income earned by US-based multinationals as closing a “loophole.” This would require US-based multinationals to pay US tax each year on their foreign source income whether they repatriate it back to the United States or keep it invested abroad. On the other hand, House Ways and Means Committee Chairman Camp has proposed moving to a territorial tax system. Others have proposed moving to a hybrid system, with a participation exemption on dividends received from related corporations. The participation exemption is meant to incentivize multinationals to repatriate foreign earnings and pay some US income tax, although at a fraction of the rate imposed on US source income.
While some additional revenue will be raised through higher tax rates on the wealthiest Americans, the deal now shifts the burden of raising even more revenue to the corporate income tax imposed on US and non-US corporations, based in, investing in, or doing business in the United States. If the economy recovers, with earnings and profits growing organically, the increased revenues could fill the budget deficit with a surplus to pay down debt. However, the growth scenario rests on sound fiscal policy, energy policy, infrastructure policy and trade policy, all of which would need to be fine-tuned by leadership in Washington. The longer Congress and the President wait, the more uncertainty there is in the economy, the more risk of a corporate income tax hike rather than a reduction; and consequently, confidence will start to dwindle. Unfortunately, we are still at the status quo, with the Administration making some modest political gains, for example, by extending unemployment benefits for another year. What is needed is a stable economic environment to attract long term investment and create jobs, with a significant component being corporate tax reform. Because Congress has placed the sequester and spending cuts as the next two items on their agenda, it appears as if Congress has missed another opportunity for genuine corporate tax reform. The members of the 113th Congress may not have another opportunity during the next two years to enact corporate tax reform due to budget constraints, so corporate taxpayers may continue to operate under the current system unless the sequester, spending cuts, and corporate tax reform are addressed comprehensively as one piece of legislation in the coming months.© 2014 Bracewell & Giuliani LLP