In a Legal Update prior to the US 2016 elections, we highlighted the possibility of tax policy legislation being considered in the lame-duck and discussed the prospects for tax reform in 2017. Post-election, the odds of any significant tax legislation being considered in the lame-duck have declined significantly. With full GOP control of both the executive and legislative branches pending in 2017, most major policy changes will be deferred until then.
Full GOP control significantly increases the odds for tax reform. In fact, it is nearly a certainty that tax reform legislation will be considered and the odds of enactment of major tax legislation within the next two years are very high. It will take time for the incoming administration to staff up, but work on legislation by Congress will begin quickly. This Legal Update provides interested taxpayers with information on some of the key considerations, with regard to both process and policy, that policymakers will need to address in the course of drafting, considering and enacting any tax reform legislation. As policymakers address these issues, those decisions will have broad ramifications on the timing and scope of any tax reform legislation being enacted into law.
Timing
The process of drafting, analyzing, reviewing and voting on tax reform legislation in Congress is time-consuming and resource-intensive. The process will take several months. Therefore, the earliest we would expect any tax reform legislation to be effective would be January 2018. We think it is quite possible that given the complex nature of tax reform and the competing demand on the time and resources of Congress from other policy issues, enactment of tax reform legislation could take until early 2019. In such a situation the effective date of any reform legislation would likely shift to January 2020. Further, many tax policy changes may be phased in over a period of time. For example, in the Tax Reform Act of 1986, the reduction in tax rates were phased in over two years and under a recent congressional proposal, the Tax Reform Act of 2014, the reduction in the corporate rate was phased in over five years.
Process
The process by which tax reform legislation will be considered can have a significant impact on the policies enacted. There are essentially two different processes that Congress can use to draft and consider tax reform legislation: 1) regular order or 2) budget reconciliation. Major legislation has been enacted into law using both of these processes and, in some cases, the combination of the two.
Regular order basically describes the normal process through which legislation is considered. In the case of tax reform legislation, it means that the tax-writing committees, Ways & Means in the House and Finance in the Senate, originate the legislation and the legislation is considered under the normal rules in the House and Senate. In the Senate, this process includes the ability of senators to filibuster the legislation.
In contrast, budget reconciliation is a special process that allows the majority party in the Senate to avoid the filibuster. Specifically, the budget reconciliation process begins with the agreement between the House and Senate on a budget resolution. The budget resolution gives the Budget Committees in the House and Senate the authority to send instructions to the Ways & Means and Finance Committees to consider tax legislation. The legislation produced by those two committees is then sent back to the Budget Committees and subsequently considered under special rules by the whole House and Senate. In the Senate, the key benefit is that the legislation can be passed with just a simple majority vote and therefore there is no opportunity to filibuster the legislation.
There are, however, significant budget and process rules that are unique to the budget reconciliation process. These rules can limit the options policymakers have in crafting the legislation. For example, one key budget rule prohibits the consideration of legislation that would increase the deficit in the long-run or beyond the ten-year budget window. This rule is why the Economic Growth and Tax Relief Reconciliation Act of 2001 (also known as the Bush tax cuts) was enacted on a temporary basis. Thus, there are significant downsides to using the budget reconciliation process.
In addition, the budget reconciliation process is generally considered a partisan exercise as it denies the minority party in the Senate its ability to filibuster legislation. If congressional Republicans were to use the budget reconciliation process, it would increase the likelihood that the crafting of the legislation would be primarily a partisan exercise.
Several key Republican policymakers in Congress as well as the incoming administration have signaled an interest in making the tax reform effort bipartisan. A bipartisan process increases the likelihood that enough members of Congress would support the legislation so that Congress would not need the budget reconciliation process to avoid the Senate filibuster. However, a bipartisan process also means that both Democrats and Republicans will likely have to compromise on key policy issues in order maintain bipartisanship.
Advisors for the incoming administration have floated the possibility of pursuing a two-step process under which Congress first considers the business aspects of the tax code, likely on a bipartisan basis, and then subsequently addresses the individual side of the code, likely on a more partisan basis.
Lastly, congressional Republicans have the option of starting the process on a bipartisan basis but subsequently moving to the budget reconciliation process if congressional Democrats are unwilling to sufficiently compromise in the negotiations. The first few months of 2017 will reveal the answer to the question of how bipartisan the process will be, and the answer to that question will likely provide the answer as to whether Congress proceeds under regular order or through budget reconciliation.
Scope
The scope of any tax reform legislation will be highly influenced by the extent to which the exercise is bipartisan. Comprehensive tax reform is generally meant to denote tax reform that applies to both the individual and business components of the tax code. Both Republicans in the House of Representatives and the incoming administration have comprehensive tax reform proposals. Chairman of the Senate Finance Committee Orin Hatch, the leader for Senate Republicans on tax policy, has been developing a corporate integration proposal that would reform only the corporate aspects of the tax code. Democrats have generally been opposed to tax reform efforts that would lower the top tax rates that apply to individuals. However, many Democrats have indicated a willingness to reform the business side of the code, and in particular, the international aspects of the code. This creates an opportunity for bipartisan legislation that addresses the business and international aspects of the code. However, if congressional Republicans start the process by trying to enact comprehensive reform, the process is more likely to be partisan, in which case, the use of the budget reconciliation process is also more likely.
Policy Considerations
The process has an impact on the policy. For example, if Congress proceeds on a process that first addresses the business and international aspects of the code, it could avoid the budget reconciliation process. This means that the legislation would not be subject to the long-term budget tests described above. This is particularly important for international reform as virtually any significant and meaningful reform of the international aspect of the code would fail the long-term budget test.
Proceeding with business tax reform first also means that Congress will have to specifically address the taxation of pass-through entities. The current administration has opposed lowering rates for pass-through entities and instead has generally advocated that large pass-through entities should be taxed as C corporations and smaller pass-through entities be dealt with through faster cost-recovery and expanded cash-accounting rules. These proposals have been viewed as non-starters by Republicans and many Democrats. Therefore, some form of relief on tax rates for pass-through entities is likely necessary.
House Republicans have proposed a structure that would provide a separate and lower rate for qualified pass-through entity income. We summarized this structure and the important political aspects of this approach in a prior Legal Update. Designing and implementing separate rate structure is complex and few details are currently available as to how Congress would attempt this. However, there are a few broad aspects we can highlight at this time. First, the rules around determining which income qualifies would likely need to be extremely arbitrary so as to minimize the ability of taxpayers to qualify income that would more properly be considered wage income. For example, it is quite possible that Congress would simply exclude certain types of income, e.g., professional services income, completely from qualifying. Congress might also set caps on the amount of income a taxpayer could qualify for under the separate pass-through rate. There are also numerous aspects of the code that interact with a separate rate structure for pass-throughs that would need to be addressed. These include the applicability of payroll taxes, treatment of carried interest and reasonable compensation rules. Because Congress has not specified decisions on many of the design issues around creating a separate rate structure for pass-throughs, taxpayers interested in these issues have a window of opportunity to influence the decision-making process.
The trade-off between the amount of benefits policymakers can provide versus the amount of revenue that can be raised through politically acceptable base broadeners will be a major issue for policymakers. We anticipate that policymakers will subject themselves to some budget constraint, regardless of the process they adopt. Even with the application of dynamic scoring, policymakers will have a finite amount of revenue they can use to provide tax reform benefits before the revenue loss is too large relative to the revenue that can be raised through politically acceptable base broadeners. The enactment of the PATH Act at the end of 2015 mitigates this constraint somewhat. That legislation made a number of temporary tax policies permanent without offsetting the revenue loss. Thus, policymakers need to raise several hundred billion dollars less in revenue to achieve the revenue-neutral reform that they did prior to 2015.
When wrestling with what benefits to provide, much of the focus will be on the options of lowering rates versus accelerating cost recovery. Any budget constraint will limit the ability of policymakers to both lower rates and accelerate cost recovery. Some industry sectors benefit more from lower rates than faster cost recovery while the reverse is true in other sectors. The ultimate balance between lower rates and faster cost recovery that is struck by policymakers could have a significant impact on how different sectors benefit from reform.
Potentially one of the biggest base broadeners policymakers will consider is the treatment of interest expense. The House Republican proposal eliminates interest deductions, both for domestic and international interest expenses, except when applied to interest income. Inclusion of such a policy would likely have a profound impact on how businesses raise capital and may have significant secondary impacts on the broader corporate debt market. Other policies that have been proposed that would limit, but not eliminate, the ability of businesses to deduct interest expenses include broad thin cap rules, deducting an inflation factor from interest expense and with respect solely to the international aspects of the code, further limitations under section 163(j).
Lastly, with regard to international tax reform, we think it extremely unlikely that policymakers will settle for an international-only tax reform. Instead, policymakers will incorporate international reform in a broader tax reform process. In addition, there is significant interest among policymakers in using some of the revenue raised in international tax reform to fund large investments in infrastructure.
In the course of designing any international tax reform, policymakers will need to address two core policy issues. First will be the degree to which the United States gives up the right to tax foreign-source income. The answer to this question will impact the size of the exemption from US tax that any repatriated income will receive. Second will be how policymakers design anti-base erosion rules to minimize or block the incentive to move operations overseas to take advantage of the reduced tax on repatriated income. Until recently, policymakers have focused anti-base erosion rules on a subset of income, namely interest and intangible income. However, the recent House Republican proposal takes a much broader approach. It proposes to make the corporate income tax code border adjustable, in a manner similar to how VATs are border adjustable. We summarized this concept in a prior Legal Update. While Congress has yet to provide any significant detail on how such a policy would be designed and implemented, the potential consequences are vast. Substantial disruptions to global supply chains are likely, and given that the United States runs a large trade deficit, the potential of such a policy to trigger significant inflation pressure is quite real.
In conclusion, we expect that policymakers will dedicate significant time and resources to the tax reform effort and full Republican control drastically increases the odds that policymakers will be successful in enacting tax reform legislation. However, exactly what path that process takes and what the final legislation looks like are very unclear at this point. Over the next several months, policymakers will make decisions that will help clarify and refine where the tax reform process will go.
Originally published 29 November 2016
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This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.
