PREFACE
What is a business? This seems like a pretty straightforward question, one hardly worth spending any time on at all. But, in fact, it is absolutely the first question to ask when you’re starting up, and essential for getting started on the right foot. You may find this statement surprising, but it is observed that the US Revenue Agency and the typical American taxpayer do not always agree! A key area of disagreement concerns the question “What is a business? In fact, the US Revenue Agency (URA), the courts and taxpayers have been arguing a lot about what is and what is not a business over the past few decades. What would seem to be a straightforward question has been a very difficult fundamental question to answer.
And the problem has historically come about because URA does not want to allow a taxpayer to deduct losses year over year in a questionable business. As a result, in the past, the tax department considered a business to be any activity that you conduct for a profit or a reasonable expectation of a profit. If the business could not demonstrate that it could become profitable, URA would deny the losses. On May 23, 2002, the Supreme Court of USA ruled on two cases, Stewart v. The Queen and the Queen v. Walls, which changed all the rules.
As a result of the Supreme Court of USA’s decision, URA now only considers the concept of “reasonable expectation of profit” if there is a personal element with respect to your business. If there is no personal or hobby element and assuming of course your business is not a sham, then URA will generally no longer question whether or not you are in fact in business.
If, however, there is a personal or hobby element in your business, then it must be determined if your business is carried on in a sufficiently commercial manner as to indicate that there would be a source of income, and therefore a business. In this case, URA would look at whether or not there is a reasonable expectation of profit from your enterprise so that it may be considered a legitimate business. It would appear, however, that the federal government was not entirely happy with the Supreme Court of USA’s decision in the Stewart and Walls cases, for on October 31, 2003 the Department of Finance released proposed amendments that would essentially reverse the court’s decision and legislate the former URA’s assessing practices.
That is, to deny business losses and other expenses unless there is a reasonable expectation of profit from that business or related activity. Originally, it was intended that if this proposed new section of the Income Tax Act became law, it would be effective for taxation years starting after 2004. What the Department of Finance found was that during the period of public consultation, many individuals and groups expressed serious concerns that a test to determine whether a reasonable expectation of profit exists may unintentionally limit a number of ordinary commercial expenses.
As a result, the Department has decided to revise the legislation in order to address the concerns of the public while still achieving the
Introduction
The corporate tax is essentially a flat rate tax; it is currently 46 percent. The rate was reduced from 52 percent to 48 percent by the 1964 tax cut, raised temporarily by the 10 percent Vietnam War but was also reduced in 1978 by the tax act to the current level.
The tax base for a nonfinancial corporation investing in fixed assets is derived by subtracting from gross sales the costs of input increases or when tax credits are allowed against calculated tax liabilities. Through various legislation, there have been increases in levels of depreciation allowances and credits at any given level of income.
In the fall of 2005, the Department of Finance stated that its intention was to replace the concept of “reasonable expectation of profit” with a more modest concept, however, at the time of writing no further details had been provided. Since 2005, there has been no mention of this issue in any federal budget. So, for now, we must wait until the Department of Finance issues its alternate proposal for the public to comment on.
Until new legislation actually comes into force, the Revenue Agency (RA) has indicated that they are assessing based on the Stewart and Walls cases. Therefore, for now, it is best to understand Revenue Agency’s current assessment practice. Based on the Supreme Court’s decision there is now a two-step process in deciding what is and what is not a business for tax purposes. If your business has no personal element involved, then it will normally be considered a business.
If the business is not successful, the Revenue Agency will normally allow the losses. In the very recent past, RA would try to deny legitimate business losses on the premise that there was no reasonable expectation of profit, therefore no source of income or no business. Now, under their current assessing practises, if there is no personal or hobby element, RA will generally have to allow the losses.
However, if there is a personal or hobby element to your business then you have to move to step two in the process. In this step, it must be determined if your business is being carried on in a sufficiently commercial manner as to still qualify as a source of income and thereby qualify as a business. To determine whether or not your business is carried on sufficiently in a commercial manner, RA will use among other tools, the concept of reasonable expectation of profit. But the anticipation of profit cannot be the only test used by RA.
The objective is to evaluate the commercial nature of your activity, not to judge your business acumen.Therefore, even though your business may not be profitable and there is a personal element involved, losses from the business can still be tax deductible if your business is operated in a sufficiently commercial nature.Developing examples of how these rules would work is tricky, as RA is just starting to announce how they plan to interpret the new rules.
However, it is probably safe to go through some extreme examples to highlight how these concepts are likely to be interpreted. First of all, if your business is profitable, then you likely have very little to worry about. CRA is mostly concerned with taxpayers deducting business losses. Profitable businesses will normally be considered in business provided that your activity is not on account of capital. Income on account of capital is normally a single transaction that results in a gain.
Instead, we are assuming your business has many transactions and therefore the income would be considered business income. Now let’s say you have a ceramics business and the ceramics you make are for a local electronics manufacturer. The ceramics have no value, other than to your customer, as it is a component in the product they are making. You do no other types of ceramics. Despite your best efforts however you have not been able to turn a profit. It is hard to suggest that there would be any personal element in this business.
Accordingly, we do not have to look at whether or not you will ever be profitable. You are operating a commercial activity and your business losses would be tax deductible. Now let’s say you only make cute ceramic statues. You would like to sell them to the public but after three years you have only been successful in selling a couple to strangers and a few to family members.
In this case you are most likely operating a hobby or at least there is a definite personal element to your business. So the question becomes have you been operating it in a sufficiently commercial nature as to suggest that your losses should be deductible as a business loss. To determine this you might look at your business plan, whether anything happened unexpectedly that caused your business to become unsuccessful and what effort did you make to correct the matter. If however, your business is really just a hobby, then your losses will not be tax deductible.
Not so much because it was not profitable, but because you really never engaged the business in a sufficiently commercial manner. The above represents the current assessing practices of RA. However, as mentioned earlier, the government was proposing some changes to the legislation that many thought would dramatically affect the deductibility of losses and expenses in the future.
According to the proposed legislation, there would be provision of only allowing deduction of losses as well as other expenses but it would be safe enough to assume that you would realize a cumulative profit from the business during the time that you carried on the business or could reasonably be expected to have carried on the business. The concept of whether or not there is a personal element to your business would be gone. If you could expect to realize a cumulative profit, then you would be able to deduct the losses.
If you did not, or could not, realize a cumulative profit then the losses would have been denied. For clarity, profit would not have included capital gains from the selling of the business or asset. So if you were intending on operating a business at a loss with the intention of selling the underlying assets for a gain a few years later, then your losses would likely not have been deductible because there would not have been a cumulative profit, given that the gain on the sale would not be considered as a part of the profit.
It is important to note that this test for reasonable expectation of profit would have been an annual test, one that if questioned you would have to defend to the Revenue Agency. As an example, it is possible that the first few years of operation you managed your business at a loss but that it is sensible to consider that your business has a reasonable expectation of making a cumulative profit.
However, say in year four, it is no longer reasonable to expect that the business can operate with a cumulative profit. Accordingly, in year four and subsequent years your losses would be denied. It becomes apparent from this that it would have been increasingly important to document exceptional events that prevented you from being profitable and to prepare
CHAPTER I
US CORPORATE TAX: NEEDS REFORM
The important thing to remember is that this is how the legislation would have operated had it been passed. As was mentioned earlier, the Federal government is currently revising its proposed legislation in order to address the concerns that were raised. Until their revised legislation is made public, we won’t know what the new rules will entail and how much of a compromise the government will make. However, by having an understanding of what the original legislation looked like we gain an idea of where the government is going.
As you can see, determining whether or not your business is in fact a business for tax purposes can be a difficult question to answer. The changes in the rules and interpretations continue to complicate an already difficult and sensitive area. In the end, if you truly believe your business is legitimate but is merely struggling, claim the losses and document as best you can the reasons why your business will be successful. If you are ever challenged by Canada Revenue Agency, seek a good tax coach and argue your position. This is a fight you will want to win.
Should You Keep Your Losses Low in the Start-Up Years?
Sometimes legitimate business operators fear that if they claim too great a loss or if they have too many years in a row with losses, that the Canada Revenue Agency will disallow the deduction of the loss. Some even fail to deduct expenses to reduce the loss or, even worse, generate income and pay tax on it to show an expectation of profit. This type of ”tax planning” is totally unwarranted.
If you are operating a legitimate business, always deduct all legitimate business expenses to reduce your tax liability. If challenged, with a good tax coach in your corner, you can often successfully argue your case and, by obtaining a favourable ruling, “Beat the Taxman” If your business is continuing to incur losses, instead of not deducting legitimate expenses, look at your business to see what expenses can be reduced or eliminated that would make your business profitable. Can you, for example, pay down debt which will reduce your interest expense or reduce some office or other business expenses.
If your business has a personal element involved and is not profitable, then you may need to show that it has a reasonable expectation of profit or that it is being carried on in a sufficiently commercial manner. Often the best support to turn too for this is your business plan. I strongly recommend that you prepare a business plan complete with forecasts of revenues and expenses for your business regardless whether there is a personal element involved or not.
The business plan will serve as the documentary proof that your business can be successful and that you embarked with full intentions of making a profit. If later your business is unsuccessful, you will have something to compare too to see what happened. If you can identify one or more “events” that happened or didn’t happen that resulted in losses to your business, then these “events” can be used to show to a tax official that at the time of starting the business there was a reasonable expectation of profit if not for these “events” and that the losses should be deductible.
CHAPTER II
TWO STEP REFORM
Corporations operate in an environment greatly changed by the growth in credit markets as well as the increasing international mobility of capital and companies. Reform is needed for the corporate tax to be a viable, progressive revenue source that does not hinder economic growth or promote economic instability. The system I propose addresses these two important economic changes with two main sets of reforms, each directed at one of the key problems just identified: A major shift to debt from equity in the corporate tax just to cope with the tax incentive of borrowing and also a change in dealing with cross border flows so as to change the terms of international tax competition. The resulting tax system should also be more progressive and much simpler than the current one.
The second would apply the corporate cash-flow tax on a destination basis, limiting the focus of the tax to transactions occurring exclusively in the United States. As observed, the key elements of this reformed tax system and compares them to the existing U.S. tax system as well as a standard territorial approach to taxing business income that many G-7 countries have adopted.
Step One: Changing the tax treatment of investment and borrowing
The first piece of the reform would eliminate the role that the corporate income tax plays in discouraging productive investment and encouraging excessive borrowing. Table 2 below helps illustrate the proposed changes by providing selected items from the cash-flow base for the nonfinancial corporate sector for the years 2005-2009. Profits before tax follow the pattern one would expect over this period, growing between 2005 and 2006, starting to dip in 2007 when the recession began, and then dropping sharply in 2008 and slightly again in 2009.
Let us assume that this measure of profits is the tax base under current law, ignoring differences between tax and book measures of profit for purposes of illustration. My proposed reforms would change the tax treatment of investment in the following manner: First, depreciation deductions would be replaced with immediate expensing for investments in equipments, inventories and plant. Immediate expensing also would be provided for net financial investment; defining increased liabilities to exclude net issues of equity.
Starting with profits before tax, this change in the tax base would involve first adding current depreciation allowances back to profits, since the initial calculation of profits as reported involved subtracting them. Then, fixed investment, inventory investment, and net financial investment would be subtracted to get to the new tax base. Although (gross) fixed investment will generally be positive, inventory investment and financial investment need not be, and each of these com- ponents is negative in some of the five years.
Shifting from depreciation deductions to immediate expensing typically will reduce the tax base; this will be true whenever investment exceeds depreciation, which is typical for a growing economy and true in each of these five years. On the other hand, net financial investment for this sector is typically negative, because the nonfinancial sector is a net debtor to the rest of the economy.
Thus, these changes in the tax base typically offset each other, and the net impact could be positive or negative. In this example, the tax base would be reduced in 2005 and 2009 and increased in 2006-2008.Note that whether the tax base rises or falls is not related in any simple way to the state of the economy, as the tax base rises in one recession year (2008) and falls in another (2009); it rises in two expansion years (2006 and 2007) and falls in another (2005).
Although my proposal makes no explicit connection between the sources and uses of funds, one way of viewing this new approach to taxation is that it provides businesses with an immediate deduction for the tangible investments they undertake in excess of the funds that they borrow to do so.
Although the conversion from the current tax base to the new tax base involves some steps, one also could have arrived at the new tax base through an even simpler process, without ever having to calculate profits in the first place. the only adjustment to this measure is that cash raised from new equity issues is excluded from receipts.
Whatever else can be said of this new method of defining the corporate tax base, it is much simpler than the present one. This simplicity extends to financial companies as well. Consider the basic case in which a financial institution has only financial assets and borrows money that it then lends, making a profit on the spread between the interest rate charged to borrowers and the rate paid to lenders.
To the extent that the borrowing and lending net out, as they largely will for companies with very little equity relative to their gross assets, there will be no change at all in the tax base, as net borrowing will be zero and there will still be a tax on inter-est receipts net of interest expense. If, on the other hand, a financial institution expands its equity base as it expands its portfolio, it will increase its net financial assets and effectively get an additional deduction for the equity expansion (regardless of whether this occurs through the issuance of new equity or the retention of earnings). The U.S.
financial sector today includes companies engaging in a variety of sophisticated transactions far removed from simple borrowing and lending, but cash-flow taxation remains simple even in such cases. It would no longer be necessary to distinguish the composition of credit flows between interest and principal, for example, because both would now be subject to the same tax treatment; this would be especially helpful when dealing with derivatives and other complex financial instruments.
For financial and non-financial companies alike, the task of the firm’s tax accounting department the IRS would be adhering to the advice memorably provided by Deep Throat in the story of Watergate, as chronicled by Carl Bernstein and Bob Woodward in 1974:
Follow the money.
The tax calculation has offsetting components, so will the effects on the firm’s incentives. Corporations financing their investments largely with equity will see a reduction in their cost of capital, as the benefit of immediate expensing of investment will offset a higher after- tax cost of borrowing.
In fact, the effective corporate tax on new, break-even equity investments will now be zero, a prop- erty of cash-flow taxation established more than 60 years ago; 15 for such investments, the immediate deduction of the cost of investment will just offset the taxes paid subsequently on earnings.
interest payments shields the subsequent investment earnings from tax, so break-even investments that return just enough to cover interest costs will face no tax. That this treatment represents a tax increase for debt-financed investments reflects the fact that under the current system these investments face a corporate tax rate that is effectively negative the corporate tax provides taxpayers with a net subsidy.
Such subsidies distort the allocation of investment funds, in particular encouraging the types of investments that can easily be. As this discussion implies, while new, break-even investments would now be subject to a uniform effective tax rate of zero, this would not be the case for other sources of income.
Tax on rents of rents and break-even returns to capital have different effects on behavior and, as a consequence, on the incidence of the corporate tax burden. While taxing the normal returns required to meet the cost of capital discourages investment and, especially in an open economy, may cause a shift in some of the corporate tax burden from capital to labor because of the resulting decline in worker productivity, taxing rents is less likely to do so, particularly if these rents are not easily shifted from the United States’s an issue that the second major piece of the proposal addresses.
Step Two: Revamping the tax treatment of cross-border flows
The U.S. corporate tax system’s current treatment of foreign- source income represents a compromise between what are commonly seen as the two main approaches: The arguments in favor of each approach are varied and complex.Simply put, moving toward the worldwide approach is seen as reducing incentives for U.S. multinationals to shift profits and capital away from the United States, while the territorial approach is seen as improving the competitiveness of U.S. multinationals with respect to their overall operations.
Moving closer to one form or the other from the current U.S. system is seen as a trade-off, helpful in one dimension and harmful in the other, and these are generally presented as the two reform options available.
Introducing the destination principle
Instead of using either corporate residence or the source of production to determine the tax base, I propose to use the destination principle, collecting tax on the basis of where a corporation’s products are used. Imposing border adjustments serves to make the VAT a tax on all domestic consumption, but another important feature is that it eliminates the incentive that domestic producers would otherwise have to engage in profit shifting for tax purposes.
Moving from our current international tax provisions to a system based on the destination principle can be seen as a two-stage process. Stage one involves eliminating of all taxes which were levied on income generated through foreign source. The second stage is to exclude from the calculation of a company’s tax base all cross-border transactions, regardless of their nature, thereby making the tax liability relate only to domestic transactions. In particular, sales abroad would not be included in receipts, nor would purchases from abroad be deductible.
The same exclusion would apply to financial transactions as well; financial flows from abroad would not be added to the tax base, nor would flows going abroad be deductible. One might view this treatment of international transactions as a super territorial system, one that ignores not only activities that occur abroad, but also those going and coming.
While a simple territorial system would worsen the transfer-pricing problem because it would encourage companies to shift the reported location of activity from the United States to low-tax countries, the two stages together would actually alleviate the problem, because such shifting would no longer be possible. Some simple examples should help illustrate why this is so. Example one:
Under the proposed tax system, such sales would be ignored and hence would have no impact on the U.S. tax base. Example two: Consider a U.S. company that borrows from a party located abroad. Because the interest paid abroad would not be deductible, this transaction would have no impact on the U.S. tax base. In both examples, the shift of a dollar of income from the United States would have no U.S. tax consequences.
.Thus, corporations would have an incentive to shift profits to the United States, even from the tax havens that have been the focus of so much attention in recent years.
Note also the simplicity of this proposed approach to interna- tional activities compared to that of the current tax system or a territorial system. The United States currently requires companies to allocate expenses for domestic interest and research and development costs, an allocation that would become even more critical.
Under the proposed approach, there would be no need do decide how to allocate such activities As per this alternative approach, cross-border transactions would initially be included in the corporate tax base and then offset using border adjustments. Indeed, the Growth and Investment Tax Plan put forward by the President’s Advisory Panel on Federal Tax Reform (PAPFTR) advocated a similar approach.
Moving ahead, doing a simplification the corporate tax would apply only to domestic activities, so the need for and logic of the domestic production deduction introduced in 2004 would disappear. By its nature, the destination-based cash-flow tax imposes no burden on the foreign operations of domestic companies. Thus, like the territorial approach, it allows U.S. companies to compete abroad on an equal footing with companies from other countries.
With investments fac- ing a zero rate of corporate tax in the United States, they will be taxed less heavily than in countries that impose positive tax rates, even low ones, on corporate income. Thus, as in the case of profit-shifting activities, the pressure of international tax competition will no longer be a relevant consideration in setting the U.S. corporate tax rate. In addition to the many benefits just described, a destination- based tax is often credited with one additional advantage that is largely nonexistent, some experts laments that the end result of border adjustment of tax makes domestic production to face more competition internationally, as exports become cheaper and imports expensive. This argument would make sense in a fixed-exchange-rate environment, for example, if applied to a country in the Euro zone regarding its trade with other Eurozone countries. The same argument applies to the destination-based corporate cash- flow tax.
The destination-based cash-flow tax would represent a major reform of our current system, the appendix provides some examples of how it would apply to companies in different situations.
CHAPTER III
ISSUES AND ANALYSIS
If it were to implement the proposed reforms, the United States would need to consider several issues, including revenue effects, changes to individual taxes, extensions to businesses outside traditional C corporations, and transition provisions, as well as the proposals potential economic benefits.
Revenue effects
The primary objective of this proposal is to change the structure of the corporate income tax to render it more sustainable, efficient, and equitable. Because there would be several significant changes in the tax base, the net impact on revenues is difficult to predict, this impact will vary from year to year. However, previous analysis of related proposals provides some idea of the proposal’s overall revenue effects.
The first step of the proposal to allow expensing of investment net of corporate borrowing is likely to have a small net impact on revenue, at least in the long run. For a closely related change in the corporate tax base to allow expensing and eliminate deductions for net interest rather than taxing net borrowing, a group of researchers estimated that the corporate income tax would have reduced corporate taxes by $18.0 billion in 1995.
However, they also estimated that most of this loss was due to business-cycle effects, noting in particular that 1995 was a stronger-than-average year for economic performance. Controlling for this, they estimated a business- cycle-adjusted change in corporate tax liability for 1995 of just -$0.7 billion. By comparison, corporate tax collections in that year were $157.0 billion. The second stage of the proposal to include only domestic transactions in the tax base is somewhat more difficult to assess in terms of revenue effects.
We can take advantage of existing revenue estimates by considering it as if it consisted of two separate components: a move to territorial taxation and border-tax adjustments to eliminate cross-border trans- actions.(While this is not how the proposal would actually be implemented, we break it down this way to take advantage of existing revenue estimates for the two components).
The Committee formed to supervise taxation estimates that exempting active foreign dividends from U.S. taxation, the key component of a territorial tax system, would increase revenues by around $7 billion a year in the near term, and $76.2 billion over the 10-year period 2010-2019. How exempting certain income that is now subject to tax (after foreign tax credits) could increase tax revenue follows from the other elements assumed for the proposal. Those include a reduction in tax deductions for certain U.S. expenses attributable to the now-exempt foreign-source income and the loss of foreign tax credits that previously could have been used to offset other foreign-source income that remains subject to tax, notably royalties. This revenue estimate is somewhat controversial because it makes particular assumptions about how a territorial system would be imposed and the extent to which sophisticated multinational corporate taxpayers would respond.
But this controversy simply reinforces my view that shifting to a territorial tax system, on its own, is not a complete answer to international tax reform because it exacerbates profit-shifting tax-planning incentives. Excluding cross-border transactions neutralizes such incentives. Moving intangible assets abroad may not have any US tax consequences, and any additional foreign tax to which the subsidiaries would then be subject would provide an incentive to keep them in the United States.
When viewed as the second component of international tax reform, border-tax adjustments would have their own revenue impact. The PAPFTR report estimated that border adjustments under its Growth and Investment Tax Plan would raise a substantial amount of revenue: $775 billion over ten years.
But unlike under the Growth and Investment Tax Plan, the border adjustments implicit in the proposed system also would cover financial transactions. These financial flows off- set to a considerable extent the flows in goods and services through the balance between capital and current accounts, which must hold at the national level. Just as the United States is a net importer, it is a net borrower, so increased capital inflows (net of interest payments made to foreign creditors) would generate reduction of tax to offset revenue increase.
The offset would not be complete, even though capital and current accounts balance overall, because corporations and other private entities are not the only ones participating in international financial transactions. The U.S. government is a big foreign borrower, too.
A tax reform as significant as the one laid out here will have many distinct revenue effects working in positive and negative directions. It is plausible that the net impact will be small and perhaps positive, but many factors are left to be considered, including three discussed next: potential modifications to individual tax rates, extension to businesses not currently subject to the corporate income tax, and transition relief.
Potential modifications to individual tax rates
Changes in corporate-level taxation also have implications for the appropriate tax treatment at the individual level. The double-taxation of corporate earnings has been one standard argument for tax provisions favoring dividends and capital gains, including those introduced in 2003 that cap the rate at 15 percent on such income. Scaling back the favorable treatment of dividends and capital gains could be considered under a reformed corporate tax since double-taxation of the returns to capital would no longer be an issue. This would be particularly true if it were ultimately determined that the net revenue impact of the proposal would otherwise be negative.
At the very least, a revenue-neutral shift in tax rates at the individual level would be appropriate to bring the treatment of interest, capital gains and dividends more into line, given that the tax system will no longer favor borrowing at the corporate level. The 2005 Growth and Investment Tax Plan took this approach and would have imposed a uniform tax rate on all interest, capital gains, and dividends. Such a flat rate tax on earnings from different sources would also simplify the tax system, which has been a motivation for the adoption of this approach under the dual-income tax systems prevalent in the Nordic countries. Extension to other business entities Gradually over recent decades, the U.S. business sector has evolved into one that is, to a considerable extent, not subject to the corporate income tax, reflecting the growth of business entities outside the traditional C corporation form.
Tax rules have played a role in this growth; for example changes to rela- tive corporate and individual tax rates in the Tax Reform Act of 1986 made corporate tax avoidance more valuable. 28 My proposed changes to corporate taxation are not designed to have a major impact on overall corporate tax collections. On this basis alone, there is no compelling need to couple them with a reformed treatment of pass-through entities.
But growth continues outside the corporate sector, particularly among S corporations and other entity forms that can, from an ownership and organizational perspective. Many see this growth as a challenge to the viability of the corporate tax base and another distortion of business decisions, in this case with respect to organizational form.
29 Further, the change proposed here in the treatment of foreign-source income and other international transactions would introduce one more distinction in the treatment of C corporations and hence would provide an additional channel through which taxes might distort the choice of organizational form. Therefore, the reform will work best if the changes extend to those companies that bear a close resemblance in their characteristics to C corporations. The simplest approach would be to subject other entities to the same reform being imposed on C corporations.
This uniformity of treatment would be more practical under the new system than under current law because the tax treatment of C corporations would be much simpler than it is now. The 2005 Growth and Investment Tax Plan took this approach, proposing to impose a 30 percent cash-flow tax on all business entities except sole proprietorships and a uniform 15 percent tax on all earnings distributed by such entities.
But this broad an extension is probably not needed if the aim is to cover companies that could serve as substitutes for C corporations. For example, consider S corporations, which, since 2004, are permitted to have as many as 100 distinct shareholders. In 2007, 90 percent of all such corporations, accounting for 58 percent of all net income of S corporations, had at most two shareholders. Therefore, limiting the reform to those S corporations with more than a few shareholders would have a minor impact on the sector as a whole, and similar rules could be applied to other entity forms. Transition provisions Even if revenue is kept constant, the adoption of a new tax system will create winners and losers, raising the issue of transition rules.
One is between equity and debt, with debt losing its previous tax advantage through the inclusion of borrowing in the tax base. The other is between new and existing sources of capital income. By implementing immediate expensing of investment, the proposal would effectively eliminate the tax on new investment. But the tax relief would apply to new investment only, and taxes on existing assets would rise if depreciation deductions were eliminated immediately.
Based on past practice, one might imagine providing transition relief by phasing in new provisions over a relatively short period of time.The 2005 Growth and Investment Tax Plan proposed the same approach for depreciation allowances on existing capital, and one could imagine a similar approach for inventories as well.
That plan would have eliminated the tax advantage to borrowing by eliminating the interest deduction, and would have followed the same five-year approach to phasing out interest deductions. My alternative approach to debt, which would add new borrowing to the tax base, already follows a smooth transition path because it would apply to existing debt only as it matures and is refinanced. Thus, the case for additional transition relief for debt is not obvious.
Transition provisions could have a significant revenue cost, as the following rough calculation shows.. 33 Assuming that 10 percent of each year’s deductions are attributable to new investment and a 30 percent tax rate (to account modestly for the fact that not all companies are taxable in a given year), $72 billion, $42 billion, and $18 billion during the four years of partial deductibility. Paying for $240 billion of tax relief would require an increase in some other taxes; a variety of approaches might be considered.
A temporary increase in the corporate income tax of five percentage points (from 35 percent to 40 percent) over the same period would provide revenues of roughly the same magnitude. Or, one might phase in any planned reductions in the taxation of interest income under the individual income tax, perhaps also keeping taxes on dividends above their long-run level during the same period.
If not carefully considered, an approach to paying for transition relief could result in perverse timing incentives. For example, a delayed implementation of full expensing should be avoided, because it would make it attractive to delay investment. But phasing in reductions in tax rates would be much less problematic because the future income from new investments would face the lower long-run tax rates.