January 14, 2014

Letter to Chairman of Senate Finance Committee Re: Tax Reform Discussion Drafts

Dear Chairman Baucus:

Taxpayers for Common Sense is a national non-partisan budget watchdog that has been working on behalf of the nation’s taxpayers since 1995. We applaud the work done to produce the tax reform discussion drafts. It has been more than a quarter-century since the last overhaul of the tax code, and in that time it has become littered with increased complexity, parochial tax treatments, and revenue giveaways.

Everyone believes federal tax policy should improve economic growth. This will reduce the rate of growth of our debt – and should ultimately decrease the overall size of our debt. Many of the proposals set forth in the discussion drafts begin to remove unnecessary favoritism for certain corporate taxpayers, reduce the number of distortions in the tax code overall, and create more certainty with regard to international taxation. We believe these changes will generally make the tax code more efficient. Please find our more detailed comments below.

We also believe that tax policy, like federal spending, must help maximize the benefits of economic growth for all taxpayers. We urge the Finance Committee to continue its work by tackling similar policies within the individual income tax system. Specific provisions, such as the Mortgage Interest Deduction, are expensive, ineffective, and predominantly benefit a small subset of individual taxpayers. The costs of this provision, and others like it, outweigh its benefits to economic growth.

Finally, there must be more regular review of the individual and corporate tax codes to ensure that they are providing a return on the taxpayer’s forgone revenue investment. The existing lack of oversight and scrutiny rewards political inertia, rather than performance.

Sincerely,

Ryan Alexander
President, Taxpayers for Common Sense

Observations on Discussion Draft on Cost Recovery and Accounting Tax Reform

Background
Thanks to a suite of special cost recovery and accounting methods, select taxpayers enjoy preferential treatment under the tax code. Under normal rules, taxpayers who make business investments in productive assets such as a plant and equipment can deduct those capital costs from their business income over a specified period of time through depreciation allowances. Special cost recovery provisions, such as the immediate deduction of intangible drilling costs, give oil and gas producers significantly more generous capital cost write-offs than those available to other taxpayers. Even small businesses, for example, are allowed to expense (write off in one year) only a limited amount of capital investment – $1 million in 2013. In general, businesses are also never able to deduct more than their costs. However, natural resource producers and royalty owners can deduct more than the amount actually invested in an asset thanks to the percentage depletion allowance.

Observations
The discussion draft repeals percentage depletion allowance, which currently allows the write off of a percentage of the income from a property without regard to the taxpayer’s investment in the property. For new wells and mines, taxpayers will no longer be able to deduct more than the amount they have invested. However, the effective date for the repeal of percentage depletion (properties placed in production after 2014) allows owners of existing mines and wells to continue to deduct amounts in excess of their actual costs. This is poor tax policy, and it contrasts with the changes proposed for depreciation and amortization of intangibles, which would slow down the recovery of costs incurred before the bill’s effective date.

• A better policy would repeal percentage depletion for all properties and allow any remaining basis in existing wells or mines to be recovered through cost depletion.

The draft reforms the tax subsidies that allow for immediate write off of intangible drilling costs (IDC), tertiary injectants, and mining exploration and development expenditures, as well as the rapid amortization of geological and geophysical expenditures. Natural resources developers would now be allowed a 5-year amortization of these expenditures. Economically, the useful lives of wells and mines on various formations can extend as long as 40 years. Non-US wells have 10-year amortizations under present law. The 5-year amortization also contrasts with the bill’s treatment of other forms of capital cost recovery, as it reduces depreciation benefits and lengthens the period for amortization of intangibles to 20 years.

Granting a short 5-year recovery period for oil and gas well investments – the same as the proposed new recovery period for research and development expenditures (R&D) – implicitly accepts the oil industry’s fallacious argument that drilling oil wells is like R&D. The drilling of oil wells presents none of the uncertainty required for R&D expensing. Indeed, the costs of designing and fabricating drilling platforms, which can represent 60 to 80 percent of the costs of drilling a well, qualifies for the IDC deduction even though little uncertainty exists on how to build a platform.

• While the discussion draft is an improvement to existing law, 5-year recovery period for oil and gas well investments only lessens the existing tax subsidy. Amortization periods should be tied to economic data.

The discussion draft rightly repeals the last-in, first-out (LIFO) inventory method, which has allowed oil refiners to maintain very favorable treatment of their costs. LIFO allows companies to defer payment on increases in the value of their goods even if those increases have nothing to do with general inflation – the avowed purpose of LIFO. It is unnecessary to allow the accumulated subsidy that has resulted from LIFO accounting be taken into income over 8 years rather than 4 years, as would occur under normal accounting rules. 

Observations on Discussion Draft on International Tax Reform

Background
The United States taxes resident individuals and domestic corporations on all income, whether U.S. source or foreign source. In the case of income earned by a domestic corporation indirectly through a controlled foreign corporate subsidiary (CFC), U.S. tax is generally deferred until the income is distributed as a dividend from the CFC to the domestic corporation. To mitigate double taxation of foreign-source income, the United States allows a domestic corporation to claim a credit for foreign income taxes paid by it and its foreign subsidiaries.

Under financial accounting standards, a company must recognize the expected tax consequences of events recognized in their financial statements,[1] including recognition of deferred income tax on undistributed earnings of foreign subsidiaries. However, an exception to this recognition applies “if sufficient evidence shows that the subsidiary has reinvested or will reinvest the undistributed earnings indefinitely.”[2] The current U.S. tax system, combined with these financial statement rules, creates an incentive for the U.S. parent of a CFC that has low-taxed foreign earnings to indefinitely reinvest those earnings outside the U.S. Estimates suggest that as much as $2 trillion of deferred income on which tax has not been accrued has not been distributed by CFCs. While these earnings are held by CFCs for investment, a significant portion is held in U.S. investment accounts.[3]

Observations
The draft proposes to end the present deferral of tax on pre-reform foreign income of CFCs.  Amounts earned by CFCs in years starting in 2014 will be deemed repatriated at the end of the tax year. A domestic corporation that is a U.S. shareholder of a CFC must include in gross income its share of the CFC’s accumulated undistributed foreign income (both current income and previously accumulated amounts), regardless of whether any distributions are made to the domestic corporation. The draft proposes a special deduction that results in a 20 percent effective tax rate on this income before foreign tax credits are included (see example below). A foreign tax credit would be allowed for taxes paid with respect to the taxable portion of the included income. 

Example: The example below assumes a CFC with $10 million of deferred pre-tax income on which it paid $2.6 million in creditable foreign taxes at a rate of 26 percent, and that the U.S. rate is 35 percent. If the income were repatriated under present law, a tax of $900,000 would be due. Under the Senate Finance Committee draft, that liability is reduced to $514,286, but the opportunity to defer tax is eliminated. 

*This presentation is simplified.  The section 78 gross up is not shown, but assumed. Technically, the special deduction would be computed with respect to after tax income the result would be grossed-up for the taxes associated with that net income.

The special deduction works to achieve a 20 percent rate on total income. This deduction is computed by dividing the excess of the current top rate for the year of deemed repatriation (currently 35 percent) over 20 percent by the top rate. In the example above, the taxable income of parent of the CFC is reduced to $5.7 million from $10 million. After the tax credits are allowed for foreign taxes paid at a 26 percent rate on the resulting taxable income, the parent would pay a lower additional tax of 5.14 percent (compared to 9 percent). In the case of income taxed at a very low rate such as Ireland’s low 12.5 percent rate, the Baucus draft would impose an additional tax of 12.9 percent, bringing the total U.S. and foreign tax to 25.4 percent, which is in the range of rates that the business community has suggested are reasonable for a U.S. rate in the context of tax reform.

• The draft makes a fair proposal for taxing accumulated deferred foreign earnings that should be acceptable to the business community.

A U.S. shareholder may elect to pay the net tax liability that results from the mandatory inclusion of pre-effective-date undistributed CFC earnings in up to eight equal installments. While the draft denies taxpayers who took advantage of tax havens and aggressive tax planning the opportunity to reap another windfall in the taxation of deemed distributions, the option to spread payments over 8 years seems like a budgetary gimmick. Many of the affected companies file audited financial statements. For these companies, the additional tax required by the deemed repatriation will have to be accrued immediately upon enactment – in advance of even the first cash payment required by the change. The eight-year spreading of payments is a cash-flow windfall.

• Some installment payment may be appropriate to allow taxpayers to manage their cash effectively, but eight years is too long a period of continued deferral. 

Observations on Discussion Draft on Energy Tax Reform

Background

Current law includes a variety of tax credits for biofuel production and distribution, biomass utilization, and use of “clean coal” technologies. Cellulosic ethanol is a form of biofuel made from cellulosic matter in plants, including corn stover (the leaves and stalks of corn plants), switchgrass, wood chips, and other plant wastes. The federal Renewable Fuel Standard (RFS) mandates production of 16 billion gallons of cellulosic ethanol by 2022. The fuel is subsidized by the federal government at a rate of $1.01 for each gallon produced.[4] Biodiesel or renewable diesel is also subsidized at a rate of $1.00 for each gallon produced or utilized in the blending process.[5] Biomass-based diesel qualifies as an “advanced biofuel” toward the RFS mandate.

An alternative fuel credit is available to companies that produce unconventional fuels at a rate of 50 cents per gallon. An alternative fuels mixture credit is available at the same rate to companies that blend traditional fossil fuels with small amounts of high carbon fuels. The Alternative Fuel Vehicle Refueling Property Credit provides a 30 percent tax credit for facilities dispensing certain alternative fuels.[6] Open loop biomass facilities, which use agricultural livestock waste nutrients, nonhazardous cellulosic waste material, or other agricultural waste materials to produce electricity, are eligible for a production tax credit of 1.1 cents for every kilowatt-hour of electricity produced and sold.

A 20 percent investment tax credit is currently available for qualified advanced coal projects that use integrated gasification combined cycle technology (IGCC), and a 15 percent investment tax credit is available for qualified advanced coal projects that use “clean coal” technology. A 20 percent investment tax credit is also available for certified industrial gasification projects. A credit of $10-$20 is available for each ton of carbon dioxide captured and disposed of in secure geological storage or used as a tertiary injectant in an oil or natural gas project. The program is limited to 75 million metric tons of qualified carbon dioxide captured.

Observations
The energy draft simplifies current energy tax incentives by consolidating over 40 separate provisions into two production tax credits and two alternative investment tax credits (ITC). The amount of the credit varies across fuel types with level of greenhouse gas emission per unit of energy produced. Energy sources that produce no CO₂ equivalent emissions receive the maximum credit. The draft phases out the new credits and ITCs when the Treasury Department (with EPA and Energy Department) determines that average CO₂ equivalents per BTU have fallen below specified targets.

• Production credits and investment tax credits are unnecessary and distort investment choices dramatically.
• Reducing the credits and ITCs for greenhouse gas effects is an improvement to current law.

The draft proposes to finally eliminate the existing patchwork of biofuel, biomass, and alternative fuel tax policies. It would replace these provisions with a “new tax credit for clean transportation fuel that is technology-neutral and performance-based.” Unfortunately, there are several problems with the new credit that make it problematic.

The new transportation fuel credit would allow corn ethanol facilities powered by biomass sources to once again become eligible for federal tax breaks, even though the Volumetric Ethanol Excise Tax Credit (VEETC) was so unpopular that it ended in 2011. For the first time, corn butanol, another corn-based biofuel, would also become eligible for the new tax credit even though the use of corn-based biofuels has failed to reduce greenhouse gas emissions. The proposed credit also fails to take into account full life-cycle carbon emissions since it would exclude carbon emitted during the production of feedstocks used in ethanol or biodiesel production, such as corn or soybeans. It would also create unintended consequences as a result of increased biomass and biofuel production, such as higher food prices and indirect land use changes which cause deforestation and production on previously uncultivated land.

• Biofuel, biomass, and alternative fuel tax preferences – including the cellulosic, biodiesel, open-loop biomass, alternative fuel, and alternative fuel property tax credits – that are expiring at the end of 2013 should be allowed to expire immediately (instead of some being extended through 2016, as the draft proposes), and they should not be replaced with the proposed “clean transportation fuel” tax credit.

The draft proposes the option of claiming a 20 percent investment tax credit after 2016 for existing facilities that undertake a carbon capture and sequestration (CCS) retrofit that captures at least 50 percent of carbon dioxide emissions. Carbon capture and storage technology is largely untested and unproven. Current carbon capture technology would need to be scaled-up as much as 100 times in order to be workable in commercial power plant. Not only would it take massive investments in infrastructure and subsidies to test the commercial viability of CCS, but any consequent clean-up, should leaks or unforeseen accidents occur, would likely be paid for by taxpayers.

• The credit for carbon capture and sequestration is not in the long-term interests of taxpayers.

In general, a better policy choice than alternative fuel production and distribution tax credits is an upstream carbon tax. It would encourage through prices the adoption of energy efficiency measures by consumers and businesses. Imposition of an upstream carbon tax would not require the creation of a large new bureaucracy to measure actual emissions and collect the tax, and the number of firms required to file tax returns for an upstream tax would be limited. It would apply to the principle sources of CO₂ emissions: coal, natural gas and petroleum products, and it could impose differing rates on each taxable substance so that each is taxed equivalently in terms of tons of potential CO₂ emissions. The CO₂ equivalence rate could be set and adjusted to achieve any desired combination of revenue collections and CO₂ emissions reductions.

• In general, an upstream carbon tax would be a much better policy choice than tax credits.