November 09, 2007
For most business taxpayers, tax legislation during the remainder of 2007 will not be about new benefits and incentives. Rather, businesses’ attention will be focused on those revenue raisers — provisions that offset the cost of those benefits and incentives already under consideration or set to expire soon.
The “paygo” rules require the cost of new tax cuts and incentives, as well as certain other legislation, to be offset with revenue raisers. This puts the business taxpayer on the defensive, because they are expected to be asked to pay for otherwise desirable initiatives in such areas as energy and education, as well as such “must do” items as modification of the individual AMT.
Revenue offsets “in play”
Many of the revenue offsets discussed are seen as “in play” for possible use in various bills.
1. Tax gap provisions. The need to reduce the tax gap has been embraced by the administration and both parties in Congress. Although noncompliance by individuals is the focus of these proposals, their burden is likely to fall on businesses through tougher reporting requirements and recordkeeping rules. Leading candidates for enactment include proposals that would require brokers to report basis on sales of publicly traded securities, require the verification of the taxpayer identification numbers of contractors and extend existing reporting requirements to cover payments to corporations as well as individuals.
More controversial proposals, such as requiring credit card companies and other payment processors to report the gross amount of payments they process for a merchant, or an expansion of the circumstances under which gross payments to certain contractors would be subject to withholding, could be considered but are less likely to be enacted.
2. Deferred compensation limits. Proposals to limit deferred compensation to no more than $1 million per year continue to attract support. The proposal currently under discussion has dropped an alternative limitation based on average prior years’ compensation that was included in earlier versions and may allow a market rate of return on previous deferrals to be excluded from the annual calculation.
3. Taxation of carried interests and sweat equity. The taxation of investment fund carried interests — the percentage interest in the profits the fund manager receives — has emerged this year as a leading tax legislative issue. Legislation has been introduced that would treat such carried interests as income from services, taxed at ordinary income rates and subject to employment taxes, and four separate rounds of hearings have already been held by the tax writing committees. Some senators have suggested any changes should also apply to other sweat equity situations, including oil and gas exploration, and real estate development.
4. Foreign tax provisions. Several proposals have been introduced that would limit the ability of a company to reduce its U.S. tax burden by reincorporating offshore, or limit the ability of an individual to avoid U.S. taxes by surrendering his or her U.S. citizenship or permanent resident status. An anti-treaty shopping provision that could require withholding on deductible related-party payments at higher rates passed the House as an offset in the farm bill.
5. Codification of the economic substance doctrine. For several years, tax legislation reported by the Senate Finance Committee has included a provision that would codify the economic substance doctrine. The latest version of this proposal would require a taxpayer to establish that a transaction be expected to change (apart from federal income tax consequences) its economic position in a meaningful way and have a nontax business purpose. Generally, a taxpayer would be expected to show that the profit potential was reasonably expected to exceed a risk-free rate of return if it relied on profit potential (whether or not realized) to establish economic substance.
Targeted revenue offsets
Certain revenue offsets are closely associated with specific tax incentives or other revenue needs. Enactment of these offsets is expected to be dependent on the enactment of related legislation.
Energy tax: Revenue offsets could include eliminating the section 199 deduction and limiting the use of LIFO for large, integrated oil and gas producers. Given the current price of oil, the general need for tax incentives for production could also be re-examined.
State Child Health Insurance Program funding: Revenue offsets focus on an increase in the federal tax on cigarettes of up to $1.00 per pack and higher taxes on cigars and other noncigarette tobaccos.
What are revenue raisers needed to offset?
Paygo rules require any legislative provision that decreases federal receipts be offset by provisions increasing receipts in the same amount. Whether an offset is sufficient is tested using five- and 10-year estimates. Ten-year estimates are used in the discussion below.
The paygo rules can be waived, but waiver should not be expected.
Legislation that could require revenue offsets includes:
1. Individual AMT. For 2006, a married couple filing a joint return had an AMT exemption of $62,550. For 2007, that amount has automatically reverted to $45,000, the same amount that applied in 1993. For single taxpayers, the exemption decreases from $42,500 to $33,750. Rules allowing certain refundable credits to offset the AMT have also expired.
Unless reversed by Congress, these automatic changes are estimated to increase total AMT-related taxes on individuals for 2007 by over $48 billion. Over 23 million individual returns are projected to be affected by the AMT in 2007, an increase of over 550 percent compared to 2006. For a married couple already subject to the AMT, taxes will increase $4563, solely as a result of the decrease in the AMT exemption.
Various proposals have been introduced that are designed to prevent this increase in the incidence of the AMT by extending and slightly increasing the AMT exemption, as well as the ability to claim refundable credits against the AMT. These proposals are generally expected to lose approximately $50 billion if they are limited to 2007, and an additional $50 to $60 billion if they are extended to cover 2008.
Proposals to completely repeal the individual AMT have also been introduced. Although no official estimates have been published, full repeal is expected to cost roughly $750 billion if the 2001 and 2003 rate cuts are allowed to expire in 2011, and over $1.3 trillion if the rate cuts are assumed to be extended.
Senator Grassley, the ranking Republican member of the Senate Finance Committee has argued that the AMT was not intended to have the effect it now has, and it should not be necessary to offset the cost of modifying or repealing it. So far, the Democratic leadership has resisted this idea. However, the need to address the AMT and the difficulty of finding adequate revenue offsets has led some observers to speculate that at least a partial waiver of the paygo rules could be granted and the cost of AMT relief not fully offset.
2. Other expiring provisions. A number of popular provisions, including the research credit, the election to deduct state and local sales taxes instead of income taxes, and a number of other incentives and tax breaks are scheduled to expire at the end of 2007. A one-year extension of all the expiring provisions is expected to cost over $20 billion.
3. Higher education incentives. Broadening college opportunity was part of the House Democrat’s “First 100 Hours” pledge. Congress has passed legislation increasing the grant money available for college, but tax incentives have not yet been considered. Legislation that would consolidate and expand existing incentives into a refundable credit, encourage the increased use of section 529 plans and make other changes could be considered later this year. Codification of the economic substance doctrine has been suggested as a possible revenue offset.
4. Energy incentives. Earlier this year, the House passed a $16 billion energy tax bill while the Senate failed in its efforts to include a $28 billion package of alternative energy tax incentives in energy legislation. A smaller package, primarily funded by revenue offsets targeted to the energy sector, could be considered later this year.
5. Agriculture. Tax provisions are expected to be considered as part of the pending farm reauthorization bill. In addition to offsetting the cost of tax incentives like an expanded conservation easement program and tax-exempt “Aggie bonds,” tax provisions may also be called upon to offset the cost of nontax provisions, such as a permanent Agriculture Disaster Relief Fund. House-passed legislation includes a $7.5 billion anti-treaty shopping offset.
Other developments — Senate Permanent Subcommittee on Investigations
The Senate Permanent Subcommittee on Investigations has sent a questionnaire to a number of multinational companies asking them to provide information regarding tax positions taken on their returns and the treatment of such positions under FIN 48. Although the questions focus on transactions involving foreign entities and jurisdictions, it is not limited to those areas. Although the subcommittee does not have original jurisdiction over tax matters, its past forays into the tax arena have arguably resulted in the eventual enactment of legislation, particularly in the disclosure of tax shelter activities.
Who to contact
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The information contained herein is general in nature and based on authorities that are subject to change. It is not intended and should not be construed as legal, accounting or tax advice or opinion provided by Grant Thornton LLP to the reader. This material may not be applicable to or suitable for specific circumstances or needs and may require consideration of nontax and other tax factors. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Grant Thornton LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.
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