This past weekend, the Senate passed a sweeping revision of the U.S. tax code with broad efforts both to simplify the code and stimulate the economy. The bill, which includes about $1.4 trillion in tax cuts, would lower the corporate rate to 20 percent from 35 percent and reshape international business tax regulations.
However, in their rush to pass this important legislation, Republicans also included a critical provision that would undercut their goals and possibly even accomplish the exact opposite.
The AMT Remains
Late Friday — just hours before the Senate voted for the bill — Republicans decided to preserve the corporate Alternative Minimum Tax (AMT), instead of repealing it as initially planned. The House version of the bill, passed on November 16, eliminated the corporate AMT, as did earlier drafts of the Senate bill. What motivated the Senate to reinsert the AMT provision? It is not at all clear. Some commentators have suggested that it could be due to a simple “drafting error.” The most likely explanation is that it is an attempt to keep the total tax cut from exceeding its capped $1.5 trillion limit.
In any case, repeal of the AMT is a crucial pillar of pro-growth tax reform, particularly because the AMT produces unnecessary complexity and disallows critical tax incentives. If Republicans want growth, they must reinstate the AMT repeal.
The corporate AMT is a parallel system that requires companies to calculate two sets of income tax liabilities and pay the resulting higher amount.
Whereas the corporate tax rate is 35 percent, the AMT has historically been set at the lower rate of 20 percent. To ensure that no corporate taxpayer breach the 20 percent floor, important tax credits, such as the Research and Development Tax Credit and the Low-Income Housing Credit, may not be used to offset the AMT tax liability. Because companies currently face the 35 percent corporate tax rate, they are rarely able to reduce their effective income tax rate to less than the 20 percent threshold. This would still be true even if they were able to reduce their effective rate using credits and deductions.
As a result, the AMT rarely forces a company to raise its effective rate back up to 20 percent. If the Senate plan were enacted, however, and the ordinary rate were reduced to 20 percent, corporations would be required to pay the higher 20 percent rate pursuant to the AMT, even if their rates were further reduced through credits or deductions. This would undermine the applicability of critical credits and incentives.
In short, if the corporate rate were reduced to the same 20 percent rate as the AMT rate, companies would be required to continue calculating both sets of tax liabilities — with all of the associated resources and costs required — but also discard any credits or deductions they could have used to offset their liabilities. This would effectively eliminate key tax incentives that generate substantial economic benefits.
Eliminating Critical Tax Incentives
Three initiatives in particular will be rendered effectively moot by the new tax provision.
1. Research and Development Credit
Under this credit, companies can offset some of the costs of innovation as long as their scientists, engineers, and associated costs are located within the United States.
According to the congressional Joint Committee on Taxation, corporations will claim $10.3 billion in research credits in 2018. This incentive is critical, at a time when the United States is ranked 16th in the developed world for public investment in private innovation. This is especially important because, unlike other countries in the developed world, the United States does not make direct public investments in private R&D. Instead, we incentivize corporate taxpayers to make those investments through tax credits and reimburse them when they do. If this incentive gets eliminated, U.S. companies may be motivated to move their R&D infrastructure to more cost-effective parts of the world, significantly harming the development of talent and innovation within the United States.
2. The Low-Income Housing Tax Credit
The LIHTC has been the primary motivator for federally chartered financial institutions to make investments in housing serving low-income communities by creating and fostering a longstanding public-private partnership between corporate taxpayers and real estate developers. This, in turn, has leading to an increase in the supply of housing for under-served communities. If this program is eliminated, banks may significantly reduce their investments in these types of financially high-risk enterprises. Considering that we have a growing population of retirees living off of fixed, low incomes as well as those who are being displaced from the workforce as the result of technology and other disruptive forces, it would be counterproductive to reduce investment in the supply of this critical housing.
3. Intellectual Property Taxation
Retaining the corporate AMT also would undermine key features of the international tax system included in the Senate Republicans’ bill. Many American companies in the technology sector currently house their intellectual property overseas in tax advantaged countries. To get companies to repatriate this IP, the Senate has proposed lowering tax rates on foreign profits or profits from intangible assets, such as including patents. Thus the GOP tax plan has the potential to unlock billions of dollars stored overseas by multinational companies by allowing them to repatriate future foreign earnings more cheaply.
However, at around 12.5 percent, the repatriation rates are far below the AMT, making them irrelevant to any company considering such a repatriation. The advantaged tax rate would be rendered moot, since the AMT would force the taxpayer to pay the effective rate of 20 percent. So the very incentive that is supposed to drive companies to repatriate their earnings would instead would give them reason either to continue harboring such assets overseas or even invest such profits in R&D overseas, further harming the U.S. economy.
Three Possible Solutions
In sum, the combination of a 20 percent corporate tax rate and a 20 percent AMT would prevent these credits from reducing a company’s tax liability below the AMT. Thus the net effect of the Senate’s effort to maintain the AMT would be to eliminate each of these incentives. Accordingly, the Senate bill must be revised.
There are at least three possible alternatives:
1. Repeal the AMT and thereby eliminate the problem altogether.
2. Allow the above incentives to offset AMT or else allow the credits to be used to offset payroll taxes (as small businesses and startups are able to do).
3. Reduce the AMT to a rate that is sufficiently below the corporate rate to allow meaningful reductions in the corporate rate based on credits and deductions.
By adopting one of these possible solutions, Congress could motivate companies to make investments in crucial areas of our economy, rather than allowing the AMT to undermine the goals the Congress set out to achieve.
Alan Tsarovsky, Esq., is Managing Director and Tax Counsel for the Tax Advisory Group.