The%20Comprehensive%20Business%20Income%20Tax

1
The Comprehensive Business Income Tax

• May 12, 2005

Kenneth W. Gideon Skadden, Arps, Slate, Meagher
Flom Washington, D.C.
2
Comprehensive Business Income Tax (CBIT)

• CBIT was an option in a 1992 Treasury Study
• CBITs objective was to tax all business income
  only once and to eliminate economically
  inefficient current corporate tax law distortions
  that
• Favor corporate debt over equity finance
• Favor the noncorporate over the corporate form
• Favor corporate retentions over distributions
• Goal of CBIT promote simplification and fairness
  by taxing corporate and noncorporate business
  entities using a single set of rules

3
CBIT General Overview

• Uniform Business Level Tax Income of almost all
  business entities would be measured and taxed at
  the entity level (very small businesses, measured
  by gross receipts, were excluded from CBIT)
• No Investor-Level Tax on Distributions
  Distributions of business income whether as
  dividends or interest generally are not taxed
  when received by investors
• Losses -- Losses incurred at entity level do not
  pass through to equity holders unused losses
  can be carried over at the entity level
• No Interest Deduction No business-level
  deduction is allowed for interest expense

The CBIT study recognized the difficulty of
separating returns to capital from returns to
labor in very small businesses. CBIT could
therefore overtax labor income to owners of ,
e.g., small proprietorships if CBIT rate was
above the relevant proprietors individual income
tax rate.
4
Comparison of Current Law and CBIT(For Domestic
Taxpayers)
Current Law Current Law Current Law Current Law
Business Entity Equity/Debt Holder
Corporate Form Equity Income Tax Tax (preferentially)
Corporate Form Debt No Tax Tax
Non-Corporate Form Equity Income No Tax Tax
Non-Corporate Form Debt No Tax Tax
Comprehensive Business Income Tax Comprehensive Business Income Tax Comprehensive Business Income Tax Comprehensive Business Income Tax
Business Entity Equity/Debt Holder
Corporate Form Equity Income Tax No Tax
Corporate Form Debt Tax No Tax
Non-Corporate Form Equity Income Tax No Tax
Non-Corporate Form Debt Tax No Tax
5
Comparison of CBIT and Current Law(Impact on
Tax-Exempt and Foreign Investors)
Current Law
CBIT
Equity Holders
Equity Holders
TaxableForeignTax-Exempt
No Tax
Tax
TaxableForeignTax-Exempt
No Tax
Corporation
Equity
Tax
Corporation
Equity
No Tax
No Tax
Return
Return
Tax
Debt Holders
Debt Holders
No Tax
TaxableForeignTax-Exempt
No Tax
TaxableForeignTax-Exempt
Tax
Debt
No Tax
No Tax
Debt
No Tax
No Tax
Equity Holders
Equity Holders
TaxableForeignTax-Exempt
No Tax
TaxableForeignTax-Exempt
Tax
No Tax
Equity
Tax
Equity
No Tax
Tax
Tax
Debt Holders
Debt Holders
Return
Return
TaxableForeignTax-Exempt
No Tax
Tax
TaxableForeignTax-Exempt
Debt
No Tax
Non-Corporate Form
No Tax
Debt
Non-Corporate Form
No Tax
No Tax
Note The illustrations do not take into account
(i) tax preferences or taxes imposed by other
countries or (ii) the 15 dividend rate for
qualifying dividends under current law.
6
Comparison of Current Law and CBIT

• CBIT
• Uniform treatment of
• Business entities (other than small businesses)
• Corporate distributions both dividends and
  interest
• Returns on business equity

• Current Law
• Differing treatment of
• Corporate and noncorporate business entities
• Corporate debt and equity
• Corporate and noncorporate equity

7
Economic Benefits of CBIT

• In 1992, the Treasury Department found that CBIT
  would produce welfare gains from
• Improved consumption choices by improving the
  allocation of resources among investments
• Improved corporate borrowing policy
• Improved corporate dividend payout policy
• Treasury compared the welfare gains of CBIT to
  the shareholder allocation, imputation credit and
  dividend exclusion prototypes
• Although each of the integration prototypes
  studied promoted more efficient consumption,
  corporate borrowing and corporate dividend
  policies, CBIT provided the largest annual
  welfare gains of the proposals

8
CBIT Treatment of Tax Preferences

• Because the current business tax base includes
  many preferences, exclusions, and credits, some
  income is untaxed
• If the current business tax base is combined with
  CBIT, there is a potential for tax-free
  distributions of untaxed business income
• Special rules would be needed to prevent tax-free
  distributions to shareholders because of
  preferences, exclusions, and credits
• Example XYZ Co. earns 100 of taxable income and
  50 of tax-exempt income. XYZ pays a 30 tax on
  100 of income and distributes the remaining 120
  as a dividend to its shareholders
• If all business distributions are tax-free,
  shareholders would be shielded from any level of
  U.S. tax (corporate or shareholder) on the 50.
• Preventing this result requires a mechanism to
  track dividend and interest payments made out of
  tax-preferred income (Preference Income")

9
CBIT Treatment of Tax Preferences

• Two Options for Treatment of Preference Income
  
• Option 1 Include in investor's income and tax at
  the investor's ordinary tax rate
• Option 2 Tax distributed preference income at
  the business entity level
• In either case, corporate distributions would be
  treated as arising first from income subject to
  the regular CBIT tax
• Option 1 better promotes economic efficiency
  because it does not distort corporate
  distribution decisions Option 2 is simpler

10
CBIT Design Issues and Anti-Abuse Rules

• To track preference income, an Excludable
  Distributions Account ("EDA") could be used to
  track U.S. tax-paid income and limit tax-free
  distributions to that amount
• Anti-abuse rules might be needed to
• Disallow interest deductions on debt-financed
  acquisitions or investments in CBIT businesses
• Distinguish nondeductible interest payments by
  CBIT entities from deductible rental and royalty
  payments and
• Distinguish nondeductible interest payments by
  CBIT entities from principal payments on capital
  equipment purchases (capitalized and deductible)

11
CBIT International Considerations

• Under our current system of international
  taxation, foreign entities would generally be
  treated as non-CBIT entities interest received
  from foreigners would be taxed
• Income shielded from U.S. tax by tax credits
  under current law would be treated as Preference
  Income taxable to a U.S. lender
• CBITs parity objective for debt and equity means
  no withholding taxes on both interest and
  dividends paid to foreign entities
• Eliminating withholding taxes reduces U.S.
  leverage in bilateral tax treaty negotiations
• Lack of deductibility of interest represents a
  major departure from current U.S. policy on
  inbound debt investment

12
CBIT Financial Intermediaries

• Financial intermediaries generally earn most of
  their income in the form of dividends and
  interest
• If received from CBIT entities, such income would
  be exempt from tax
• Financial institutions generally incur
  substantial non-interest expense to produce net
  interest and dividend income
• Financial institutions may respond by attempting
  to recharacterize interest income as fee income
  to allow CBIT borrowers to deduct such fees while
  financial institutions deduct operating expenses
  against such fee income
• Recharacterizing interest income as fees may
  permit better matching of a financial
  institution's income and expenses but is
  problematic with respect to borrowers

13
CBIT Market Impacts and Transition

• Interest rate on CBIT debt (tax-exempt to
  holders) should be lower than interest rate on
  non-CBIT (taxable) debt
• State and local debt will lose tax advantage
• Long phase-in of CBIT advisable to mitigate
  effects on borrowers and lenders
• Transitional anti-abuse rules may be necessary to
  prevent acceleration of interest deductions and
  deferral of interest income
• Grandfather rules should be avoided

14
CBIT Combination with Other Proposals

• Combination of CBIT with other proposals (e.g.,
  expensing) could move the current income taxation
  of business towards a consumption tax
• Combination of CBIT without limitations on the
  debt financing of CBIT debt and equity
  instruments could lead to arbitrage opportunities
  by investors
• Combination of expensing without CBIT treatment
  of debt will lead to arbitrage opportunities by
  businesses