May 6, 2013
The Honorable Max Baucus, Chairman
The Honorable Orrin G. Hatch, Ranking Member
Committee on Finance
United States Senate
219 Dirksen Senate Office Building
Washington, D.C. 20510
Re: Tax Reform Options and Proposals to Raise Tax Revenues under the March 23, 2013 Budget Resolution
Dear Chairman Baucus, Ranking Member Hatch, and Members of the Finance Committee (the “Committee”):
This paper contains suggestions as the Committee reviews proposals to reform the Internal Revenue Code of 1986, as amended (the “Tax Code”).
The Concurrent Resolution of the Senate Budget Committee proposes a deficit reduction plan and instructs the Senate Finance Committee to report legislation that will reduce the deficit by $975 billion through changes to the Tax Code. In particular, the budget guidelines acknowledge the goals of fairness as well as boosting economic growth.
The United States remains the world’s most desirable location for new companies to develop innovative technologies, resulting in job creation and increased productivity, especially in technology hubs such as the Silicon Valley, Boston and New York. However, companies also find themselves paying the highest tax rates in the world. In addition, domestic companies are subjected to a worldwide, rather than territorial, tax basis, placing them at an additional competitive disadvantage.
As an attorney who has represented international startup and tech companies in Silicon Valley since 1991, I observe that even startup companies now find it worthwhile to structure their operations offshore and limit their involvement in the United States. This development is significant since much new technology is developed and exploited in a startup environment. When the startup community leaves the U.S., the future of technology development and innovation also leaves the U.S. Much of the industrialized world awaits this migration with incentives, accommodating immigration laws and, importantly, low tax rates.
No one disagrees that fundamental tax reform is needed or that companies operating in the U.S. must confront negative incentives artificially created by our tax system. This paper suggests approaching tax reform and rebuilding our economy on three basic principles:
- Lower corporate tax rates;
- Territorial taxation while limiting deferral of tax on excess foreign intangible income; and
- Restricting the states from undercutting federal tax incentives through inconsistent, excessive and unfair tax policies.
Increasing revenues solely through removing or restricting tax expenditures, especially small business incentives such as additional depreciation under section 179 of the Tax Code, would unfairly shift a large portion of the tax burden to small business. This paper proposes increasing the tax base, rather than increasing the tax on the existing base, as a means of resolving the tax/budget gap.
Corporate Tax Rates. Schedule A compares the federal and state tax burdens on companies doing business in California and in the United States as compared to companies located in other countries.
Faced with this dramatic tax rate difference, a company seeking a jurisdiction in which to establish a business presence must clear a high tax rate hurdle before it can consider the United States. Multinational companies must pay a blended federal and state U.S. rate that is much greater (up to 25%) than in other industrialized nations. A glance at the numbers illustrates that reducing corporate rates may be the single most significant tax factor confronting inbound and international investors.
Territorial Taxation/Excess Foreign Intangible Income. The Budget resolution notes the migration of intangibles from the U.S. to low- or no-tax jurisdictions and, in fact, almost every large multi-national company has a foreign IP holding company structure in place. It is likely only because mobile or intangible income can be easily moved offshore (and reduce the effective worldwide tax rate) that U.S. companies have tolerated high corporate tax rates. As noted, a system that encourages foreign migration of intangibles is costly in the long run, as jobs, business and economic activity shift to foreign jurisdictions. Thus, any proposal to reduce corporate tax rates should also encourage the repatriation of foreign earnings back to the U.S., both through territorial taxation and cessation of tax deferrals on foreign mobile (or intangible) income.
Limits on State Taxation. One of the factors contributing to the decline of American competitiveness has been the increasing tax bite of states seeking new forms of revenue. For example, as illustrated in Schedule A, the state of California takes almost 9% in additional taxes. In states such as California, even a lowered 25% federal corporate tax rate will result in an excessive combined federal and state rate. Thus, a tax reform proposal that seeks to increase the taxable base through lower corporate rates and territoriality must also address the effect of state taxes on those goals. In particular, the following general tax initiatives would be most consistent with the federal tax reforms:
- Extend Public Law 86-272 to apply to all income;
- Mandatory Tax Code conformity with respect to certain federal tax incentives; and
- State compliance with international treaty obligations.
Each of these ideas is further developed below.
It is important to note that there is precedent for federal oversight when states have over-reached on tax issues. For example, Public Law 104-95 prohibits state taxation of certain pension income of nonresidents. Public Law 86-272 (PL 86-272) prohibits the states from imposing net income based taxes on non–domiciliary sellers of tangible personal property. Both of these laws reflect the power of Congress to limit state taxation of interstate commerce.
Extend Public Law 86-272
No discussion of raising the tax base by lowering rates can ignore state income taxes. While it may seem that states should be free to compete with other states with respect to tax rates and other incentives, at the global level the competition is more properly framed as a comparison of combined U.S. federal and state tax rates vs. foreign country tax rates. Voters in California, for example, recently increased the top marginal individual income tax rate to 13.3%. The result of this increase will not merely force companies out of California; because of California’s unique position as the nation’s technology and venture capital hub, the likely result will be to force companies out of the country. In that regard, confiscatory state income taxes frustrate federal tax policy and should be restrained so as to not burden interstate and international commerce.
PL86–272 prohibits a state from taxing a company’s income if it’s only activities are solicitation of orders for sales of tangible personal property which are sent outside the state for approval or rejection and are filled from outside the state. Since the enactment of PL 86-272, however, the global economy has evolved, and remote services and information technology are now significant businesses worldwide. The law, however, has not kept pace with these changes and the concepts that limit a state’s right to tax sales of tangible personal property have not been extended to other types of income.
In the new economy, companies from all over the world may do business in the U.S. with very little physical contact. Based on an ambiguity left open in Quill v. North Dakota, many states are now imposing income taxes based on “economic nexus” as opposed to physical presence. Economic nexus refers to nexus based on the amount of business done in a state. California nexus exists, for example, if a taxpayer’s sales in California exceed the lesser of $500,000 or 25% of the taxpayer’s total sales, a taxpayer’s real and tangible personal property in California exceeds the lesser of $50,000 or 25% of the taxpayer’s total of such property or if compensation paid by a taxpayer in state exceeds the lesser of $50,000 or 25% of the total compensation paid. R&T Sec. 23101.
Unfortunately, the result is a confusing and contradictory set of tax rules that complicate business decisions. A comparison of state nexus laws is compiled at http://www.cob.sjsu.edu/nellen_a/taxreform/economic_nexus.htm. Unfortunately, the trend is to tax companies that have no physical contact with a state, thus undermining Congressional initiatives designed to make the US more competitive in the global economy.
The Quill case has left the door open for Congress to define the extent of the states’ right to tax out of state businesses. Congress should act to impose a uniform nexus standard by extending PL 86–272 to income from services and intangibles.
Mandatory Tax Code conformity with respect to certain federal tax incentives
The Tax Code contains many provisions designed to encourage innovation of investment in various areas. For example, the research and development (R&D) credit encourages new R&D. Recently, the tax exemption for gains from the sale of qualified small business stock (QSBS) was extended. Again, however, the economic activity encouraged by the Tax Code is frustrated by some states’ nonconformity with federal tax law.
The Franchise Tax Board in California, for example, has recently determined that the state QSBS tax exemption is unconstitutional because it required that economic activity occur in the state. That reasoning could be extended to deny state R&D and Enterprise Zone credits as well.
The federal policy behind the enactment of the QSBS provisions (in this case, to encourage investment in startups) is frustrated by a contrary state tax treatment. At a 13.3% top marginal rate (when the federal savings was only 15% [20% in 2013]), it is easy to see that state tax treatment is almost as significant as federal tax treatment of this particular item.
The state codes are filled with provisions that contravene the policy behind the federal laws. Congress should designate certain incentives as mandatory for state tax purposes. QSBS is one example.
State compliance with international treaty obligations
One of the more significant impediments to the conduct of commerce between U.S. companies and companies in ther nations is the lack of treaty protection at the state level for foreign trading partners. U.S. income tax treaties exclude coverage of state income taxes, and no U.S. income tax treaty extends to state taxes. As a result, foreign companies regularly find themselves exempt from federal taxes but burdened by state taxes if they attempt to do business in this country.
For example, a foreign corporation might find that it is exempt from federal tax on its US business income because it lacks a US permanent establishment, yet find that it is subject to tax under a state’s economic nexus standard. Similarly, that corporation might claim an
exemption from withholding on dividends, interest or royalties under a tax treaty, yet find itself subject to state tax withholding on the same income.
When the federal government enters into an income tax treaty to avoid double taxation of income, state tax rules completely undercut that policy. The states should be required to conform to federal law in this important area.
The foregoing is a non-exclusive list of areas in which tax reform could serve to increase the table base and promote a consistent federal/state policy goal. As a tax and business law practitioner, my perspective is entirely anecdotal and economic analysis is appropriate to gauge the economic drain that results from state tax overreaching. I am available for meetings, testimony or further comments if requested.
Very truly yours,
Roger Royse, Founder
Royse Law Firm, PC