The Trump Administration and the Republican leadership in the House and Senate have made comprehensive tax reform a top priority in 2017. Major changes to the tax code for businesses are expected, including reductions in corporate tax rates and taxes for pass-through income.
FEI Daily spoke with the 2017 Tax Council Policy Institute (TCPI) Pillar of Excellence Award recipient Pamela (Pam) F. Olson, PwC U.S. Deputy Tax Leader & Washington National Tax Services Leader, on The House GOP tax reform Blueprint, the border adjustment proposal, and how to deal with path dependence.
FEI Daily: While simplification and lower tax rates will be cheered by U.S. businesses, what kind of challenges will the first major changes to the Internal Revenue Code since 1986 present to corporate tax and finance executives, especially in regard to internal processes, policies and operations?
Pam Olson: Some of that depends on how significant the tax changes are. If we were to adopt a system like the House Blueprint, where we’re essentially switching from an income tax to a consumption-based tax, there will be huge operational changes that would have to be made to capture different kinds of information and put systems in place to be able to comply. If we make more minor changes, if we were to go with a Dave Camp H.R.1 style tax, which is base-broadening and rate-lowering, then fewer changes would be needed. There would still be re-programming that would have to be done but it wouldn't be anything near the scale of change that would have to occur if we adopt something like the House Blueprint.
FEI Daily: The House GOP tax reform Blueprint proposes a 25 percent tax rate for income generated by pass-through entities, while the Trump plan has called for taxing pass-through income at 15 percent. Regardless of where the number ends up, many taxpayers may try to game the system by receiving compensation from their employers through a pass-through entity. How could Congressional tax writers structure the pass-through provision to prevent tax avoidance? Could any potential limitations have an impact on legitimate pass-through entities’ ability to take advantage of the new rate?
Olson: Yes. The way I think about what they are trying to achieve with the lower rate on pass-through businesses is essentially to capture the equivalent of corporate income, and to tax that at the 25 percent rate. That means you have to separate out, as occurs at the corporate level, all the things that are wages and salaries, or wages and salary equivalent, because all of that part of the enterprise’s income should be taxed at the 33 percent rate. It should be taxed at whatever the earner's rate is. That should be separated from the income that’s the equivalent of the corporate income tax that’s eligible for the lower rate.
A lot of that is going to be return-on-capital kinds of income, so one of the things they can do would be to say that some categories of business don't get the 25 percent rate because they are not relying on capital to produce their return. Accounting firms might not be put into the category of business that can claim the pass-through benefit.
If you did that kind of thing, you would start to separate out who are your pure service providers that don't rely on much in a way of capital to generate the return, whose income is basically wages and salary that should be taxed at the higher rate. Just take those kinds of businesses out of the mix and then what you'd be left with is the kind of business that does rely on capital to generate their profits. You’d still have to figure out how to separate out what should be paid out as wages and what’s the remainder that should be eligible for the lower rate. It won't be easy. If they do draw some bright line and say "This kind of business is a service oriented business. It does not qualify," there will certainly be businesses that complain about it. But that’s the easiest way to separate wages and salaries from the profits of the business.
FEI Daily: The House Republican leadership’s tax plan would generate significant revenue to help offset revenue lost due to reduction of corporate tax rates. Why is the border adjustment plan so controversial?
Olson: Neil Irwin’s had a really good article in the New York Times (A Tax Overhaul Would Be Great in Theory. Here’s Why It’s So Hard in Practice). He talks about path dependence and how we make public policy choices that dictate the way businesses organize themselves and structure their operations. If you want to change one of those rules, you would end up with a lot of resistance from the people who are path-dependent on the direction that we've gone.
When I was at Treasury, one of the proposals that we worked on was an enormous simplification proposal that dealt with retirement savings and all other savings. We created two special savings accounts that were intended to replace the other different kinds of saving accounts in the code. One is called "Retirement Savings Account" and the other one is called "Lifetime Savings Account." You could use a Lifetime Savings Account for health, education, or when your refrigerator broke and you needed to replace it, and this would avoid you having to borrow money to buy the refrigerator. You could use it for any purpose that you wanted. The idea was to make it simple as you possibly can so people don’t worry about putting money into the savings account that they won't be able to get back out again except for particular purposes without paying penalties.
We encountered enormous resistance from the education savings account providers, the medical savings account providers, and the retirement savings account providers who had built up their plans’ infrastructure on the basis of what the rules were on the code — and all of the sudden they were saying "we are going to rip those out." They worried they were going to lose their customers for their peculiar savings account, whatever it might be. That's path dependence. We've had that in spades with the House Blueprint.
For the border adjustment, if the economists’ projections are right and the dollar appreciates in value enough to offset the lost deduction and offset the gained benefit from exporting goods that aren't included in taxable income, then it all washes out and it doesn't matter. But the fear that a lot of people have is that even if I accept the premise that it’s going to adjust, I'm not sure how fast it's going to adjust. I don't know whether it's going to adjust evenly. Will the dollar will appreciate more against the Peso than it does against the Loonie, or more against the Pound than it does against the Euro, and those kinds of changes happen on a daily basis. Companies put in place hedging plans to deal with the risks associated with it. But this is an unknowable, and so everybody is scrambling to try to figure out how to arrange or rearrange their affairs today to anticipate what’s coming down when they don't know what's coming down.
FEI Daily: With regard to tax administration, many large companies feel that IRS audits have become inefficient and unmanageable, and many companies have expressed frustration with some of the IRS’ examination practices, particularly when it comes to using outside vendors to participate in exams. Do you expect any of those issues will be addressed by Congress this year?
Olson: The House Blueprint does have a plan to try to make the IRS more service-oriented and user-friendly. We need to help the IRS adapt. Now if we were to actually do what the House Blueprint talks about, stripping the IRS down so it’s got two different operations. Taking the enforcement function and putting it somewhere else. And then having the service function that helps taxpayers pay their taxes, understand what their responsibilities are, satisfy the liabilities, etc. That might take a little bit of the confrontation out of the arrangement. But we really need to change the mindset at the IRS and I'm just not sure whether a statutory change in the organization is going to do that.
FEI Daily: What’s the biggest change you’ve seen in tax?
Olson: The biggest change is probably what’s happened in the rest of the world while we’ve stayed static. Every other country is changing its tax system to adapt to the changes and methods of doing business, and their increased reliance on a consumption tax, which isn't an immobile tax base, versus relying on a corporate tax base that is very mobile. Every other country has gone in that direction. They’ve lowered their tax rates. They’ve adopted territorial systems. They’ve focused on capturing the tax based within their jurisdiction without trying to go around the world, while we have stayed focused on taxing around the world.
FEI Daily: Congratulations on receiving the Pillar of Excellence Award. As a leader in tax law, policy and administration, both in the public and private sector, what does this award mean to you?
Olson: It's a tremendous honor to get the Pillar of Excellence Award because the planning committee is your peers and your clients. I have been around the tax community and tax policy community in particular, for a number of years. When I started my career in Washington I was working on legislation and regulation, and then I started doing tax policy-related projects like commenting on regulations and testifying on the Hill, and then I went to Treasury. Of course, Treasury is all about tax policy. I spent lots of time around the business community understanding their issues and what needed to be fixed in the tax code.