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September 2, 2010
Presidential Advisory Panel Releases Report with Tax Reform Options - Some Options Offered of Interest to Real Estate and REITs
Report and Options Do Not Represent Administration Policy
On August 27, the President's Economic Recovery Advisory Board (PERAB) released a report ( PERAB Report) that outlines the pros and cons of options for changes in the current income tax system to achieve three broad goals: simplification; improvement in compliance; and reform of the corporate tax system.
The PERAB Report is one of a long line of reports, both from presidentially appointed commissions such as President Bush's 2005 Advisory Panel on Federal Tax Reform ( Bush Tax Reform Panel), and from the Treasury Department and Congressional sources, most of which have not led to fundamental changes. Furthermore, the PERAB Report was developed by a Subcommittee of the Advisory Board and operated under a limited mandate. As a result, the PERAB did not consider "overarching" tax reform, a consumption or value-added tax or options which cumulatively would raise taxes on married individuals earning less than $250,000. Moreover, where the Report presents an option it also articulates the pros and cons associated with the option.
As further described below, the PERAB Report contains a number of proposals that could affect REITs and the entire real estate industry, including: imposition of the corporate income tax on certain large and/or publicly traded entities; faster depreciation or "expensing" for new investments; limitations on the deductibility of net interest; changes to the capital gain rules (including depreciation recapture); and, modifications to the like-kind exchange rules. While the PERAB Report does not mention REITs specifically, NAREIT recognizes that it is important to begin a dialogue with policymakers with respect to this Report to provide our industry's input and perspective.
Headed by former Federal Reserve Chairman Paul Volcker, the PERAB was given a limited mandate. While the options it proposes were meant to achieve the three goals noted above, it specifically was not tasked with recommending "major overarching tax reform" such as the 1986 tax reforms; the reforms outlined by the Bush Tax Reform Panel; or a value-added tax in addition to or in lieu of the current income tax system. Furthermore, the PERAB was asked to exclude options that would raise taxes for families with incomes less than $250,000 per year. Finally, as the PERAB Report emphasizes, the Report "does not represent Administration policy... [It] is meant to provide helpful advice to the Administration as it considers options for tax reform in the future." [1]
The PERAB Report separates its proposals into five major sections. First, it detailes simplification options. This section includes proposals concerning simplification for families and retirement and savings incentives; taxation of capital gains; tax filing; small business; and the alternative minimum tax (AMT). Second, it describes various compliance options. Third, it suggests a number of options related to corporate tax reform, including as noted above and further discussed below, subjecting firms with certain "corporate" characteristics to the corporate income tax. Finally, it proposes a number of options for changes to the corporate income tax with respect to multinational companies.
Set forth below is a discussion of the PERAB Report's proposals most relevant to REITs and the wider real estate industry. Please note that this Policy Report does not discuss the last part of the PERAB Report that could significantly impact REITs operating abroad because it does not appear that any of those proposals would affect REITs differently than other C corporations.
Corporate Tax Reform
Perhaps of greatest interest to the REIT industry is the Report's option concerning possibly
"review[ing] the boundary between corporate and non-corporate taxation" in the context of corporate tax reform. Specifically, the PERAB Report notes that while the U.S. has the second highest statutory corporate income tax rate (behind Japan) in the Organization for Economic Co-operation and Development (OECD), the corporate tax revenue raised by the U.S. as a share of GDP is the fourth lowest in the OECD.
The PERAB Report suggests one reason for this apparent incongruity is the relatively narrow corporate tax base when compared with the size of the business sector. The Report then notes five distortions in the corporate tax system that result in "deleterious" consequences. Specifically, the Report states:
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Because certain assets and investments are tax favored, tax considerations drive overinvestment in those assets at the expense of more economically productive investments. Because interest is deductible, corporations are induced to use more debt, and thus become more highly leveraged and take on more risk than would otherwise be the case. Because the corporate tax results in higher effective rates on corporate businesses, business activity and investment are shifted to non-corporate businesses like partnerships and S corporations, or to non-business investments like owner-occupied housing.... Because MNCs [multinational corporations] do not pay income taxes on income earned by foreign subsidiaries until that income is repatriated, those firms have incentives to defer repatriation, to shift taxable profits to low-tax jurisdictions, and to engage in costly tax planning; nevertheless, the system of international taxation makes U.S. MNCs less competitive in foreign markets and even at home. Because of its complexity and its incentives for tax avoidance, the U.S. corporate tax system results in high administrative and compliance costs by firms.... All of these factors act to reduce the productivity of American businesses and American workers, increase the likelihood and cost of financial distress, and drain resources away from more valuable uses.
Report at p. 65.
In order to eliminate these perceived inefficiencies, the PERAB Report offers a number of options. In one group of options, the Report suggests broadening the corporate tax base by: i) requiring firms with certain "corporate" characteristics to pay the corporate income tax; ii) limiting the deductibility of net interest expense; and/or, iii) limiting so-called "tax expenditures," those specific deductions and credits that "substantially" narrow the business tax base ( e.g., research and experimentation tax credit, low-income housing tax credit, accelerated depreciation, exemption of credit union income from gross income, etc.). None of these proposals mentions REITs or the dividends paid deduction (DPD) specifically.
In another group of options, the Report proposes reducing the marginal corporate income tax rate by: i) reducing the top corporate income tax rate; and/or, ii) increasing the immediate expensing permitted for new investments.
The most relevant of these options are discussed below. Impose Corporate Income Tax on "Corporate"-Like Entities
The PERAB Report indicates that the growth of non-corporate businesses (which it describes as " non-C corporations"), including partnerships, limited liability companies (LLCs), S corporations, and other pass-through entities, is a factor that has contributed to the erosion of the corporate income tax base. The PERAB believes a reasonable tax reform goal in this area could be "tax neutrality with respect to organizational form." The Report then suggests several ways to achieve this neutrality. -
Impose Corporate Tax on Publicly Traded Entities
The first option suggested "would be to require firms with certain 'corporate' characteristics – publicly traded businesses, businesses satisfying certain income or asset thresholds, or businesses with a large number of shareholders – to pay the corporate income tax." [2] While the Report does note that a primary factor in determining whether a business is treated as a corporation for tax purposes is its access to public markets, the Report then focuses on publicly traded partnerships (PTPs), which are fully exempt from the corporate income tax if, among other things, their income consists mainly of natural resource or portfolio-type income. The Report suggests one approach could be to end the current-law exemptions for entities with such income, or, on a more limited basis consistent with proposed legislation, to remove the PTP exception for PTPs with passive-like income derived from providing investment adviser and related asset management services. It says that doing so would "eliminate the distortions that result from different tax treatment for PTPs and from businesses that provide similar services and operate in similar ways." [3]
The potential impact on REITs from this option is unclear. To begin with, unlike PTPs, REITs of course are fully subject to the corporate income tax. However, as a result of the myriad of requirements designed to ensure that they are real estate focused, widely held, and distribute most of their income to shareholders (none of which apply to comparably operating C corporations, partnerships, LLCs, or S corporations), they may claim a DPD.
A REIT's failure to satisfy any one of these many requirements would lead to full imposition of the corporate income tax and inability to re-elect REIT status for four years unless the IRS permits such re-election before then. Because of the many requirements specifically applicable to REITs, it would be inaccurate to claim that elimination of the DPD would "eliminate distortions that result from different tax treatment ... from businesses that provide similar services and operate in similar ways." Furthermore, eliminating the DPD for REITs would ignore the policy of making professionally managed, income-producing real estate available to investors from all walks of life as well as the overarching instructions not to raise taxes on families earning more than $250,000 a year.
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Impose Corporate Tax on Certain "Large" or Widely-Held Companies
As an alternative, the Report provides an option using company size and/or number of shareholders as a basis for corporate taxation. Also, it suggests that there may be an industry or sector in which imposition of corporate tax would be appropriate, like for large S corporation banks or credit unions.
Again, the Report does not mention REITs, and seems to gear its thinking to those entities not currently subject to corporate taxation.
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Eliminate Double Taxation of Corporate Income Tax Through "Integration" with Individual Income Tax
The third option in this area provided by the Report would be to eliminate double taxation of corporate income and harmonize tax rates on corporate and non-corporate income through "integration" with the individual income tax. One way to achieve this result would be to allow individual shareholders to credit their share of a corporation's corporate income tax.
Elimination of corporate taxation through some type of integration was most recently proposed by President Bush in 2003. This proposal ultimately led to the reduction in the top marginal rate applicable to "qualified dividends" (generally that corporate income that had been subject to corporate-level tax) from 39.6% to 15%, which is scheduled to expire at the end of 2010. At the time, NAREIT engaged in a successful dialogue with Administration and Congressional policymakers to ensure that REIT dividends resulting from income previously taxed at the corporate level (e.g., taxable REIT subsidiary dividends and income subject to built-in gains tax) and REIT capital gains distributed to shareholders would be subject to the 15% top marginal rate.
The PERAB Report notes a number of disadvantages with respect to the above-mentioned options. First, subjecting more businesses to the corporate tax would increase the cost of capital and thereby decrease investment and the flow of equity into those businesses. Second, if the corporate tax were imposed on entities based on size or shareholder base, there would be many complexities – particularly relating to fluctuations of size or shareholder base and/or avoidance by splitting a large business into various parts. Third, existing pass-through businesses unaccustomed to the corporate tax rules would have to accustom themselves to these rules. On the other hand, the Report notes that there could be a reduction in the compliance burden for large pass-through businesses that currently report their income on the individual returns of their shareholders and/or partners. Furthermore, it points out that recent shifts from the corporate into non-corporate sector have resulted in some market efficiencies, for example, with respect to the formation of joint venture partnerships. Finally, it notes that integrating the corporate system with the individual tax system could result in a revenue loss because credits from corporate tax paid reduce individual tax revenues. The PERAB Report suggests these lost revenues could be offset by taxing corporate income at a higher rate than at the individual level.
Limit Deductibility of Net Interest
In order to achieve a goal of broadening the corporate tax base, the PERAB Report provides an option limiting the deductibility of net interest ( i.e., the excess of interest expense over interest income), such as by limiting deductibility of net interest to 90% of expense in excess of $5 million of expense per year (the first $5 million would be fully deductible). Current law encourages debt because interest is deductible while generally dividends are not. Limiting interest expense would reduce the disincentive against equity financing and could lead to reduced debt dependence as well as the chances of future financial distress. It also could create a more level playing field between those business projects that have easy access to debt financing and those that do not.
With respect to REITs, this proposal could have advantages and disadvantages. If enacted, it could encourage increased equity investment to REITs. On the other hand, the proposal could result in limiting interest deductions by taxable REIT subsidiaries, thereby increasing their corporate tax liability. Increase Immediate Expensing for New Investment
As a means of reducing the effective corporate tax rate, the PERAB Report provides an option with respect to the immediate expensing (deducting) of new investment. The Report notes that doing so could provide more investment per dollar of tax revenue lost than merely cutting the corporate tax rate because existing capital would not receive the "tax break." Immediate expensing also would put investments in physical capital, normally deducted over many years, on par with investments in certain intangible capital, which are deductible immediately.
While in some sense REITs and the larger real estate industry could benefit from increased depreciation deductions, the PERAB Report does note some disadvantages to this proposal. For example, it notes first that it could benefit some capital-intensive industries over other industries that invest more in intangible assets. Increased expensing for new investment also would cause a reduction in value in older investments that would not benefit from expensing. Further, if the deductibility of interest expense remains unchanged, immediate expensing of new investment could maintain or even increase the incentives for debt financing. Of course, there are significant transition issues involved with respect to such an approach, especially with respect to old vs. new assets. Simplification of Capital Gains Taxation and Reform of Depreciation Recapture
The PERAB Report contains a detailed discussion regarding the complexity applicable to the current taxation of capital gains, particularly relating to the various tax rates that apply to capital gains. For example, a maximum rate of 28% applies to gains from collectibles and sales of certain small business stock. On the other hand, real estate depreciation recapture under Section 1250 of the Internal Revenue Code is taxed at a maximum capital gains rate of 25%. Finally, the current law maximum tax rate for other capital gains is generally 15%, but is due to increase to 20% in 2011.
Furthermore, the Report also mentions current law's complexity involving like-kind exchanges under Section 1031 of the Internal Revenue Code, including deferred exchanges through intermediaries. It states "[m]ost transactions that occur under Section 1031 only loosely resemble an exchange and instead effectively confer rollover treatment on a wide range of business property and investments. Rollover treatment is conferred only if the taxpayer complies with a series of complicated rules, and there is much uncertainty surrounding these transactions." [4]Harmonize 25% and 28% Capital Gains Rates
The Report provides an option that would either tax Section 1250 recapture and collectibles at ordinary tax rates or tax them both at 25%, 28%, or at a rate between the 25% and 28%. The Report notes that eliminating or raising these "preferential" rates would disadvantage real estate held for investment. The argument for taxing Section 1250 recapture at a rate greater than that applicable to non-recaptured capital gain is that the relevant depreciation deductions reduced the tax applicable to income taxed at ordinary income tax rates. On other hand, a good argument can be made that existing depreciation useful lives are far in excess of many properties' true useful lives, and taxing Section 1250 gain at lower than ordinary income rates provides some recompense. Limit or Repeal Section 1031 Like-Kind Exchanges
The Report contains a wide variety of options for reforming the taxation of like-kind exchanges. First, it provides an option to tighten the eligibility for Section 1031 treatment. Alternatively, it proffers disallowance of the deferral of gain from like-kind exchanges entirely. Finally, it opens the door to treating developed property and undeveloped property as separate property classes, thereby prohibiting the rollover of developed property into undeveloped property from qualifying as a like-kind exchange.
The Report acknowledges that these proposals would raise tax rates on real property, and that current law provides "an escape valve" for the 35% corporate capital gains rate. If the like-kind exchange rules were limited, there would be additional pressure to lower the corporate tax rate as well as additional revenue to assist in doing so. Note that in 1989 the House of Representatives approved legislation to limit deferrals under Section 1031 to exchanges of properties that are "similar or related in services or use," but the limitation was not ultimately enacted. CLICK HERE to read the 1989 Conference Report.
As noted above, the PERAB Report does not reflect Administration policy. The PERAB also operated under constraints which do not apply to the Administration or to Congress.
At this point, it is wholly unclear whether the Administration or Congress or both have any interest in seriously considering, let alone enacting, any of its series of tax reform options.
Nonetheless, the state of the economy, together with deficit-connected fiscal issues, may provide the impetus for serious consideration of tax legislation next year and beyond. No doubt, the PERAB Report will be one of many reports and studies considered by the Administration and Congress when it undertakes such a tax legislative journey. Consequently, NAREIT will be in dialogue with relevant policymakers to provide our industry's perspective with respect to relevant aspects of the PERAB Report.
Footnotes
[1] Report at p. vi.
[2] Report at p. 75 (emphasis added).
[3] Id. at 76.
[4] Report at p. 37.
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