Time for Corporate Tax Reform

TTX Corporation fares pretty well in its annual tax bill, paying substantially less than the U.S. corporate rate of 35 percent, says Barrett Peterson, the company’s manager of accounting standards, procedures and analysis.

The Chicago-based private company, which maintains railcar fleets for North America railroad companies, has around 1,100 employees and $1 billion in annual revenue. Peterson credits the company’s low tax bill primarily to depreciation tax breaks it gets from capital investments.

But at other mid-size companies whose businesses are not as capital intensive - banks, insurance companies and other service providers, for example – high corporate taxes can stop spending on innovation and hiring. “If the corporate rate was lowered it would help because we don’t have a lot of deductions," says Howard Fowler, CFO of Transforce Inc., a Springfield, Virginia-based staffing company in the trucking industry.

Such inconsistencies and a general consensus that the current U.S. corporate tax rate is too high have politicians and finance executives taking up a decades-old discussion about reform yet again.

It’s no secret that U.S. corporate taxes are high. U.S.-based companies included in Forbes’ 2010 Global 2000 list have the sixth highest tax rate in the world, with an average effective rate of 27.7 percent compared to 19.5 percent for their foreign counterparts, according to an April 2011 report by Price Waterhouse Coopers.

In his state of the union address, President Obama called for lowering the corporate tax rate, and at the same time, eliminating most deductions and loopholes that companies use to lower their tax bill.

CFOs and finance managers at mid-size companies should pay special attention to the debate, since businesses that size often lack staff and internal knowledge needed to legally reduce their tax bill. “A huge number of mid-market companies are overpaying taxes,” says Victoria Powell, a Jackson, Mississippi, tax consultant and former tax attorney at Shell Oil. “Tax is the biggest line-item budget next to salaries, so if you can save some you are doing a good thing.”

The Problems: It’s Complicated
According to finance experts, here are some of the biggest tax issues facing mid-size companies today:

1. A complicated tax code. Over the years, U.S. tax law has become convoluted and keeping up with annual changes is overwhelming. According to Powell, companies have too many options for structuring their businesses. Choosing from multiple iterations of C and S corporations and limited liability companies, each with specific rules for filing and deductions, creates havoc. Pension law is also complicated by the different available 401(k)s, each with unique tax requirements and restrictions. “Those mean millions in deductions to companies” and in some cases, those deductions are being mishandled, Powell says.

A long history of tax breaks for different industries, business entities or situations has created a cultural expectation of special treatment, Fowler says. Lowering the corporate tax rate to 15 or 20 percent and simultaneously restructuring the code to include fewer deductions and exemptions would reduce the complexity and need for industries to lobby for specific reductions. “We need a commitment to simplicity,” Fowler says.

2. Too many exemptions. Of 500 companies in Standard & Poor’s stock index, 115 paid a corporate tax rate of less than 20 percent over the last five years, according to The New York Times. That puts mid-size companies that can’t afford the same armies of legal and accounting staff as larger corporations at a disadvantage, Fowler says. “The folks who get harmed are those who are not powerful enough to lobby, those of us who have spent decades trying to work hard and build businesses.” GE is often cited for its aggressive use of deductions. This year, the country’s largest corporation will pay no taxes, according to various media reports. “In the last few years they have had losses so they can use that to offset taxes, but they work very hard to get all the deductions and loopholes they have lobbied for over the years,” says Andrew Bareham, a CPA with KatzAbosch, a Baltimore accounting firm.

3. A current structure that hurts investors and the economy. High tax rates inhibit business growth by leaving companies less capital to hire employees or open facilities, plus they have to spend time and money analyzing a gargantuan tax code. Also, investors are less likely to put money into new or established companies if they are unsure how taxes will affect their return. “I’ve heard economists estimate that the regulatory uncertainty is costing 3 to 4 percent of GDP growth,” Fowler says. When Congress lowered rates on capital gains taxes, it triggered a surge of people selling assets and then paying taxes on the proceeds, says Robert Wood, a tax lawyer with San Francisco-based Wood & Porter. “Lower rates stimulate economic activity, and that might also be true with corporate taxes.”

4. A current structure that hurts companies’ efforts to go global. Mid-size companies know they have to go global, but there's a price to pay for international expansion. U.S. companies with foreign operations have their revenue taxed in the country of origin and again at the U.S. rate minus a foreign tax credit. To avoid such double taxation, some U.S. companies never bring earnings from foreign revenues back home, Bareham says. If they don’t, they’re not spending those earnings on new construction, R&D or other investments, which doesn’t help the U.S. economy. Most people don’t realize that name-brand U.S. companies like Microsoft, IBM and GE earn two-thirds of their revenue outside the United States and those earnings stay offshore, Peterson says.

What Next?
Within the next few years, Congress could implement a territorial tax rate that would eliminate double taxation on foreign profits. Peterson suggests cutting the corporate tax rate to 30 percent, which could require the government to offset the losses by raising taxes on consumer goods or creating a value-added tax rate (VAT). “Pick a set of rules, keep them simple and lower the rates,” Fowler says. “The result will likely raise revenue and it will certainly reduce the uncertainty that we all face nowadays.”

However, with a divided Congress and an election year coming up, most experts don't think a major tax overhaul is on the horizon. Closing loopholes and undoing all the tax breaks is much tougher than a rate change, Bareham says. “I can't see anything happening this year,” he says.

Instead, gradual reform might be a more realistic option, says Wood, the tax attorney. One example of how that approach has worked in the past is a 2006 IRS regulation that simplified how companies describe their business entity, which went from pages of documentation to a simple checkbox on the tax form. The change “was almost heresy when it was first brought up but it has eliminated a huge amount of work for tax accountants to determine how an entity should be taxed,” he says.

Powell, the Mississippi tax consultant, believes a phased approach is the best hope for reform. She says Congress should start by drawing a line in the sand about the maximum tax for any corporation or individual. “Maybe it should be that government can never take more than 40 percent of what you have.”

She also favors convening an independent commission of economists, tax lawyers, accountants, educators and other private-sector experts to study the tax code line by line and evaluate the impact of change.

Meanwhile, midsize companies could form industry groups to share information on tax rules. Such grassroots cooperation could help everyone, Powell says. “Why do you want to spend your money complying with change? That doesn't represent growth, or productivity.”