Tax Issues for High Tech - a video!

Tax issues for high tech - no doubt this will continue to be a hot area for many years to come. Changes in how we live and do business challenge existing tax rules. This a key focus for this blog and my research.

I recently delivered a one hour webinar for Accounting Fly for college accounting majors and recent alums on this topic.  They have it posted to You Tube, so if interested, I share it with you - HERE.  It is not intended to be a deep dive into complex issues, but an awareness of "high tech," some of the key rules and issues that exist, and why.  It includes a bit about the "new economy."

What do you think?

Innovation box tax reform proposal

Sample patent from Microsoft

On July 29. 2015, the House Ways and Means Committee announced that some members had drafted a bill calling for an innovation box (aka patent box), similar to what is used in a few others countries, such as the UK. Chairman Ryan praised the bill as relevant to international tax reform and helping US companies be more competitive.

The proposal has two parts:

1. 71% deduction of the lesser of (a) "innovation box profit for the year" or (b) taxable income (without the deduction).
2. Provision to allow US companies to bring back to the US foreign intellectual property tax free.

While that may sound simple, the challenge will be in defining "innovation box profits." That involves a few more definitions. It is not the definitions that will be most challenging, but identifying a company's costs relevant to each definition.

"Innovation box profits" = "Tentative innovation profit" x a ratio comparing 5 years of US R&D to 5 years of total costs. It appears that the rationale for this ratio is to be sure this primarily benefits companies that engage in a lot of R&D.  For example, if a company generated a lot of profit from a patent, but there was not significant R&D spent to create that, that company's deduction would be reduced.

There is a lot more. I won't go into to define "tentative innovation profit" but that will be the challenging area. It will be similar to calculating the Section 199 or DPAD deduction in that a company needs to identify its cost of sales and other expenses attributable to the innovation profits. That will be challenging and a key IRS examination area.

Observations:

• The proposal is a deduction rather than a lower rate on innovation profits. I note this because some of the explanatory information suggests the proposal is for a 10% rate rather than 35% rate on innovation profits, but the benefit instead is what I refer to as a "bonus" deduction in that it is not a cash outlay, but an extra deduction (similar to how the Section 199 deduction works).
• Given that R&D spending as a percentage of all spending factors in, why not just increase the research tax credit? That would be easier to calculate.  If the research tax credit remains along with the innovation box, it will be more difficult for some companies to use the credit because their overall tax will already have been reduced due to the extra deduction.
• Why not reform the research credit by increasing the percentage, keeping only the simplified version of the credit, and allowing start-up companies to also use the credit against payroll taxes (since they might not have taxable income)?  But still enact the part to encourage companies to bring their foreign IP to the US - and reform our system so that the tax rules don't encourage developing IP outside of the US to start with.
• Perhaps the innovation box is offered because the OECD BEPS project suggests this regime is permissible in that it better matches value generation with taxation (see Q&A 19 - 21 from OECD). Also, per the bill sponsors: "The OECD BEPS project will soon require every innovation box to include a nexus component. In other words, a company will have to locate its research and development—and the high-paying jobs that go with it—in the country offering the special tax rate."  However, it seems that the research credit should also be fine in that it is for R&D in the US and will reduce your US taxes.  If there are foreign profits from the R&D, they are taxed where generated (and in the US unless we also move to a territorial system).
• Why 71% and not 70%? Why not a different rate on the profits rather than a deduction? As a deduction, the issue arises as to the effect of the deduction creating a loss (negative taxable income). The proposal specifies that the innovation deduction is not considered in calculating an NOL (similar to the 199 deduction). And if a company has negative taxable income prior to measuring the deduction, there is no deduction because the lesser of (a) innovation box profit and (b) taxable income would be taxable income at zero.  In contrast, a credit carries over if not usable in the year generated.

So, it is an interesting idea to have on the table as part of tax reform discussions. Perhaps it will help highlight a need to have a system that encourage more innovation in the US and the best design for the research credit. Let's see what happens.

The sponsors are seeking comments on some specific questions including definitions and approaches for allocating expenses between the innovation profits and other sources.

Additional resources:

• Section-by-section analysis
• Technical explanation from the JCT (22 pages)
• Rationale (2 pages)
• Why needed (from House Ways and Means)

What do you think?

A Permanent R&D Credit - Will It Happen this Year?

4/29/14 House Ways & Means Committee Markup Meeting

The federal income tax credit for certain R&D expenditures (primarily wages and supplies) has been a temporary provision since first enacted in 1981 (it first expired in 1985 and has been extended about 14 times since). The temporary credit seems odd considering the following:

• Every President and probably most legislators since 1985 have called for a permanent credit.
• Unlike most other credits, there is economic justification for the credit beyond only incentivizing R&D in the U.S. There are spillover effects from a company's R&D activity and the credit helps compensate for them.
• Most countries not only have a lower corporate statutory income tax rate, but also research and innovation incentives on a permanent basis.
• Our global economy enables companies to take advantage of permanent incentives in other countries and then the US loses the R&D work. R&D work involves the need for a highly educated and compensated workforce, something good for our economy and society.
• A permanent credit would enable companies to better plan for its use likely resulting in more R&D work in the US. It is impossible to plan to fully utilize the credit when it continues to expire with renewal uncertainty (once in the late 1990s, it was left to expire for one year).
• A permanent credit means there is no need for renewal of it which often happens retroactively and diminishes the incentive value of the credit.

But, today, there is no research credit because it expired at the end of 2013.

On April 29, 2014, the House Ways and Means Committee held a markup meeting to look at just six of the 57 provisions that expired at the end of 2013. One of these proposals was H.R. 4438 to make the research tax credit permanent. It would also make significant changes including the following:

• Repeal the "regular" credit that uses the 1984-1988 base years and only keep the alternative simplified credit that looks at qualified research expenditures in the past three years for the base.
• Increases the simplified credit percentage from 14% to 20% (10% in the first year the business has QRE).

The proposal passed by the Ways and Means Committee did not include some items just recently proposed by Congressman Camp in his Tax Reform Act of 2014 discussion draft, released February 2014. The discussion draft (pages 73-74) proposed to exclude supplies from the credit as well as not have it apply to software development costs. He also proposed earlier to only increase the simplified credit to 15% (from 14%).

The Joint Committee on Taxation estimates the cost of the modified, permanent credit at about $15 billion per year (JCX-44-14).

For a list of the other five expired items the committee voted to make permanent, click here.

Next steps?  The House needs to vote and the Senate Finance Committee needs to review and the Senate vote.  Then if both the House and Senate have approved, it would go to President Obama for signature. I think if it all goes as separate bills, the research credit has a better chance of being made permanent because President Obama has also called for a permanent credit (see FY2015 Greenbook, page 12).

The issue of whether renewing expired provisions requires revenue offsets must be resolved.  The House Ways and Means Committee has posted a piece from the Heritage Foundation (4/28/14) that says renewing an expired provision is not a tax cut so it does not need a revenue offset for revenue neutrality. The issue relates to assumptions made (or not made) in the CBO baseline and estimates of discretionary spending. Congressman Camp seems to be following the assumption that revenue offsets are not needed as there are none for the permanent tax credit and the Heritage Foundation article is posted to the committee's website.  Others say that extending tax cuts (such as a credit) requires revenue offsets (tax increases or spending cuts) to be revenue neutral. See articles from the Center for Budget and Policy Priorities (CBPP) and the Committee for a Responsible Federal Budget (CRFB). I agree with the CBPP and CRFB. The CBO baseline assumes that expired provisions permanently expire. Also, one of several reasons why these provisions are temporary rather than permanent is that when a tax cut is in only one year of a ten-year budget, it costs less than if it were in for each of the ten years. Thus, bills with these items only in as temporary measures don't need as much revenue offset.

We'll see what happens with H.R. 4438. It certainly has support and I believe it can also be down outside of tax reform as there are reasons that justify having a research tax credit (see a few more in testimony on incentives for innovation I delivered to the Senate Finance Committee in 2011).

What do you think?

SJSU MST's Contemporary Tax Journal publishes Spring/Summer 2013 issue

I'm proud to announce the publication of the 4th issue of the student-run, online journal of the San Jose State University MST Program. You can find the journal here (current and past issues):

http://www.sjsumstjournal.com/

Here are the topics covered in the Spring/Summer 2013 issue:

TAX ENLIGHTENMENTS

• 100th Anniversary of the 16th Amendment 
• Research Credit: A Journey of Uncertainty
• Nonqualified Use of Principal Residence 
• A Tax Haven in the Friendly Sky?

ARTICLES

• Apple's Big Win Highlights Uncertainty in Valuing Tech Investments
• Seeking articles - see our submissions policy

FEATURE

• Summaries from the 28th Annual TEI-SJSU High Tech Tax Institute
• Summaries from the TEI-SJSU Tax Policy Conference - Tax Reform: Status, Needs and Realities

FOCUS ON TAX POLICY

• Transferability of the Research Tax Credit
• Return of the 20% Capital Gains Rate for Certain High Income Individuals 
• Surtax on Millionaires 
• Excessive Compensation - How Much is Too Much? 
• Increase and Make Permanent the Research Tax Credit 
• Preferential Treatment of Capital Gains
• Repeal of the Inclusion of Social Security Benefits in Gross Income 

TAX MAVENS

• Dan Kostenbauder, VP Tax Policy, Hewlett Packard Company 
• Fred Silva, Senior Fiscal Policy Advisor, California Forward  

There are wonderful pieces here - I hope you'll take a look!  Thank you!! 

Groups Raise "Corporate Welfare" Argument in California

This month, the Reason Foundation and Howard Jarvis Taxpayers Foundation released a 59-page report - Tax Credits in California - Economic Growth Engine or Wasteful Corporate Welfare?  The report suggests that California would be better off eliminating several corporate income tax and sales tax preferences applicable to corporations and lowering the corporate tax rate. The report also notes one property tax preference for certain computer programs (no mention of the favorable reassessment rule that corporations benefit from in the Prop 13 shaped property tax system).

Per the report:

"If these tax breaks could be eliminated and replaced with across-the-board tax cuts, California’s economy would benefit significantly from more innovation, more economic growth and greater satisfaction of consumers’ desires. The only real losers would be the companies currently benefitting from the tax breaks. As it is, special carve-out incentives for some mean higher tax rates for everyone else."

The report also notes that per data from the Legislative Analyst's Office (also from the Department of Finance), tax expenditures total about $30 billion annually in the personal income tax, $5 billion in the corporate tax and $9 billion in the sales tax. The report focuses only on the $5 billion. The tax benefits or "breaks" focused on in the report include the research expense deduction, research tax credit, film credit, hiring credit, expensing of timber growing costs, sales tax breaks for farm equipment and periodicals.

The report does a good job of explaining some of the key arguments against special rules in the tax system, such as lack of transparency and accountability and economic inefficiency.

But, I think the report does some disservice for these reasons:

• Focusing on part of the $5 billion of corporate tax expenditures rather than the bigger amounts in the personal income tax ($30 billion per year) and the sales tax ($9 billion per year). And the sales tax total of tax expenditures does not include the billions not collected because California's sales tax system exempts consumption in the form of personal services and digital goods.
• Focusing on "credits" in the title of the report and for most of the "waste."  Why not refer specifically to tax breaks or tax expenditures. Not all special tax breaks are tax credits.  In the personal income tax, the largest tax expenditures are deductions (such as the home mortgage deduction which is the largest of all tax expenditures) and exclusions (such as for employer-provided health care).
• Not addressing potential benefits to the state of the research deduction and tax credit. California has a generous research tax credit and can serve as an economic development tool to attract high paying jobs. While the report notes some research questioning the value of this credit (which is already incentivized at the federal level), it overlooks other problems in California that may lead businesses to not want to locate in the state. For example, in California, companies pay sales tax on manufacturing equipment - something not owed in most states. The report calls for having more businesses pay sales tax by removing some current exemptions.
• Why not more on property tax reform? (Yes, I know one of the co-authors is a strong supporter of keeping Prop 13 unchanged.) There are arguably some inefficiencies in the property tax as applied to businesses in that the same size and type of businesses may have drastically different property tax bills, which can cause competitive advantages and some businesses paying more so others can pay less.

But, I encourage reading of the report.  It is timely in that at the federal level, many elected officials are calling for base broadening - for both individuals and businesses. The report raises the profile of the cost of tax expenditures and raises some good points, albeit, in my opinion, with a few problems noted above.

What do you think?

California and Incentives for Job Creation and Innovation

On 12/5/11, the California Assembly Revenue & Taxation Committee held a hearing on job creation and innovation (see prior post). I had the opportunity to testify. A few points I offered:

• California has one of the most generous research tax credits among the states and an underutilized jobs credit. Identify why these provisions are not promoting job creation and innovation to the desired level. For example, in 2009, $400 million was set aside for a $3,000 per new job tax credit for employers with employees with less than 20 employees. In November 2011, only $75 million has been used.
• Conform California law to more favorable depreciation rules of federal MACRS and Section 179 expensing. Encourage Congress to allow the IRS to update depreciable lives, such as for computers and semiconductor manufacturing equipment which generally is too long (5 years). In addition, encourage Congress to modernize Section 179 to apply to both tangible and intangible assets. While there should be discussion of whether any special rules, such as tax credits, should be in the law (they tend to add complexity and inequities and inefficiencies), there are considerations in designing the base that affect the economy. For example, to calculate taxable income of a business, depreciation needs to be calculated. If equipment can be depreciated using double-declining balance over 3 years, that has a different economic impact and affect on interstate and international business competitiveness than straight-line over 10 years.
• Encourage Congress and the IRS to improve the federal research tax credit including making it permanent.
• Develop a plan to phase out the sales tax on business purchases of manufacturing and R&D equipment. This might be funded by broadening the sales tax base for consumers to include consumption of personal services and digital goods, and to repeal the elective approach to apportionment (adopting the single sales factor approach due to its economic development foundation).
• Be ready with incentives for corporations to utilize cash in California should the federal government enact a repatriation tax break.

I had 18 recommendations which you can find here.

Four items in particular I found interesting about the hearing:

1. Three people testified via Skype - we could see and hear them well and they could hear us and participate. It did go down once for a few minutes, but technicians restored the connections.
   
2. The business rep panel for the most part suggested that California needs to get rid of the elective apportionment and go to just single sales factor apportionment. I agree and had the opportunity to note that, today, the corporate income tax has become an economic development tool. Thus, if we want to use it to encourage companies to locate employees and property in the state without having their tax bills go up, we offer single sales factor apportionment. But, at the same time to tell companies that do not locate payroll and property here, we want your CA taxes to be lower too, we are just fools (I didn't say fools, but that is what we are).
3. Professor Robert S. Chirinko, University of Illinois at Chicago, shared some of his research findings on the benefits of jobs credits. In a nutshell, that research found that there were no benefits. He also noted that such provisions can have some negative impact because when enacted, the incentives are not usually immediately effective so employers delay hiring until the effective date.
4. The Legislative Analyst's Office seems to have modified its view on the California research. James Nachbaur, an economist with the LAO presented a background paper on the credit. In a 2003 report, the LAO stressed that a key purpose of a research credit is to address spillover effects, but that the federal credit already handles that so why would a state also offer a credit? The 12/5/11 report notes that 2003 comment, but does not emphasize it. I think this may be because since 2003, corporate income taxes have become more of an economic development tool meaning that we should view a state research credit primarily in terms of whether it causes companies to engage in R&D in the state rather than elsewhere.

The hearing information should be posted to the committee's website soon.

What do you think?

President Obama's New Stimulus Proposals & Tax Policy

Over Labor Day Weekend, President Obama announced new plans to help stimulate the economy (9/8/10 post to White House blog + Wall Street Journal, 9/6/10 "Obama to push tax break"). The plans include:

• Research tax credit - eliminate the 20% regular credit that uses a base period of 1984 - 1988 and just have the simplified credit but increase the credit rate from 14% to 17%; make this credit that has been temporary since 1981 permanent. [White House fact sheet]
• Equipment expensing - allow businesses to fully expense equipment in the year of purchase through 2011 (so rather than extending 50% bonus depreciation, move to 100% expensing). [White House fact sheet]
• Permanently extend tax cuts for middle class individuals. In the press release, President Obama indirectly acknowledges that he means 98% of individuals when he refers to this group of taxpayers (he refers to efforts to hold up his plan by those who want to also extend the cuts for the "wealthiest two percent of Americans").
• Wants Congress to pass the small business jobs bill that includes a broadened exclusion for qualified small business stock (IRC Section 1202).
• Additional support for middle class families including making the American Opportunity Tax Credit permanent.

While President Obama is proposing these measures as economic stimulus, given that a few are permanent, it goes beyond that goal. Would these changes move our tax system into the 21st century and meet principles of good tax policy? Overall, I don't think so.

My observations:

• Research tax credit - I think this is a good move. It simplifies the law by having only one formula for calculating the credit. It brings certainty to this temporary measure that has been extended at least 12 times. It last expired on 12/31/09 so businesses have been waiting over 8 months to know if it will be extended for 2010. While they might believe that it will be given that it has been retroactively extended in the past (other than one year), companies cannot make that assumption on financial statements which causes challenges. Also, when companies are looking at where to locate R&D operations, the US doesn't look too good relative to countries with permanent R&D incentives. Since the credit only applies to R&D labor in the US, a permanent credit sends a strong message that the US does want to have these high-paying jobs here.
• Temporary expensing of assets - this really is a timing adjustment rather than a new tax deduction. Relative to 50% bonus depreciation, full expensing is easier. One thing I wonder is whether such an incentive might cause a significant increase in equipment purchase only to drop off thereafter which would hurt companies that provide the equipment. Expensing might be a starting point to further business tax changes such as changing from an income tax to a consumption tax, such as a business activity tax (BAT). [For more on BAT, see Tax Notes article by Bill Barrett.]
• Permanent tax cuts for 98% of individuals described as the middle class - I think this is too expensive and unrealistic. I really don't believe that a married couple making up to $250K (or unmarried person making up to $200K) is the middle class. Given our large, unending deficits and debt, I don't think it makes sense to extend a temporary tax cut to such a large group of individuals. Also, the dollars not used for such a broad tax cut could be better targeted to provide real economic stimulus on a temporary basis without jeopardizing forever the ability to reduce the deficit and pay down the debt.
• Temporary 100% exclusion (rather than 50%) for qualified individuals who acquire "qualified small business stock" during the stated time period. I think this could be effective stimulus if it encourages people to want to invest in qualified businesses. High income/wealth individuals can best afford to make these investments, but I think this is still better stimulus than an across the board capital gains tax cut (such as the President wants to give to 98% of individuals), because it is targeted to encourage new investment.
• Permanent American Opportunity Tax Credit - I think this is too generous in that it helps a married couple with up to $180,000 of income get cash to pay for a child's college tuition. I think equity could be better served by using the money to help those who can truly not afford to get a Bachelor's, Master's or doctorate to do so rather than giving cash to people who can afford to send their child to college and beyond. Also, this credit is focused on those individuals fortunate enough to complete college in four years. Today, data on graduations is tracked using a 6-year graduation rate, yet this credit only covers the first 4 years of college. I have more on this one in a recent article in the AICPA Tax Insider - here.
• PAYGO - the only tax cut above that doesn't need to be "paid for" is the extension of tax cuts to 98% of individuals. That is the legal reality under the PAYGO rules, although not the budget reality (after all, there is no free lunch!). The other provisions, need revenue offsets (tax increases). So, it is not possible to provide a full analysis of the proposals until the entire tax package is available - we shouldn't forget that! [For more on PAYGO: Congressional Research Service report, PricewaterhouseCoopers article, and White House OMB information.]

What do you think?

The Research Credit - The Saga Continues

In recent times, I've written about an almost 50-year old temporary provision of the law (PL 86-272 on nexus for income taxes), this post is about a 28 year old temporary provision - our federal research tax credit. It's odd that it has remained temporary for so long because all presidents since 1981 and most of Congress has said they support a permanent credit. President Obama's 2010 revenue proposals include making the credit permanent (p. 15) - we'll see what happens.

While the research credit was created and has been renewed over ten times to benefit the economy, some taxpayers have likely found it to be a difficult or mysterious provision. A recent taxpayer victory on the documentation needed to claim the credit on amended returns and what guidance applies in interpreting terminology, illustrates the challenges and frustration that both taxpayers and the IRS face in dealing with a temporary provision (its temporary nature causes it to not go too high on the list for issuing guidance).

I've got a brief article on the recent case (McFerrin) and current proposals for modification and permanence you may find of interest: The Research Credit — The Saga Continues, recently published in The AICPA Corporation Taxation Insider.