The Comprehensive Business
Income Tax
May 12, 2005
Kenneth W. Gideon
Skadden, Arps, Slate, Meagher
& Flom
Washington, D.C.
Comprehensive Business Income Tax (“CBIT”)
•
CBIT was an option in a 1992 Treasury Study
•
CBIT’s objective was to tax all business income
only once and to eliminate economically inefficient
current corporate tax law distortions that:
 Favor corporate debt over equity finance
 Favor the noncorporate over the corporate form
 Favor corporate retentions over distributions
•
Goal of CBIT: promote simplification and fairness
by taxing corporate and noncorporate business
entities using a single set of rules
2
CBIT: General Overview
•
Uniform Business Level Tax – Income of almost all
business entities would be measured and taxed at the entity
level (very small businesses, measured by gross receipts,
were excluded from CBIT)*
•
No Investor-Level Tax on Distributions – Distributions of
business income – whether as dividends or interest –
generally are not taxed when received by investors
•
Losses -- Losses incurred at entity level do not pass through
to equity holders – unused losses can be carried over at the
entity level
•
No Interest Deduction – No business-level deduction is
allowed for interest expense
* The CBIT study recognized the difficulty of separating returns to capital from returns to labor in very small
businesses. CBIT could therefore overtax labor income to owners of , e.g., small proprietorships if CBIT rate
was above the relevant proprietor’s individual income tax rate.
3
Comparison of Current Law and CBIT
(For Domestic Taxpayers)
Current Law
Corporate Form
Non-Corporate Form
Business Entity
Equity/Debt Holder
Tax
Tax (preferentially)
Debt
No Tax
Tax
Equity Income
No Tax
Tax
Debt
No Tax
Tax
Equity Income
Comprehensive Business Income Tax
Corporate Form
Non-Corporate Form
Business Entity
Equity/Debt Holder
Equity Income
Tax
No Tax
Debt
Tax
No Tax
Equity Income
Tax
No Tax
Debt
Tax
No Tax
4
Comparison of CBIT and Current Law
(Impact on Tax-Exempt and Foreign Investors)
Current Law
CBIT
Equity Holders
Corporation
Return
Equity
Tax
Tax
No Tax
Tax
No Tax
Debt
Taxable
Foreign
Tax-Exempt
Corporation
Return
Debt Holders
Tax
Taxable
Foreign
No Tax
Tax-Exempt
No Tax
Investment
Equity
Tax
Tax
Debt
Equity Holders
No Tax
Taxable
Foreign
No Tax
Tax-Exempt
No Tax
Debt Holders
Taxable
No Tax
Foreign
No Tax
Tax-Exempt
No Tax
Investment
Equity Holders
Equity Holders
Equity
No Tax
Return
Non-Corporate
Form
Debt
Tax
Tax
Tax
Taxable
Foreign
Tax-Exempt
Debt Holders
Tax
Taxable
No Tax Foreign
Tax-Exempt
No Tax
Equity
Tax
Return
Non-Corporate
Form
Debt
No Tax
No Tax
No Tax
Taxable
Foreign
Tax-Exempt
Debt Holders
No Tax Taxable
No Tax Foreign
No Tax Tax-Exempt
Note: The illustrations do not take into account (i) tax preferences or taxes imposed by other countries or (ii) the
15% dividend rate for qualifying dividends under current law.
5
Comparison of Current Law and CBIT
Current Law
CBIT
Differing treatment of –
Uniform treatment of –
 Corporate and noncorporate
Business entities (other than
small businesses)
business entities
 Corporate debt and equity
Corporate distributions –
both dividends and interest
 Corporate and noncorporate
 Returns on business equity
equity
6
Economic Benefits of CBIT
 In 1992, the Treasury Department found that CBIT
would produce welfare gains from—
1. Improved consumption choices by improving the
allocation of resources among investments
2. Improved corporate borrowing policy
3. Improved corporate dividend payout policy
 Treasury compared the welfare gains of CBIT to the
shareholder allocation, imputation credit and
dividend exclusion prototypes
 Although each of the integration prototypes studied
promoted more efficient consumption, corporate
borrowing and corporate dividend policies, CBIT
provided the largest annual welfare gains of the
proposals
7
CBIT: Treatment of Tax Preferences
 Because the current business tax base includes many
preferences, exclusions, and credits, some income is untaxed
 If the current business tax base is combined with CBIT, there is
a potential for tax-free distributions of untaxed business income




Special rules would be needed to prevent tax-free distributions to
shareholders because of preferences, exclusions, and credits
Example: XYZ Co. earns $100 of taxable income and $50 of tax-exempt
income. XYZ pays a 30% tax on $100 of income and distributes the
remaining $120 as a dividend to its shareholders
If all business distributions are tax-free, shareholders would be shielded
from any level of U.S. tax (corporate or shareholder) on the $50.
Preventing this result requires a mechanism to track dividend
and interest payments made out of tax-preferred income
(“Preference Income")
8
CBIT: Treatment of Tax Preferences
•
Two Options for Treatment of “Preference Income” –
 Option 1: Include in investor's income and tax at the
investor's ordinary tax rate
 Option 2: Tax distributed preference income at the business
entity level
•
In either case, corporate distributions would be
treated as arising first from income subject to the
regular CBIT tax
•
Option 1 better promotes economic efficiency
because it does not distort corporate distribution
decisions; Option 2 is simpler
9
CBIT: Design Issues and Anti-Abuse Rules
•
To track preference income, an Excludable
Distributions Account ("EDA") could be used to
track U.S. tax-paid income and limit tax-free
distributions to that amount
•
Anti-abuse rules might be needed to:
•
•
•
Disallow interest deductions on debt-financed
acquisitions or investments in CBIT businesses;
Distinguish nondeductible interest payments by CBIT
entities from deductible rental and royalty payments; and
Distinguish nondeductible interest payments by CBIT
entities from principal payments on capital equipment
purchases (capitalized and deductible)
10
CBIT: International Considerations
• Under our current system of international taxation,
foreign entities would generally be treated as nonCBIT entities – interest received from foreigners
would be taxed
• Income shielded from U.S. tax by tax credits under
current law would be treated as Preference Income
taxable to a U.S. lender
• CBIT’s parity objective for debt and equity means
no withholding taxes on both interest and dividends
paid to foreign entities
 Eliminating withholding taxes reduces U.S. leverage in
bilateral tax treaty negotiations
 Lack of deductibility of interest represents a major
departure from current U.S. policy on inbound debt
investment
11
CBIT: Financial Intermediaries
• Financial intermediaries generally earn most of their
income in the form of dividends and interest
 If received from CBIT entities, such income would be
exempt from tax
• Financial institutions generally incur substantial
non-interest expense to produce net interest and
dividend income
 Financial institutions may respond by attempting to
recharacterize interest income as fee income to allow
CBIT borrowers to deduct such fees while financial
institutions deduct operating expenses against such fee
income
 Recharacterizing interest income as fees may permit
better matching of a financial institution's income and
expenses – but is problematic with respect to borrowers
12
CBIT: Market Impacts and Transition
• Interest rate on CBIT debt (tax-exempt to holders)
should be lower than interest rate on non-CBIT
(taxable) debt
• State and local debt will lose tax advantage
• Long phase-in of CBIT advisable to mitigate effects
on borrowers and lenders
• Transitional anti-abuse rules may be necessary to
prevent acceleration of interest deductions and
deferral of interest income
• Grandfather rules should be avoided
13
CBIT: Combination with Other Proposals
• Combination of CBIT with other proposals
(e.g., expensing) could move the current
income taxation of business towards a
consumption tax
• Combination of CBIT without limitations on
the debt financing of CBIT debt and equity
instruments could lead to arbitrage
opportunities by investors
• Combination of expensing without CBIT
treatment of debt will lead to arbitrage
opportunities by businesses
14