The Comprehensive Business Income Tax May 12, 2005 Kenneth W. Gideon Skadden, Arps, Slate, Meagher & Flom Washington, D.C.

2 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

3 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.

4 Comparison of Current Law and CBIT (For Domestic Taxpayers) Current Law Business EntityEquity/Debt Holder Corporate FormEquity IncomeTaxTax (preferentially) DebtNo TaxTax Non-Corporate FormEquity IncomeNo TaxTax DebtNo TaxTax Comprehensive Business Income Tax Business EntityEquity/Debt Holder Corporate FormEquity IncomeTaxNo Tax DebtTaxNo Tax Non-Corporate FormEquity IncomeTaxNo Tax DebtTaxNo Tax

5 Tax No Tax Current LawCBIT Debt Investment Corporation Non-Corporate Form Return No Tax Equity Taxable Foreign Tax-Exempt Equity Holders Debt Holders Tax Taxable Foreign Tax-Exempt Equity Taxable Foreign Tax-Exempt Debt Equity Holders Debt Holders Tax No Tax Taxable Foreign Tax-Exempt Tax No Tax Tax Debt Tax Investment Corporation Non-Corporate Form Return Tax Equity Taxable Foreign Tax-Exempt Equity Holders Debt Holders No Tax Taxable Foreign Tax-Exempt Equity Taxable Foreign Tax-Exempt Debt Equity Holders Debt Holders No Tax Taxable Foreign Tax-Exempt No Tax 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. Comparison of CBIT and Current Law (Impact on Tax-Exempt and Foreign Investors)

6 Comparison of Current Law and CBIT Current Law Differing treatment of –  Corporate and noncorporate business entities  Corporate debt and equity  Corporate and noncorporate equity CBIT Uniform treatment of –  Business entities (other than small businesses)  Corporate distributions – both dividends and interest  Returns on business equity

7 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

8 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")

9 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

10 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)

11 CBIT: International Considerations Under our current system of international taxation, foreign entities would generally be treated as non- CBIT 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

12 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

13 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

14 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