The current innovation box proposal abandons pass-throughs
Lawmakers have unveiled a new proposal that exclusively provides C corporations with a reduced tax rate on income from producing goods tied to U.S. intellectual property (IP). The “innovation box” proposal would define IP broadly to include patents, inventions, formulas, processes, designs, patterns, know-how, videos, and computer software. It applies to products sold both in the U.S. and abroad, and is limited only by a company’s research expenses. It essentially offers a broad-based rate cut for all C corporations producing goods and performing research, while excluding identical businesses organized as pass-throughs.
Grant Thornton supports efforts to make the U.S. tax system more competitive for business investment, but believes any new incentives should be available to all U.S. businesses, regardless of their form.
No businesses – especially the dynamic pass-through businesses that drive U.S. economic growth – should be placed at a competitive disadvantage.
Pass-throughs represent the fastest-growing and most important segment of the economy
Grant Thornton urges lawmakers to make all business eligible for any innovation box.
How the innovation box works
An innovation box is the equivalent of a rate cut on certain types of income. The version currently under discussion would provide a 71% deduction for qualified income from production tied to domestic IP. Thus, creating a reduced effective rate for C corporations that keep their IP in the U.S. A company’s deduction is calculated by:
- Determining income from domestic IP (the definition of IP is broad, nearly any production will qualify).
- Multiplying this IP profit by the ratio of domestic R&D costs over the last five years to total costs (other than cost of sales, interest, and taxes) over the last five years.
- Multiplying the result in step 2 by 71%.
The final amount can be deducted by the C corporation, providing a reduced effective rate for production income tied to IP. In addition, under the proposal companies can move its foreign-based IP back to the U.S without paying any U.S. tax on the transfer, so that this “domesticated” IP may be eligible for the innovation box.
Impact puts pass-throughs at a competitive disadvantage
Pass-through businesses face the same international pressure as C corporations. Fairness demands that all businesses, whether organized as traditional corporations or as pass-throughs, be treated equally. Otherwise, the innovation box proposal puts domestic pass-throughs at a competitive disadvantage against domestic corporations for activity here in the U.S.
The cost of the proposal is also expected to be offset by the elimination of tax benefits currently available to all businesses, such as the expensing for research costs under internal revenue code section 174. This would result in a tax increase for partnerships, S corporations and sole proprietorships, who would receive nothing in return for giving up a valuable tax benefit.
Pass-throughs would have less after-tax revenue than their C corporation competitors, making it more difficult for them to expand both activity and employment. Consider two U.S. producers who each keep their IP in the U.S. They have identical income, and each business spends approximately 25% of expenses (minus the cost of goods sold, interest, and taxes) on qualified research. The innovation box deduction increases the C corporation’s rate advantage over the pass-through from 4.9 percentage points to over 11, and gives it $540,000 more to invest back into its business.
If the goal of international reform is to provide a more competitive tax landscape for U.S. companies, it is unfair and unproductive to arbitrarily exclude a core business segment based on entity choice. An innovation box cannot be successful if it excludes 4 out of every 5 businesses. It should not provide a domestic C corporation with a new benefit and unfair advantage against a domestic pass-through for activities here in the U.S.
We ask you to make pass-throughs eligible for any innovation box or other incentive geared to make U.S. businesses more competitive internationally.
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