Tax Reform: Who Pays, Who Profits : Would Pay : <i> High-Tech Company Could Lose Big</i>

“‘When there is an in come tax,” Plato said, “the just man will pay more and the unjust less on the same amount of income.”

Twenty-three centuries later, the Treasury Department has concluded much the same. It doesn’t buy the Greek philosopher’s premise that income taxes and justice are mutually exclusive, of course.

But in its mission of tax reform, the Treasury has acknowledged that injustice runs deep in the tax laws and must be routed out. On the other hand, many taxpayers would pay a heavy price for the reforms.

To translate the Treasury’s theories to real-world cases, The Times examined how the taxes of three individuals and two companies would be affected if the agency’s tax-simplification proposal were enacted in full. Tax calculations were performed by the Los Angeles office of the Price Waterhouse accounting firm.

The analysis relies on several assumptions: All provisions have been phased in; inflation is at 4%; and the proposed depreciation method was in effect when assets were acquired. To calculate taxes under current law, 1984 tax rates and law are used, even when the taxpayer’s most recent available numbers are from the 1983 tax year.

Among the case studies, the individual “winner” has relatively low income while the individual “loser” is a wealthy man with substantial tax shelters. The family for whom the proposed changes would result in a wash, falls somewhere in the middle.

The business “winner” is in retailing, an industry that isn’t favored under the current tax system. The corporate “loser” is a high-technology company. Some analysts had speculated that high-tech companies would fare well, especially in comparison to smokestack industries.

Two years ago, prompted by U.S. government incentives, Z Company moved some of its computer manufacturing operations from its Southern California headquarters to Puerto Rico and saved millions of dollars in the process.

The company’s savings stem not from lower wages--which are in line with its compensation to California workers--but from taxes. As an incentive to business investment in its island possession, the U.S. government provides tax credits to subsidiaries of U.S. manufacturing companies doing business in Puerto Rico.

Last fiscal year alone, the small but fast-growing and profitable computer equipment and peripherals company paid only $350,000 in taxes on its Puerto Rico earnings--and those were in Puerto Rican taxes; it paid no U.S. income taxes on the earnings--instead of the $2.76 million it would have paid had there been no tax break.

Now, as part of its ambitious proposal to simplify the nation’s tax laws and rid them of favoritism, the Treasury Department suggests that the tax break given U.S. companies with operations in Puerto Rico be abolished. At first, it would replace the existing tax credit with a wage credit, which would gradually be phased out.

Because it derived more than 80% of its pretax earnings in fiscal 1984 from its Puerto Rico manufacturing operations, Z Company (along with Puerto Rico) would emerge as one of the big losers of tax reform if this provision survives the legislative process.

Not even the huge tax cut that would result from the proposed reduction in corporate rates to 33% from the 46% rate Z Company currently pays would make up for the loss of the lucrative Puerto Rico tax break. This one change would reduce the company’s earnings by about $1 million, or 56%.

Out of fear that the merest mention of this proposal and its potential effect on future earnings would send the company’s stock price tumbling, Z Company agreed to participate in this detailed study of the proposed reforms only if its real name isn’t used. Other companies interviewed for possible participation in this project expressed the same concerns.

Some even suggested that this concern is a major reason why many companies have not been as vocal in objecting to the Treasury’s plan as some expected.

Under the Treasury proposal, Z Company also would lose its investment tax credit, which cut $350,000 from its tax bill in fiscal 1984. Additionally, it would lose some tax benefits it now receives from entertaining business customers and from the accelerated depreciation of its capital assets.

In all, the proposals when fully implemented would more than double Z Company’s taxable income, to $12.07 million from $5.9 million. Its federal income tax bill would increase 122% to $2.94 million from the $1.32 million it paid for fiscal 1984. And its earnings would be cut in half.

Precisely how much it would lose in the entertainment and depreciation categories is a question that continues to confound the company’s financial and tax experts even after dozens of hours of study.

On the entertainment side, companies would be permitted to deduct only a specified amount for meals (the figure varies depending on whether the entertaining is done over breakfast, lunch or dinner). All other entertainment deductions would be disallowed.

And in figuring depreciation under the proposed real-cost recovery system, companies would be required to adjust the value of their depreciable assets for the effect of inflation before figuring the depreciation allowance.

The result is nothing short of a bookkeeping nightmare.

“Their objective is admirable,” said Z Company’s tax specialist. “No one could quarrel with trying to get rid of the abuse in the entertainment area or with trying to adjust the value of assets to their current market value. But the way they propose to do it requires an almost insurmountable amount of record-keeping.”

After hours of discussion and study, Z Company executives concluded that the proposal would not allow them to deduct $125,000 in entertainment expenses as they do now.

If the cost of entertaining were no longer allowed, “we would probably maintain a somewhat smaller posture on entertainment,” a Z Company executive predicted.

After even more discussion and study on the depreciation proposal, the company decided to ignore the question entirely for purposes of this story.

It is the Puerto Rico proposal, along with the proposed elimination of preferential treatment of capital gains, that has this company worried.

Nearly two-thirds of its operations and one-third of its employees are in Puerto Rico, which has become something of a haven for dozens of U.S. high-tech companies since the U.S. government began granting tax credits for industrial development there.

“We have always had a management that looked at the tax laws and tried to take advantage of them and that’s absolutely the only reason we ended up in Puerto Rico,” said a top Z Company executive. “If they take away the incentives, there would be nothing to justify the distance (from Southern California) and the management problems . . . and we would go someplace else.”

That someplace else probably wouldn’t be in the United States, the executive said--particularly not if the Treasury carries through with its proposal to end the preferential treatment of capital gains.

The capital gains proposal would have no immediate tax effect on Z Company. But company executives fear that Z Company would encounter tremendous problems in trying to raise money and that its growth would grind to a halt if potential investors no longer had a tax incentive for putting their money at risk in stocks of young, fast-growing companies.

“This company is a perfect example of how lower taxes on capital gains really got a company going,” said a Z Company executive whose personal funds helped start the company. “Had there been no capital gain incentive, I would have put my money elsewhere and I’ve been told by a lot of people who helped us keep going after the first year that they feel the same way.”

The loss of the capital gains tax would “significantly alter this company’s strategies,” the executive said. “We would cut back on research and development (which currently accounts for about 10% of sales) and we would very likely discontinue our growth posture because I seriously doubt that we could keep raising the money to fuel that growth.”

The executive termed “fallacious thinking” the Treasury’s argument that its tax-reform package actually helps high technology to the possible detriment of other industries because of the plan to retain the research and development credit.

“Even if they took away that credit (which cut Z Company’s taxes by $650,000 in fiscal 1984), we would keep doing research anyway. That’s an important part of our business.”