International Aspects of U.S. 'Tax Reform' -- Is This Really Where We Want to Go?
The article "International Aspects of U.S. 'Tax Reform' -- Is This Really Where We Want to Go?" authored by H. David Rosenbloom was published in the January 2, 2018 issue of International Tax Report. The article's full content is below. Please visit this link to view the article on International Tax Report's website.
The “international provisions” of U.S. tax legislation wending its way through Congress (not yet signed into law at this writing) have received short shrift in the mainstream press and, indeed, generally. That set of provisions in the Senate Bill was accepted at conference by the House of Representatives with little apparent discussion or objection and only modest alterations were made. Although these provisions effect many important changes in the law, most have attracted little public notice.
The Lack of Politics
The main reason for this striking lack of attention is that the international provisions are not seen as political. Factions have not developed to defend or attack these provisions, at least not outside the swarm of lobbyists undertaking to tinker and tailor the provisions to their clients’ liking. To the extent the international provisions have gored a few oxen, the beasts have tolerated the abuse in light of other very beneficial aspects of the changes wrought by the legislation – especially reduction of the general corporate tax rate to 21 per cent. Without political juice to justify a news report, or serious and understandable objections from anyone, the international provisions have basically sat there waiting to be incorporated into a deal struck on other grounds.
The main reason the provisions are not political is because they are complicated, both in their own right and when considered against the backdrop of provisions they would replace – also hellishly complicated. An understanding of what is going on with international aspects of U.S. income tax under either old law or the law to be brought into being via the international provisions is not something that can be casually or readily acquired. The statutory language of the new provisions is dense, and rife with rudderless jargon, bewildering cross-references, and new and unfamiliar terminology. Heroic efforts of staff to explain the provisions in declarative sentences have been helpful to some extent, but the lack of transparency that has consistently characterised the development of the legislation has not. Almost everything Congress has done in the service of “tax reform” over the past several months has bordered on the indecipherable. Much better for the uninitiated party seeking to comment publicly on the legislation to focus on individual and corporate rate proposals and other “headline” items, which can be understood fairly easily and the implications of which are relatively clear.
This paper is not intended to examine or explicate the international provisions, since the details are both stultifying and confusing and there will be many other commentators emerging in due course to undertake that task. Rather, the aim here is to step back and offer some general observations about the direction in which these provisions would seem to move the U.S., especially the provisions affecting the foreign income of corporations and their foreign affiliates. (Individuals receive virtually no attention in the international provisions.)
Corporation Tax and CFCs
At the outset it is useful to note that the international provisions are not nearly so muddled as the opaque drafting would lead one, at first reading, to conclude. In fact, the policies underlying these provisions can be identified easily. There is to be a “fresh start,” as of 2018, for earnings of foreign corporations owned to the extent of at least 10 per cent by U.S. corporations, coupled with a mandatory tax at reduced rates of 15.5 per cent for earnings accumulated from 1987 through 2017 and maintained in cash or its equivalent and 8 per cent for the non-cash accumulation. For some unspecified reason, older earnings are not subject to this mandatory tax, which is payable over eight years starting in 2017.
Going forward, there will be a much reduced general corporate tax rate of 21 per cent, obviously intended to lure investment to, or back to, the U.S. There will also be a favourable effective tax rate of 13.125 per cent for exported goods and services and a minimum effective rate of 10.5 per cent on income earned by controlled foreign corporations (CFCs) with U.S. corporate shareholders. (As is typical through the international provisions, individuals do not benefit.) Inbound investment is targeted in a serious re-write of the earnings stripping rules relating to interest payments, but not limited to payments to related persons. In addition, certain deductible “base erosion” expenditures, including interest, made by U.S. corporate taxpayers to foreign related parties will be subject to a separate and independent alternative minimum tax (not characterised as such in the legislation) at a rate of 10 per cent, with no foreign tax credits allowed. Arguably, this base erosion tax can be seen as a pro tanto reduction of the amount allowed as a deduction – a characterisation that holds implications for the question whether the base erosion tax violates the nondiscrimination provisions of U.S. tax treaties (in addition to the treaty requirements of a foreign tax credit).
These highlights of the legislative purpose are accompanied by a wide array of provisions sometimes tightening (but sometimes loosening) statutory rules aimed at perceived abuse. These include legislated acceptance of the arguments of U.S. tax authorities regarding outbound transfers of intangible property, an override of a court decision to allow taxation of sales of partnership interests by foreign persons, modest adjustments of subpart F rules, thoroughgoing revision of the foreign tax credit regime, and a sharp restriction on the ability of U.S. persons to transfer U.S. assets to related corporations abroad. Throughout the text there is manifest hostility toward hybrid entities and hybrid transactions, and especially toward inversions past and future.
Thus, the policy case for the international provisions can be succinctly summarised: incentives for U.S. investment and especially for U.S. exports, a benign view of income from foreign investments of U.S. corporations, and a limit to the erosion of the U.S. tax base, especially via the interest deduction.
If the policies at work are clear, it must also be said that the international provisions have a distinctly isolationist flavour. They take no account of the larger world, where countries other than the U.S. exist and have their own ideas about taxation. They make no accommodation to the U.S. network of tax treaties, which the international provisions appear to violate in several respects. In fact, the word “treaties” cannot be found in these provisions at all.
Perhaps the most striking aspect of the international provisions is their drastic revision of the manner in which the U.S. taxes foreign income of U.S. corporations, whether that income is earned directly by such corporations or by foreign subsidiaries controlled by such corporations. Income earned by a CFC and not attributed to a U.S. trade or business of that corporation would be subject to two distinct modes of current taxation of the U.S. corporate shareholder, depending on circumstances. Where the income is assumed by statute to be of a type that should have been earned in the U.S., and thus is caught by the anti-abuse regime of subpart F, the new provisions make numerous changes but keep the fundamental structure and the normal (now 21 per cent) corporate rate. When the income exceeds a threshold amount equal to 10 per cent of the tax basis of tangible assets held by all CFCs of the U.S. corporate shareholder, and the income does not fall within subpart F, a minimum tax at an effective rate of 10.5 per cent applies. This is, obviously, a reduced rate by comparison with either the rate applied to subpart F income (21 per cent) or the rate applicable to domestic income of the corporate shareholder (also 21 per cent). It may not be a reduced rate, however, by comparison with the actual effective rate that has been applied in recent years to CFCs in some industries.
Significantly, this “global intangible low-taxed income” that is subject to a reduced rate of U.S. tax is computed on the basis that all CFCs are considered one. That is, tangible assets and losses of any such corporation will be aggregated with tangible assets and positive income of other CFCs, with the result that no one foreign country will know how much income earned within its borders exceeds the 10 per cent return on tangible assets and is subject to U.S. tax. A foreign tax credit may be claimed for foreign taxes paid or accrued by the CFCs, but only for 80 per cent of the amount of foreign tax actually paid multiplied by the percentage that included income bears to total CFC income reduced by subpart F income, dividends received by the CFCs, and certain other amounts. Again, the general idea is that all CFCs are lumped together and treated as a single entity for purposes of the credit. An overall effective foreign tax rate of 13.125 per cent (80 per cent of 13.125 = 10.5) will zero out U.S. tax liability on this slice of income.
Income of a CFC owned by one or more U.S. corporate shareholders and not covered by either of the regimes just described will default to exemption and can be repatriated to the U.S. free of tax. Exemption will also apply to pre-1987 earnings accumulated by foreign corporations owned to the extent of at least 10 per cent by U.S. corporate shareholders, since the repatriation tax does not apply to this income. And exemption will apply to any future earnings of foreign corporations in which a U.S. corporation owns at least 10 per cent of the stock, but the foreign corporation is not a CFC. This last type of income is not subject to either the subpart F rules or the new tax on global intangible low-taxed income.
U.S. Treaty Obligations
The net effect of these provisions, I believe, will be a notable withdrawal of the U.S. from the world of international taxation, where it has been a leader at least since the end of the Second World War and arguably as long ago as the 1920s. The U.S. tax treaty network has been developed, as most treaty networks have always been developed, on a bilateral basis, with a main goal of alleviating international double taxation one country at a time. The new international provisions move sharply away from that approach to the world, by dividing the universe of taxation into the U.S. on the one hand and everywhere else on the other, and by lumping all CFCs (and thus all countries) together for purposes of the broad “minimum tax” on low taxed intangible income.
Independently, the new base erosion minimum tax on amounts paid by a corporate taxpayer to a related foreign person arguably violates the non-discrimination article found in all U.S. tax treaties. The denial of any foreign tax credit for the alternative minimum BEAT tax, and the allowance of such a credit on global intangible low-tax income only to the extent of 80 per cent of foreign taxes actually paid, also raise treaty issues. If the international provisions are meant to override U.S. treaty commitments, which is constitutionally possible, the result of this cavalier treatment of U.S. treaty obligations will be to reduce U.S. leverage in negotiations. The U.S. multi-national community will be very much on its own insofar as the taxation of operations outside the U.S. is concerned.
This seems odd in two distinct ways. In a world where the principles of the OECD’s Project on Base Erosion and Profit Shifting (BEPS) have widely, if somewhat chaotically, taken hold, the prospects for international tax initiatives by foreign countries are obviously substantial and disputes regarding the tax to be collected from U.S. multi-national affiliates are likely to be large, contentious, and frequent. In addition, though Congress has spoken loudly of its desire to promote “growth,” much of the U.S. multi-national community sees true growth opportunities as lying outside the U.S. We have a mature economy with modest population increments and (as we all know) increasing restrictions on immigration. Markets abroad hold greater potential, and it can be expected that U.S. parented companies will continue to invest substantially in foreign countries. Traditionally, the U.S. has stood behind its companies, ready to provide support, and nowhere has this been clearer than in the area of international taxation. The treaties and related activities at the OECD, the UN, and in other international fora, not to mention in the State Aid cases initiated by the European Commission, have all borne witness to energetic U.S. efforts to defend the interests of U.S. based companies. The international provisions of the new legislation seem designed, and possibly intended, to hinder those efforts.
So-called “patent box” aspects of the international provisions – the “foreign derived intangible income” rules – are similarly focused exclusively on the U.S., with no apparent thought given to other countries, their likely reactions, their assessments of U.S. policy, or the fact that we live in a globalised world. These rules provide a preferential effective tax rate (13.125 per cent) for exports above and beyond a threshold amount of income equal to 10 per cent of the tax basis of tangible U.S. assets. (The threshold adopted here is similar to the one used in determining global intangible low-taxed income.) This is bound to engender adverse reactions abroad, since other countries have long made clear that they will not grant deductions for payments by their taxpayers when those payments constitute preferential income under the tax laws of a resident country. Furthermore, it has been observed that the foreign derived intangible income provisions may well violate U.S. commitments to the World Trade Organization. They may therefore ensnare the U.S. in acrimonious litigation over “export subsidies.” The U.S. track record in such controversies is not impressive.
The underlying problem is that the international provisions have been crafted on the unstated assumption that the U.S. is the only country whose tax policies matter. That is unfortunate not simply because it is untrue but because it holds the potential for serious harm to U.S. interests. It is a shame to see the country fritter away a position of world leadership in a field as important as international taxation – a field that has gained immeasurably in international recognition as a result of BEPS and other developments in the OECD, the European Union, and at the UN. The fact that the U.S. Congress pretended for years that the BEPS project did not exist is emblematic of the attitude that is now manifest in the new international provisions. Our companies are likely to pay a price for the decline in U.S. leadership but, make no mistake, it will ultimately have negative influence in many corners of our national life.
The information contained in this commentary is accurate at time of publication and any further updates will be addressed in a future edition of International Tax Report.
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