Senator Baucus Offers Discussion Draft for Comprehensive International Tax Reform
November 2013On November 19, 2013, Senator Max Baucus (Dem, MT), Chairman of the Senate Finance Committee, released a discussion draft of international business tax reform legislation (the “discussion draft”). As we have discussed in earlier columns, the Senate Finance Committee previously had released a series of "tax reform option papers" identifying various tax issues. The committee now is releasing a series of “discussion drafts” presented as bills in draft form to amend current law. International tax reform was the first topic released. The staff of the Joint Committee on Taxation also prepared a "technical explanation" of the discussion draft. We review the current state of international corporate tax reform and then discuss some highlights of the discussion draft as well as some of its possible implications.
Review of US Corporate Tax Reform Efforts
Some shortcoming of the current system
We previously have discussed various aspects of the international corporate tax reform effort in the United States. The effort is motivated by several key factors. The United States has a relatively high top corporate tax rate (35%) compared to other countries, which many recognize as limiting the competitiveness of US multinationals. Also, unlike other developed countries, the United States does not have a territorial tax system. Business income of the foreign subsidiaries of US multinationals is taxed either when it is repatriated to the United States as a dividend, or, in the year earned, if it is subpart F income or earnings invested in United States property.
As a result of skillful tax planning, as well as some taxpayer-favorable regulations and amendments to the Code over the years, many U.S. multinationals have millions of dollars (or in some notable cases, billions of dollars) of earnings in subsidiaries located in relatively low-tax or no-tax jurisdictions that is not Subpart F income. This lowers the company’s effective tax rate below the U.S. statutory rate and increases its competitiveness. Some of this planning is inconsistent with the current G20 BEPS effort and is a thorn in the side of many source countries, which see income flowing into these jurisdictions.
For public accounting purposes, companies typically have declared these offshore earnings to be "permanently reinvested" outside United States in order to avoid booking the residual U.S. tax that would be due on this income when it is repatriated to the United States. Some commentators have observed that, in practice, the current U.S. corporate income tax system has the effect of exempting from U.S. income tax low-tax offshore income, while allowing a full foreign tax credit for foreign income taxes paid on high-tax offshore income. This is a result that probably was not contemplated when the current international tax system was last overhauled in 1986.
While this planning strategy reduces the company's effective tax rate for accounting purposes, management views these earnings as "locked out" of the United States because of the high residual U.S. tax that would be upon repatriation of the earnings. The high tax cost of bringing this income back to United States (referred to as the lockout effect) is a significant problem for many corporate treasurers because they may not deploy this cash in the United States.
In summary, the US international tax system has a variety of shortcomings that, depending upon your perspective, should be addressed by tax reform. The statutory rate is too high, the current system encourages BEPS activity resulting in adverse media attention and retaliation by source countries, the current worldwide framework is out of step with the territorial system most of the rest of the world has adopted, and the current system encourages the “lock-out” effect making US multinationals less competitive.
The Camp proposal
In October 2011, the House Ways and Means Committee released a discussion draft of a bill that would amend the Internal Revenue Code to replace the current system of taxation of offshore income with a territorial tax system and lower the corporate income tax rate from 35 percent to a rate of perhaps 25 percent. The discussion draft is commonly referred to as the “Camp Proposal” because Congressman Dave Camp (Rep., MI) is the chairman of the House Ways and Means Committee, which initiates tax legislation.
The Camp proposal has eight major components: (i) reduce the statutory corporate income tax rate, (ii) provide a deduction for dividends received by a domestic corporations from a CFC, (iii) exclude gains and losses realized by United States shareholders on the disposition of shares of certain active foreign corporations, (iv) tax income currently deferred in certain foreign corporations at a low rate upon transition to the new system, (v) modify the foreign tax credit regime, (vi) modify the rules of the current system concerning the taxation of passive income, (vii) restrict opportunities for erosion of the U.S. tax base resulting from migration of intangible property, and (viii) deny a deduction for interest expense of U.S. shareholders that are members of worldwide affiliated groups with excess domestic indebtedness.
Overview of the Baucus Discussion Draft
The discussion draft has two options (referred to as Option Y and Option Z) for reforming the taxation of controlled foreign corporations (“CFCs”) and a set of reform provisions that would apply regardless of which option is chosen. Unlike the Camp proposal, the discussion draft specifies no precise reduction in the corporate income tax rate. The discussion draft also is more comprehensive and broader in scope than the Camp proposal.
Option Y of the discussion draft would change the status quo by providing for a limited territorial income tax in the form of a 100% dividends received deduction for 10% US shareholders of a CFC with respect to the foreign source portion of dividends paid by the CFC. This mechanism also would exempt gain on the sale of shares in a foreign corporation from US tax to the extent the gain was treated as a dividend under section 1248.
Option Y also would modify the rules of Subpart F in order to ensure that the dividends received deduction was available only to income from the conduct of an active foreign business and high-taxed income. Option Y would add to the Code two new categories of subpart F income: "United States related income" and “low-taxed income.” This modification would discourage the shifting of income from the United States to low-taxed jurisdictions.
United States related income is the sum of “imported property income” and “United States services income.” Thus, income from importing property into the United States by the CFC or a related person would be subject to current US tax. United States services income is income derived in connection with services provided with respect to persons or property located in the United States.
Low-taxed income is any item of income that is subject to a foreign income tax that is less than 80 percent of the maximum US corporate tax rate. Under option Y, this income would be taxed at by the United States at a rate equal to 80 percent of the maximum federal corporate income tax rate. This result would be accomplished by amending the Code to allow the US shareholder of a CFC a deduction equal to 20% of the amount of gross income attributable to low-taxed income.
Option Y also would modify the foreign tax credit limitation by expanding the number of categories to six. This would limit opportunities for cross-crediting foreign income taxes.
Option Z of the discussion draft would change the status quo by eliminating any deferral of income earned by CFCs by expanding and overhauling Subpart F. This option would tax U.S. shareholders of CFCs on their share of all income of the CFC earned during the year. However, one type of income, “active foreign market income,” would be taxed at a preferred rate by way of a partial exemption. The discussion draft proposes a 40 percent exemption. Active foreign market income is “income attributable to economically significant activities of a qualified trade or business derived in connection with property sold or exchanged for use outside the United States or services performed outside the United States with respect to persons or property located outside the United States.”
Option Z also would change the taxation of gain on the sale of shares of a CFC by repealing section 1248 and by allowing an exclusion from gross income for a portion of the gain realized. In general, the exclusion is based on the portion of the CFC’s historical earnings that have been excluded from Subpart F income by reason of the preferential treatment of modified active income.
Option Z would modify the foreign tax credit limitation by redefining the categories of income subject to a separate limitation. In general, there would be three main categories as opposed to two under current law.
The Common Provisions
The common provisions span a wide range of international tax topics, including reform of the foreign tax credit, limits on the entity classification (check the box) election for foreign entities, reform of the passive foreign investment company (or PFIC) rules, reform of the income sourcing rules, provisions to prevent base erosion and changes to the FIRPTA rules. Some of these changes are both innovative and controversial. We discuss a few of the more significant below.
Limits on entity classification
The discussion draft would treat as a corporation any business entity that otherwise would be eligible to elect its taxable status if it is either wholly owned by a CFC or by two or more members of an “expanded affiliated group” one member of which is a CFC. Thus, a foreign business entity wholly owned by a CFC could not elect to be disregarded as separate from its corporate shareholder. Similarly, a foreign business entity that is partly owned by a CFC could not elect to be treated as a partnership. These changes would greatly limit the use of the check the box election to avoid subpart F income. If enacted, this provision would have a broad impact, creating massive amounts of subpart F income for many U.S. mutinationals absent significant restructuring.
Modification of the title passage rule
The discussion draft generally would treat as U.S. source income any sale of inventory property when a taxpayer’s office or fixed place of business within the United States is a material factor in the sale. Thus, U.S. taxpayers could not create foreign source income simply by passing title outside the United States. Many U.S. taxpayers have relied on the title passage rule to create foreign source income which has the effect of increasing their foreign tax credit limitation.
Expense disallowance rule
There are two versions of the expense disallowance rule in the discussion draft; one for Option Y and one for Option Z. The Option Y disallowance rule would disallow a deduction for the portion of a United States shareholder’s interest expense that is apportioned to income of a CFC that is exempt from taxation by the United States. The Option Z disallowance rule is similar to the Option Y rule; however, it applies to the portion of interest expense that is apportioned to the income of the CFC that is exempt from taxation by the United States because it is attributable to active foreign market income. These rules implement the principal that expenses allocable to tax-exempt income should be disallowed. There is a similar rule the domestic provisions. Nevertheless, for US multinationals such disallowance would be painful.
Denial of deductions for payments made in a base erosion arrangement
This provision disallows the deduction for a payment made to a related party in connection with a “base erosion arrangement.” The discussion draft defines a base erosion arrangement as “any transaction or series of transactions, or other arrangement, that reduces the amount of foreign income tax paid or accrued and involves a (1) hybrid transaction or instrument, (2) hybrid entity, (3) an exempt arrangement, or (4) a conduit financing arrangement.” Although the Joint Committee’s technical explanation does not explain the reasoning of the rule, it clearly is aimed at hitting a wide variety of tax arbitrage transactions that create a deduction in the United States without any corresponding foreign income inclusion. Discouraging such transaction is consistent with the BEPS initiative of the G20 countries.
Repeal of portfolio interest exemption on corporate debt
The discussion draft would impose a 30-percent withholding tax on payments arising from corporate obligations held by nonresident aliens and foreign corporations. This effectively repeals the portfolio interest exemption available under current law, and would require borrowers and lenders to rely on income tax treaties.
The technical explanation does describe the reason for this change, although the provision is grouped with other provisions intended to prevent base erosion. In light of the fact that withholding taxes are commonly believed to be borne by borrowers, such provision appears contrary to the interest of the US fisc.
Although the Joint Committee on Taxation did not provide a revenue estimate to accompany the discussion draft, this draft legislation, if enacted, would appear to increase (in some cases dramatically) the US tax bill of most US multinationals in the long run, while offering the benefit of repatriating low-taxed earnings at a lower US tax rate than is currently available in the short run. The discussion draft, as a whole, therefore is unlikely to receive any significant support from US multinationals unless it is accomapnied by a cut in the corporate tax rate.
In light of the current division of control of the Congress (the Republicans controlling the House and the Democrats controlling the Senate), the discussion draft can best be viewed as the current opening position of the Democrats in any negotiations with Republicans on international tax reform. Should the Congress have the political will to address tax reform as part of upcoming budget negotiations early next year, elements of the discussion draft could become a part of a broader tax reform bill.
 Available at: http://www.finance.senate.gov/newsroom/chairman/release/?id=f946a9f3-d296-42ad-bae4-bcf451b34b14 See our post of June 2013 discussing the options for taxing business entities. JCX-15-13 (November 19, 2013) This is a tentative tax rate. Or tax at a maximum rate of 21%. See section 7874(c). Section 265. This benefit is not as generous at the corresponding benefit of the Camp Proposal. How strongly the Democrats on the committee support various elements of the discussion draft is difficult to judge from the technical explanation. It is unusual in that it provides no policy arguments to support the individual provisions.KEYWORD: Corporate Tax Reform
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