The Obama Administration Releases Its Fiscal Year 2014 Budget
April 2013On April 10, 2013, President Obama delivered his administration's proposals for the federal government's 2014 budget to the U.S. Congress. The budget addresses both federal spending and federal revenue (i.e., taxes). Each year, the tax proposals included in the budget are published separately in a book with a green cover, which is referred to colloquially as the "Greenbook." This year's Greenbook has two main components: (i) a traditional budget proposal, i.e., proposed tax increases, and (ii) a framework for revenue-neutral tax reform.
The Budget Proposals
The administration contends that its budget proposals would reduce the deficit by $1.8 trillion over 10 years through a combination of spending cuts and revenue (tax) increases. The budget proposal is detailed and includes numerous tax provisions; however, the included revenue raisers generally are aimed at individuals and do not affect either corporations or non-U.S. taxpayers directly. For example, the administration proposes a "Buffet rule,” which would require households with incomes over $1 million to pay at least 30 percent of their income in taxes. The administration also proposes to limit the deduction or exclusion for contributions to tax-favored retirement plans once a plan is funded to provide a certain level of benefits.
The Framework for Revenue Neutral Tax Reform
Like its budget proposal, the administration's framework for revenue neutral tax reform cuts a wide swath. The framework includes (i) tax incentives for manufacturing, R&D, and clean energy, (ii) tax relief for small business, (iii) incentives to promote regional growth, (iv) reform of the U.S. international tax system, (v) reform of the taxation of the insurance and financial industries, (vi) elimination of fossil fuel preferences and (vii) other revenue changes and loophole closers. The administration's latest effort appears to be a little less ambitious (and less specific) than the administration's February 2012 "Framework for Business Tax Reform." Unlike the administration's 2012 proposal, this latest “framework” does not contain a specific reduced corporate income tax rate, and it does not include some of the previously proposed revenue raisers to finance that rate reduction. We described briefly below three of the more significant international tax provisions included in this year's Greenbook.
Defer Deduction of Interest Expense Related to Deferred Income of Foreign Subsidiaries
Income earned by foreign subsidiaries of U.S. corporations generally is not taxed in the hands of the shareholder until it is distributed (e.g., as a dividend). The major exception to this rule is the U.S. subpart F regime, which treats certain income earned by "controlled foreign corporations" as a deemed dividend to certain shareholders in the year it is earned. Under current law a shareholder's interest expense that is properly apportioned to foreign-source income may be deducted currently, even if that foreign source income is not currently taxable (e.g., because it is earned by foreign subsidiary and the tax on that income is currently deferred). The administration is concerned that allowing a current deduction for this interest expense may cause U.S. businesses to shift their investments and jobs overseas, thereby hurting the domestic economy.
The proposal would defer the deduction of interest expense that is allocated and apportioned to shares of stock of a foreign corporation to the extent that the expense exceeds an amount proportionate to the taxpayer's pro rata share of income from such subsidiaries that is currently subject to U.S. tax. This provision is estimated to raise $36 billion over 10 years.
Tax Currently Excess Returns Associated with Transfers of Intangibles Offshore
Many U.S. multinationals have transferred intangible assets to their foreign subsidiaries, and U.S. tax law does not forbid such transfers. U.S. transfer pricing regulations issued under section 482 are intended to ensure that taxable intercompany transfers of intangible assets are priced under the arm’s-length principle. In addition, transfers of intangible assets to foreign subsidiaries that might otherwise be tax-free under certain provisions of the Internal Revenue Code are generally made taxable under the rules of section 367(d). The administration is concerned that such transfers put significant pressure on the enforcement and effective application of U.S. transfer pricing rules. The administration also cites evidence that the shift of ownership of intangible assets to low-taxed affiliates has significantly eroded the U.S. tax base.
The administration proposes that if a U.S. person transfers an intangible asset from the United States to a related controlled foreign corporation, the excess income from transactions connected with, or benefiting from, the transferred intangible would be treated as a new class of subpart F income, provided the income is subject to a low foreign effective tax rate. The income to be included in this new category of subpart F income would be defined as the excess of gross income from transactions connected with or benefiting from the transferred intangible over the costs properly allocated and apportioned to the income increased by a percentage markup. This provision is estimated to raise $24 billion over 10 years. The author understands that a similar provision also may be under consideration by other G20 countries as part of the OECD's ongoing work on base erosion and profit shifting (BEPS).
Earnings Stripping by Expatriated Entities
Non-U.S. investors in a U.S. company often will find it advantageous to fund that company with a significant amount of debt in order to reduce the company's U.S. income tax liability. The Congress has responded to this with section 163(j), which provides a general limitation on the deductibility of interest paid by a corporation to related persons. Interest that is not currently deductible may be carried forward indefinitely and deducted in future years, subject to the limitation of section 163(j) in that year.
Congress also has enacted section 7874, which is intended to discourage the expatriation of a U.S. company (i.e., transaction in which a U.S. parent company is effectively replaced with a foreign parent). Although the rules under section 7874 have a broad scope and currently significantly limit opportunities for expatriation, the administration is concerned that opportunities continue to exist for companies that expatriated prior to the tightening of section 7874 to erode their U.S. tax base by using debt owned by related foreign companies. The proposal would tighten the rules under section 163(j) in various ways (e.g., by eliminating the current debt-equity safe harbor and limiting the period during which excess interest could be carried forward to 10 years). This provision is estimated to raise $4 billion over 10 years.
Prognosis for Tax Reform
Many of the tax proposals, including most of the international tax proposals, contained in the fiscal 2014 budget have been proposed by President Obama in earlier budgets. For the most part, Congress refused to enact these tax proposals during President Obama's first term. This is due in large part to the fact that the House of Representatives was controlled by the Republican Party during that time (and continues to be so controlled today) and many Republicans do not support any type of tax increase. Nevertheless, the administration's international proposals are worthy of notice because they highlight some significant themes in current U.S. international tax policy. If, and when, the administration and Congress can reach an agreement on international tax reform legislation, such legislation most likely will include some elements of the administration's proposals.
 The administration’s proposed spending cuts (not contained in the Greenbook) would replace the spending cuts contained in the Budget Control Act of 2011.
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