President Obama’s Budget Would Tighten U.S. Subpart F Rules
On March 4, 2014, the Obama administration released its fiscal 2015 budget. The revenue proposals of the budget are contained in in a document commonly referred to as the Green Book. The 2015 Green Book, which contains 297 pages of proposed tax increases and tax expenditures, includes 17 international tax reform proposals that would significantly raise taxes on U.S. multinationals. While the proposals are unlikely to garner much political support in the near future, some of them may enter into the mix of any political compromise needed to fund a revenue neutral reduction in the corporate tax rate – should serious corporate tax reform discussions materialize after the Congressional elections in the fall.
Proposed changes to subpart F
Rather than discussing all 17 international reform proposals, I discuss below only the administration’s four proposed changes to the anti-deferral rules of subpart F. Subpart F planning has been a key element of the tax strategy of U.S. multinationals seeking to maintain a competitive effective tax rate in the face of competition from non-U.S. companies headquartered in lower tax jurisdictions with territorial tax systems.
Income from intangible assets
One proposal is aimed at taxing the return on intangible assets that are transferred out of the United States. Currently, such transfers are typically taxed under section 367(d), which treats such transfers as a sale in exchange for a periodic royalty. This proposal would supplement section 367(d).
When a U.S. person transfers an intangible asset to a related controlled foreign corporation, the “excess income” from transactions “connected with or benefiting from” the intangible would be treated as subpart F income, if such income is subject to a low foreign effective tax rate. This is quite a broad class of income and appears to include income from sales of personal property that benefit from the transferred copyright, trademark, or patent.
“Excess intangible income” is defined as the excess of gross income from transactions connected with or benefiting from such covered intangible over the costs allocated and apportioned to this income, increased by a percentage markup. The markup is not specified. This income also would be placed in a separate foreign tax credit category when determining the limitation on the foreign tax credit in order to eliminate the opportunity to cross credit other taxes and thus lower the U.S. tax on the income.
Income from digital goods and services
Subpart F also would be expanded by creating a new category of subpart F income for transactions involving digital goods or services. The administration’s description of the provision is brief:
“Foreign base company digital income, generally would include income of a CFC from the lease or sale of a digital copyrighted article or from the provision of digital services, in cases where the CFC uses intangible property developed by a related party (including property developed pursuant to a cost-sharing arrangement) to produce the income and the CFC does not, through its own employees, make a substantial contribution to the development of the property or services that give rise to the income.”
Under this proposal, U.S. companies generally could not own their intellectual property in one business entity and provide digital goods or services through another, related, business entity without creating subpart F income for the company providing the digital goods or services. This provision, therefore, generally would discourage the ownership of intangible assets in a low tax jurisdiction.
Limit the manufacturing exception for foreign base company sales income
A third proposed amendment is aimed at related-party contract manufacturing arrangements, which have been acceptable for many years. This proposal is significant because related-party contract manufacturing relationships are a centerpiece of the deferral planning of many U.S. multinationals. Principal companies located in low-tax jurisdictions often contract with related manufacturing affiliates in high-tax jurisdictions. The income earned by the principal company is not foreign base company sales income (a category of subpart F income) when the principal is considered to be the manufacturer for U.S. tax purposes.
Under the proposal, subpart F income would be expanded to include income of the CFC from the sale of property manufactured on behalf of the CFC by a related person. In the past, the IRS litigated the position that, for purposes of determining foreign base company sales income, related and unrelated contract manufacturers should be treated as branches of the contract manufacturer’s principal, thus, potentially creating subpart F income for the principal under the branch rules of section 954(d)(2). The courts rejected that argument in the 1990s in two high profile cases. This proposal would effectively overturn those cases.
Eliminate look through-treatment for payments to reverse hybrids
The final proposed change to the subpart F would address the use of “reverse hybrid” entities. A reverse hybrid is a business entity that is treated as a pass-through entity under non-U.S. tax law but is treated as a corporation under U.S. tax law. Reverse hybrids may be used in connection with the subpart F “look-through” rules to reduce foreign income tax with a deductible payment, while avoiding the creation of foreign personal holding company income subject to current U.S. tax. The proposal would disallow the benefit of the look-through rules of section 954(c)(3) and (c)(6) to payments made to a foreign reverse hybrid. Thus, the income earned by reverse hybrids would be subpart F income in many cases.
Although the outlook for near term action on these proposals is poor, they also may be viewed as a strategic response by the U.S. Treasury to the BEPS initiative, which some view as targeting U.S. multinationals (at least in part). Indeed, the Deputy Assistant Secretary of the Treasury for International Tax Policy, Robert Stack, recently stated in a meeting of the Tax Executives Institute that the United States is committed to protecting the U.S. tax base. Because the U.S. grants a credit for foreign income taxes, this means opposing increases in taxes imposed on U.S. companies by other countries.
Viewed through the lens of the BEPs initiative, the international proposals in the Green Book would provide support to the Treasury Department in negotiations with source states, such as China and India, that may propose amending their laws in order to raise taxes on multinationals generally. Expanding subpart F allows the United States to argue that some of the BEPs proposals are unnecessary.
Viewed as a package, these proposals would eliminate the deferral of U.S. tax on much of the income earned by U.S. multinationals outside the United States and thus raise their effective tax rate. These proposals, therefore, run counter to recent Congressional corporate tax reform proposals that would move the United States to a territorial tax system for most income earned outside the United States.
 General Explanations of the Administration's 2015 Revenue Proposals, available at http://www.treasury.gov/resource-center/tax-policy/Pages/general_explanation.aspx/ Profit Shifting: Stack: U.S. Will Continue Focus on Clear Rules, Maintaining Base in BEPS Project, 58 Daily Tax Report G-6, March 26, 2014.
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