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The Obama Administration’s International Tax Proposals
Background Support for the proposals fell roughly along partisan lines, with Democratic responses ranging from cautious conceptual support to enthusiasm and Republican responses ranging from reserved to skeptical. The business community responded with an emphatic denouncement of the proposals, decrying the characterization of current provisions as tax breaks that provide an advantage to job exporters and arguing that the proposals undermine carefully considered measures designed to keep the playing field level for U.S. multinational corporations. A week later, the U.S. Treasury Department released its "General Explanations of the Administration’s Fiscal Year 2010 Revenue Proposals" (also known as the "Greenbook"), which expanded on the initial proposals, generally to the detriment of U.S. multinationals, and added some significant provisions. The following discussion focuses on the international tax components of the proposals. Proposals 1. Foreign Investment Disincentives and U.S. Investment Incentive
U.S. Expenses Supporting Deferred Income Administration Proposal: Claiming of U.S.-incurred expenses supporting the generation of deferred income, excluding research and experimentation expenses, would be deferred until the deferred income is recognized in the United States. Interestingly, the expense deferral also results in a favorable mismatch for the U.S. coffers, whereby those to whom the expenses are paid are subject to U.S. tax, while those paying the expenses are not allowed a deduction for U.S. income tax purposes. The proposal would enter into effect in 2011, and the administration estimates the proposal would raise $60.1 billion from 2011 to 2019. Please note that for this provision – as well as the proposal on FTC administration – the revenue goals seem unlikely to be reached if the initiatives are actually successful in prompting U.S. investment. In other words, calculation of the revenue appears to be conditioned on the measures failing to change behavior. What to Watch For: The framing of the issue ignores the fact that most expenses supporting deferred income in anything other than an indirect way are already disallowed under the “ordinary and necessary” standard and must be passed along to the entity they benefit – or foregone altogether. Consequently, the real impact will be in the definition and identification of an expanded pool of expenses supporting deferred income, which are not already excluded under existing law. The proposal specifically cites interest but also refers to existing allocation and apportionment rules, calling into question whether stewardship and general and administrative expenses would be subject to deferral in an exercise similar to the determination of foreign source income for purposes of claiming FTCs. Based on the reference to Regulation Section 1.861-8, such an exercise would also treat money as fungible and apportion interest based on assets rather than any kind of a tracing exercise. However, the Greenbook does not address what would happen in the unlikely event that the foreign operations were more heavily leveraged than those in the United States. Watch for the fungibility concept to be limited to domestic borrowing and the resulting interest expense. Assuming that the measure passes largely as proposed and assuming that it extends to all the same expenses allocated and apportioned for purposes of determining the FTC limitation, the measure includes a potentially huge unintended, or at least unstated, impact on the ability to claim FTCs. The deferred expenses are carried forward, but nothing is said about the ability to carry forward any excess FTC limitation and release the limitation at the same time the deferred expenses are released. As a result, the pool of deferred expenses will grow denser and denser with the passage of time, creating a huge drag on the FTC limitation. The measure likely would result in a condition similar to the impact of an overall foreign loss but without the protection of the rule allowing a taxpayer to limit the FTC limitation impact to 50 percent of the income generated from foreign sources in the period. In addition to the economic impact of the expense deferral itself, the implementation of the proposed measure likely will create an administrative nightmare certain to shift income from taxpayers to tax advisers. The execution of the measure will borrow an infrastructure to identify and track deferred expenses from the FTC area but also will require a system for determining how and when the deferred expenses are released for claim against the recognition of deferred income. Furthermore, the measure is likely to raise the ire of U.S. trading partners as, aiming to get a local deduction for amounts expended, U.S. parent corporations seek to charge expenses to their foreign subsidiaries that would otherwise be deferred. Changes to Foreign Tax Credit Administration Administration Proposal: FTCs would be based on a blended worldwide pool of taxes rather than on an entity-by-entity basis. In addition, foreign taxes on income not currently recognized would be expressly deferred until the income generating the taxes was recognized. The proposal would enter into effect in 2011, and the administration estimates the proposal would raise $43 billion from 2011 to 2019. What to Watch For: The administration’s proposal appears to require a major overhaul of direct and indirect FTC rules. The second leg of the administration’s proposal requires the establishment of a set of rules identifying when foreign taxes precede foreign income. Once those rules have been established, the simplest way to administer the deferred expenses would be to add the deferred taxes to the global tax pool used in determining FTCs under the first leg of the administration’s proposal. The real upshot is that although deferral is not expressly eliminated or limited by this provision, the blended tax rate inherently forces FTC claims to assume no deferral in the foreign taxes and foreign earnings entering into the computation of the FTC, which means taxpayers no longer will be able to manage the rigorous and harsh FTC limitation rules by matching dividends from high-tax jurisdictions with dividends from low-tax jurisdictions. As a result of the changes to the FTC regime as well as the unintended impact on the FTC from expense deferral, watch for a decrease in reported earnings per share without a significant change in tax revenue to the Treasury as taxpayers provide valuation allowances for expiring FTCs under the Financial Accounting Standards Board (FASB) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes.” Similarly to the previous proposal, the implementation of the proposed changes to foreign tax credit administration also appears likely to create an administrative nightmare. The execution of this proposal effectively would create the need to track taxes, earnings, and profits globally and force the computation of a super aggregate deemed-paid tax on dividends. Many taxpayers already engage tax advisers to provide additional assistance focused on the entities paying dividends. The administration’s proposal would presumably expand the exercise to all foreign entities owned or partially owned by the taxpayers or create an expanded exercise on an annual basis. In addition, the way earnings pools are tracked would be radically changed as the need to account for earnings in multiple currencies collides with the local currency convention in existing deemed FTC calculations. Finally, a plethora of currency-related gain and loss issues would be introduced into the calculation of foreign tax credits. Expansion of Super-royalty on Incorporations of Foreign Branches Administration Proposal: Intangible property subject to the “super-royalty” – that is, an imputed royalty commensurate with income computed annually with the benefit of hindsight – imposed by Internal Revenue Code (IRC) Section 367(d) in the context of an outbound contribution to capital would be extended to include work force in place, goodwill, and going-concern value, notwithstanding that existing international tax rules expressly exclude goodwill and going concern from the definition of intangibles that are subject to the super-royalty. The proposal would enter into effect in 2011, and the administration estimates the proposal would raise $2.9 billion from 2011 to 2019. What to Watch For: U.S.-based companies often expand internationally by initially operating in branch or representative office form. As their operations in any given non-U.S. jurisdiction grow, those companies frequently elect or are forced to establish a formal legal presence for bona fide business purposes. Currently, IRC Section 367(d) establishes a super-royalty for intangible property presumably generated in the United States and contributed to a foreign corporation in the form of capital. Certain kinds of intangible property, most notably the items mentioned above, were excluded from the super-royalty, presumably because their values were very subjective in nature, very difficult to compute, and of a kind not typically realized other than as a transaction disposing of an operation. The royalty imputed by IRC Section 367(d) is not deductible for local income tax purposes, subjecting taxpayers to double tax on the contribution of tainted assets. Under existing rules, many taxpayers carved out tainted intangible property (patents, trade names, manufacturing know-how) from the branch assets contributed to a foreign corporation and charged a royalty for such items based on a formal or informal transfer pricing study or valuation. The proposed change does three things to discourage foreign corporations beyond the current disincentives:
Watch for decreased international expansion and increased use of independent agents, dealers, and manufacturers for entities moving forward with global expansion. This decrease in activity will eliminate permanently from U.S. taxation the income of early expansion activity by putting it in the hands of unrelated, independent parties. When a given foreign operation is of sufficient size, sustainability, and profitability to make it an attractive addition to a U.S.-based principal’s operations, look for U.S. companies to establish foreign entities to buy out the unrelated parties or buy pertinent assets, which will represent a real economic expenditure beyond what is currently expended in homegrown expansion efforts. As a consequence, a reduction in the resources available for U.S. investment by those companies expanding global operations is likely. Permanent Enactment of Credit for Research and Experimentation Administration Proposal: Permanently enact the R&E credit currently in place. The proposal would presumably enter into effect in 2010, and the administration estimates the proposal would cost $74.5 billion over the next 10 years. What to Watch For: The administration’s proposal appears to retain existing rules. Time will tell whether making the existing rules permanent is enough to affect behavior and add to R&E-based activity in the United States. At a minimum, the permanent enactment of the credit will help retain the current R&E base. Other Proposals Watch for a limited but loud outcry from foreign investors and certain U.S. FTC claimants affected by the proposal. The main complaints likely will be that the justification is underdeveloped and the measure does not appear to increase U.S. investment since an 80/20 company is a U.S. corporation that happens to operate internationally. An 80/20 should represent a preferred international operating structure, as its earnings from international operation are not deferred for U.S. tax purposes. The intended benefit to the U.S. coffers appears to be the small amount of additional taxes on dividends and interest to foreign lenders and investors, but the provision also results in a further restriction on U.S. taxpayers that rely on the foreign source treatment of 80/20 companies to claim foreign tax credits. The Greenbook contains several new measures that have very limited applicability and will not be discussed here beyond inclusion in this list:
Restriction of Check-the-box Rules Administration Proposal: Any eligible foreign entity electing to be treated as a DRE would instead be treated as a corporation for U.S. tax purposes unless it is owned directly by the U.S. parent or by an entity taxed as a corporation organized in the same country as the eligible entity electing DRE status. The proposed treatment would subject the U.S. owner to the Subpart F rules. Interestingly, IRC Section 954(c)(6) currently provides relief from Subpart F for the “abusive” income cited in the example provided in the May 4, 2009, White House press release, even if the DREs were treated as corporations under the proposal. This provision, originally designed to level the playing field for U.S. multinationals by allowing them to deploy earnings from foreign operations to fund foreign expansion, was set to expire at the end of 2009. Another administration proposal extends the provision through 2010, but the extension is somewhat perplexing in that the proposed restriction of the check-the-box rules would not address the perceived problem if the look-through relief provision excepts targeted transactions from accelerated income recognition under Subpart F. Under the administration’s proposal, any existing DREs not meeting the requirements contained in the proposal would be deemed to convert to corporations and, consequently, be subject to existing tax rules regarding the incorporation of a branch. The proposal would go into effect in 2011, and the administration estimates the proposal would raise $86.5 billion from 2011 to 2019. What to Watch For: As mentioned previously, do not expect an extension beyond 2010 for the look-through exception to Subpart F contained in IRC Section 954(c)(6) with respect to dividends, interest, rents, and royalties between controlled foreign corporations (CFCs). In addition, the administration’s proposal as outlined in the Greenbook appears to overrule, when applicable, the exception from Subpart F treatment in the existing branch rules when the disparity in tax rates between the related parties is under an acceptable threshold. Finally, expect U.S. parent companies to be put at a distinct disadvantage in the global marketplace as the ability to plow tax-deferred earnings generated outside the United States into global expansion without incurring U.S. tax is restricted or eliminated. The administration of the restricted check-the-box rules would not be as burdensome as some of the measures discussed above because taxpayers would simply apply existing Subpart F rules. The rules surrounding the deemed conversion, on the other hand, extend the impact of this proposal far beyond the economics related to Subpart F. Virtually every U.S. taxpayer with a disregarded entity will need to review the entity’s organization to determine whether it will be affected by the proposal. Affected entities will also need to determine what the impact will be of the international reorganization tax rules that would apply to either a deemed incorporation of a tainted branch or, alternatively, any restructuring initiated in response to the proposed restriction of the check-the-box rules. Measures Targeting Tax Haven Abuse by Individual U.S. Taxpayers Administration Proposal: Implement a network of changes to existing reporting and withholding rules that would help the IRS identify individual tax evaders and provide a disincentive to engage in such activity. The proposed changes:
The proposal is estimated to raise $8.7 billion during the first 10 years it is in effect. What to Watch For: The direct economic effect would presumably be limited to those illegally sheltering income outside of the United States, but the cost of administration would increase, as would the carrying costs of legitimate foreign investors in non-QIs due to the newly required withholdings. The measures would co-opt financial institutions and QIs into the audit process by requiring increased understanding of and accountability for clients’ affairs – particularly for clients that have gone to some length to hide illegal activity. The proposed change would make syndicated investment in the United States less attractive. Look for decreased participation in the QI program as reporting rules and qualification become more difficult, likely causing foreign financial institutions to opt for non-QI status and comply with the new withholding provisions. The proposal would result in the overcollection of taxes and would pass along to investors the responsibility for and costs of the resulting refund claims. Additional IRS Human Resources Administration Proposal: Hire 800 new agents, economists, lawyers, and specialists to focus specifically on international tax issues. What to Watch For: Look for new hires under this initiative to adopt a presumption of tax evasion when interacting with taxpayers. The compensation offered to the new agents likely will determine, in part, their capabilities. Current unemployment rates should allow the IRS, which tends to offer comparatively modest levels of compensation, to attract more capable resources than it otherwise would be able to. Contact Information 1www.whitehouse.gov/the_press_office/LEVELING-THE-PLAYING-FIELD-CURBING -TAX-HAVENS-AND-REMOVING-TAX-INCENTIVES-FOR-SHIFTING-JOBS-OVERSEAS/ Download PDF Under U.S. Treasury rules issued in 2005, we must inform you that any advice in this communication to you was not intended or written to be used, and cannot be used, to avoid any government penalties that may be imposed on a taxpayer. 
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