While the Senate chair’s mark on tax reform envisions a territorial regime and one-time transition tax on accumulated earnings that is akin to the House’s proposal, some of its more prominent international base erosion measures bear only thematic similarities to its counterpart, with significant operational differences standing between the two.
“The most game-changing feature of the House and Senate bills is the provision preventing erosion of the U.S. base through payments other than interest,” John D. McDonald of Baker McKenzie said. “Both chambers recognize that they can't go to a territorial system without tightening up subpart F. At the same time, they can't just tighten subpart F without also going after foreign-parented entities or else they increase the incentive to invert or just be acquired by a foreign parent.” (Related coverage.)
One of the largest base erosion revenue gainers in the Senate’s November 9 proposal is an inbound provision that would impose a 10 percent base erosion minimum tax, expected to generate $123.5 billion over 10 years, according to an estimate by the Joint Committee on Taxation. This tax is calculated on the difference between actual tax liability and what the company would have incurred if it hadn’t moved profits offshore. The provision defines a base erosion payment as a deductible payment to a related foreign person, defined as a 25 percent owner of the taxpayer or a related person under section 482. It would apply to taxpayers with annual gross receipts of $500 million and a base erosion percentage of at least 4 percent. That percentage is calculated by dividing the base erosion tax benefits by the deductions allowed. The provision would be effective starting in 2018.
Joseph Calianno of BDO USA LLP noted that although it is structured differently than the House proposal, the base erosion minimum tax conceptually is trying to address a similar issue as the House’s controversial excise tax.
Under the Tax Cuts and Jobs Act (H.R. 1), the House intends to address base erosion by both U.S.-based and foreign-based multinationals by proposing a 20 percent excise tax on payments made by U.S. corporations to related foreign corporations that are deducted, included as costs of goods sold, or included in a depreciable asset basis, unless the foreign affiliate elects to treat them as effectively connected with a U.S. trade or business. It was the most surprising international provision of the bill and the most contentious. An amendment from House Ways and Means Committee Chair Kevin Brady, R-Texas, that followed a few days later, which allowed for partial foreign tax credits and expanded the number of deductions allowed against the tax, sharply curtailed the anticipated revenue generated from the tax. The Joint Committee on Taxation’s initial projection of $154.5 billion in revenue over 10 years fell dramatically to $7 billion. On November 9 a second amendment made to change how the FTC is calculated increased the predicted revenue by $87.6 billion.
“The House bill is more targeted in a way, because the foreign tax credit for specified payments lessens the burden on those offshore companies operating mainly in countries like France, Germany, or Italy who are paying tax at higher rates,” McDonald said, adding that that measure’s conversion of related-party deductible payments into effectively connected income would necessitate a Form 1120-F filing, a complex FTC determination, and possibly a branch profits tax. He said the Senate bill would effectively allow a taxpayer to make deductible payments to related foreign parties, even if they are located in low-taxed countries, but only up to one-half of the taxpayer’s taxable income, measured before the deductible payment, before being subjected to a higher rate of tax.
“In sum, the Senate version still allows for the possibility of some base erosion, but it will certainly be a lot easier to administer for the IRS and taxpayers. This is because you don't need any information about the foreign related parties to calculate the U.S. tax. So, the choice for the conference committee will be whether they prefer a tougher clampdown on erosion or ease of administration,” McDonald continued.
Reuven Avi-Yonah of the University of Michigan Law School argued that the Senate’s relatively straightforward proposal is a significant improvement over the House bill. He still foresaw opposition to the Senate bill coming from the same parties that fought the border-adjustment tax, such as retailers like Walmart. He added that both chambers’ provisions could run into treaty problems.
“It is not really different from imposing tax on royalties where a treaty has zero withholding, or changing transfer pricing when we are supposed to do it on an arm’s-length basis, or denying a deduction for those two things where a treaty says . . . we’re not supposed to discriminate,” Avi Yonah said. “Yes, we can do a treaty override, but [other countries] are still going to complain, and that means they’re probably going to tax us. And then we get into a double taxation issue because there is no foreign tax credit offset against the 10 percent.”
Avi-Yonah added that WTO issues could also present a significant hurdle, as the tax should be interpreted as a tariff on imported goods. “They’re going to sue us and there will be sanctions, and then how do you collect the [$123.5] billion in revenue?”
As another anti-base erosion measure, the Senate proposal would target related-party hybrid transactions, denying a deduction for interest or royalties paid if there is no corresponding inclusion to the related party in the other country or if the related party is allowed a deduction for the amount. The provision has “a [base erosion and profit shifting]-like feel,” according to Calianno, who also cited its similarity to an Obama administration proposal made in its 2016 budget to “restrict the use of hybrid arrangements that create stateless income.”
The Senate would also end special rules for domestic international sales corporations beginning in 2019. Both of these rules have no House counterpart.
GILTI as Charged
Often the easiest assets to shift offshore, intellectual property is also in the Senate bill's cross hairs. To combat profit shifting on passive and mobile income, the Senate’s proposal would impose tax on a U.S. shareholder on its global intangible low-taxed income (GILTI).
GILTI is defined as the excess of a shareholder’s net controlled foreign corporation-tested income over net deemed tangible income, the latter being equal to 10 percent of the aggregate pro rata share of the qualified business asset investment (QBAI) of each CFC. The tested income of a CFC is the excess of gross income with some exclusions, over deductions allowed under section 954(b)(5). QBAI is the average aggregate of adjusted bases in tangible property used in a trade or business that is eligible for section 167 depreciation. The proposal permits an 80 percent FTC on income included as GILTI. There are no carryforwards or carrybacks for the separate FTC basket created by GILTI.
Because the provision allows a domestic corporation to deduct foreign-derived intangible income at 37.5 percent of the lesser of the GILTI inclusion plus the foreign-derived intangible income or taxable income, the end result is a tax rate of 12.5 percent on intangible income. The proposal also provides special rules for transfers of intangible property from CFCs to U.S. shareholders. The rule states that for some of those distributions, the fair market value will be treated as not exceeding the adjusted basis. For non-dividend distributions, a U.S. shareholder’s basis in stock of the CFC is increased by the distribution that would otherwise be includable in gross income. The special rules apply to distributions received by a domestic corporation from a CFC that are made before the close of the third taxable year starting in 2018.
The GILTI provision is effective for tax years beginning in 2018.
While the general inclusion of GILTI is expected to generate $115.5 billion over 10 years, per a JCT score, the deduction for foreign-derived intangible income derived from a U.S. trade or business within the U.S. is expected to lose $86.4 billion, and special rules for transfers of intangible property from CFCs is expected to lose another $34.1 billion.
By contrast, as one of its main base erosion measures, the House’s bill favors a global minimum tax on 50 percent of foreign high returns of a U.S. parent which, while involving a complex calculation, would likely result in less than a 10 percent tax, given the allowance for a routine return. It has already been panned by some experts as mostly ineffective against offshore planning when the proposed U.S. rate is 20 percent.
McDonald said that while both the House and Senate proposals significantly reduce the tax incentives for offshore intangibles, the Senate adds an extra incentive to keep those intangibles in the U.S. with its deduction for foreign-derived intangible income.
“If these bills go forward, many companies may simply decide to onshore their intangibles. If they can do so at full value and get an amortization deduction at a 20 percent rate, that may, in some cases, prove more attractive than deferral under the new regime. Recognizing this, the Senate bill provides that onshored intangibles will have a carryover tax basis. Thus, if the intangible is self-created by the offshore corporation, it will come back to the U.S. with a zero basis,” McDonald said.
Calianno added that the special rules envisioned by the provisions would mitigate the tax cost of getting intellectual property back to the U.S. and also would reduce the incentive for IP migrations.
Avi-Yonah said his primary concern with the Senate proposal is that it is limited to the extent that taxpayers do not have tangible assets offshore.
“That is very problematic because it is an incentive to shift jobs, not profits,” Avi-Yonah said. He added that he thinks it is unjustified to offer intangibles a lower tax rate, despite the ease with which those assets could be shifted. “We’re talking about Google, Amazon, Facebook, Apple. Those are all highly profitable companies because they have unique intangibles . . . these companies will continue to do exactly the same thing with these intangibles if they were taxed at the full 20 percent rate,” he said, warning against a race to the bottom.
Territoriality and Other Similarities
There are some areas in which the similarities between the two chambers’ proposals are more apparent.
Both the House and Senate seek to limit interest expense deductions when U.S. shareholders have excess domestic indebtedness. The Senate proposal defines excess domestic indebtedness as the amount that exceeds 110 percent of the total indebtedness if the total debt-to-equity ratio were proportionate to worldwide debt to equity. It allows an indefinite carryforward for disallowed interest. The House seeks to limit interest expense to the extent that it exceeds 110 percent of a corporation’s share of global earnings before interest, taxes, depreciation, and amortization, with a five-year carryforward for disallowed expense.
McDonald sees the Senate’s approach as necessitating complex rules for measuring equity, since that would be dramatically different across countries.
“For example, when stock of a company is acquired and a section 338 election is not available or not made, will they allow something like the fixed stock write-off election in the proposed section 163(j) regulations? If foreign subsidiaries depreciate assets slower than the U.S. does, what happens? Does the group have to recalculate the amortization of their non-U.S. and non-CFC affiliates on a U.S. basis? That would be pretty onerous. Or does the group just wind up with lower debt-equity ratios outside of the U.S.? Or, will they use nontax, i.e., accounting, figures?” McDonald asked. “The manner in which they sort this out will matter a lot from company to company.”
Like the House, to achieve territoriality, the Senate envisions a 100 percent exemption for foreign-source dividends received from 10-percent-owned foreign entities with a disallowance of FTCs. The JCT estimates the Senate’s provision to cost $215.6 billion.
Meyer H. Fedida of Cleary Gottlieb Steen and Hamilton LLP argued that there is a “glitch” with the participation exemption system contemplated by both the Senate and House when dealing with tiered foreign companies.
“Unless the second-tier corporation is related (i.e., more than 50 percent ownership) to the first tier, the earnings of the second-tier foreign subsidiary would still be taxable,” Fedida said. “In order for the rules to work to really exclude earnings from 10-percent-owned foreign subsidiaries (held directly and indirectly), section 954(c)(6) needs to be expanded to cover not only dividends from 50-percent-owned corporations, but also dividends from corporations with respect to which the CFC’s shareholder is a 10 percent owner.”
The Senate also proposes a bifurcated rate on the deemed repatriation of offshore accumulated earnings, though at a rate lower than the House. The Senate’s proposal calls for a 10 percent tax on earnings held as cash and 5 percent on other assets. The House’s measure as initially proposed would have required a 12 percent tax on earnings held as cash and 5 percent otherwise, a rate predicted to receive pushback from multinationals for being too high. Brady’s second amendment to the House proposal crept that rate up even higher — 14 percent and 7 percent, respectively. In both the Senate and House proposals, the amount would be payable over eight years, if the taxpayer so elects.
“There is absolutely no justification to have a transition tax of anything other than 35 percent because it doesn’t affect efficiency. It doesn’t affect competitiveness. It doesn’t affect anything other than the balance sheet of multinationals, and God knows they can afford it,” Avi-Yonah said, adding that raising the rates could solve any budget woes that might be encountered. “It’s a pure political play.”
The Senate allows for deferral on the transition tax for shareholders of S corporations until a triggering event occurs — either a change in corporate status, liquidation or termination, or a transfer of stock unless the transferee assumes the tax liability.
But as a strong warning against would-be inverters, the Senate proposal would also impose a 35 percent tax on the accumulated earnings of entities that become expatriated entities under section 7874 any time in the next 10 years. Dividends from section 7874 surrogate foreign corporations are also not entitled to lower rates on qualified dividends.
The Senate’s transition tax proposal is effective for tax years beginning before 2018 and is estimated to raise revenue by $190 billion.
Both bills’ modifications to subpart F provisions also bear striking similarity. They call for inflation adjustment of the de minimis exception for foreign base company income; the repeal of inclusion based on withdrawal of previously excluded subpart F income from qualified investment; the modification of stock attribution rules for determining a CFC; the elimination of a 30-day control requirement for inclusion; the elimination of inclusion of foreign base company oil income; and making the look-through rule permanent. Both proposals also call for the repeal of section 902 indirect FTCs.
Calianno called attention to the effective date in the Senate’s subpart F changes to stock attribution rules and the definition of a U.S. shareholder to include a U.S. person who owns 10 percent of the value of all classes of stock, both of which are effective for the last taxable year of foreign corporations beginning before January 1, 2018.
In total, the Senate’s dramatic reinterpretation of the U.S. international tax regime is predicted to increase revenues by $104.4 billion over 10 years.
Marie Sapirie contributed to this story