Tax Analysts is having a roundtable discussion this Friday morning at the National Press Club in Washington D.C. on President Obama’s international tax proposals. It looks like it will be well attended, and there has been a last minute change to a larger conference room to accommodate the larger-than-expected crowd. All are invited to attend or listen to the audio simulcast that will be available at Tax.com on Friday June 12 from 9 to 11 a.m. I have been asked to kick-off the discussion with a quick overview of the major components of the Obama plan. The following is my attempt to explain these complex provisions as simply as possible.
Under current rules large swathes of low-tax foreign profits earned by U.S. multinationals escape U.S. tax. One major reason is that foreign income of foreign subsidiaries is not subject to U.S. tax until dividends are paid to the U.S. parent corporation. This delayed payment of U.S. tax — often a permanently delayed payment — is called “deferral” and it is at the heart of the escalating debate on U.S. international tax rules.
Until President Obama first revealed the specifics on his plan for international reform on May 4, the business community feared he would eliminate deferral outright. But the administration instead compromised and opted for a set of proposals that would limit the benefits of deferral. Here are the four most important — accounting for $187 billion out of the entire $210 billion the administration hopes to raise from international tax reforms. The effective date for all of these proposals is the beginning of 2011.
(1) Reform “check-the-box” rules as they apply to foreign entities ($86.5 billion over the 2011-19 period). In 1997, the Clinton Treasury screwed up big time when it unintentionally opened a huge loophole in tax rules designed to limit deferral. Before the Treasury flubbed it, profits in high-tax countries could not be shifted to low-tax countries without triggering U.S. tax. The effect of this change was to allow U.S. corporations to lower their effective rates of tax in high-tax countries by engaging in artificial transactions with subsidiaries in low-tax countries. The Obama proposal would return us to pre-1997 law.
(2) Reform the foreign tax credit so taxes and income are always matched ($18.5 billion). Some multinational corporations were using complex tax-planning techniques to claim foreign tax credits on income not subject to U.S. tax. This allowed foreign income to escape U.S. tax and to have the burden of foreign taxes offset by a U.S. tax credit-yielding a net tax burden on this foreign income of close to zero. This is an abuse that makes the U.S. government subsidize foreign investment so its net tax burden is zero. The Obama plan would close this obvious loophole.
(3) Limit U.S. tax deductions for expenses related to favorably taxed foreign income. ($60.0 billion) Under current law, some deductions relating to foreign income may be taken before the income related to those deductions is subject to tax. The Obama proposal would delay these deductions until the corresponding income was subject to tax. This type of “matching” proposal could make sense if it was done properly—that is, if deductions were properly allocated between foreign and domestic income, and if foreign governments as well as the U.S. recognize this allocation. But figuring out the right amount of deductions to disallow is a tricky business (and it is certainly wrong if interest expense is allocated on a “water’s edge” basis instead of the superior “worldwide” method). And the proposal does not make adjustments for the lack of conformity between domestic and foreign accounting for deductions.
(4) Reform the foreign tax credit so residual U.S. tax is determined on an average, or pooled, basis ($24.5 billion). Under current law and current practices, U.S. multinationals generally do not repatriate profits unless there are sufficient U.S. foreign tax credits to shelter those profits from U.S. tax. Under current law multinationals can eliminate U.S. tax on low-taxed foreign income by pairing it with high-tax income that generates large foreign tax credits. Under the Obama proposal, multinationals would no longer be able to “cross-credit.” Instead, any income that is repatriated into the United States will be subject to a U.S. residual tax equal to the difference between the U.S. rate and the average foreign rate paid by the U.S. multinational on its foreign income. This proposal imposes a new tax penalty on the repatriation of dividends from their foreign subsidiaries to their U.S. parent. This is not a good outcome because it reduces, rather than increases, the tax penalty on bringing foreign profits into the United States.
I am mostly sympathetic to the general objectives of the Obama plan — that is, reducing but not eliminating the tax advantages for foreign investment by U.S. multinationals. But I disagree with the specific approach, which I believe is unduly complex and has numerous undesirable side effects.