The Obama administration's proposals aimed at limiting offshore tax abuse are a major change in a generation-old debate on how to tax the earnings of U.S.-owned foreign subsidiaries.

"It's a pretty big deal," said Jerry Martin, director of international tax for RSM McGladrey. "Elimination of deferral could be quite significant, since the U.S. corporate tax rates are the second highest in the world. The proposals would subject all foreign earnings to a higher rate."

Currently, businesses that invest overseas can take immediate deductions on their U.S. tax returns for expenses supporting their overseas investments, but nevertheless defer paying U.S. taxes on the profits from the investments. The administration proposals would reform the rules so that, with the exception of research and experimentation expenses, companies cannot receive deductions on their U.S. tax returns supporting their offshore investments until they pay taxes on their offshore profits.

The proposals would close "loopholes" that allow U.S. businesses that pay foreign tax on overseas profits to claim a credit against their U.S. taxes for the foreign taxes paid, and would reform the check-the-box rules to require certain foreign subsidiaries to be considered as separate corporations for U.S. tax purposes.

The proposals also include a package of disclosure and enforcement measures to make it more difficult for financial institutions and wealthy individuals to evade taxes, and would require foreign financial institutions that have dealings with the U.S. to sign an agreement with the Internal Revenue Service to become a Qualified Intermediary and share as much information about U.S. customers as U.S. financial institutions. Institutions that fail to sign would face the presumption that they may be facilitating tax evasion and have taxes withheld on payments to their customers.

GENERATIONAL STRUGGLE

The anti-deferral provisions create a competitive issue, observed Martin. "A U.S. company operating in Singapore pays tax at a 35 percent rate, while the Singapore company pays tax at the Singapore rate of 18 percent. Without deferral, the U.S. company will be at a competitive disadvantage, because it cannot operate at the same cost structure as the Singapore company."

"The changes they're putting on the table are quite substantial," agreed Robert Culbertson, former associate chief counsel (international) at the IRS and a tax partner at the Washington office of Paul Hastings. These fundamental issues get debated every generation, he noted. "The big historical event was the passage of the Controlled Foreign Corporation rules during the Kennedy administration in 1962," he said. "What we ended up with in the code was a compromise which reflected the political process at the time."

"Since the proposal in 1962 was to repeal deferral altogether, the compromise was a set of rules that were very complicated. Those rules were modified in the 1986 Act, but not in terribly significant ways. The discussion centered on whether and when the U.S. ought to be imposing tax on U.S.-owned subsidiaries with offshore earnings. It's the same thing again. However, what they're proposing is not a frontal assault on deferral. They're not proposing to repeal it as Kennedy proposed in 1961, but they are proposing changes to the way the rules work that represent some very significant alterations."

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