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."
"Under current law, if you pay a dividend from a company that pays a high rate of foreign tax," he explained, "the dividend will bring with it a foreign tax credit for the high foreign taxes you're paying. The proposal would say, instead of giving a foreign tax credit for the entity that pays the dividend, look at all the entities as a group, and give the foreign tax credit on average. So if you have two subsidiaries, with one subject to 35 percent tax and the other subject to zero tax, when you take a dividend out of either subsidiary you will get a credit of 17.5 percent."
"My concern is that the level of complexity that these changes would add to an already complicated set of rules is quite daunting," Culbertson noted. "These are large-scale changes to a set of rules that have been heavily debated over the years. There are a lot of policy debates that underlie each of the decisions in the current rules, and some very strong policy responses about whether these proposals are a good thing for the U.S. economy or not. The focus seems to be to reduce incentives to create jobs overseas, but if a company is making a decision on where to locate a plant, it's unrealistic to assume that the U.S. tax burden is what drives the decision. There will be foreign tax burdens as well, especially for decisions driven by where markets, workers and resources are."
WHAT WILL IT MEAN?
"The devil is in the details," said Martin. "All these provisions are meant to have a revenue effect, and they will. We're discussing with our clients how they will fund this cash need, and the impact the provisions will have on their operating plans."
In general, the proposals constitute a more limited anti-deferral mechanism than could have been proposed, according to Martin: "It is certainly less aggressive in eliminating deferral than it could have been. Nonetheless, it is significant enough - companies that are affected will feel the impact."
Both the administration proposals and the response to them have been vague, according to Gary Melcher, director of international tax services at cbiz.
"At this point they're just proposals - there's no statutory language," he observed.
"We're writing more rules, but to do what?" he asked. "They just keep writing rules into the system, and as a practitioner we love it, but at the same time you have to question whether this is absolutely necessary. Clients generally want to comply, but they don't want to pay for complying with an overburdened system."
Deferral has been mischaracterized as a tax break, but is in actuality a vital mechanism to relieve American businesses from double taxation, according to U.S. Chamber of Commerce chief economist Dr. Marty Regalia. "The United States is the only major industrialized country which double-taxes the overseas earnings of our companies," he observed. "Since other countries don't subject their companies to double taxation, U.S. companies need deferral to stay competitive in the global marketplace."
Tax Foundation senior research fellow Robert Carroll, Ph.D, noted that the real problem is that the U.S. tax system is increasingly out of line internationally. "Other countries have shifted to a so-called territorial system, where only company profits generated within a country's borders are subject to tax. Japan shifted to a territorial system earlier this year and the United Kingdom announced a similar change just two weeks ago. The United States is now the only country with both a worldwide system and a corporate tax rate above 30 percent," he said.
TAX-DISADVANTAGED?
The newly formed PACE (Promote America's Competitive Edge) Coalition, representing the Business Roundtable, the National Association of Manufacturers, the National Foreign Trade Council and the U.S. Chamber of Commerce, stated that 95 percent of the world's consumers live outside of the U.S. "For U.S. companies to serve these markets and increase jobs in the U.S., they must be able to compete internationally on a level playing field."
"This is a jobs and fairness issue," said John J. Castellani, president of the Business Roundtable. "The overseas operations of U.S. multinational companies support jobs and higher living standards here at home. If the United States moves unilaterally to raise the taxes on U.S. companies operating abroad, it will put our employers at a big disadvantage with foreign competitors."
"Repeal of deferral would put U.S. companies at a disadvantage because other countries choose to embrace territoriality," observed Washington-based tax attorney Martin Tittle. "But with repeal of deferral you can lower the corporate tax rate on everybody so you don't actually collect any more tax. The administration proposal is certainly meant to collect more tax initially, but they're open to reduce the corporate rate at some point in the future."
"If we are building a plant in China it may be because we're producing for the Chinese market," noted Culbertson. "The question is, who are our competitors and what is their cost structure? How will a German and an American company compete with each other?"
"These are issues that have been very heavily debated and deserve study, because the economic effects of our conclusions are so important," he said. "I would hope that there will be active debate and dialog before anything gets put into law."
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