The following Fiscal Policy Memo provides a brief overview of the issue of competitiveness and U.S. taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. policy, including summaries of current law and recommendations for reform.
Subpart F The federal government’s system of “anti-deferral” rules, which lead to the taxation of certain kinds of foreign-source income in the year it was earned even though the U.S. parent company did not repatriate those profits during the year. Subpart F refers to the chapter in the U.S. tax code that houses these complex rules.
Some of the rules being considered for reform include:
- Base Company Rules
- Look Through Rules
The following two sections explore each set of Subpart F rules.
I. Reforming Foreign Base Company Income Rules
Current lawThe foreign base company rules were enacted in 1962 as part of the original enactment of Subpart F. The original intent of Congress in enacting these rules was to prevent taxpayers from shifting “passive” income from high-tax jurisdictions (either the United States or high-tax foreign nations) to low-tax jurisdictions. 1
There are five categories of foreign base company income, and the two that receive the most attention are foreign base company sales income and foreign base company services income. Foreign base company sales income is earned when a subsidiary sells property produced outside of its country of incorporation, property that it either purchased from a related party 2 (the parent company or an affiliate) or sold to a related party and is not for ultimate use in the country the subsidiary is incorporated in. 3 Similarly, foreign base company services income is income earned by a subsidiary when it performs services for a related party outside the country in which it is incorporated. 4
To illustrate how the rules attempt to prevent a company from moving “passive” income to a low-tax subsidiary, assume that Hometown Computers will sell 1,000 U.S.-made computers to a Dutch customer. Rather than ship them directly to the Netherlands, Hometown has its Irish subsidiary purchase the computers from the home factory and sell them at a markup to the Dutch customer. Even though in substance this is all U.S. derived income, because of this arrangement, part of the profit from this transaction is now allocated to Ireland 5 which has a lower corporate tax rate than the U.S. Because the taxpayer is able to shift profit from the U.S. to Ireland, the total current worldwide tax amount is lowered. The foreign base company sales income rules operate in this scenario to cause all the income allocated to Ireland to be taxed immediately in the United States as a deemed dividend, thus negating any potential tax advantage from placing the low-tax Irish subsidiary in the transaction.
There is an exception to the IRC Section 954(d) foreign base company sales income rules under Treas. Reg. Section 1.954–3(a)(4)(i) for situations in which the controlled foreign corporation is considered to be the “manufacturer” of the property. The subsidiary will be deemed the manufacturer if it substantially “transforms” the property or if the functions performed by the CFC are substantial in nature.
The reality is that Subpart F applies too broadly to income earned by centralized sales and services companies. For example, the foreign base company rules would apply if the Irish subsidiary purchased products from Hometown’s manufacturing plant in Germany and sold to customers in Switzerland. Such Irish income would be Subpart F income even though the transaction’s only connection with the United States is tangential at best.
Service companies are similarly impacted by these rules. Let’s say that the Swiss affiliate of “ServiceCo,” a U.S. consulting firm, enters into a contract to provide services to a Swiss customer but has to subcontract some of the technical work to its U.K. affiliate. Even if ServiceCo Switzerland compensates the U.K. affiliate at “arm’s-length” terms for the subcontracted services, all of the Swiss income received from its Swiss customer would be foreign base company services income. The broad applicability of these rules has generated considerable confusion, complexity, and negative commentary from tax professionals.
Proposed remedyUnder the proposals being considered in the House and Senate, the foreign base company sales and foreign base company services income rules would be repealed in most cases. Hence, such income would not be Subpart F income and would be eligible for deferral. One exception under the bill is that if the product is made in the United States and sold to a foreign subsidiary, and then sold back to a U.S. corporation, any income earned by the foreign subsidiary would not qualify for deferral and would be taxed immediately. However, if the taxpayer makes a product in the United States and sells it to a foreign subsidiary for consumption in a different foreign country, the income earned by all of the non-U.S. subsidiaries will be deferred.
Impact of proposalAt the time the “foreign base company” rules were enacted, multinational companies were far less common than they are today. As a result, these rules now have the effect of defining purely active business income as Subpart F income. Under the existing system, a U.S.-based multinational company that is solely engaged in active foreign business operations through multiple subsidiaries can incur significant U.S. taxation simply by redeploying its active foreign assets among its foreign businesses. This inhibits the ability of U.S.-based companies to respond to market opportunities by imposing a U.S. tax cost on business decisions. This provision will save U.S. firms $37 billion over the next ten years.
The current rules encourage tax-motivated behavior by creating radically different U.S. tax results based on minor differences in the foreign corporate structure. For example, if a taxpayer operates in multiple foreign jurisdictions using a single foreign corporation (rather than multiple subsidiaries), intercompany transactions among the offices of that entity will not generate Subpart F inclusions. The proposal would substantially narrow the circumstances in which Subpart F would accelerate U.S. taxation of the active business income of a foreign subsidiary and thereby reduce the incentive for complex, tax-motivated corporate structures. In the course of reforming the rules to reflect the reality of modern business activity, the proposal would also substantially reduce the extraordinary complexity of the rules, which makes compliance difficult, expensive and uncertain.
Footnotes 1. The Senate committee report explained the legislation’s intent as follows: “As in the case of sales income, the purpose here is to deny tax deferral where a service subsidiary is separated from manufacturing or similar activities, but only where they are performed outside the country in which the controlled foreign corporation is organized.” 2. A related party for this purpose means any affiliated corporation or significant owner of an affiliated corporation. See IRC § 954(d)(3). 3. See IRC § 954(d)(1). 4. The concept of foreign base company services income is made even broader through Treasury Regulations which provide that services income will be deemed to be “for or on behalf of a related person” if the CFC: (1) receives substantial financial benefit from a related person for performing such services; (2) performs services which a related person has been obligated to perform; (3) performs services with respect to property sold by a related person and such services constitute a condition or material item of such sale; or (4) received substantial assistance contributing to the performance of such services from a related person. 5. Because the U.S. multinational can allocate all of the risk of the transaction to the Irish subsidiary, a significant portion of the income can also be allocated to where it will be taxed at a lower rate. See IRC § 482. Richard Caves, Multinational Enterprise and Economic Analysis (1996) at 192-93.
II. Reforming Look-through Rules for Payments Between Controlled Foreign Corporations
Current lawCurrently, when one foreign subsidiary makes a payment of dividends, interest, royalties, etc. to a sister company in a different foreign country, the income to the recipient corporation is Subpart F income. 1 These payments are taxed immediately even though they are entirely within the same multinational group. 2 This can make the issues of intra-group financing quite complicated.
Many corporations have been able to avoid both the problems with the foreign base company rules and the rules categorizing payments between CFCs as Subpart F income by adopting what are called hybrid entity structures. Hybrid entities are treated as corporations for local foreign purposes, but disregarded for U.S tax purposes.
Under these structures, if all of the foreign subsidiaries underneath one foreign parent company are disregarded for U.S. tax purposes, there are no dividend payments and no interest payments. There are also no sales among subsidiaries because all of these entities are treated for U.S. purposes as a single entity. There are only transfers between accounts, etc., none of which are Subpart F income. Hence, for the well advised, these rules are much less burdensome.
Proposed remedyUnder proposals being considered in the House and Senate, payments between foreign subsidiaries would no longer be Subpart F income, as long as the underlying activity which generated the payment in the first place was an active business, rather than a passive investment. If the income is generated by a passive investment, it will be Subpart F income 3.
Impact of proposalAlthough this proposal would save U.S. firms a modest $2.2 billion over the next ten years, the effect this proposed change to the foreign base company rules and inter-company payments is so significant that the U.S. would come close to creating a territorial system for active foreign source income. As long as income is invested in an active business abroad, the income would not be taxed in the United States until repatriated.
Essentially what these rules would do is create two groups: a foreign group and a U.S. group. Transfers from the foreign group to the U.S. group can be subject to tax, and all passive income of the group is subject to tax. All active foreign source income of the subsidiaries that has not been transferred to the U.S. parent would not be subject to tax in the United States.
This provision does not, however, change any of the definitions of what constitutes “active income” and “passive income,” even though technological changes and certain market conditions have rendered some of some of Subpart F’s definitions obsolete. This includes the interpretation of “royalty income” which, for many high-tech firms, is their principle form of active income.
Footnotes 1. See I.R.C. § 954 (c). 2. These payments could result in income if they were within a U.S group, under the consolidated return regulations. See the regulations under I.R.C. § 1502. 3. But see I.R.C. § 959.
Foreign Tax Credits Current U.S. tax law allows U.S. companies to claim a credit against their U.S. taxes for taxes paid in other countries. These credits are meant to avoid the double taxationDouble taxation is when taxes are paid twice on the same dollar of income, regardless of whether that’s corporate or individual income. of earnings. Foreign tax credits are limited to the U.S. corporate tax rate. Therefore, U.S. corporations pay a minimum of 35 percent on their worldwide earnings.
Some of the rules being considered for reform include:
- Foreign Tax CreditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. “Baskets”
- Alternative Minimum Tax
- Credit Carryover Rules
- Interest Allocation Rules
The following four sections provide an overview of each of these foreign tax credits, including summaries of current law and recommendations for reform.
I. Reducing the Number of Foreign Tax Credit “Baskets”
Current lawThe foreign tax credit system as described earlier has an additional layer of complexity to it. One of the key sources of complexity derives from a desire to prevent cross-crediting of foreign taxes paid on active foreign source income with income earned from foreign passive investments.
The idea of cross-crediting is fairly simple. Assume that there are two items of foreign source income, each equal to $100. The first is taxed abroad at a 10% rate and the second at a 45% rate, in a year in which the U.S. tax rate is 35%. If we were to apply the foreign tax credit limit on an item-by-item basis, the first item would have a tentative U.S. tax of $35, and a credit of $10, yielding $25 paid to the U.S. government. The second item would have a tentative U.S. tax of $35, with a credit of $45, yielding no payment to the U.S. government, and because of the foreign tax credit limit, there would be no refund of the additional $10. If on the other hand, cross-crediting were permitted, total income would be $200, resulting in a tentative U.S. tax of $70, a foreign tax credit of $55 ($10 + $45 = $55), and therefore, only $15 would be owed the U.S. government rather than $25.
U.S. taxpayers are permitted to “cross-credit” only within certain separate limitation categories or “baskets.” The reason for these separate baskets is a desire to not allow taxes paid on active foreign source income to be cross-credited against income from passive investment (which is generally quite mobile and subject to low rates of tax). There are currently nine baskets. The foreign tax credit limitation must be calculated separately for each basket. This system imposes significant compliance costs on U.S. business.
Proposed remedyProposals being considered in the House and Senate would reduce the number of separate baskets to two.
Impact of proposalThis proposal would significantly reduce the compliance costs associated with the foreign tax credit. In addition to saving companies roughly $6.1 billion over ten years, it would also reduce overall effective rates by making foreign tax credits more valuable.
Footnotes 1. See Terrence Chorvat, Ending the Taxation of Foreign Business Income 42 Ariz. Law Rev. 835 (2000).
II. Eliminating the AMT’s Limitation on the Use of Foreign Tax Credits
Current lawIf a U.S. company makes no profits in the United States, but makes a profit abroad, and pays tax on the foreign source income at a rate equal to or greater than the U.S. rate, the taxpayer will still owe tax to the U.S. Treasury. This does not occur because of the foreign tax credit rules, but rather because of the alternative minimum tax (AMT) rules which prevent the foreign tax credit from exceeding 90% of the U.S. tax for AMT purposes.
Proposed remedyProposals in the House and Senate would eliminate this limitation on the use of foreign tax credit under the AMT.
Impact of proposalThere is little serious argument to retain this provision, other than from those who seek political advantage in the fact that some U.S. corporations may not pay any U.S. tax in a given year, even though they pay at least the U.S. rate on their income form foreign countries. This will decrease AMT payments as well as effective tax rates on foreign source income for companies subject to the AMT. Over ten years, this provision will save companies more than $6.7 billion.
III. Extending the Carryover Period on Excess Foreign Tax Credits
Current lawIf a U.S. company has an excess foreign tax credit in a given year, the tax code permits the company to apply the unused portion of the credit to either the previous two tax years or carry it forward to apply it sometime during the next five tax years. The credit may be taken in those years so long as it does not exceed the foreign tax credit limitation in the year in which it is applied. In other words, the company cannot get a refund on the excess credit amount. If at the end of five years, the taxpayer has still not used the credit, it will expire unused.
Proposed remedyProposals in the House would permit U.S. taxpayers to carry the credit forward for 10 years before it expires. A Senate proposal would permit companies to carry the credit forward for 20 years.
Impact of proposalThese provisions are reasonable and fair proposals to reduce the potential of double taxation on corporate taxpayers. There is little policy rationale for restricting the carry-forward to five years. This proposal will save firms $6.7 billion over the next ten years.
IV. Reforming Interest Expense Allocation Rules
Current lawThe more expenses a company is allowed to allocate against foreign source revenues, the lower foreign source income will be, and therefore the lower the foreign tax credit limitation will be. Under the current interest expense allocation rules, the interest incurred by U.S. members of a group is allocated between foreign source and U.S. source income based on where the assets of the group are. 1 Foreign subsidiaries owned by the group are treated as assets that produce foreign source income. Hence, interest expense allocated to foreign subsidiaries is generally deducted from foreign source income.
One of the problems with this arrangement is that it does not account for debt which is incurred by the foreign subsidiaries themselves. That is, while interest paid by U.S. subsidiaries is partially allocated to foreign source income, none of the interest paid by foreign subsidiaries is allocated to U.S. income (because the foreign subsidiaries do not pay U.S. tax). Almost all commentators agree that this allocates too much debt and interest to foreign source income. Therefore, these rules often do not allow U.S. taxpayers full use of the foreign tax credits, and therefore, they increase the effective tax rate on foreign source income.
Proposed remedyUnder proposals in the House and Senate, the interest expense allocated would include the interest of the entire group, even that incurred by the foreign subsidiaries. Debt incurred by the foreign subsidiaries which is allocated to foreign source income is then subtracted out from the amount allocated to the United States.
Impact of proposalThis is clearly a more analytically correct way to deal with interest expense. While some commentators have had problems with the specific applications of the formula in some instances,2 these proposals clearly offer a more accurate way to allocate interest expense than the current rules. Over ten years, this proposal will save companies more than $23 billion.
Footnotes 1. See Treas. Reg. §§ 1.163-8 through -12. 2. See Lee Sheppard, “News Analysis – The Good and Bad in the Thomas Bill,” Tax Notes, July 23, 2002.
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