Introduction Representative Bill Thomas, Chairman of the House Ways and Means Committee, recently introduced H.R. 5095, the American Competitiveness and Corporate Accountability Act of 2002. The legislation has three major yet disparate policy objectives:
1. Bring the U.S. into compliance with the World Trade Organization (WTO) ruling that the U.S. Extraterritorial Income regime (ETI) – successor to the Foreign Sales Corporation (FSC) – constituted an unfair trade subsidy to U.S. export companies. Failure to comply could subject U.S. firms to as much as $4 billion in trade sanctions. H.R. 5095 brings the U.S. into compliance with the WTO ruling by repealing the ETI regime.
2. Reduce flaws in U.S. international tax laws to improve the ability of American multinational firms to compete in international markets. The bill makes 20 substantive changes to these international tax rules, including: repealing the Controlled Foreign Corporation (CFC) rules on foreign “base company” sales and service income; improving the interest allocation rules that companies use to calculate their foreign tax credits; reducing the number of 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” from nine to three; and repealing the limitation of foreign 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. credits under the Alternative Minimum Tax.
3. Halt the erosion of the U.S. tax base from various tax minimization and avoidance practices. H.R. 5095 contains an array of provisions to: (1) stem corporate “inversions,” in which U.S. multinational firms re-incorporate at least a portion of their business in a low-tax foreign country – such as Bermuda – in order to lower their worldwide tax burden; (2) tighten rules against “earnings stripping,” where foreign-based firms strip earnings out of their U.S. subsidiaries through the use of inter-company debt; and (3) penalize those “tax shelters” that have no substantive business purpose other than tax avoidance.
The bill’s disparate policy objectives present a challenge in assessing the overall economic effects that would result if these measures were enacted as proposed. The Joint Committee on Taxation (JCT) has estimated that, as a whole, H.R. 5095 is revenue neutral, meaning that total federal tax collections will not change substantially in any of the next ten years or in the aggregate over the ten year budget window. That doesn’t mean the bill is “revenue neutral” for every firm impacted however. On the one hand, H.R. 5095 brings the U.S. into compliance with the WTO ruling by repealing the FSC/ETI regime which gives eligible companies as much as $4.5 billion per-year in favorable tax treatment for their exported goods. According to the Joint Committee on Taxation, eliminating the FSC/ETI regime reduces tax benefits to eligible firms by $51 billion over the next ten years.
In the short-term, therefore, repealing the FSC/ETI regime will mean a hefty tax hike for a relatively small group of export-reliant companies and could cause job losses in certain industries and regions of the country. This is especially true for companies exporting to highly competitive foreign markets who cannot pass the cost of the tax along to consumers. Companies that dominate their markets, or who provide sole-source products, can more easily pass this tax along to consumers. Ironically, some of this tax hike will be exported to European consumers.
Over the long-term, economic theory suggests that repealing FSC/ETI will reduce the value of the dollar which, in turn, will make U.S. export goods more competitive in the global market. Studies have shown that while FSC/ETI expanded exports for certain products, it also drove up the value of the dollar in foreign exchange markets. The higher value of the dollar encouraged more imports, thus canceling FSC/ETI’s effect on the balance of trade. Repeal would reverse this process, thus weakening the value of the dollar and encouraging more exports.
However, one of the reasons that these export tax credits were created was to combat the European “border tax adjustments” that remove the Value Added Taxes (VAT) from exported products. This is often thought to give foreign imports a price advantage in global markets, an issue that doesn’t disappear with the repeal of FSC/ETI.
On the other hand, the core competitiveness elements in H.R. 5095 are overdue steps toward simplifying the existing international tax rules and repealing some of its most punitive elements. These reforms will save U.S. multinationals more than $86 billion over the next ten years. More importantly, these reforms will greatly help U.S. multinationals compete and export globally. Studies show that each dollar that U.S. firms invest overseas produces $2.00 worth of additional exports. This, in turn, will mean an increase in the number of better-paying, export-related jobs in the U.S.
Lastly, the impact of the bill’s provisions to protect the U.S. tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. could have repercussions far beyond what lawmakers intend. As will be discussed below, the provisions in the bill that are intended to prevent foreign-based multinationals from stripping income out of their U.S. subsidiaries could have a chilling effect on direct foreign investment. There is also the question of whether or not the improvements to Subpart F and the foreign tax credit rules will be sufficient to prevent some U.S. firms from seeking to lower their tax burden by re-incorporating offshore.
Unfortunately, the major elements of H.R. 5095 have pitted the interests of U.S. exporters against the interests of both U.S. multinationals and U.S. subsidiaries of foreign firms. In part, this is due to Congress’s strict adherence to the misguided notion of “revenue neutrality,” which requires that any tax cut – even those that spur greater economic activity – be offset by a comparable increase in other taxes. As a result, some corporate taxpayers (exporters and foreign subsidiaries) will pay higher taxes to finance the better tax treatment of foreign investments (multinationals).
To be sure, the reforms to U.S. international tax rules are long overdue and will bring substantial benefits to the economy. But measures are also needed that will make the U.S. economy a better place to do business in and to export from. H.R. 5095 falls short of achieving this goal.
One measure that would improve the position of exporters and make the economy a more attractive place to invest is a cut in the corporate tax rate. At 35 percent, our corporate tax rate ranks as the fourth highest among the 24 leading industrial countries in the world. Countries with lower corporate rates include: France (33.3 percent); Great Britain (30 percent); and Japan (30 percent). Even socialist countries such as Denmark (30 percent), Finland (29 percent), and Sweden (28 percent) have lower rates.
While cutting the U.S. rate, say from 35 to 30 percent, would not make all FSC/ETI losers whole, increasing the after-tax return for exported goods would clearly benefit U.S. exporters overall. And since a reduction in the top corporate tax rate is broad-based, even purely domestic firms would benefit substantially.
It also seems reasonable that a substantial reduction in the U.S. corporate tax rate would discourage corporate re-incorporations and the practice of earnings stripping. Indeed, a lower U.S. corporate tax rate would be likely to attract a considerable amount of new foreign investment into the economy. Over time, the dynamic effects of such a reduction in the corporate rate would substantially reduce its cost to the U.S. Treasury.
THE ECONOMICS OF INTERNATIONAL TAXATION While little understood outside of corporate tax departments and a handful of congressional committees, the international tax laws administered by U.S. and foreign governments can dramatically affect business decision making, job creation and retention, plant location, competitiveness, and the long-term health of the U.S. economy.
The basic tenets of sound tax policy are that income should be taxed once and only once – as close to the source as possible – and that a tax system should be neutral to business decision making. As can be expected, most tax systems, including the U.S. corporate tax system, fall far short of these ideals.
“Worldwide Taxes” Vs. “Territorial Taxes” Generally, the U.S. taxes companies on their income at the rate of 35 percent whether it’s earned here or abroad by a subsidiary. Since the foreign subsidiaries of U.S. firms pay income taxes to their host countries, the U.S. addresses the problem of double-taxation by allowing firms to take a credit against their U.S. tax for income taxes they paid to another country. Since tax rates vary greatly between countries, the U.S. foreign tax credit system is far more complicated than it first appears.
For example, suppose that Hometown Computer Company earns $100 million in U.S. profits and $100 million in profits from its Swedish subsidiary. Under a purely worldwide tax system, Hometown Computers would owe $35 million, at the 35 percent rate, on its U.S. earnings and another $35 million on its Swedish earnings. In order to avoid the double-taxation of the Swedish earnings, the U.S. system gives Hometown a $28 million foreign tax credit for the income taxes it paid to Sweden at its 28 percent corporate rate. However, under the U.S. system, Hometown still owes $7 million in U.S. tax on those residual Swedish earnings. This amount represents the difference between what the company paid to the host country and what that income would have been taxed had it been entirely generated in the U.S.
There is a limit to the foreign tax credits U.S. firms can take, and the limit is equal to the U.S. rate. Suppose that Hometown also does business in Belgium, which has a top corporate tax rate of 40.2 percent, 5.2 percentage points higher than the U.S. rate. In this case, Hometown would pay $40.2 million in Belgian tax on that $100 million in income. However, Hometown could only take a foreign tax credit equal to the U.S. rate, or $35 million. Because Hometown cannot take a full credit for the taxes it paid in Belgium, it is said to be in an “excess credit” position.
Complicating this simple example is the fact the U.S. system does not tax profits earned abroad until companies actually return those profits to the U.S. This part of the U.S. international tax system is called “deferral” because companies can defer paying taxes on that foreign-source income as long as they reinvest that income in an active foreign subsidiary.
Further complicating things is that the U.S., like many countries, has a system of “anti-deferral” rules which tax certain kinds of foreign-source income in the year it was earned even though the U.S. parent company had not repatriated those profits. These complex rules are commonly referred to as “Subpart F,” owing to their chapter in the U.S. tax code.
The Costs of Complexity Not surprisingly, most economists and tax practitioners agree that the U.S. international tax regime is inefficient, complicated, and expensive for companies to comply with. For example, based upon a survey of the tax officers of 1,672 large firms, Slemrod and Blumenthal found that the costs these companies incur to comply with U.S. international tax laws represent about 39 percent of their overall tax compliance costs. For Fortune 500 companies the cost ratio was nearly 44 percent.
Moreover, Slemrod and Blumenthal found that the costs associated with complying with U.S. international tax laws are “disproportionately high relative to the companies’ foreign activities.” Indeed, while the typical Fortune 500 company dedicated 44 percent of its compliance resources to international taxes, only 27.8 percent of its assets, 30.1 percent of its sales, and 26.2 percent of its employment were generated abroad.
Taxes Matter Compliance costs are not the only burden of international tax laws. Multinational firms also commit considerable resources on tax planning in order to minimize their tax burden. Contrary to what most lawmakers believe about corporate behavior, economic studies paint a fairly conclusive picture of how sensitive multinational firms are to tax rates and tax rules, and to what extent they will alter their business arrangements to minimize their tax.
For example, using data aggregated from more than 500 multinational tax returns, Grubert and Mutti found that “average effective tax rates have a significant effect on the choice of locations and the amount of capital invested there. A lower tax rate that increases the after-tax return to capital by one percent is associated with about 3 percent more real capital invested if the country has an open trade regime.” Based upon these results, they predict that were taxes not a motivating factor, approximately one-fifth of U.S. capital abroad would be in a different location.
In another study of corporate tax sensitivity, economists analyzed the investments of U.S. manufacturing firms in 58 countries. They found that not only are multinationals highly sensitive to host country tax rates, but that they were twice as sensitive in 1994 as they were just a decade earlier. The study’s authors report, “These results are consistent with increasing international mobility of capital and globalization of production.”
Not only are U.S. firms sensitive to the different tax rates abroad, but studies also have found that foreign investors are sensitive to U.S. taxes – especially state corporate income tax rates. These studies find that state tax rates have a significant effect on the location of new plants. One such study found that high-tax states are negatively correlated with the establishment of new plants and the expansion of existing ones (meaning, the higher the rate, the lower the new investment), but these states are positively correlated with foreign purchases of domestic firms.
Given the sensitivity of multinationals to host country taxes, it is not unexpected to find that these firms will go to great lengths to arrange their business transactions to minimize their tax burden.
Tax Minimization Strategies There are many techniques multinational firms can employ to minimize their worldwide tax burdens. One such method is through the aggressive use of “transfer pricing” – the price a parent company charges its overseas affiliate for a product, component, or trademark. Although complicated in practice, the simple goal of this technique is to book the higher expenses in a high-tax country – thus minimizing the after-tax profits – and book the profits in the lower-tax country where they can be deferred.
Although revenue authorities in most countries strictly monitor transfer pricing within firms in order to abate tax avoidance, James R. Hines found “The pretax profitability of foreign affiliates is negatively correlated with host country tax rates (Hines and Rice 1994), which is suggestive of tax-motivated transfer pricing…” As Goodspeed and Witte explain, “If the subsidiary is providing the parent with an input, there is an incentive to charge a very high price for the input. Since this will result in high revenue in the low-tax country and high costs in the high-tax country, the effect will be to transfer profits from the high-tax to the low-tax country.”
Another method firms use to minimize their global taxes is to shift the balance of tax-deductible debt and royalty payments between high-tax and low-tax countries. For example, the tax codes of many countries, including the U.S., give a tax advantage to debt-financed expansion by allowing firms to deduct the interest costs of their loans from their taxes. However, there is no similar preference for equity-financed investments. Similarly, royalty payments are tax deductible, but dividend payments are not.
Because of these incentives, many parent firms will lend capital to their foreign subsidiaries (especially to those in high-tax nations), which allows the subsidiary to deduct the interest payments paid back to the parent, and thus lower its taxable income. For the parent, the interest payments are taxed as income, but presumably at a lower tax rate than would be the profits earned by the subsidiary in the higher-taxed country.
One study by Grubert analyzed the dividend, interest, and royalty payments by 3,467 foreign subsidiaries to their parent American companies in 1990. It found that “high corporate tax rates in countries in which American subsidiaries are located are correlated with higher interest payments and lower dividend payout rates.”
There is considerable evidence that multinational firms are sensitive to the taxes they pay on repatriated profits through dividends – although some studies show this sensitivity is only evident when effective tax rates fluctuate frequently as opposed to when rates are stable. A 1990 study by Hines and Hubbard found that only 16 percent of foreign subsidiaries of American firms paid dividends to the parent company in 1984, and those that did had a particular tax advantage. They conclude that “a one percent decrease in the repatriation tax is associated with a four percent increase in dividend payout rates.”
Similarly, a more recent study by Desai, Foley, and Hines asserted that “One percent lower repatriationTax repatriation is the process by which multinational companies bring overseas earnings back to the home country. Prior to the 2017 Tax Cuts and Jobs Act (TCJA), the U.S. tax code created major disincentives for U.S. companies to repatriate their earnings. Changes from the TCJA eliminate these disincentives. tax rates are associated with one percent higher dividends. This implies that repatriation taxes reduce aggregate dividend payouts by 12.8 percent, and, in the process, generate annual efficiency losses equal to 2.5 percent of dividends.” These efficiency losses have the same effect as an additional tax placed on multinational firms and their shareholders, workers, and customers.
As Gordon and Hines sum up the empirical literature, “The reported profitability of multinational firms is inversely related to local tax rates, a relationship that is at least partly the consequence of tax-motivated use of debt financing, the pricing of intrafirm transfers, royalty payments, and other methods.” In other words, tax rates matter. And countries with higher tax rates will always see a higher incidence of tax minimization strategies among multinationals than low-tax countries.
DESCRIPTION AND ANALYSIS OF H.R. 5095 The three disparate policy objectives of H.R. 5095 were shaped by a rare confluence of events beginning with the WTO ruling against the U.S. Foreign Sales Corporation rules, combined with rising concerns over the tax code’s impact on the competitiveness of U.S. multinationals and the erosion of the U.S. tax base from sophisticated tax minimization or avoidance techniques.
It is important to assess each of these issues separately before assessing the bill overall.
Foreign Sales Corporation/Extraterritorial Income Exclusion Since the early 1960s, the U.S. has maintained a series of export-related tax benefits for export-intensive corporations. While clearly designed to spur U.S. exports, these provisions were also seen as a way of leveling the playing field with countries that employ “border tax adjustments” to remove the Value Added Taxes (VATs) from the price of export products before they are shipped abroad. This is estimated to save European exporters as much as $100 billion a year in tax payments on export sales.
Border tax adjustments (BTAs) can be precisely calculated in a VAT system because the tax is levied on the products themselves. However, BTAs are more difficult to employ in a country like the U.S. that relies on direct taxes such as corporate income taxes. While it is widely recognized that corporate taxes are borne by consumers, workers, or shareholders, there is no agreement as to what share of the tax each group ultimately bears. In fact, the proportions change all the time. As a consequence, it is difficult to determine how much of the corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. should be stripped out of a U.S. product’s price before it is exported abroad.
This clash of direct and indirect tax systems has been a source of continual conflict between the U.S. and its European trading partners for more than thirty years. The first U.S. export-related tax law, known as DISC, for “domestic international sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding. corporations,” was challenged by the Europeans in the 1970s as violating the General Agreement on Tariffs and Trade (GATT). This dispute continued until 1984 when Congress replaced the DISC with a new law called the Foreign Sales Corporation (FSC).
In 1997, the European Union (EU) challenged the legality of the FSC regime before the World Trade Organization (WTO). A WTO panel eventually agreed with the EU and struck down the FSC regime. In 2000, the U.S. Congress replaced the FSC with a new export-related regime call the Extraterritorial Income Exclusion Act (ETI), which lawmakers believed would bring the U.S. into compliance with the WTO ruling.
Once again, the EU challenged the ETI regime and, in January 2002, a WTO Appellate Body ruled that the ETI constituted a prohibited export subsidy. In August 2002, the WTO ruled that if the U.S. did not come into compliance with the Appellate decision, then the EU could impose more than $4 billion worth of sanctions against U.S. products.
H.R. 5095 bluntly brings the U.S. into compliance with the WTO ruling by repealing the ETI/FSC regime.
The economic consequences of this action are mixed. The immediate effect, of course, will be a roughly $4.5 billion annual tax hike on export companies that take advantage of the ETI/FSC regime. The impact of this tax hike will vary according to which direction a company can pass along the tax – forward to consumers through higher prices, down to workers through lost jobs, or back to shareholders through lower share prices.
Companies in highly competitive markets are less able to pass the tax along to consumers and will likely either cut jobs or dividends. In the short-run, this will cause job losses in certain industries. A recent study estimated that more than 1 million jobs were directly attributable to ETI/FSC-benefited exports. The effect of the ETI/FSC repeal on this group of workers will depend upon how each firm reacts to the tax increase.
Another immediate impact will be on the share price of ETI/FSC beneficiary companies. Desai and Hines investigated the impact on share prices solely from the EU’s filing of its complaint with the WTO on November 18, 1997. Their findings demonstrate the extent to which taxes and tax benefits are capitalized into share prices: Generally speaking, major American exporters evidenced the largest negative abnormal stock market returns on November 18, 1997. This effect was greatly attenuated for exporters with net operating loss carryforwards, for whom tax subsidies are less valuable than they are for others…[T]he prices of more profitable firms exhibited the most pronounced negative reactions to news of the European complaint.
Companies that dominate various markets, or those who are essentially sole-sources for certain products, can more easily pass along the tax hike to consumers. Ironically, this will prove detrimental to European consumers who have benefited from these lower-priced goods. To some extent then, the tax hike resulting from the repeal of the ETI/FSC regime will be borne by European consumers and taxpayers.
Although it may seem counterintuitive to non-economists, repealing ETI/FSC could create the conditions for increased exports. One of the unseen effects of ETI/FCS is that it boosts the value of the dollar which, in turn, boosts the quantity of imports. As Brumbaugh explains, “The tax benefits increase foreign purchases of U.S. exports, but to buy the U.S. products, foreigners require more dollars. The increased demand for U.S. dollars drives up the price of the dollar in foreign exchange markets, making U.S. exports more expensive … [and] imports cheaper. The net result is a higher level of both imports and exports, but no change in the overall balance of trade.”
Desai and Hines studied the impact of the events surrounding the WTO controversy on the value of the U.S. dollar relative to other major currencies such as the British pound sterling. They found that events favorable to the European position led to a weakening in the value of the dollar relative to other major currencies. This suggests that the repeal of the ETI/FSC regime will further weaken the value of the dollar which will make the price of U.S. export goods cheaper to foreign consumers. This, in turn, will lead to an increase in U.S. exports which will benefit all domestic exporters.
While a weaker dollar may benefit all exporters, it is not likely to fully compensate those industries affected by the repeal of the ETI/FSC law. Moreover, the issue of European border tax adjustments still lingers as a problem for the global competitiveness of U.S. products.
MEASURES TO IMPROVE U.S. GLOBAL COMPETITIVENESS H.R. 5095 contains 20 measures to reform and simplify some of the most complex and punitive areas of the U.S. international tax regime. Not only will these measures reduce unnecessary compliance costs for U.S. companies, they will also minimize the possibility that profits earned abroad and kept abroad are taxed before companies choose to repatriate those profits to the U.S. As a whole, these measures will greatly enhance the competitiveness of U.S. firms doing business in international markets.
Improving the competitive position of these firms in the global market returns substantial dividends to the U.S. economy. “Approximately one quarter of the 1999 U.S. Gross National Product of $9.3 trillion was produced by U.S. non-bank multinationals.” In 1998, these parent firms employed 21 million people in the U.S., about one of every six jobs in the economy.
Contrary to the popular belief that U.S. firms “export” jobs overseas, the reality is that these firms are heavily reliant on their domestic operations for everything from R&D and marketing support to the manufacturing of goods sold by foreign subsidiaries. Indeed, in 1999, U.S. multinationals contributed roughly $440 billion of merchandise exports, about two-thirds of all merchandise exports that year. A recent study by the Organization for Economic Cooperation and Development (OECD) finds that each dollar of outward foreign direct investment is associated with $2.00 of additional exports and an increase in the bilateral trade surplus of $1.70.
In a recent study of the impact on domestic employment of the overseas manufacturing of U.S. multinationals, Lipsey determined: “There is no indication in aggregate data that movements of production from the United States to foreign affiliates have had any negative effect on employment by parent firms or in the United States as a whole, at least in the last twenty years.”
Lipsey did find some effects of foreign production on employment within firms. Some firms did shift “more labor-intensive segments of their production to their developing country affiliates and the more capital-intensive segments to their home operations…” Yet, Lipsey found only a “weak evidence for a wage or skill effect. If there is any effect it is that foreign operations are associated with higher wages at home.”
Six of H.R. 5095’s more significant reform measures include:
1. 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.
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 (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. 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.
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 Germany, 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 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 remedy Under H.R. 5095, 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 branches 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.
2. 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. These payments are taxed immediately even though they are entirely within the same multinational group. 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 H.R. 5095, 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.
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.
3. Extending the Carryover Period on Excess Foreign Tax Credits from Five Years to Ten
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 remedyUnder H.R. 5095, the U.S. taxpayer will be permitted to carry the credit forward for 10 years before it expires.
Impact of proposalThis provision is fairly non-controversial. There seems to be little policy rationale for restricting the carry-forward to five years. This proposal will save firms $6.7 billion over the next ten years.
4. Reforming Interest Expense Allocation Rules
Current law The 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. 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 H.R. 5095, 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, H.R. 5095 clearly offers a more accurate way to allocate interest expense than the current rules. Over ten years, this proposal will save companies more than $23 billion. 5. Reducing the Number of Foreign Tax Credit “Baskets”
Current law The 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 remedyH.R. 5095 would reduce the number of separate baskets to three.
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.
6. Eliminating the AMT’s Limitation on the Use of Foreign Tax Credits.
Current law If 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 remedyUnder H.R. 5095, this limitation on the use of foreign tax credit under the AMT would be eliminated.
Impact of proposalThere is little serious argument for 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.
PROVISIONS TO PROTECT THE U.S. TAX BASE H.R. 5095 contains a number of specific provisions intended to prevent the erosion of the U.S. tax base. Two of the more significant provisions are intended to prevent inversions and so-called “earnings-stripping.” As will be seen, these provisions could effectively stifle these tax-minimization techniques, but they do not correct the systemic problems in the tax code that prompt such techniques. Moreover, the earnings-stripping rules in particular could have a chilling impact on foreign investment in the U.S.
Anti-Inversion Provisions The bill contains three provisions intended to prevent U.S. companies from re-incorporating in foreign tax jurisdictions. The first provision would impose a three year moratorium on “mailbox” inversions. A mailbox inversion occurs when a U.S. company transfers its incorporation to a foreign tax jurisdiction, typically one like Bermuda that has no corporate income tax, without relocating employees or any other business activity to the new jurisdiction. The company continues to act like a U.S. company in all respects other than its tax liability on income earned abroad.
H.R. 5095 would simply disregard mailbox inversions that take place after March 20, 2002. Firms that re-incorporate in low-tax jurisdictions but do not shift substantial economic activity to the new jurisdiction would be treated for tax purposes as if they never inverted.
The second provision aimed at preventing corporate inversions would impose a “20 percent excise tax on the value of all stock options and stock-based compensation held by insiders, top executives, and directors when a company inverts.” Under current law, if a company’s re-incorporation is accomplished through a stock transaction, in which the overseas corporation purchases most of the shares in the domestic corporation, existing shareholders (whether or not they become shareowners in the new, foreign corporation) may face capital gains taxation at the time of inversion. This is due to section 367 of the U.S. Internal Revenue Code, added in 1998, which requires shareholders to recognize a gain on the exchange of stock for tax purposes. This provision was added to the code as an “exit toll” with the intention of making inversions less palatable to U.S. corporations.
H.R. 5095 would apply the section 367 exit toll to stock options held by top corporate executives and directors. The goal of this provision is to give corporate managers a greater financial stake in any decision to invert.
Finally, the bill contains another provision intended to prevent corporate inversions that would disallow firms that transfer assets to a newly incorporated foreign parent company from using foreign tax credits or net operating losses (NOLs) to offset taxes due on the sale. Under current law, when a U.S. company transfers assets to a foreign parent company, the U.S. company faces a tax liability equal to 35 percent of the sale, which may be offset by foreign tax credits or NOLs. H.R. 5095 would prevent firms from using such credits to offset the sale of assets to a foreign parent company.
The problem with imposing punitive “exit toll” taxes on inverting companies or simply ignoring the fact that some companies choose to re-incorporate in a low tax jurisdiction is that such an attitude ignores the reasons that the company felt it necessary to do so in the first place. Many U.S. companies facing stiff competition internationally find themselves priced out of certain markets due to the high U.S. corporate income tax rate. Establishing a corporate parent in a low-tax jurisdiction is a mechanism through which these companies can remain competitive. Denying U.S. companies this option forces them to remain competitive in other ways, which may include reducing their workforce, moving actual operations and jobs to other countries, or seeking acquisition by a foreign firm. In fact, this is encouraged by the elimination of mailbox inversions.
Earnings Stripping Rules Perhaps the element of H.R. 5095 with the highest chance of producing unintended consequences is the provision to prevent earnings-stripping by companies that re-incorporate in low-tax jurisdictions and by the parent companies of U.S. subsidiaries. Specifically, the bill would:
“… alter earnings-stripping rules by eliminating the 1.5-to-1 debt-to-asset safe harbor, disallowing related party interest expense to the extent that the U.S. subsidiary of a foreign-owned company’s debt-to-asset ratio exceeds the foreign company’s worldwide debt-to-asset ratio, reducing the allowable interest expense from 50 to 35 percent of adjusted taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. …”
While these changes will certainly crack down on the most prominent cases of this practice, specifically companies that repatriate in order to lower their U.S. and worldwide tax burdens, these measures will also impact the customers, workers and shareholders of hundreds of foreign-based companies with huge investments in the U.S. economy.
The first order impact of these changes will be an effective tax increase on many U.S. subsidiaries of foreign companies who have financed new plant and equipment through inter-company debt. Of course, the higher taxes paid by these subsidiaries will translate into either higher prices for U.S. consumers, lower wages for the employees of the subsidiary, or lower earnings for shareholders of the company. Moreover, increasing the effective U.S. tax rate for these companies could chase new investments into neighboring economies such as Mexico and Canada.
Ironically, over time the attempt to stem the abuse of inter-company debt could actually lead to lower tax collections, not higher collections. As for most of us, the cheapest place for a subsidiary to borrow money for expansion is from its parent. Since interest payments are deductible, the lower interest rate paid to parent companies translates into smaller tax deductions and, thus, more taxes paid to the Treasury.
However, if lawmakers are successful in curtailing inter-company lending, many subsidiaries could be forced to borrow from commercial lenders at higher rates. These higher rates will translate into higher interest payments, larger tax deductions, and less tax revenue for the government. Thus, the attempt to halt the erosion in the U.S. tax base could lead to a further erosion of the tax base.
Furthermore, a crackdown on the U.S. subsidiaries of foreign firms could lead to retaliation by our major trading partners. Inter-company lending is not unique to foreign-based companies. Studies find wide use of the practice by American firms as well, especially in high-tax countries. Current U.S. rules on inter-company debt are already seen by many in the international community as moderately tough. A further tightening of these rules could prompt other countries to respond in kind, thus harming the foreign investments of U.S. firms.
Lastly, it remains an open question as to whether earnings stripping by foreign multinationals is a serious problem that needs to be corrected. While some economic studies have found that foreign-owned subsidiaries do pay less tax than U.S. firms, this is not necessarily the result of aggressive tax planning.
For example, Grubert, Goodspeed, and Swenson documented that “foreign-controlled U.S. companies report less taxable income than similar companies with American interests.” However, they determined that roughly half the difference in tax liabilities is due to non-tax reasons such as exchange rate fluctuations, firm size, and age. The authors speculated that the remaining differences could be caused by aggressive tax planning, but that other factors such as the willingness of foreign owners to accept early losses to gain market share or the poor performance of these U.S. ventures could be equally culpable.
A more recent study by Blouin, Collins, and Shackelford investigated whether U.S. firms acquired by foreign multinationals pay less tax after the acquisition as the result of aggressive tax planning. Their findings were decisive: “In short, we find no evidence to support claims that foreign acquisitions result in disproportionate tax reductions compared with domestic acquisitions.”
Despite these findings, the U.S. Treasury has indicated its concern that earnings stripping techniques are being employed by foreign parent companies. If this is indeed the case, and if foreign multinationals employ these techniques in high-tax countries in the same manner that U.S. multinationals do in similar circumstances, this gives further credence to the argument that the U.S.’s high corporate tax rate is the root of the problem, not the behavior itself.
CONCLUSION The three distinct policy objectives of H.R. 5095 make it difficult to assess the overall economic impact of the bill. Clearly the provisions that produce the biggest bang for the economy and the competitiveness of U.S. multinationals are the 20 measures designed to simplify and reform U.S. international tax rules. In many respects, these measures create the effect of a territorial system, protecting foreign-generated income from U.S. tax until companies choose to repatriate these profits, if they ever do. These measures will also dramatically reduce the cost of complying with U.S. international tax law, a system that generates relatively little income for the government at an extremely high cost to business and the IRS. These compliance savings alone could total into the billions of dollars each year.
The bill also repeals the ETI/FSC regime in order to bring the U.S. into compliance with the WTO ruling. In the short-term, this measure will mean a roughly $4.5 billion per year tax hike on those firms that have enjoyed this benefit. Depending on each firm’s position in the market, such a tax hike could result in job losses, lower share prices, or price hikes passed along to European consumers. And because the bill adheres to Congress’s often misguided notion of “revenue neutrality,” these higher taxes are used to finance the competitiveness measures – thus pitting the interests of domestic exporters against those of multinational companies.
Lastly, the bill’s attempt to protect the U.S. tax base could have serious unintended consequences. In particular, the provisions intended to tighten earnings stripping rules could have a chilling effect on new foreign investment in this country and on the operations of current subsidiaries of foreign parent companies.
In short, H.R. 5095 goes a long way toward improving the competitiveness of U.S. multinationals abroad which, in turn, will lead to a rise in U.S. exports and more high-wage jobs in domestic home offices. But to achieve the maximum economic benefits, lawmakers should look to match these reforms with measures that will make the U.S. economy a better place to do business in and to export from. Cutting the top corporate tax rate, say from 35 percent to 30 percent, would be a significant step toward achieving that goal.
Broadly speaking, a large body of economic evidence suggests that cutting the top corporate tax rate would:
1. Make the U.S. rate comparable to the rates of our major trading partners. Since the United States lowered its top corporate tax rate in 1986 from 46 to 34 percent, other leading countries have followed suit and lowered their corporate tax rates. Whereas the United States did have one of the lowest rates in the world, now only four OECD countries have a higher top statutory rate than the U.S.
2. Reduce the domestic costs of U.S. exporters. Lower tax costs for U.S. exporters should translate into lower prices of goods shipped abroad, thus making those goods more competitive overseas.
3. Help small firms trying to enter foreign markets. Small firms cannot afford to take advantage of deferral and must repatriate any profits to finance their on going operations. Reducing the corporate rate would reduce the tax penalty for repatriating those profits and improve the ability of these emerging firms to expand into foreign markets.
4. Encourage multinationals to increase the amount of dividends repatriated back to the U.S. A lower rate would reduce the tax penalty against reinvesting foreign profits back into the U.S. This would lead to more investment in the U.S. by domestic multinationals.
5. Encourage greater foreign investment in the U.S. While the U.S. is a highly desirable market for foreign firms, a lower rate would spur more investment and encourage those companies to reinvest their U.S. profits here.
To be sure, the biggest obstacle to cutting the top corporate rate is its perceived cost to the U.S. Treasury. Calculated on a static basis, this is undoubtedly true. However, the real cost to the Treasury will be dramatically less because of all the new economic activity generated by the cut in the corporate rate.
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