Administration Proposes to Repeal Deferral, Haircut the Foreign Tax Credit and Interest Expense Deductions, Override Treaties, and Abandon Arm’s-Length Transfer Pricing for Intangibles

As the above title indicates (it is only a modest exaggeration), the Treasury Greenbook regarding the FY 2016 budget proposes a radical restructuring of the system for U.S. taxation of foreign income of U.S. multinational enterprises (MNEs). Some Congressional players have suggested that these proposals are an opening bid in a negotiation. While Republican reaction has varied from lukewarm to apoplexy, Democrats, a few Republicans, and the tax and financial press have suggested that there is enough common ground with past Republican proposals that such negotiations might possibly bear fruit. While the compromise that could result from such negotiations is highly unlikely to be a good thing for most U.S. MNEs (indeed, it would likely make many U.S. MNEs less competitive vis-a-vis their foreign-flagged competitors than today), there is at least a remote possibility of such a compromise. It is important, therefore, to at least briefly consider the Greenbook international proposals.

First, the Administration proposes to repeal deferral. The Greenbook calls it a “supplement [to] the existing Subpart F regime with a per-country minimum tax…” but, in fact, it is a repeal of deferral. All foreign income of U.S. MNEs would be subject to immediate taxation when earned, albeit some at a lower rate, and some protected by a sort-of foreign tax credit if the foreign tax rate is generally above 22.35%. Unlike the current system in place since the dawn of the income tax, no U.S. tax would be deferred until foreign income is repatriated to the United States. The separateness of a CFC from its U.S. shareholders, partially breached in 1962, would be mostly obliterated—realization at the CFC level is essentially realization at the U.S. shareholder level—but only for income, not for losses.

Under this new regime, foreign income that is not subject to the ordinary corporate rate as effectively connected income (ECI) or under traditional Subpart F categories (proposed to be expanded, as noted below) would be subject to a “minimum tax.” The minimum tax rate is 19% less 85% of the per-country foreign effective rate. In addition, foreign earnings would include disregarded payments deductible elsewhere and would exclude an “allowance for corporate equity” (ACE). The ACE allowance would provide a risk-free return (at an as-yet unspecified rate) on equity invested in “active assets,” i.e., assets that do not generate foreign personal holding company income (such as intangibles that are not actively licensed).

Rather than provide an actual foreign tax credit (FTC), the proposal would provide a surrogate for a partial FTC through the 85% of the foreign effective rate that is subtracted from the 19% minimum rate. Rather than allowing a credit for actual foreign taxes paid with respect to CFC and branch income, the 19% rate is reduced by a portion of the foreign effective rate. The foreign effective rate is computed on a per-country basis, averaged over a rolling five-year period. For example, assume that a CFC has operated in Ireland for six years, its effective Irish tax rate for years 1 and 2 was zero due to start-up losses, and its effective rate for years 3 through 5 was 12.5%. For year 6 its minimum U.S. tax rate on year 6 foreign earnings in Ireland would be 11.5%1 for a combined U.S. and Irish tax rate of 24%. Depending on the ACE deduction from Irish earnings, this nominal rate could be somewhat reduced. Since the combined Irish and home country tax rate for many of our competitor countries would be 12.5% (or even lower — 7.5% when you average over the five years in the example), this obviously does very little to make U.S. MNEs competitive with MNEs from other countries with regard to taxes.

For CFCs or branches with high foreign effective tax rates, there might be no U.S. minimum tax. For example, assume that a CFC had operated in Australia for five years and paid tax at an effective rate of 30% each year. The U.S. shareholder of CFC would owe no U.S. minimum tax on CFC’s Australia earnings.2 However, it would also have no excess FTCs to protect Australia-source royalties that CFC might pay its U.S. shareholder.

The per-country computation of the effective foreign rate, together with the presumed repeal of §902 in the minimum tax regime, is rather clearly aimed at eliminating any possibilities of cross-crediting. Where foreign effective rates are above 22.35%, the regime would also encourage U.S. MNEs to reduce their foreign taxes to as close to that rate as possible, also apparently a desired goal. While traditional FTC averaging and “hyping” would be dead, presumably the system would encourage earnings-stripping from high rate countries to lower rate countries to minimize the amount of earnings subject to a foreign rate in excess of 22.35%. Thankfully, §954(c)(6) would be made permanent to facilitate this.

There is some question as to whether this surrogate for a partial FTC complies with U.S. tax treaties. Virtually every U.S. tax treaty modifies the guarantee of an FTC with the words “subject to the limitations of the law of the United States (as it may be amended from time to time without changing the general principle hereof).” It is likely, however, that treaty partners would not consider a 15% haircut to the FTC, especially in a case where the ACE deduction may be immaterial, to be a reasonable limitation consistent with the general principle of an FTC. That the income is subject to a rate of U.S. tax appreciably lower than that applicable to domestic income might be used to justify such a haircut. It is far from certain, however, that such a justification would be acceptable to our treaty partners. While enactment of the proposal, of course, could simply override any pre-existing treaty as a legal matter, Congress might be reluctant to enact a regime that overrides virtually every U.S. tax treaty.

In addition to haircutting FTCs, interest deductions for interest expense incurred by a U.S. corporation but allocable to foreign earnings would either be haircut or denied. In the Irish example above, such interest might be less-than-50% deductible.3 In the Australia example, no deduction would be permitted for such interest. While other countries may haircut their exemption for foreign income to do rough justice with regard to deductions allocable to exempt income, the proposed combination of a FTC haircut and an interest deduction haircut makes the treaty challenge noted above more likely. Other than revenue, it is hard to see a principled policy reason to combine the two.

The 19% minimum tax on foreign earnings would be effective for future earnings. For untaxed CFC earnings that have accumulated under the current system, the Greenbook proposes a 14% one-time tax, whether such earnings are repatriated to the United States or not. The FTC allowed against such tax would be haircut in proportion to the ratio between the 14% rate and the top U.S. corporate rate. As a result, the FTC permitted for the one-time tax on untaxed accumulated CFC earnings would be cut by 60%.4 This tax would be payable ratably over five years. Apparently there would be no interest charge on the years two through five payments. Unlike former Ways and Means Chairman Camp’s proposal, there would be no distinction between earnings in cash versus earnings that were invested in non-liquid assets. The substantial rate of 14%, its application to all earnings whether or not repatriated, and the haircut FTC could make it very hard for some taxpayers to raise the cash necessary to pay the tax.

The proposal also endorses some aggressive IRS and OECD theories in the transfer pricing area that are hard to characterize as arm’s length. Both of these are termed “clarifications.” First, where multiple intangible properties are transferred, or where intangible property is transferred with other property or services, valuing everything on an aggregate basis would be permitted. This would endorse the “tantamount to a sale of the entire business” theory that the IRS has advanced in several transfer pricing challenges, a theory that has been uniformly rejected by the courts.5 While, given the proposed addition of goodwill and going concern value to the definition of “intangible property” for §482 and §367 purposes and existing regulations,6 this may not be considered as aggressive as challenges based on older transfer pricing law, it is nevertheless not widely accepted as arm’s length. Second, though not inconsistent with current regulations,7 the proposal would permit the IRS to ignore the actual transaction entered into by the taxpayer and consider, instead, the prices or profits that the taxpayer could have realized by choosing a realistic alternative to the actual controlled transaction. This approach is the subject of one of the more controversial BEPS proposals. It is also doubtful whether it is truly consistent with the arm’s-length principle, a nicety the OECD can ignore by suggesting that “special measures” are necessary in certain transfer pricing situations. However, Congress may be reluctant to endorse such an approach.

In addition to these and several targeted international proposals, the Greenbook proposes several changes to “traditional” Subpart F. Possibly the least defensible of these is the proposal, also made in the FY 2015 Budget, to create a new category of Subpart F income for transactions involving digital goods and services. While this proposal is presumably responsive to the BEPS report on dealing with digital goods and services, its carryover to the FY 2016 Budget is rather less-than-serious, given comments over the past year from Treasury personnel and the Administration’s close ties to Silicon Valley and the high-tech community. The proposal creates a new category of Subpart F income, “foreign base company digital income” (FBCDI). FBCDI would consist generally of income from the sale or lease of a digital copyrighted article (e.g., software) or from the provision of a digital service where the CFC uses intangible property developed by a related person (including via a cost sharing arrangement) and has not, through its own employees, added substantial value.

Obviously, if enacted, these proposals would constitute a sea change in the U.S. taxation of foreign income. At the rates proposed, these provisions will not be enacted. However, if commentators are correct that they are an opening bid and share significant theoretical common ground with Republican proposals, it is not ridiculous to think that some modified version of these proposals might eventually become law. Given how far out of step with the rest of the world such a system would be, how complex the system would be, and how uncompetitive on taxes they would make U.S. MNEs, most observers in the private sector must hope this does not happen.