International Tax Reform: Perspectives on Reforming U'S' Taxation of Foreign Business Income

1
International Tax Reform Perspectives on
Reforming U.S. Taxation of Foreign Business Income

• Stephen E. Shay
• Partner, Ropes Gray LLP
• Lecturer in Law, Harvard Law School
• Prepared for
• The Presidents Advisory Panel on Federal Tax
  Reform
• Washington, DC
• May 12, 2005

2
Overview of Presentation

• Take Away Points
• Reform Alternatives
• Appendix A Planning Under Current Law
• Appendix B Assessment of Current Law

3
Take Away Points

• The taxation of foreign income directly affects
  the U.S. tax base
• If foreign income is taxed at a lower combined
  effective rate than U.S. income, taxpayers will
  shift U.S. income to foreign income
• Reduced taxation of foreign income subsidizes
  U.S. investment in low-tax foreign countries -
  Why there and not in Des Moines?

4
Take Away Points

• Allowing high foreign taxes to be used as credits
  
• to offset U.S. tax on low-taxed foreign income,
  or
• to offset U.S. tax on U.S. income treated as
  foreign under current rules
• subsidizes countries that impose high foreign
  taxes

5
Take Away Points

• Today, US tax planners
• reduce foreign taxes below U.S. effective rate,
• defer U.S. tax on foreign income subject to low
  effective foreign income tax, and
• use transfer pricing to shift additional income
  to low-tax deferral environment, and
• when income is repatriated to the U.S.,
  cross-credit excess foreign tax credits from
  high-taxed foreign income to offset U.S. tax on
  low-taxed foreign income in same foreign tax
  credit limitation category

6
Take Away Points

• This tax planning has been rewarded by favorable
  court decisions and Congressional passage of
  homeland dividend relief
• Untaxed earnings may be repatriated for one year
  at effective U.S. tax rate of 5.25 or less if
  reduced by foreign tax credits

7
Take Away Points

• There is no reason to tax a U.S. persons foreign
  income more favorably than U.S. income
• A credit should be allowed for foreign tax to
  avoid double taxation of income
• The unproven efficiency gains of lower taxation
  of foreign income do not outweigh
• the strong equity arguments against favored
  treatment of foreign income
• the very substantial complexity required to
  achieve and defend favored treatment of foreign
  income
• The inevitable and wasteful tax planning that
  will result

8
Take Away Points

• Fundamental reforms, described below, that reduce
  the effective rate differential between U.S. and
  foreign income are feasible if tax reform
  broadens business tax base and lowers U.S. tax
  rate on business income

9
International Tax Reform Alternatives

• Fundamental international tax reform alternatives
  include
• Expand current taxation of U.S.-controlled
  foreign corporation earnings, subject to a
  foreign tax credit that constrains
  cross-crediting, or
• Exempt active foreign business income that bears
  a sufficient effective rate of foreign tax (or
  have a functionally equivalent condition) to
  mitigate tax-motivated shifting of economic
  activity

10
International Tax Reform Alternatives

• Expand Current Taxation of Foreign Income
• Expansion of current taxation of U.S.-controlled
  foreign corporation earnings, unlike exemption,
  would not encourage investment in lower-taxed
  countries
• Expansion of current taxation of U.S.-controlled
  foreign corporation earnings would encourage
  non-tax motivated redeployment of earnings (there
  would be no separate repatriation tax)
• Expansion of current taxation of foreign income
  would reduce many complexities arising from
  deferral

11
International Tax Reform Alternatives

• Expanded current taxation of foreign income
  should be accompanied by improvements to the
  foreign tax credit to restrict cross-crediting
  against low-taxed foreign income and U.S. income
  masquerading as foreign income
• It also will be necessary to balance improved
  residence taxation of U.S. persons with stronger
  U.S. source taxation of foreign-owned business to
  discourage expatriation to foreign ownership

12
International Tax Reform Alternatives

• A second best alternative Exemption of active
  foreign business income
• An exemption proposal should require a minimum
  foreign effective rate of tax or a functional
  equivalent as a condition for exemption of active
  foreign business income
• Like current taxation, exemption would eliminate
  the repatriation tax, but
• Exemption also would encourage U.S. persons who
  can perform some business activities abroad but
  who need the cash in their U.S. business to shift
  business functions abroad

13
International Tax Reform Alternatives

• Exemption of active foreign business income
  (contd)
• It is critical not to exempt active foreign
  business income that is not foreign and not
  subject to foreign tax or the problems of current
  law will remain and worsen

14
International Tax Reform Alternatives

• If the U.S. shifts to a consumption tax and does
  not continue to tax business income,
• foreign countries will have little reason to keep
  income tax treaties with the U.S.
• foreign countries could increase their income
  taxation of U.S. companies foreign business
  operations

15
Appendix A

• Planning Under Current Outbound International Tax
  Rules

16
Planning Under Current Rules - Deferral

• US tax planners try to (and do)
• reduce foreign taxes below U.S. effective rate,
• defer U.S. tax on foreign income subject to low
  effective foreign income tax, and
• shift income to low-tax deferral environment

17
Planning Under Current Rules - Deferral

• Current transfer pricing rules allow income
  shifting to controlled foreign corporations in
  low-taxed countries
• No penalty for singles and doubles, only for
  swinging for the fences and getting caught

18
Planning Under Current Rules - Deferral

• Planning rewarded (examples)
• Dover case affirms use of (retroactive)
  check-the-box planning to avoid Subpart F
• Hospital Corporation of America, UPS other
  transfer pricing cases affirm nothing ventured,
  nothing gained approach to transfer pricing and
  tax planning DHL case an exception

19
Planning Under Current Rules - Deferral

• Planning rewarded
• In 2004, Congress passed homeland dividend tax
  relief to encourage repatriation of foreign
  earnings
• Untaxed earnings may be repatriated for one year
  at effective U.S. tax rate of 5.25 or less if
  reduced by foreign tax credits

20
Planning Under Current Rules Foreign Tax Credits

• When income is taxed by U.S., tax planners try to
  (and do)
• Generate low-taxed foreign income (using weak
  U.S. source rules), and
• Use foreign tax credits from high-taxed foreign
  income to offset U.S. tax on low-taxed foreign
  income in same limitation category

21
Planning Under Current Rules Foreign Tax Credits

• Low-taxed foreign income may be from either
• activities in low-tax foreign countries, or
• U.S. activities that generate income that Code
  allows to be treated as foreign income
• Low- and high-taxed income may be created by
  separating foreign taxes and income using U.S.
  tax planning techniques check-the-box
  planning and more

22
Planning Under Current Rules Foreign Tax Credits

• Planning rewarded (examples)
• Intel case and subsequent regulations affirm
  source rule treating U.S. activity for export
  sales as foreign income
• Guardian Industries case affirms use of
  check-the-box planning to split foreign taxes
  from foreign income
• Compaq and IES cases affirm use of structured tax
  planning to trade foreign tax credits and
  weakness of anti-abuse doctrines

23
Appendix B

• Assessment of Current Outbound International Tax
  Rules

24
Assessment of Current Law

• Problems of current law are not difficult to
  diagnose
• Effectively unlimited deferral offers too much of
  a rate differential for companies to resist it
  is a hole in the system
• Like water draining from a bathtub, U.S.
  multinationals are legally shifting increasing
  portions of their profits to low- or zero-tax
  foreign countries See Martin A. Sullivan, U.S.
  Multinationals Move More Profits to Tax Havens,
  102 Tax Notes 690 (Feb. 9, 2004)

25
Assessment of Current Law

• Transfer pricing rules need adjustments, but the
  biggest need is smarter enforcement
• Weak source rules and broad cross-crediting high
  foreign taxes against U.S. tax on other foreign
  income under porous foreign tax credit limitation
  result in de minimis U.S. tax on repatriated
  foreign income

26
Assessment of Current Law

• Joint Committee on Taxation
• The present-law system thus creates a sort of
  paradox of defects on the one hand, the system
  allows tax results so favorable to taxpayers in
  many instances as to call into question whether
  it adequately serves the purposes of promoting
  capital export neutrality or raising revenue.
  (JCS-02-05 Jan. 27, 2005)