Monday, April 29, 2013

Alan Viard's "PPL: Exposing the Flaws of the Foreign Tax Credit"

About a month ago, I commented here on PPL, the U.S. Supreme Court's pending foreign tax credit case that raises the question of whether a retroactive UK tax, meant to claw back the benefits that investors derived when government-owned utilities were privatized at what turned out to be too low a price, should trigger foreign tax credits for U.S. companies.

The legal dispute reflects the fact that economically identical taxes may be creditable or not, depending on how they are formally described.  For example, if you had a $5 perpetuity and the pre-tax interest rate is 5%, so it is worth $100, a 40% "income tax" is hard to tell apart from a 2% "property tax," since either one will cost you $2 per year.  Yet only foreign "income, war profits, and excess  profits taxes" qualify for the foreign tax credit.

The IRS has raised a few eyebrows, along with a legal challenge that generated a circuit split and Supreme Court review, by taking an apparently formalistic stance here, and saying that the U.K. tax is not creditable because it was not called or expressly structured as an income tax.  More often, the IRS wants to look at economic substance, while taxpayers rest their cases on self-selected form that supports favorable tax results.

But here, saying that "substance" should control runs into the problem that the underlying law on its face rests on arbitrary and formalistic distinctions.  Should any tax that can be shown to be equivalent to an income tax be creditable, even though it's clear that some such taxes are not meant to be creditable?  If so, then how exactly is one supposed to draw the fantastical line between taxes that win due to income tax equivalence and those that lose despite it (and thus that are also equivalent to the ones that win)?

In today's Tax Notes, Alan Viard has a very nice piece exploring PPL's conundra.  Rather than argue that the case should come out one way or the other, he uses it as a vehicle to expose the fundamental problems with foreign tax creditability and the related illogic and arbitrariness of efforts to draw lines between taxes that are creditable and those that are not.  In addition to agreeing with his analysis, I'll admit to having been personally gladdened by his references to some of my recent work on foreign tax credits (to be further developed in my forthcoming book on international tax policy).  A few samples of the article's discussion include the following:

"Reiterating a point made a half century ago by Peggy Musgrave, Daniel N. Shaviro of the New York University School of Law recently emphasized that from the standpoint of American well-being, U.S. taxpayers’ foreign income tax payments are no different than their other foreign tax payments, nontax foreign business costs, and reductions in foreign income. The credit reduces American well-being by artificially and inefficiently diluting U.S. taxpayers’ incentives to minimize foreign income taxes, because those taxes can be offset by the credit. The credit prompts American companies to operate in high-tax countries, to be less zealous in challenging foreign tax assessments, and to enter transactions that reallocate other parties’ foreign income tax liabilities to them in exchange for other benefits. Statutory and regulatory restrictions on the credit cannot satisfactorily combat those incentives....

"Despite its unusual generosity, the FTC has enjoyed almost unanimous support"  [For example, to bring out the lack of coherent - or any - analysis more bluntly than Viard does, it's not classified as a tax expenditure because it's not classified as a tax expenditure.  That is to say, it has not been defined as a tax expenditure because it has been defined as not a tax expenditure.] ....

"As Shaviro has emphasized, the FTC gives U.S. taxpayers an artificial incentive to pay foreign income taxes rather than incur other taxes or nontax costs. That incentive makes no sense from the standpoint of U.S. national well-being, because there is no meaningful distinction between foreign income taxes and other foreign costs ....

"Empirical evidence recently presented by Kimberly Clausing and Shaviro confirms that a country’s provision of an FTC prompts its investors to direct their overseas investments toward high-tax countries. Clausing and Shaviro found that OECD countries with credits placed a larger share of their foreign direct investment in high-tax countries (statutory corporate tax rate above 30 percent) and a smaller share in low-tax countries (statutory rate below 15 percent) than the OECD countries that exempt overseas income or have a hybrid credit/exemption system. The difference persisted in a statistical analysis that controlled for countries’ GDP levels, geographical distance, and other relevant variables.

"As Shaviro points out, if the FTC were immediate, refundable, and completely unlimited, a U.S. taxpayer would not incur even a $1 cost to avoid a $1 billion foreign income tax liability because the taxpayer would receive a fully offsetting $1 billion reduction in its U.S. taxes. Of course, nobody actually wants the taxpayer to incur the $1 billion liability and stick the U.S. treasury with the tab, so Congress and the IRS have taken steps to prevent that type of extreme result.

"The rules are so extensive and intricate precisely because they are trying to negate the basic incentives built into the credit. Yet, they can address only the most extreme cases.... 

"Some observers object that the removal of the FTC would lead to a dramatic, and potentially undesirable, increase in the U.S. tax burden on U.S. taxpayers’ foreign-source income. As Shaviro emphasizes, however, the appropriate size of that tax burden is a separate question from the degree of relief for foreign income taxes. If taxing foreign income at ordinary rates without a credit is deemed to result in too high of a U.S. tax burden on that income, the solution is to lower the tax rate applicable to the income. Rate reduction provides relief impartially to income that has been heavily taxed abroad and income that has been lightly taxed abroad, avoiding the credit’s bias in favor of the heavily taxed income. As explained above, that bias is the source of the credit’s flaws."

To be sure, there is a distinction between the arguments that (a) unilaterally providing a foreign tax credit is bad policy [I say "unilaterally" because exemption systems effectively make foreign taxes deductible, rather than creditable], and (b) once one has a foreign tax credit and hems it in hither and yon so as to limit the resulting damage, one is likely to find coherent line-drawing impossible.  But Viard nicely shows not only that both of these propositions are true, but also that they are closely logically linked.  One cannot solve the PPL case by determining what taxes "should" be creditable given the underlying policy aims, when there is no non-circular there there.

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