Tuesday, November 19, 2013

Senate Finance Committee international business tax reform discussion draft: Part 2

OK, just very briefly on some added details of the Discussion Draft.

It's pretty aggressive in expanding U.S. taxation of U.S. companies' foreign source income (FSI), relative to present law that of course reflects the companies' large advances over the last 15 years in perfecting their avoidance of the U.S. tax.  (This in turn has resulted both from technological advances in tax planning, and from changes in the U.S. rules, such as the introduction of "check-the-box" rules for foreign entities that make subpart F, imposing current U.S. tax on suspected tax haven income, close to a joke or a relic.)

That's potentially fine, substantively if not (one suspects) politically, subject to two caveats.  One is the extent to which companies would use creditable foreign taxes to pay more foreign tax, rather than more U.S. tax.  But the other is the U.S. corporate residence electivity question: if we make it too tax-costly to be a U.S. company, increasing numbers of U.S. companies will opt out, via transactions that permit them to take foreign affiliates out of the U.S. chain of direct ownership.  No reason, perhaps, to set the U.S. tax price too low, but one also doesn't want to set it too high.

Among the key features of the Discussion Draft is a choice between "Option Y" and "Option Z," which are two alternative means by which the U.S. tax on resident companies' foreign source income is expanded.  Under Option Z, some FSI of U.S. companies would be fully taxed, with foreign tax credits.  But other FSI, generally I think that which is deemed to carry less of a smell of being "really" U.S. source or of having been artificially shifted through tax planning, is in effect 60% taxable in the U.S. with foreign tax credits, and 40% exempt without foreign tax credits.

Suppose, for example, that the U.S. corporate tax rate is still 35% (although I think the plan is to use the Discussion Draft to help finance lowering the U.S. corporate rate), and that a U.S. company earns $100 of FSI that is subject to the 60% rule under Option Z.  60% of the income is U.S.-taxable but gets foreign tax credits, and 40% is exempt but gets no foreign tax credits.  So the U.S. tax rate on this income, pre-foreign tax credits, would be $21, but the FTC would only reimburse 60% of the foreign taxes paid.

Say that the company pays $20 of foreign tax on this $100 of income.  The foreign tax credit is 60% of this amount, or $12, leaving an overall U.S. tax liability of $9 (i.e., $21 minus $12).  Increase the foreign tax fby $10 to a total of $30, and the FTC increases by $6, or to $18, reducing the U.S. tax to $3 (i.e., $21 minus $18).  So a $10 increase in foreign taxes reduces the U.S. tax from $9 to $3 (illustrating the 60% MRR).

I am starting to think that Option Z is a treaty-compatible version of what I discuss in my book.  To wit, the U.S. taxes FSI at a rate that is somewhere between 0% and the full U.S. rate, and foreign taxes are deductible-plus, but not fully creditable, thus retaining a degree of foreign tax cost-consciousness.  But it appears to be treaty-compatible, because you don't literally "double-tax" any given dollar of foreign income, by virtue of breaking it into two distinct pieces, each of which is formally "taxed once."

I wish I had thought of that!  But I didn't, and the book has gone final.  That petty personal regret aside, kudos to the Senate Finance staff (and their colleagues on other staffs) for filling in this gap.  I still need to spend more time on the proposed legislation, in order to understand the definitional attributes of the income that they would treat this way under Option Z, but it looks like they've actually proposed something that I have been calling for (although, again, not to be vainglorious on the subject of who gave them the idea).

Option Y is a global minimum tax system, under which one must pay 20% somewhere, or else the U.S. will make up the difference.  It therefore results in zero cost-consciousness with respect to foreign taxes, as one's foreign tax liability increases from 0% to 20%.  So not a great idea from a U.S. standpoint, even if we agree that current law is worse overall.  The point once again is that, even insofar as you don't change the foreign tax credit, repealing deferral makes its real world incentive effects worse.

Nonetheless, hurrah for Option Z - which, at a minimum, appears to contain the seeds of a very interesting implementation approach that potentially improves on just about everything else that is currently out there.

1 comment:

Henry Smith said...

Thanks for sharing such a informative article about Business Tax Planning