Obama Administration international tax reform proposals - part 1: 19% minimum tax

Today the Obama Administration released a Greenbook explanation of the revenue proposals in its 2016 budget.  As has usually been the case with Presidential budgets for decades, the proposals are presumably DOA so far as their short-term enactment prospects are concerned.  But they may enter The Conversation (so to speak) as items that might be taken off the shelf at some time in the future, or at the least may influence future thinking by policymakers.

The Greenbook as a whole is more than 300 single-spaced pages long.  So I will just focus on two items that are attracting a lot of attention in the area of international taxation.  The first is the 19% minimum tax, while the second is the one-time (or transitional) 14% tax on previously untaxed foreign earnings.

Both proposals are significant, and in my view would significantly improve current law.  If I were the Legislative Tax Czar for five minutes (counting on gridlock to give my decisions a chance to survive for a while), I might significantly modify the first proposal, but I would definitely adopt the second one.  I'll discuss the 19% minimum tax in this blog post, and the one-time 14% tax in a follow-up

19% Minimum Tax - The first proposal is to repeal the current US international tax rule under which foreign earnings of US companies through their foreign subsidiaries ("CFCs") (a) generally benefit from deferral, and thus do not generate any US tax liability for the US parent until repatriation occurs (e.g.,via an actual or deemed dividend), but (b) are indeed taxable upon repatriation, subject to the allowance of foreign tax credits.  The Administration would make US companies' repatriations of their foreign earnings newly tax-free.  But, in place of the current deferral regime, it would impose a 19% "minimum tax" on a US parent's foreign earnings through its foreign subsidiaries (or its foreign branches).

The minimum tax is a bit tricky to explain, especially after spending just a short time with the inevitably terse Greenbook explanation.  But let's do it in stages.  Please note: the steps below are NOT computational steps that a US taxpayer would actually take - rather, they are meant to help one (including me) understand what the proposal does.

Step 1: Suppose initially that the US simply repealed deferral and applied a 19% tax rate to all foreign source income (FSI) of US companies, without allowing foreign tax credits.  A US company, Engulf and Devour, Inc. ("ED-Co") earns $100 in the Caymans on which it pays no foreign tax, and $100 in the UK on which it pays $14 of UK tax (I pick this amount since the UK has a 21% corporate tax rate, but also offers tax benefits such as its "patent box" regime that may reduce the amount of tax a given company owes).   Since the UK taxes reduce earnings, ED-Co would have $186 of FSI, and at a 19% rate would owe $35.34 of US tax at the 19% rate,

Step 2: Ah, but the proposal does indeed do something rather like allowing foreign tax credits.  For now, suppose that what it did was literally to allow them, subject (as under present law)  to an overall foreign tax credit limitation that prevented one from reducing one's US tax liability on FSI to below zero (as would happen under some facts if foreign tax credits were refundable).  Now the result would be that ED-Co has $200 of FSI (since the UK taxes paid are creditable rather than deductible).  On this, its US tax liability would be $24 (i.e., $38 pre-credit liability at the 19% rate, minus $14 of credits).

Step 3: As I have been pointing out in my writing about international tax policy, foreign tax credits without deferral can induce the companies that are incurring them to have zero cost-consciousness with respect to their foreign tax liabilities.  For example, ED-Co, under the hypothetical proposal that I describe in Step 2, would pay overall taxes of $38 ($14 to the UK and $24 to the US).  It might figure: why not make life simpler by getting rid of the tax planning games that permit it to pretend it is earning $100 in the Caymans.  Say it decides to shift that entire $100 to the UK, where the full 21% rate will apply.  (After all, why bother looking for further UK tax benefits when it doesn't affect the bottom line.)  Suppose that ED-Co also allows its UK tax liability on the $100 that was already there to grow from $14 to $17, once again to economize on tax planning costs.  Now, by express hypothesis, ED-Co has $200 of pretax earnings in the UK, on which it is paying $38 of UK tax,  So it owes the US $38 pre-credit, minus $38 of foreign tax credits, with the result that it actually pays the US zero.

In this scenario, what has the 19% minimum tax accomplished?  Not much, from a US standpoint.  We are still getting zero in tax from ED-Co, but it is now paying foreign taxes of $38 instead of $14.  So its shareholders, many of whom may be American, are effectively $24 poorer, and the US Treasury hasn't gotten anything.  Conclusion: foreign tax credits are intolerably generous, from a US national welfare standpoint, once deferral is no longer blunting US companies' sensitivity to their foreign tax costs.  Hence, a minimum tax proponent may want to think about modifying the proposal to prevent companies from being wholly indifferent to their foreign tax costs.  The Administration evidently understood this concern, so it did something somewhat different than this to preserve non-zero foreign tax sensitivity on the part of US companies such as ED-Co.

Step 4: Suppose one made foreign taxes only 85% creditable, so that each dollar of foreign tax paid reduced one's US tax liability by only 85 cents.  Then each dollar of added foreign taxes that ED-Co paid would cost it 15 cents,after considering the US tax consequences.  Accordingly, ED-Co would not reduce its foreign tax planning in the manner that I described under Step 3, except insofar as the benefits to it from such reduction exceeded the marginal US tax cost.  But doing it this way might raise treaty concerns, since our bilateral tax treaties with dozens of foreign countries say that we must generally either exempt or offer foreign tax credits to the FSI earned by our companies in the other country.

Step 5: In addition to being potentially controversial on treaty grounds, the "85% credit" idea that I described in Step 4 might also be disliked by US policymakers given its susceptibility to cross-crediting.  Suppose that another company, NED-Co (Northern Engulf & Devour, Inc.) earned $100 in Assyria, on which it paid $45 of foreign tax, and $100 in Babylonia, on which it paid zero foreign tax.  Pairing the high-tax country with the low-tax country would enable NED-Co to pay zero to the US under my hypothetical 85% plan, since 85% of $45 is $38.25 (sufficient to wipe out the $38 of pre-credit US liability at a 19% rate on $200 of FSI).  But arguably NED-Co "should" have paid $19 on its untaxed Babylonian income.  If one takes this view, one may want to apply per-country foreign tax credit limits (whether it's a full credit or an 85% credit).  With per-country limits, NED-Co would pay zero US tax on its Assyrian income, but it would pay $19 on its Babylonian income.

Step 6: At last we are getting within hailing distance of the actual Administration proposal.  OK, it is a minimum tax that is applied on a per-country basis.  Let's go back to ED-Co, in the scenario where it earned $100 in the Caymans on which it paid zero tax, and $100 in the UK on which it paid $14 of tax.  With 85% credits and a per-country limitation on credits, ED-Co would pay $19 of US tax on its Caymans income, and $7.10 of US tax on its UK income.  (This comes from taking $19 of pre-credit US liability on the UK income, and then subtracting a foreign tax credit equal to $11.90, i.e., 85% of $14).  But again, this might run into treaty problems with the UK, as we are neither exempting nor fully (or even quite close-to-fully) crediting ED-Co's UK taxes.

Step 7: Instead of providing that the 19% minimum tax would be offset by an 85% per-country foreign tax credit, the Administration proposal says that the US tax due on FSI equals "19 percent less 85 percent of the per-country foreign effective tax rate."  The latter amount - the per-country foreign effective tax rate - is computed by looking 60 months back at the end of each tax year, and figuring out just how much tax the US company actually paid in the country at issue, as a percentage of the income that it earned in that country during that period.

To make things really simple, let's suppose that ED-Co always pays tax at the UK at a 14% annual effective rate.  (You can see the point of not giving full credit for the 21% UK statutory rate, given the concessions such as patent boxes that may often prevent it from fully applying.)  Then we indeed get the above result: Ed-Co pays $7.10 of US tax on its $100 of pre-tax UK income.  And it still of course pays $19 of US tax on its $100 of Caymans income.

Suppose ED-Co also earned $100 in a higher-tax country, such as my fictional Assyria.  So long as a US company is paying at least 22.35% (as an effective rate) in a given country, it owes zero US tax with respect to its earnings in that country. (85% of roughly 22.35% equals 19%.)  Assyria in my example, at least as applied to NED-Co, is way above that figure.  So there is no US tax on the Assyrian income, but also no US cross-crediting-equivalent benefits from paying so much tax there.

I will leave it to experts on our bilateral tax treaties to assess whether there is any plausible treaty challenge to the proposed mechanism for implementing something that, in its bottom line effects, is rather like offering 85% foreign tax credits with per-country limitations.

A few further details: (1) Under the per-country approach, how does one decide where a US company's FSI actually arose?  So far as I understand it, the proposal does this by determining the country in which each CFC is resident - under actual foreign rules, nor our own.  Companies that are resident nowhere, under the relevant foreign countries' residence rules, get hit with the full 19% rate.  There are a bunch of further details to handle multi-country residents, various tax planning games such as those using  various"hybrid" structures, etc.

(2) In at least one respect, the proposal is more generous to US companies than the explanation so far might suggest.  It offers an allowance for corporate equity (ACE) to the extent that one actually has equity in a given country invested in active assets in that country.  Thus, in all of my UK examples, suppose that ED-Co had $500 of equity in its UK subsidiary, and that the subsidiary had $300 of "active" assets, such as factories, in the UK.  For purposes of determining the amount of income that is subject to the 19% minimum tax, ED-Co would be permitted to deduct a risk-free return on that $300.  Suppose the risk-free rate of return was 2%.  Then Ed-Co's UK income, for purposes of the 19% minimum tax, would be reduced by $6 to $94.

(3) US companies would probably pay more taxes on royalties that they earn abroad under the proposal than they do under present law.  At present, royalty inflows are in theory fully taxable at the 35% US corporate rate.  But in fact they often generate very little if any US tax liability, because companies can take steps to shelter their royalty income from US tax via cross-crediting.  This would no longer happen under the proposal, so the present law full US tax rate on such income (35%) would now actually apply.  [I ignore for purposes of this discussion possible changes to the general US statutory rate.]

OK, what do I think of all this?  I am glad to see deferral eliminated and the foreign tax credit in effect scaled back.  So it is in the ballpark of what I'd like to see, although I worry about the workability of the per-country rules.

It is also generally in the ballpark of the the "Camp proposals," made when Dave Camp was the Ways and Means chair.  On the face of things, he set forth the possible design of a "territorial" system which contained anti-tax haven rules, while this is a "worldwide" system, albeit with a lower tax rate for FSI than for domestic source income, and with something like 85% per-country foreign tax credits.  But the difference in substance may be a lot less than the difference in form.  For example, both approaches exempt FSI earned in countries where the effective rate is at least 22.35%, and both aim to impose US tax liability on FSI that shows up in tax havens.

Does this mean that the Administration proposal might actually get a hearing from Congressional Republicans?  I am skeptical, given not only the state of tax and budgetary politics in Washington but also the fact that remaining Republican Congressional leaders did not appear to be wildly enthused about the Camp proposals.