Yesterday at NYU Law School, I participated in a “debate” with audience voting on alternative propositions at the annual NYU-KPMG Tax Lecture. Other panelists were Bob Stack from Treasury, Michael Plowgian, David Rosenbloom, and Paul Oosterhuis, plus Willard Taylor was the moderator. The debate propositions were preceded by a talk by Oosterhuis and Rosenbloom on the Treasury’s newly issued proposed regulations under section 385, which provide that, in certain cases when one member of an affiliated group distributes what’s ostensibly a debt instrument to another member of the group, the instrument is classified as equity, rather than as debt. The point is to disallow interest deductions by U.S. companies (owned by foreign companies) that might otherwise serve to strip profits out of the U.S. tax base – not limited to companies that have recently inverted.
One point that emerged from the talk was that, in principle, it might have been better for the Treasury simply to deny interest deductions in these cases, rather than reclassifying the instruments as equity (which potentially has broader implications, not necessarily within the purpose being served). But the fact that the Treasury was acting under section 385, which deals with debt versus equity classification rather than with the allowance of interest deductions, presumably made this necessary.
Anywhere, here are the debate propositions, followed by approximations of what I tried to say.
1) Regulations proposed 2 weeks ago under section 385 would treat the distribution of a note to a related foreign person (and similar transactions) as equity, disallowing any deduction for interest. Is this a good idea?
Since the moment the new regulations came out, I have been expecting the net balance of public commentary to be heavily slanted against them. And while I found the Oosterhuis and Rosenbloom comments at the session to be thoughtful and fair, I am still expecting this.
Both Steve Shay of Harvard Law School and Steve Rosenthal of the Urban-Brookings Tax Policy Center have been speaking publicly in favor of the regulations. (Shay helped point the Treasury in this direction.) But most of the other people who will be commenting have client interests, and/or are comfortable with the way things were before the regs were issued.
One possibly countervailing factor, however, is that those who are speaking for or on behalf of U.S. firms that aren’t inverting may be glad to see foreign firms’ relative advantage in profit-shifting out of the U.S. narrowed by the new rule – although only “new” earnings-stripping by such firms, as distinct from that which they already had in place, is potentially impeded.
Academic types, such as myself, even when willing or strongly inclined to take a pro-government position, don’t generally go as deep in the weeds as one would need to go in order to address the rules in detail. (And while we can certainly do legal analysis of them, we may not be as well-equipped as people in practice to figure out how the practicalities will develop.) Maybe this aversion to going deep in the weeds is our bad – but certainly it can affect the overall tenor of the debate.
That said, here are four particular observations regarding the new section 385 regulations:
First, section 385 gives the Treasury VERY broad discretion. So anyone who wants to argue that the regs are invalid is swimming steeply uphill. It’s true that the regs address particular practices that were not specifically in Congress’s collective mind when it enacted the provision in 1969. But the grant of broad discretion seems clearly to have been meant to let the Treasury respond to new developments. Note also that this is not just an anti-inversion provision.
Second, one could see the regulation as a small and admittedly discrete move away from separate entity tax accounting for multinational groups. Given the general economic significance (and potentially large tax significance) of the lines between legally distinct but economically integrated affiliated entities, this is a good direction to be going in.
Third, it’s important, and probably a good thing, that the regulation addresses “inbound” investment – i.e., U.S. economic activity by multinationals with a foreign parent – rather than just inversions. A key reason for the inversion wave is that, in addressing profit-shifting out of the domestic tax base, the U.S. rules appear to over-rely on residence-based rules that apply only to U.S. multinationals, relative to rules that affect foreign multinationals. This is a topic I’ll be addressing further in other settings.
Fourth, by acting unilaterally (here as previously) in response to the recent inversion wave, the Treasury has rejected old, 1980s-vintage notions of comity between the branches, by acting on a live and prominent policy topic rather than working with Congress via the design and enactment of new legislation. But guess what – it isn’t the 1980s anymore! We now live in a world where the tax legislative process has generally broken down, unless one party holds all the levers. This is going to keep happening in the future, under both Democratic and Republican administrations. Whether one regrets the lost 1980s of bipartisan legislation or not, that world is gone, and comity norms are going to change in consequence. So one might as well get used to it.
2) Should the EC retroactively revoke rulings issued by the tax authorities of EU member states? Are there better ways to address the concerns? Is revocation consistent with US tax treaties?
It’s useful to look at this from an EU standpoint, just so one can understand what they’re about Then there’s plenty of time to think about it from a US standpoint.
From an EU standpoint, it’s totally understandable that they would issue the “state aid” rulings requiring countries to take back favorable tax rulings that mainly had been issued to U.S. companies. If the EC wants to restrain certain types of race-to-the-bottom internal competition between member states, it can’t let labels (such as the use of the tax system to deliver what are effectively subsidies) to lead to frustration of their policy!
Also, when one is adjudicating the merits of what has been done – in effect judicially, although the EC is a commission, not a court – of course it will apply “retroactively.” Saying “Next time we’ll be really mad!,” and acting only nominally prospectively, would have been widely scoffed at, and would likely have failed to deliver a credible message to EU governments.
That said, from a US standpoint I am concerned about the degree of focus on US firms. And I also understand that the EU structure makes it trickier for us to figure out how to negotiate individually with EU countries. But that’s relevant to how we should respond – not to whether what they’re doing makes sense from their standpoint.
One last point, however – while the US doesn’t benefit directly – indeed, it loses – when a given US company (with mainly US shareholders) ends up paying more tax to EU countries, we may benefit indirectly in the long run, if it lowers the expected after-tax return to US companies from profit-shifting out of the US.
To put it differently, the EU may have affected its prospective tax-attractiveness, and this potentially benefits the US insofar as there is zero-sum tax competition at work between us.
3) Given the EC’s almost exclusive focus on US companies, should the US invoke section 891?
This provision permits us to double the tax rates on residents of foreign companies that subject US taxpayers to discriminatory taxes. The apparent EU focus on US companies in the state aid cases has led some to urge that we consider invoking this provision. (BTW, the chance that this will actually happen is probably about zero.)
I think of it this way. In principle, bluffing is great, if one specifies in advance that it will actually work. So if we threatened to invoke §891 and won valuable concessions of some kind from the Europeans, great.
But it’s hard to bluff effectively if you aren’t actually willing to pull the trigger. And here I don’t think we should, plus the Europeans surely know that we won’t, plus there is also a downside to attempted Trumpist bullying.
So no, on balance we shouldn’t invoke section 891 or even waste too much breath pretending to think about it.
How should we respond, insofar as we’re seriously concerned about the focus on US companies? I’d say, by doing something we might actually want to do anyway – doing more to address profit-shifting out of the US by EU (and other non-US) companies.
4) Is the US discussion of international tax reform disproportionately focused on “outward” investment by US corporations? What about foreign investment in the US? Can the two be separated?
Is this in part what the §385 regulations are about? Should the US consider a US version of the UK “diverted profits” Tax? Should the US challenge supply chain structures and/or significantly broaden and tighten the earnings-stripping rules?
The inbound and outbound rules are closely conceptually linked. These days, our main reason for taxing outbound is to address profit-shifting out of the US by US companies. Likewise, our inbound rules address profit-shifting out of the US by non-US companies.
So it’s the same problem, just involving different groups of companies. And of the two sets of rules get too out of whack, you get incentives for inversions, among other things.
The US rules may be too lax overall on profit-shifting out of the US – although that is legitimately debatable.
But what’s clear is that we’re more lax in this regard on inbound than outbound. So even if we can do a better job addressing outbound by US companies, we need to bring those rules into balance with those for inbound investment.
Transfer pricing and earnings- stripping are the 2 obvious places to focus.
Finally, without endorsing the particulars of the UK diverted profits tax, it’s definitely an example of seeking to address domestic tax avoidance by non-resident companies.
5) Without any way to force members to sign on, is BEPS going anywhere? Will it become irrelevant? Will it make a meaningful contribution to the international tax rules or just cause disruption?
I’d restate the question as: Is the glass ¼ full or ¾ empty?
I expect BEPS’s true results to fall far short of the rhetoric and expectations. I wish had a dollar for every speaker at every conference on OECD-BEPS over the last 3 years. I’d be a rich man.
From all that attention, you might think it would end up being a bigger deal than it actually is going to be.
But you can’t force members to sign on – views and interests differ – and the BEPS methodology, such as continuing to rely on separate-company accounting within affiliated groups, is a bit unpromising for BEPS.
That said, some real changes may indeed not just emerge but persist. But the main thing is that, if the global tax policy climate has indeed changed, BEPS may be remembered as a harbinger or leading edge of this change, even if what really matters is that change, rather than its particular content.
6) If the US corporate tax rate on US multinational income is reduced, should pass-through entities help pay for the reduction?
Lowering the corporate rate ought to be fully financed. Otherwise, we worsen the long-term budget picture and hand windfall gains to current investors, who are generally from the top of the income and wealth distribution.
Base-broadening (from an income tax standpoint) that applies to the pass-through sector as well as the corporate sector is the logical way to do it. This obviously implies raising taxes for pass-throughs.
Is that so bad? Well, I think it verges on making corporate tax reform a political non-starter. But it might not be so bad in substance for one very simple reason. Recent research suggests that the partnership sector (although not sub S corps or proprietorships) is currently comparatively lightly taxed. So the shift in taxes from the corporate to the pass-through sector might tend towards equalizing their overall tax burdens.
Two final points about broadening the base to pay for corporate rate cuts. First, even if it’s revenue-neutral, it tends to hand a windfall to existing investment, at the expense of new investment. That generally isn’t a great idea.