Yesterday, in our final session of the 2018 NYU Tax Policy Colloquium (my 23rd season of same), my colleague Mitchell Kane presented "International Tax Reform: The Tragedy of the Tax Commons, and Bilateral Tax Treaties."
The current draft was written before the 2017 tax act took form, but the act then added greatly to its immediate policy relevance (as will no doubt be reflected in the next draft). In particular, it's directly relevant to the question of whether one of the key international provisions in the 2017 act, known as GILTI (for "global intangible low-taxed income") is compatible with bilateral tax treaties. This is not just a U.S. question under U.S. tax treaties, although it certainly is that, since, if other countries choose to enact GILTI-like rules they would face the same question under other treaties.
In broad outline, GILTI works as follows. (And again, I have a forthcoming article draft that discusses it in more detail.) U.S. companies, with respect to much of their foreign source income (FSI), including that earned through their foreign subsidiaries, must (1) compute the portion that exceeds a 10% deemed return on tangible business assets held abroad, (2) include 50% of that amount in taxable income, and (3) pay U.S. tax on whatever liability remains after claiming foreign tax credits for 80% of the foreign taxes paid on that income.
Simplified illustration: say Acme Products has $100X of relevant FSI, and $100X of foreign business assets. A 10% return on the latter is $10X, so we reduce the relevant FSI by that amount, to $90X. Then we include half of it (or more specifically, include the whole thing then deduct half), reducing the net GILTI inclusion to $45X. At a 21% U.S. corporate tax rate, that would yield U.S. tax liability of $9.45X. But suppose the relevant foreign taxes paid on the FSI are $10X. 80% of that is $8X. So the U.S. tax liability on the GILTI inclusion is reduced from $9.45X to $1.45X.
Why foreign tax credits for only 80% of the foreign taxes paid? This reflects an issue that I think I can reasonably say I introduced to the literature, namely the incentive effects, from a unilateral national welfare standpoint, of having a 100% marginal reimbursement rate (MRR) for foreign taxes paid. Full foreign tax credits offer a 100% MRR. GILTI is a kind of global minimum tax rule at a 10.5% rate, but with full foreign tax credits U.S. companies with tax haven income might simply pay the full 10.5% abroad (perhaps economizing on the tax planning needed to stash it in pure havens) and we'd get zero revenue. There's no direct gain to U.S. interests in this scenario from U.S. companies, to some extent owned by U.S. individuals, now paying higher foreign taxes and still no additional U.S. taxes.
The 80% foreign tax credit restores some incentive to economize on foreign taxes paid. It also kind of makes the GILTI a 13.125% global minimum tax. In theory, pay that rate globally and you'll zero out your U.S. tax liability on GILTI. (But sometimes this is only true in theory, not in practice, due to various odd features of GILTI that can result, for example, in the loss of foreign tax credits due to a mismatch between when the taxable income arose under U.S. versus foreign law.)
This brings us to the treaty issue. Bilateral tax treaties between the U.S. and other countries generally say that one should offer either exemption or foreign tax credits for FSI of a resident of one of the treaty partners that was earned in the other treaty partner's jurisdiction. So how can we both tax GILTI, to a degree, and offer only incomplete foreign tax credits?
I noted this issue in my work on foreign tax credits, but I think it's fair to say that I expended close to zero intellectual capital in trying to resolve it. I left it for others to ponder, and happily they did. First Fadi Shaheen wrote on the issue, and now Mitchell Kane is following up. (Side point: it appears that the only thing they disagree about is whether they disagree about anything.)
Here is a very quick summary of Shaheen's contribution: Both formally and in terms of the purpose of the foreign tax credit, it's permissible to take a dollar of FSI and divide it into a portion that gets exemption and a portion that gets the foreign tax credit. A case in point is Option Z in international tax reform proposals that were disseminated a few years back by then-Chairman Baucus of the Senate Finance Committee. It provided that FSI would be 60% taxable and with full foreign tax credits allowed, and 40% exempt. Hence, if one put the two pieces back together, and given the then-prevailing 35% U.S. corporate tax rate, the covered FSI would in effect be taxed at 21 percent and would get 60% foreign tax credits.
Returning to Shaheen's generalization, he argues, to my mind convincingly (on all grounds relevant to statutory interpretation) that, so long as the two pieces add up to at least 100%, a mixed approach is U.S. model treaty-compliant. (The case for its being OECD model treaty-compliant is apparently clearer still.) If that's correct, then GILTI is more generous than it needs to be in order to satisfy tax treaties. Again, it taxes only 50% of the FSI (even ignoring exclusion of the deemed return on tangible business assets), yet offers 80% foreign tax credits.
Case closed if one accepts the analysis, except for one further issue. Treaties are bilateral, whereas GILTI applies globally. So, might it be an issue if Country A were to argue that less than 100% of the FSI that U.S. companies derived there was getting either exemption or foreign tax credits, given interactions with other FSI and foreign taxes within the GILTI basket? This is an issue that Kane and Shaheen both plan to consider further. (Shaheen's article, like Kane's draft, preceded GILTI.)
Even at this earlier stage, Kane offers a further development of Shaheen's explication of how one can combine exemption with creditability without relying entirely either on one or on the other, so long as one provides sufficient relief under the two approaches considered jointly. I believe that his interpretation of what a typical bilateral tax treaty requires can be explained as follows:
(1) The residence country can't cause its residents' FSI to be taxed higher than domestic source income (considering both its and the source country's taxes), unless this results from the source country's imposing a higher tax;
(2) Where the above follows from the source country's tax, the residence country can't impose any residence-based tax on the FSI. But where the source country charges less tax on it than the residence country would if the income were earned in the residence country, the residence country can charge a tax equaling anything up to the amount of that shortfall. (Charging more would lead to violation of Rule 1 above.)
While this may initially sound both a bit abstract, and not especially close to the precise language of bilateral tax treaties addressing "double taxation," Kane has done historical research showing how this relates to and fulfills the purposes expressed throughout the history of the treaty process regarding why double taxation is considered potentially bad and what the rules against it are trying to accomplish. So it is defensible based on underlying intention, as well as more formally via his analysis of typical treaty language.