Saturday, December 05, 2015

Foreign tax credits to the rescue?

Michael Graetz had an op-ed in Friday's Wall Street Journal decrying, on due process of law grounds,  recent European Commission challenges to tax planning by U.S. companies such as McDonald's, Starbucks, Amazon, and Apple.

The issue is the companies' cozy transfer pricing agreements with friendly and accommodating EU countries - Luxembourg, the Netherlands, and Ireland - that helped the companies greatly lower their overall EU tax bills. The European Commission views these agreements as involving illegal state aid, and is threatening the companies with large penalties that Graetz views as in tension with the rule of law, given the lack of prior notice that this might happen.

Graetz does not dispute that the EC is almost surely right in viewing the challenged transfer pricing agreements as substantively ridiculous, shifting reported profits to low-tax countries where there is neither significant economic activity nor value creation.  He expresses concern, shared by the U.S. Treasury, that the E.C. is particularly targeting U.S. companies, in keeping with European self-interest and political sentiment.

But here, as he notes, is the bright side, from the companies' standpoint:

"Ironically, if the EU labels these assessments as underpaid back income taxes, instead of fines, the companies' payments may be used to offset their U.S. income taxes dollar-for-dollar, and American taxpayers would ultimately pay the bill."

He is referring, of course, to foreign tax credits, which, when claimed immediately and in full, can make U.S. companies wholly indifferent to whether their foreign tax liabilities (up to the foreign tax credit limit) are low or high. The companies only cared about their EU tax liabilities because, given deferral, they did not anticipate claiming U.S. FTCs at any particular time.

So far as I can tell, structuring the assessments to qualify as foreign tax-creditable shouldn't be all that hard. After all, Luxembourg and Netherlands are being told: By failing to collect enough income taxes, you offered improper state aid. Rebating the state aid means that you collect those underpaid income taxes after all. So why wouldn't it be creditable, if structured intelligently?

Here's what I would guess might happen next. The companies will immediately use the foreign tax credits, by repatriating just enough foreign earnings to generate the requisite amount of pre-credit U.S. tax liability. So the U.S. Treasury gets no actual tax revenue.

Now, at this point the companies still aren't entirely happy. After all, they presumably would have preferred to pay no further EU taxes and keep the earnings abroad.  Then they wouldn't have incurred a pre-credit U.S. tax liability that needed to be offset by using the FTCs. But from their standpoint, at least the burden of paying those extra EU taxes has been partly offset by the benefit of tax-free repatriation.

Is Graetz entirely correct in saying that, in this scenario, "American taxpayers would ultimately pay the bill?" Formally, yes - but substantively, perhaps no.

Suppose we take as given the repatriations that I am hypothesizing.  Then, by claiming foreign tax credits for the EU penalties, the companies save an equal amount of U.S. taxes, thereby (it seems) shifting the cost from themselves to American taxpayers.

But again, suppose the repatriations only occurred due to the creation of the foreign tax credit claims. Then the U.S. taxes that the credits offset wouldn't otherwise have been imposed. So American taxpayers merely fail to gain revenue, rather than losing it.

Does this take too short-term a view?  After all, suppose that the occurrence of a taxable repatriation at some point was inevitable. Then the companies are getting to wipe out, in the year of the repatriation, U.S. tax liabilities that they otherwise would have incurred in the future.

But why should one think that future taxable repatriations are inevitable?  After all, Congress may at some point enact another tax holiday, or "permanently" lower the repatriation tax rate, or partly/wholly forgive the deferred liabilities in the course of shifting to a territorial system.

Here are the main conclusions I draw:

1) Substantively, the companies still lose despite getting the foreign tax credits (assuming that they do indeed get them). The loss equals the extra EU taxes paid minus the value to them of getting to repatriate without incurring further (U.S.) tax liabilities.

2) U.S. taxpayers lose insofar as the companies would otherwise have had greater taxable repatriations at some point in the future - but the extent to which this is so is quite unclear.


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