Monday, November 06, 2017

Broader thoughts on the House Republican bill's international provisions

I realize that my posts on the proposed pass-through legislation have been quite harsh. I really don't like sounding that way - it literally makes me heartsick, but I find those provisions to be so bad, indefensible, and redolent of bad faith that I'm pretty much driven to it. I feel it's necessary to sound the alarm.

The international provisions in the House Republican bill are different. So it's with considerable relief that I can address them, albeit still just preliminarily here, in an entirely different tone.

I've already briefly addressed, in that less heated vein, section 4301 of the House bill, which requires current incluson by U.S.-headed multinationals of foreign high returns. Herewith a bit of expansion in scope.

I would group the international tax provisions in the House bill into three categories.

First, tax cuts that are mainly from exemption, plus making permanent a rule in the current Code that facilitates foreign-to-foreign tax planning by U.S. companies, would lose $212B during the period. (Note, however, that exemption here just means dividend exemption - subpart F, which denies deferral to certain foreign earnings, would remain in place with specified changes, and would now have the effect of denying exemption, rather than denying deferral.)

Second, anti-base erosion provisions would raise $265B during the period. So we are already, at this point, plus $53B in projected revenue.

Third, the deemed repatriation provision for pre-enactment unrepatriated foreign earnings would raise $212B.

Should #3 be added together with ##1 and 2? If so, then the net revenue increase rises to $265B. The answer to this is Yes or No, depending on your purpose. It is additional tax liability from US multinationals. On the other hand, it's from past stuff that doesn't have the same relevance for incentives and tax burdens going forward. The US companies would certainly have voluntarily paid something to wipe clean the deferred liability. But I doubt that the amount they'd be happy to pay is anywhere as high as $212B. I imagine that they anticipated getting off cheaper (and probably still do).

To return to the cynical tone for a moment, what seems to have happened here is that the House Republicans pulled a Willy Loman on the US multinationals. In short, those companies are liked, but not well-liked, by the House Republicans, and hence have been sacrificed to the cause of directing more of the kitty to the pass-throughs, for whom even "well-liked" is probably too milquetoast a term (try "loved").

I don't know as yet how U.S. multinationals are reacting to this. They can't be ecstatic, although it's true they get the general U.S. rate reduction. They may even, for all I know at this early point, be strongly opposed. One  thing that's got to displease them in particular is that, even if none of this passes, the anti-base erosion provisions are now on The List. The fact that a generally business-friendly House Republican leadership proposed them may offer a kind of free pass for others to re-propose them in the future, and to have a strong talking point to the effect of: This can't be crazy harsh - look at who proposed it!

I mentioned in my earlier blog post that the provision (sec. 4301) requiring current year inclusion by US shareholders of certain foreign high returns (projected to raise $77B in ten years) has the virtues of (a) taxing the income that is subject to it at a rate between 0 and the full domestic rate, and (b) making foreign taxes only partly creditable, hence having a marginal reimbursement rate (MRR) that is between the marginal tax rate and 100%. Both of these very general ranges are the ones that I have argued for, which obviously leaves a whole lot of room for debate about too high vs. too low. This provision appears to be aimed above all at rents, such as from intellectual property, that typically ends up in a tax haven at the expense of US as well as foreign tax bases.

The next of the three anti-base erosion rules addresses interest-stripping - in other words, the use of intra-group interest deductions and strategic placement in the US of third-party bank borrowing - that companies would use to reduce US source taxable income. Notably, it applies to foreign-headed as well as US-headed multinational groups. The key term of art, making one potentially subject to the rule, is membership in an "international financial reporting group." I don't as yet know how problematic (or not) that will be to apply, but I do like the aim of moving towards residence-neutrality in anti-base erosion rules (i.e., not just applying such rules to US companies). Here the 10-year revenue estimate is $34B.

The third anti-base erosion rule is the biggest, with a 10-year revenue estimate of $154.5B. It definitely raises some issues, but certainly has the advantage of being interesting.

It slaps a 20% excise tax on payments from domestic companies to related foreign companies if the payment is either deductible in the US or added to the basis of something. One exception to the application of this rule is for certain commodities transactions. But the big exception is for payments at cost (i.e., with no markup). Once again, it's residence-neutral, with respect to US vs. foreign multinational, via application to international financial reporting groups.

Here is a possible illustration (if I am understanding this correctly). US company buys good or services from a foreign affiliate for $1M.  If the foreign company has sold it to the US company at cost (i.e., its cost  was $1M), no effect. But if there is any markup (its cost was <$1M) then bingo, 20% excise tax, or $200K.

Let's elide for now the issue of determining the foreign company's cost, which the statute does indeed address (it appears, under pro rata type principles for expenses of doing lots of different things). The result would be over-harsh, and subject to a severe cliff effect since the whole thing becomes taxable as soon as there's any markup, if one imagined it actually applying. But the excise tax appears to be intended as a hammer that taxpayers will opt out of, rather than as something that's actually meant to apply frequently.

One way to avoid it is by electing, as the provision permits, to have the payments to the foreign affiliate treated as effectively connected US business income. In other words, one avoids the 20% excise tax on the gross amount by electing to pay a 20% income tax on the net profit. This eliminates the transfer pricing benefit to having the US affiliate pay a high price to the foreign affiliate. Plus, it applies this 20% tax to the profit that the foreign affiliate would have treated as foreign source even with reasonable and defensible transfer pricing.

The other way to avoid it is by doing a true arm's length sale with a third party. That presumably is meant to assure that the arm's length price will truly be a market price. I would think that one has to look at what happens next, on the other side of the transaction, to address strategic use of third party companies as well-compensated intermediaries, and the statute contains an authorization for the Treasury to issue regulations addressing conduit transactions. This could end up being drafted either narrowly, for pure conduits that just get a fee for spending 5 minutes in the middle, to more broadly, if both sides of the transaction (US company to third party, third party to foreign affiliate of US company) are sufficiently closely scrutinized.

This may be quite significant. After all, it seems eminently worthwhile to pay an accommodation party something just to get out of all the rest. But if the high revenue estimate is correct then it must not be (in the estimators' judgment) quite as trivial as all that.

Hard to tell at this point how this provision would work out in practice - e.g., too harsh? too avoidable? too complicated and uncertain? It also may raise treaty issues.  I would expect US companies to aim a lot of fire at this provision if it goes far enough for this to be worth their while, and if they agree as a ballpark matter with the revenue estimate,.  What they have to say may be illuminating, even if (to mix the metaphors) one has to discount it with a grain of salt. But it does look like the House Republicans have taken a urprisingly big swing at transfer pricing games by both US and foreign multinationals.

One further political aspect here is that a lot of the pain (such as it is) is being imposed on foreign multinationals, rather than US multinationals. The latter may be fine with this!

While I think a whole lot more work and information will be needed to evaluate the anti-base erosion rules, it does look like they should be taken seriously, and at a minimum added to the list of proposals in this genre to consider no matter what happens (or doesn't) to the rest of the U.S. international tax regime.

Again, it feels much better, on my part, to be able to take such a tone rather than the sharply hostile one that I felt was unavoidable with respect to the pass-through proposals.

Message to US multinationals: the House Republicans don't like you as much as you thought they did. True, they'd undoubtedly be happy to give you everything you want if the political cost to them was low enough. But they evidently like you a whole lot less than they like their friends in the pass-through sector. This is something you should keep in mind even if, with changing circumstances, they choose to re-align with you.

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