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In his Fiscal Year 2012 budget, President Obama included a number of proposals affecting the current international tax provisions of the Internal Revenue Code, revising similar proposals from the Fiscal Year 2010 and 2011 budgets. /1/ While the budget does propose extending two important international tax benefits – the Subpart F active finance and look-through exceptions – the vast majority of the proposals are intended simply to raise revenues without regard for their effect on U.S. jobs or the competitiveness of U.S. companies that also operate abroad. These changes would generally be effective beginning in 2012.
The Obama Administration estimates /2/ that the package of international tax changes would raise more than $129.2 billion through 2021, although the Joint Committee on Taxation (JCT) scores the package at $133.15 billion over ten years. /3/ Based on the Administration’s estimates, the limitations on deferral and foreign tax credits would account for nearly 70 percent of that revenue. Several of the Administration’s proposals were included as revenue raisers in legislation to extend state Medicaid and educational funding in August 2010. /4/
More recently, House Ways & Means Committee Chairman Dave Camp (R-MI) released draft legislation on international tax reform on October 26, 2011. The proposal envisions a significant shift in U.S. tax rules applicable to foreign earnings of U.S. companies, effectively moving the United States to a territorial system based on a 25-percent corporate tax rate. /5/ The Committee has requested comments on the discussion draft and is expected to evaluate revisions well into 2012.
Debate on tax reform is expected to continue as major portions of the tax code are set to expire once again, including the Subpart F active finance and look-through exceptions, which will expire along with the annual business tax provisions at the end of 2011. /6/ Moreover, efforts to enact budget reforms continue to contemplate the role that tax reform, both domestic and international, should play in addressing the serious fiscal challenges facing the nation and the need for U.S. businesses to remain competitive in the global marketplace.
In recent years, a growing number of U.S. retailers have expanded into the global marketplace through the establishment of both retail operations in other countries as well as subsidiaries that strengthen the supply-chain of goods and services they provide to their customers.
Despite its competition with Japan for the highest corporate tax rate in the world, the United States is one of the last major industrialized countries to tax all of the worldwide income of its citizens, including the domestic and foreign earnings of U.S. companies as well as the income earned abroad by foreign subsidiaries of U.S. multinationals. Typically, other countries tax their domestic companies on a territorial basis, with tax imposed only on the income earned within their borders and not on the earnings of their multinational companies’ foreign subsidiaries that are located outside of their national borders.
Current U.S. tax law attempts to address the competitive advantage that foreign territorial tax systems pose for U.S. companies in two ways. First, under the so-called “deferral rule,” U.S. companies are not taxed on income from the active business operations of a foreign subsidiary until that income is repatriated to the United States, typically through dividend payments. The long-standing policy of the deferral rule allows U.S. multinationals to remain competitive against their foreign competitors, which are not subject to tax on their worldwide income at all. The deferral rule, however, applies only to foreign earnings derived from active business operations. The Subpart F rules, enacted in 1962, prevent U.S. multinationals from deferring tax on foreign income that is generally not related to active operations, such as interest and dividends from investments of their foreign earnings.
The Obama Administration’s budget proposal would restrict the ability of U.S. companies to deduct interest expenses associated with foreign earning until such earnings were repatriated to the United States. The result would be increased U.S. taxes for businesses that can no longer deduct financing expenses, which can also relate to U.S. headquarter jobs and other selling, general and administrative expenses, allocated to foreign earnings that are necessarily reinvested abroad to maintain the company’s global business operations. This proposal is made worse by requiring companies to allocate such expenses under the same flawed rules as currently apply to foreign tax credits, without the benefit of the worldwide interest allocation rule that Congress has repeatedly delayed, most recently until 2021 under the HIRE Act. /7/ Accordingly, the proposal would create additional disparities between the U.S. tax system and that of our major trading partners, further eroding the competitiveness of U.S. businesses.
Second, since 1917, the United States has allowed a U.S. company that repatriates the income of its foreign subsidiary to reduce its U.S. tax liability by any foreign taxes paid on that income through a “foreign tax credit,” which reduces the potential for double taxation of the same income by the United States and a foreign jurisdiction. The Obama Administration’s budget proposal would limit the availability of foreign tax credits by requiring companies to calculate them on a combined basis rather than by the taxes paid by each subsidiary making up the U.S. company’s worldwide organization. Despite this combined approach, another Administration proposal (now enacted) /8/ requires companies to match their foreign tax credits with the associated repatriated income to prevent so-called “cross crediting,” which was previously permitted. As a result, U.S. businesses now have to combine credits derived from high- and low-tax jurisdictions but are not able to apply the credits to the overall repatriated income, making it more likely that they will be subject to double taxation of their foreign earnings.
While the Obama Administration has put forth targeted international tax proposals, the Treasury Department under the Bush Administration released a study /9/ in December 2007 outlining three broad approaches to overhauling the corporate tax code. The first approach would replace the corporate income tax with a business activity tax (BAT) on gross receipts, minus the cost of goods and services purchased from other businesses, at a tax rate between 5 percent and 6 percent (to achieve revenue neutrality). The second approach would lower the corporate tax rate by eliminating the majority of current business tax deductions, and implement a territorial system for the taxation of U.S. companies’ foreign earnings. Treasury estimated that to maintain revenue neutrality the rate could be lowered to 28 percent with full business-tax base broadening or 31 percent if accelerated depreciation was retained. The third approach offered a package of proposals, short of full reform of the tax code, aimed at specific areas of the business tax system that could be modified. While Treasury found that the BAT option would result in modest improvements in economic performance, the second option would require significantly lower business tax rates (e.g., 20 percent) or greater equipment expensing in order to achieve significant benefits to the U.S. economy and the competitiveness of U.S. companies.
Also at the end of 2007, former House Ways and Means Committee Chairman Charles Rangel (D-NY) introduced a $1.3 trillion tax measure, the Tax Reduction and Reform Act of 2007 (H.R. 3970), /10/ which was partially offset by provisions similar to the Obama Administration’s limitations on the deferral rule and on the use of foreign tax credits. Although the legislation did not receive a hearing or markup, it continues to serve as a marker for a broader tax-reform agenda.
For more information, please contact Mark Warren, tax consultant at mark.warren@rila.org.
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