Department of the Treasury released the Green Book, the collection of lengthier descriptions of the tax provisions. There are significant changes to the international tax proposals that, if enacted, could increase taxes on active foreign income of US- based multinationals.
Impose a 19-Percent Minimum Tax on Foreign Income
The Obama Administration proposed that the US currently tax active foreign income earned in “low”- tax jurisdictions by foreign subsidiaries. This active foreign income would be taxed at 19 percent with some modifications as described below. This proposal is either a partial repeal of deferral or a partial territorial tax system. The proposal would apply to a US shareholder of a Controlled Foreign Corporation ("CFC"), a US corporation with foreign branch operations, or a US corporation earning services income abroad. Subpart F income would continue to be taxed currently at the US corporate tax rate. Because the minimum tax would be imposed on an ongoing basis for foreign earnings, any earnings subsequently repatriated to the US would not be subject to any additional tax. The proposal would either tax foreign earnings immediately under the newly proposed minimum tax, or subpart F, or not at all so long as the earnings were subject to sufficient foreign tax or exempt from an allowance for corporate equity.
The proposal calculates the tax base for the minimum tax by creating an allowance for corporate equity ("ACE"), which is an exception from the tax for the “return based on the actual activities undertaken in a foreign country." ACE would exempt the risk-free return on equity invested in assets where the assets do not produce the aforementioned “passive” income. For example, if a UK CFC had $100 in income, had $500 of active UK assets, and assuming a risk free rate at 2 percent, then $10 in income would be exempt under ACE. This would leave the income subject to the 19 percent minimum tax at $90 rather than $100. Essentially, it is intended to carve out an exception for actual investment in assets and equity for the ongoing business in the foreign jurisdiction rather than the accumulation of passive income offshore.
Additionally, no US tax should be due on the subsequent sale by a US shareholder of stock in a CFC, as was previously the case under Code Section 1248. The gain previously attributable to the undistributed earnings of the CFC would now be taxed currently, and no untaxed earnings would remain for section 1248.
Impose a 14-Percent One-Time Tax on Previously Untaxed Foreign Income
The Administration also proposed a one- time, mandatory, 14 percent tax on untaxed foreign earnings earned before January 1, 2016, as part of tax reform. The proposal does not look at how the earnings and profits are invested (e.g., cash versus plant property and equipment) or provide for different rates depending on such investments.
It is worth noting that these two proposals look very similar to former Senate Finance Committee Chairman Max Baucus’s “Option Z” proposal from his 2013
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7 Tax News and Developments February 2015
international tax reform plan. Chairman Baucus proposed to tax 60% of a CFC’s active income at full US rates for an effective tax rate of 21 percent.
Chairman Baucus also proposed taxing currently all previously untaxed income much like the proposal in the Green Book. The details differ only in the rate and the time period over which the tax would be due. Chairman Baucus suggested a 20-percent rate payable over 8 years whereas the Administration proposed a 14- percent rate payable over 5 years.
Extend the Look-Through Treatment of Payments Between Related Controlled Foreign Corporations
The Green Book also suggests that the temporary subpart F “look-through” exception should be made permanent. The “look-through” exception has been extended since enactment, but is frequently extended retroactively. Last year, the Administration was silent on the extension of Code Section 954(c)(6).
Making the “look-through” exception permanent is necessary to be consistent with the other recommended changes to the subpart F regime and allows for the application of the minimum 19-percent tax on the CFC’s income rather than requiring current taxation at full US statutory rates under subpart F.
Limit the Ability of Domestic Entities to Expatriate
Inversion transactions, where a US corporation is replaced by a foreign corporation under Code Section 7874, have garnered significant attention from the press, the government, and the Obama Administration. The Obama Administration’s proposal is aimed at making it more difficult to engage in an inversion transaction and, once undertaken, to make it more difficult for inverted corporations to operate in the US as if they had never inverted.
Current law requires that “if the continuing ownership of historical shareholders of the domestic corporation in the foreign acquiring corporation is 80 percent or more (by vote or value), the new foreign parent corporation is treated as a domestic corporation for all US tax purposes (the '80-percent test')".Failing the 80-percent test essentially means the transaction has failed to effect an inversion. “If the continuing shareholder ownership is at least 60 percent but less than 80 percent, the foreign status of the acquiring corporation is respected but certain other adverse tax consequences apply, including the inability to use tax attributes to reduce certain corporate-level income." The proposal would make it more difficult to invert by replacing the 80-percent test with a greater-than-50- percent test and eliminate the 60-percent test altogether.
Second, even if the ownership thresholds are satisfied, the transaction would be treated as an inversion if, immediately before the transaction, the fair market value of the domestic entity is greater than that of the foreign acquiring corporation, the expanded affiliated group is primarily managed and controlled in the United States, and the expanded affiliated group does not conduct substantial business activities in the country in which the foreign acquiring corporation is created or organized.
The proposal would also grant the IRS the ability to share tax-return information with other Federal agencies “for the purpose of administering an agency’s anti-inversion rule." This provision is aimed at ensuring that other Federal agencies do not enter into contracts with inverted companies where Congress has passed legislation to prevent such contracts.
Restrict Deductions for Excessive Interest of Members of Financial Reporting Groups
The Administration also proposes to limit deductions for interest expenses among certain consolidated groups in order to further prevent base erosion and profit shifting. The proposal is very similar to one of the options under consideration at the Organization for Economic Cooperation and Development as part of Base Erosion and Profit Shifting Action 4. Under the proposal, “a member’s deduction for interest expense generally would be limited if the member has net interest expense for tax purposes and the member’s net interest expense for financial reporting purposes (computed on a separate company basis) exceeds the member’s proportionate share of the net interest expense reported on the financial reporting group’s consolidated financial statements (excess financial statement net interest expense)."
The Administration’s view is that base erosion occurs where a multinational group’s inter-company debt exceeds its third-party debt. The proposed response shows this by targeting all net interest rather than only the interest where an income base is eroded from high-tax jurisdictions to low-tax jurisdictions.
It is of note that the matching principle for interest income and expense is no longer in the proposal. The matching principle operates to ensure that no interest deduction is taken on an expense without a corresponding inclusion of income for the same interest elsewhere.
Miscellaneous Item Not in Proposal – Excess Return Proposal
Lastly, it may be worth noting a few items that were previously included in proposals that are not in the Green Book. The Excess Return proposal previously found in Obama Administration proposals to tax “excess returns” is not in the FY2016 Green Book. The prior proposals discussed taxing as subpart F income the transfer of intangibles from a US parent to CFCs in low-tax jurisdictions.
The 19-percent minimum tax demonstrates that the Administration is very interested in the US, and not other countries, taxing the low-taxed or no-where taxed income. As tax reform begins to take shape in the Senate and possibly the House, it will be interesting to see if either party looks at the Green Book proposals and considers the architecture of the proposals as part of broader tax reform. Certainly, some of these proposals will appear in amendments and will be introduced as legislation, but the chances of passage are very small outside of tax reform.