Senate Finance Committee Chairman Max Baucus (D-Montana) has released the first of a coming series of detailed tax reform proposals, this one on international tax. 

Today, Baucus  also released proposals on tax administration and simplification and tomorrow he will release proposals on cost recovery and tax accounting issues.

Before the release of the international tax proposal, US Treasury Secretary Jack Lew praised it as consistent with the Administration’s positions and urged Congress to consider it promptly. 

Baucus’s House counterpart, House Ways and Means Committee Chairman Dave Camp (R-Michigan), praised him for releasing the draft and making another significant contribution to advancing tax reform, which is the highest priority for both chairmen.  The ranking Republican on the Finance Committee, Senator Orrin Hatch (R-Utah), did not sign onto the proposal because of his preference that Baucus wait until after the pending budget negotiations are completed in mid-December.  Hatch nonetheless said he understood Chairman Baucus’s decision to act now and pledged his commitment to continue working with him on tax reform.

This is the first time that Chairman Baucus has released detailed tax reform proposals in legislative language, signifying his resolve to advance the cause of tax reform during this, his last term in the Senate. Because the formal process of consideration will not begin until some time in early 2014, Baucus has given stakeholders until January 17, 2014 to comment on the proposal.

Chairman Camp is expected to release a comprehensive tax reform proposal some time either before the end of 2013 or in early 2014, and tax reform will be one the major issues that dominate debate in the second session of this Congress starting the first week of January.  The Finance Committee tax staff is expected to carefully review all comments and, given Baucus’s interest in engaging the public in the reform, the invitation to comment should be taken very seriously.

Companies with international operations

The Baucus proposals, which are discussed in detail below, should be studied very closely by companies with international operations.   In some cases, income earned in foreign operations that is not currently taxable will be subject to US tax on a going forward basis, and a one-time tax (at a possible rate of 20 percent) would be imposed on the accumulated earnings of these subsidiaries through the date of enactment not previously taxed by the US.  This one-time tax can be paid over an eight-year period (the Camp proposal sets the one-time tax at a 5.75 percent rate). 

Although there are differences between the Baucus proposals, the previously issued international proposals released by Chairman Camp and the White House tax reform proposals, there are also many common themes among them.

All would:

  • impose tax on some foreign income that currently is not taxed
  • in some respects establish minimum global tax rates to address common concerns regarding the flight of US business to low-rate foreign jurisdictions and
  • contain provisions to deal with concerns regarding base erosion and profit shifting. 

In effect, all of these proposals start from the proposition that the US Treasury is disadvantaged by the ability of American companies to structure their foreign operations to take advantage of very low tax foreign jurisdictions.   

Stated goals of the proposals

The proposals contained in the discussion draft are intended to simplify the current rules, create a US tax environment that encourages companies to remain in the US, reduce incentives for US and foreign companies to shift profits to low tax jurisdictions and promote repatriation of funds to the US. 

A summary of the key provisions to achieve these goals follows.

Summary of key provisions

Reform of foreign income deferral: replacing subpart F deferral system

The draft proposal replaces the current foreign income deferral system with a new system that either taxes substantially all of the income of foreign subsidiaries of US companies immediately when earned (Option Z, below) or exempts the income from US tax indefinitely (Option Y, below).  More specifically, the draft proposes two alternatives for replacing the current subpart F income deferral system.

Option Y (exempting most foreign source income of CFCs from taxation)

Option Y replaces the current categories of subpart F income of a controlled foreign corporation (CFC) with United States related income, low-taxed income, foreign personal holding company income, and insurance income.

  • United States related income, which is income derived in connection with, or is related to, the United States, includes (1) manufacturing, producing, growing, or extracting property imported into the US by the CFC or a related person; (2) the sale, exchange or other disposition of property imported into the US by the CFC or a related person; or (3) the lease, rental or licensing of property imported into the US by the CFC or a related person.  Income derived in connection with services provided with respect to person or property located in the US would also be related income under the proposal.
  • Foreign personal holding company income retains the categories of passive income from current law, but without the exception for de minimis amounts of foreign personal holding company income and without application of the “look-thru” rules for determining the character of dividends, interest, rents and royalties paid by a related CFC.
  • Low-taxed income includes any item of income (other than related income, foreign personal holding company income, insurance income and certain other income) if the effective rate of foreign income tax on such income is less than 80 percent of the maximum US corporate tax rate.  A US shareholder of a CFC would be allowed a deduction of 20 percent of the amount included in gross income attributable to low-taxed income.
  • Dividends received from another CFC which is a member of the same expanded affiliated group would be excluded from subpart F income.

All foreign income falling outside of the scope of subpart F income under Option Y would enjoy permanent deferral from US taxation by operation of a 100 percent deduction for foreign source dividends received by 10 percent US shareholders of CFCs.  This deduction would also apply to certain gains from disposition of CFC stock.

Option Z (subjecting substantially all CFC income to US tax)

Option Z replaces the existing definitions of subpart F income with active foreign market income, modified active income and modified non-active income.

  • Active foreign market income is income attributable to economically significant activities of a qualified trade or business derived, through the substantial contribution of officers or employees of a CFC, in connection with property sold or exchanged for use outside the United States or services performed outside the United States with respect to persons or property located outside the United States. Passive income would generally be excluded from active foreign market income.
  • Modified active income is 60 percent of active foreign market income.
  • Modified non-active income is the net income of a CFC determined without regard to active foreign market income.
  • The treatment of foreign insurance income would generally remain unchanged from current law.

Foreign income falling outside of the scope of subpart F income under Option Z would enjoy permanent deferral from US taxation as previously taxed earnings and profits that are excluded from a US shareholder’s income upon distribution. 

The scope of income caught in the wide net cast by these expanded definitions would render many current US multinational structures substantially less efficient.  Therefore, consideration should be given as to the compensation structure for a company’s CFCs. 

Repatriation of previously deferred foreign income

Whether Option Y or Z is adopted, the discussion draft proposes that a domestic corporation that is a US shareholder of a CFC include its pro rata share of the accumulated deferred foreign income in gross income as of the close of the last taxable year of the CFC that ends before January 1, 2015.  A deduction of an applicable percentage of this mandatory inclusion would be permitted and a foreign tax credit would be allowed for taxes paid with respect to the taxable portion of the included income.  The increase in the US tax liability as a result of this inclusion could be paid in installments over a period of up to eight years.

A current inclusion such as this could have a substantial negative impact on the financial statements of many US multinationals that have previously taken the position of permanent reinvest of their foreign earnings offshore.  The Chairman’s staff notes that they would especially like to hear comments on “appropriate transition rules and effective dates that allow for an equitable and orderly transition that is neither punitive, nor results in windfalls.”  Because this one-time hit to the company’s financial statements could be significant, it will be important for those affected companies to provide their comments during the comment period.

Reform of the check-the-box rules

The draft proposal treats as a corporation any business entity that would otherwise be eligible under the entity classification rules to elect its taxable status if it is wholly owned either by a single CFC or by two or more members of an expanded affiliated group, one of which is a CFC.  The rule is not applicable to entities wholly owned by one or more domestic entities.

Provisions affecting base erosion and profit shifting

The definition of intangible property for purposes of sections 367(d) and 482 would be modified to specify that workforce in place, goodwill and going concern value are intangible property.  The draft proposal also modifies the definition of intangible property to include any other item the value of which is not attributable to tangible property or the services of an individual. 

The basic approach of the existing transfer pricing rules with regard to income from intangible property would remain unchanged.  However, the IRS’s authority to specify the method to be used to determine the value of intangible property, both with respect to outbound restructurings of US operations and to intercompany pricing allocations, would be clarified.

The draft proposal disallows deductions for any related party payment arising in connection with a base erosion arrangement.  For this purpose, a related party payment is defined as any payment made by a domestic corporation (or a foreign corporation subject to tax on income effectively connected with the conduct of a trade or business in the US) to a related party, but does not include any payment to the extent that the payment gives rise to a subpart F income inclusion to a US shareholder.

These provisions are an indication that the US government is looking to take positions consistent with the OECD initiative to address base erosion and profit shifting.  In addition, the provisions support the notion that structures allowing for the generation of so-called “stateless income” should be significantly restricted, if not eliminated.

Allocation of interest on a worldwide basis: accelerated timetable

The draft proposal accelerates, to taxable years beginning after December 31, 2014, the election to apportion interest expense on a worldwide basis for purposes of matching interest expense to income generated by borrowed funds.  Under current law, this election may be made for taxable years beginning after December 31, 2020.

US international tax reforms: reducing ability to defer US taxes on profits attributable to foreign operations

In addition to the above, the draft proposal includes the following US international tax reforms:

  • Clarifies that gain or loss from the exchange of a partnership interest by a foreign person is effectively connected to a US trade or business to the extent the transferor is considered to be engaged in a US trade or business by reason of its membership in the partnership, codifying the IRS’s long standing, embattled position (See Rev. Rul. 91-32)
  • Limits the “portfolio interest” withholding tax exception by restoring withholding on interest paid by domestic corporations to residents of countries not providing similar benefits for US investors
  • Updates the rules addressing foreign investment in US real estate, including by exempting any US real property interest held by a qualified foreign pension fund or by a foreign entity wholly owned by a qualified foreign pension fund
  • Limits interest deductions for domestic companies to the extent the earnings of their foreign subsidiaries are exempt from US tax and to the extent the domestic companies are over-leveraged when compared to their foreign subsidiaries
  • Limits the extent to which foreign tax credits can eliminate US tax on income from investments in foreign companies that are not CFCs
  • Expands the definitions applicable to determining whether a foreign corporation is a CFC
  • Repeals the domestic international sales corporations rules
  • Repeals the dual consolidated loss rules
  • Reforms the foreign tax credit rules
  • Reforms the “passive foreign investment company” rules.

Overall, these proposals are likely to significantly reduce the ability to defer US taxes on profits attributable to foreign operations.  US-based multinationals will likely see the proposals as anti-competitive, while tax reform supporters will likely view the measures as ensuring that multinationals pay their fair share of US taxes through the elimination of existing so-called “loopholes.”  Unlike many tax law changes, these proposals are essentially retroactive, which could be viewed as particularly onerous.  Even if the current US tax rates are lowered in an effort to balance this impact, it seems likely US multinationals with tax-favored foreign operations will find the package objectionable. 

Given the fact that many of the provisions reflect conceptual agreement between Chairmen Camp and Baucus and the Administration, it is very important that those with a vested interest in the US future of the US international tax system provide their comments by January 17, 2014 to the Chairman for full consideration.  As Chairman Baucus has repeatedly stated, “tax reform is not going away.”