If enacted, the proposals would significantly increase the U.S. tax burden on a wide range of multinational businesses, as well as compound the complexity of an already highly complex area of the tax law.

On May 11, 2009, the Obama administration released descriptions of the international tax proposals included in its fiscal year 2010 budget submission.  These proposals would fundamentally alter key features of the U.S. system for taxing cross-border income, such as the benefit of deferral of foreign-source income earned by foreign subsidiaries of U.S. parent companies and the foreign tax credit mechanism for mitigating the potential double taxation of cross-border income by source and residence countries.  If enacted, the proposals would significantly increase the U.S. tax burden on a wide range of multinational businesses, as well as compound the complexity of an already highly complex area of the tax law.   Like most of the administration’s other revenue-raising proposals, these proposals would take effect in 2011.

Background

One stated priority of the Obama campaign was “reforming deferral to end the incentive for companies to ship jobs overseas.”  This concept was never explained in detail during the campaign, leaving the business community to speculate whether President Obama would propose a substantial repeal of the deferral of foreign-source income of foreign subsidiaries of U.S. companies—as former presidential candidate Senator John Kerry had proposed, as had current National Economic Council Director and former Treasury Secretary Lawrence Summers—or instead would propose a more limited set of “reforms” of the deferral system.

The first clues to President Obama’s intent came with the release of a budget outline on February 26, 2009.  A revenue table in that outline included a $210 billion revenue increase over the budget period for the following item:  “Implement international enforcement, reform deferral, and other tax reform policies.”  The outline offered no further explanation of the proposal.  Based on the large revenue estimate, as well as congressional testimony of administration officials, it appeared that the administration was envisioning a substantial repeal of deferral, or something similarly significant.

No further detail was made public until May 4, 2009, when the White House and U.S. Treasury Department, in conjunction with a presidential press conference, released high-level descriptions of the core international tax proposals in the budget submission—i.e., the “check the box,” expense deferral and foreign tax credit proposals discussed below, as well as some international enforcement proposals.  The May 4 press releases indicated that these proposals were estimated to raise $198.3 billion over the budget period, and that additional international tax proposals bringing the total revenue increase in this area to $210 billion would be unveiled shortly.

A week later, on May 11, 2009, the administration unveiled the complete set of proposals, with the release of the White House Office of Management and Budget’s “Analytical Perspectives” volume and the Treasury Department’s “Green Book.”  These proposals are discussed below.

“Check the Box” Override

One of the most significant Obama administration proposals is to override the 1996 “check the box” entity classification regulations to treat most single-member foreign business entities as corporations for U.S. tax purposes.   Under current rules, a single-member foreign business entity can often be disregarded as separate from its owner (at the taxpayer’s election), with the result that transactions between the entity and its owner generally are disregarded for U.S. tax purposes, and the entity’s assets and income generally are treated as those of the entity’s owner.  This treatment can have a significant effect on how the anti-deferral rules of subpart F, the foreign tax credit and other rules apply to a structure.  Under the proposal, this “disregarded entity” treatment would be eliminated as a possibility in most cases, with exceptions for situations in which both the entity and its owner are organized under the laws of the same country, and, except in cases of U.S. tax avoidance, for situations in which the foreign entity is owned directly by a U.S. person.  The extent of the “U.S. tax avoidance” concept applicable for purposes of the latter exception remains unclear.  The proposal is estimated as raising $86.5 billion over the budget period.

Observations

The “check the box” regulations have been in force since 1997, and corporate structures have been built on the premise that disregarded entities are indeed disregarded as separate from their owners for most U.S. tax purposes.   If this proposal were enacted, many corporate structures would need to be unwound and redesigned, at tremendous cost to taxpayers.

It also bears mentioning that a similar proposal included in the Joint Committee on Taxation’s 2005 “Options” report was estimated as raising only $1.2 billion over a similar effective period.  Recent data do suggest that deferred earnings of foreign subsidiaries of U.S. companies have increased significantly in recent years, but even accounting for such data, there would appear to be a large gulf between the administration’s revenue estimate and the prior congressional estimate.

Deferral of Deductions Allocable to Deferred Foreign Income

The administration also has proposed changes—patterned on proposals introduced in 2007 by House Ways and Means Committee Chairman Rangel—that would leave the deferral of foreign subsidiary earnings intact, but would impose significant tax costs to such deferral as a way to counteract the “incentive” that some believe is created under the deferral system in favor of overseas investment. 

Under this set of proposals, certain U.S. expenses (e.g., interest expense) would be allocated in part to deferred foreign earnings, and deductions for the portion of such expenses so allocated would be deferred.  The amount of expenses deferred would be carried forward into future years, although the mechanics of how the carryover would interact with the current-year computation in the carry-to year are not specified and may differ from the mechanics as outlined in the Rangel proposal.  Unlike in the Rangel proposal, research and experimentation expenditures would not be subject to deferral. 

This proposal is estimated as raising $60 billion over the budget period.

Observations

This proposal generally would render deferral much less attractive, although with a highly variable impact across different industries and companies.  The extent to which a company relies on debt financing would play a major role in determining the impact of the proposal—companies with large amounts of U.S. borrowing would be particularly hard hit, while companies with relatively little U.S. borrowing could face only a relatively small tax increase.  Companies in a large overall foreign loss position would be placed in an especially difficult bind, as they cannot repatriate foreign earnings without incurring double taxation, and yet non-repatriation of these earnings would lead to the loss of U.S. interest deductions under the proposal.

In addition, although many details of this proposal remain open, it is clear that the proposal would place considerable new weight on existing expense allocation concepts.   It remains to be seen how well those concepts might bear this additional weight.

Pooling Approach to Foreign Tax Credit

Another proposal designed to increase the cost of deferral relates to the foreign tax credit.  Under this proposal, a U.S. shareholder’s indirect foreign tax credit would be determined based on the aggregate earnings and profits and foreign taxes of all foreign companies with respect to which the shareholder can claim indirect credits.  This proposal also is similar to one set forth by Chairman Rangel in 2007, although the Rangel version of the proposal would have included a U.S. shareholder’s direct foreign tax credits in the aggregated pool. 

This proposal would eliminate the foreign tax credit benefit of maintaining separate high-tax and low-tax chains of subsidiaries, as an indirect credit brought up from a high-tax subsidiary would be reduced, potentially quite significantly, by reason of the existence of deferred low-tax earnings elsewhere in the group. 

This proposal is estimated as raising $24.5 billion over the budget period.

Observations

This proposal may raise concerns under U.S. tax treaties, which obligate the United States in its capacity as a residence country to relieve the potential double taxation of income sourced in a treaty-partner country through the use of a foreign tax credit.  Although U.S. treaties typically reserve the right for the United States to limit this foreign tax credit under U.S. internal law, this right expressly does not extend to changes in U.S. internal law that would “chang[e] the general principle” of the double taxation article of the treaty.  The same concept also features prominently in the OECD model income tax treaty.  The Obama proposal would have the effect (and the intent) of denying foreign tax credits on dividends of earnings from, say, Germany, based on the existence of deferred earnings elsewhere in the corporate structure in, say, Ireland.  Germany might reasonably complain that this denial of credits would violate the “general principle” of the double taxation article of the U.S.-German tax treaty, in that the United States as a residence country would be failing to relieve double taxation of German-source income based on factors entirely extraneous to the U.S.-German investment and trade relationship.

Prevention of Foreign Tax Credit “Splitting”

The Obama administration also has proposed the adoption of a “matching rule” to prevent the separation of creditable foreign taxes from the associated foreign income.  Although details are lacking, the proposal presumably would target arrangements like the one at issue in the Guardian Industries case, in which a direct foreign tax credit was claimed by a U.S. person that was legally liable under foreign law (via a direct foreign check-the-box disregarded entity) for foreign taxes on income that was earned by separate lower-tier foreign subsidiaries (and thus was not currently includible in income for U.S. tax purposes).  The proposal is estimated as raising $18.5 billion over the budget period.

Observations

Although the general intent of this proposal is relatively clear, the mechanics are not, thus creating some uncertainty as to the proposal’s effects.   The proposal as currently described also might be interpreted as denying foreign tax credits in certain common and generally uncontroversial situations, for example where a foreign country imposes tax on an item that does not constitute income under U.S. law or administrative guidance, such as a foreign withholding tax imposed on a conforming transfer pricing adjustment (addressed in the Schering case).

Other Proposals

Additional international tax proposals included in the administration’s budget submission include the following:

  • “Clarifications” of the definition of intangible property for purposes of sections 367(d) and 482 (codifying the Internal Revenue Service’s position that workforce-in-place, goodwill, and going concern value are defined intangibles for these purposes, among other items)

  • Tightening of the earnings stripping rules of section 163(j) for certain companies that “inverted” in any taxable year beginning after July 10, 1989, within the meaning of anti-inversion legislation enacted in 2004

  • Repeal of the boot-within-gain limitation with respect to certain cross-border reorganizations effectuating a repatriation of foreign earnings

  • Repeal of the rule treating dividends received from “80/20” companies (i.e., a U.S. company that earns at least 80 percent of its gross income from an active foreign business) as foreign source

  • New rules treating income earned by a foreign person from an equity swap referencing U.S. equities as U.S.-source to the extent attributable to or calculated by reference to dividends paid by a U.S. corporation (reversing foreign source treatment under current regulations)

  • New restrictions on foreign tax credits for taxpayers that are subject to a foreign levy and that also receive a specific economic benefit from the levying country (e.g., an oil company that both pays taxes to a foreign government and has arrangements with that government allowing the company to extract oil)

  • International enforcement proposals

These proposals are estimated as raising (almost exactly) the balance of the additional revenue needed to meet the administration’s $210 billion target for its entire international tax package.

Conclusion

The Obama administration proposals in the international tax area would impose significant new tax burdens and complexity on U.S.-based multinationals (and, to a lesser extent, on non-U.S.-based multinationals).  Some have suggested that the proposals, taken together, are tantamount to the substantial repeal of deferral.  The administration’s revenue estimates certainly reflect a view that a very significant amount of revenue would be raised from these changes, representing the greater part of the revenue that might be raised from substantial repeal.  Yet the changes are more complex and uncertain in their application than substantial repeal would be, with the potential for highly variable effects across companies and industries.

While there will undoubtedly be a great deal of activity surrounding these proposals during the remainder of 2009, it appears unlikely that the administration will mount a major effort to enact the proposals before 2010, and the proposals by their terms would not take effect until 2011.   Potentially affected companies should use this time to try to estimate the impact of the proposals under their particular circumstances, and to develop appropriate policy advocacy and planning responses.  In addition, although the administration might not push to enact the proposals this year, it is always possible that individual proposals could be included as “offsets” in other legislation that may be considered this year, thus bringing particular urgency to these modeling, advocacy and planning efforts.