Highlights of Discussion Draft
On November 19, 2013, Senate Finance Committee Chairman Max Baucus (D-Mont.) released a “Discussion Draft” of international tax reform proposals. The Discussion Draft proposes significant changes to the taxation of foreign income, including substantially expanding the definition of subpart F income, an immediate 20% tax on certain unrepatriated foreign income, and a series of other changes. More detailed analyses of the Discussion Draft proposals will begin appearing in the coming days and weeks on our tax reform blog, www.TaxReformLaw.com (read TaxReformLaw.com for posts on the responses to Sen. Baucus’ international tax Discussion Draft, the timing of Rep. Camp’s tax reform plans, the insurance-specific issues in the Discussion Draft, and Sen. Baucus’s tax administration and cost recovery tax reform discussion drafts).
One of the key proposals in the Discussion Draft is requiring that foreign income be currently taxed at certain minimum rates. The Discussion Draft proposes two options for implementing this new regime:
- “Option Y” requires that all income from products and services sold into foreign markets be subject to an effective tax rate that is at least 80% of the U.S. corporate tax rate, either by the U.S. or a foreign jurisdiction.
- “Option Z” taxes foreign active income from products and services sold into foreign markets at 60% of the U.S. corporate tax rate, and nonactive income at 100% of the U.S. corporate rate.
Under both options, passive and highly mobile income would be subject to current tax at the full U.S. corporate tax rate. The Discussion Draft also proposes a series of other significant changes, including:
- A transition rule applying a 20% tax on foreign earnings not previously subject to U.S. tax, payable over eight years
- Repealing the “check-the-box” rules for entities held by controlled foreign corporations
- Repealing the portfolio interest exception for corporate bonds
- Simplifying the passive foreign investment company rules
- Adjusting income sourcing rules, including changes to the “title passage” rule
- Introducing a series of anti-base erosion proposals, such as adjusting the rules applicable to the transfers of intangible property.
According to Sen. Baucus, the Discussion Draft intends to reduce incentives for multinational companies to shift profits to low-tax foreign jurisdictions, reduce incentives for U.S. business to move offshore, end the “lock-out effect” on foreign income, increase the competitiveness of U.S. businesses, and simplify the international tax rules. Similar to the reform discussion drafts issued in recent months by the House Ways and Means Committee Chairman Dave Camp (R-Mich.), the Discussion Draft is presented in proposed legislative language and is accompanied by a Technical Explanation prepared by the Joint Committee on Taxation (the “Joint Committee Explanation”).
Two Options for Taxing Income Earned by CFCs
The Discussion Draft presents two separate options for taxing income earned by controlled foreign corporations (CFCs): “Option Y” and “Option Z.” Both options are intended to eliminate the “lock-out” effect of the current deferral regime; and both propose generally to impose a minimum tax on CFC income as it is earned with a full exemption for foreign earnings upon repatriation. Both options would also generally tax passive and highly mobile CFC income and CFC income from selling products and providing services to U.S. customers on an annual basis at the full U.S. corporate tax rate. Each of the options proposes a separate regime for taxing CFC income from selling products in, and providing services to, foreign markets.
Generally, Option Y would impose a current minimum tax of at least [80%]1 of the U.S. corporate tax rate on U.S. shareholders of CFCs according to their pro rata share of CFC foreign business income. Taxpayers subject to this tax can use full foreign tax credits (FTCs) to offset it.
Option Y would establish a dividend exemption system where a domestic corporation that is at least a 10% U.S. shareholder of a CFC would receive a 100% dividends received deduction for the foreign source portion of the dividends received from the CFC. Hybrid dividends – dividends treated as such for U.S. tax purposes for which the CFC receives a deduction (or similar tax benefit) – are not eligible for the dividends received deduction. The deduction also is not applicable to dividends received from “10/50 companies.”
In conjunction with the dividend exemption system, Option Y significantly modifies subpart F of the Internal Revenue Code. Option Y repeals foreign base company sales, services and oil-related income as well as current section 956, adds two new categories of subpart F income – “U.S. related income” and “low taxed income” – and makes some changes to the definition of foreign personal holding company income.
“Low taxed income” is defined as income not taxed at least at an effective rate of [80%] of the maximum U.S. corporate rate. If the provisions are enacted and the percentage remains at 80, many CFCs not currently characterized as earning subpart F income will generate such income. However, a deduction would be allowed for [20%] of the “low taxed income” included in U.S. gross income. “U.S. related income” includes “imported property income” and “U.S. services income.”
While the dividends received deduction would generally be applicable to the foreign source portion of a dividend received, the U.S. shareholder would remain taxable on a current basis on its pro rata share of the “new” subpart F income.
The Discussion Draft retains and makes permanent the exceptions from foreign personal holding company income and insurance income for active banking and financing income, exempt insurance company income, and active insurance income with slight modifications. In general, the modifications eliminate the necessity of having a home country business, modify the application of the rules to qualified business units, and in the financing exception codify a list of activities that are characterized as a lending, finance or financial service business. In addition, two new requirements are added to the definition of a qualifying insurance company for purposes of both the exempt insurance exception and the active insurance exception: 50% of gross revenue must be from premiums and certain related requirements must be met and its insurance liabilities must exceed 35% of its total assets. The exceptions do not apply for purposes of the new “low taxed income” category of subpart F.
Option Y would also modify the foreign tax credit limitation by applying it separately to six categories of income: (1) passive income; (2) subpart F income attributable to “United States related income”; (3) subpart F income attributable to “low-taxed income”; (4) foreign branch income; (5) subpart F income attributable to insurance income; and (6) all other income.
Option Y would disallow a deduction for a portion of the interest expense that represents the interest apportioned to the income of a CFC that is exempt from taxation in the U.S., either because it is not subpart F income or effectively connected income.
Generally, Option Z would impose a current minimum tax on U.S. shareholders of CFCs according to their pro rata share of all CFC income at [60%] of the U.S. corporate tax rate if such income is derived from active business operations (but at the full U.S. rate if not).
Option Z would substantially redefine subpart F. Option Z would repeal sections 952 through 956 and define subpart F income as the sum of [60%] of “modified active income” plus 100% of “modified nonactive income.” The provisions for including subpart F insurance income generally remain the same, although the definition of exempt insurance income has been modified to include the gross receipts and assets tests described in Option Y and remove the home country risk requirement.
“Modified active income” is generally defined as “active foreign market income” less deductions (including taxes) allocable thereto. “Active foreign market income” is generally income attributable to economically significant activities of a qualified trade or business. It generally does not include income (i) with respect to property disposed of for use of disposition in the United States; (ii) for services provided in the United States or with respect to persons or property in the United States; or (iii) passive income. Special rules are provided for income derived in an active banking or finance business and active insurance business, as well as for active rents and royalties and certain income of derivative dealers, so that such income is characterized as “active foreign market income.”
“Modified nonactive income” is generally defined as gross income without regard to “active foreign market income” less allocable deductions.
Losses are split into two categories: active foreign market losses and qualified losses. When used, such losses cannot reduce income below zero, and only qualified losses can reduce “modified nonactive income.”
Special rules would apply so that [40%] of “modified active income” not included as subpart F income (i.e., the excluded income) is characterized as previously taxed income under section 959 when distributed, but is also treated as being distributed before the amounts that were actually included as subpart F income.
Option Z would also repeal current section 1248 and, instead, exclude from the gross income of a 10% U.S. shareholder a portion of any gain from the sale or exchange of stock in its CFC. The excluded portion would be the CFC’s historical earnings that have been excluded from subpart F income by reason of the preferential treatment of “modified active income.”
Option Z would also apply the FTC limitation separately for three separate categories of income: (1) subpart F income from active foreign market income; (2) passive income; and (3) all other income.
Common Provisions to Both Options
In addition to taxing non-exempt CFC income when earned, both Option Y and Option Z also provide a full exemption for foreign earnings upon repatriation.
Both options propose the same transition rule for the taxation of previously deferred foreign income. This rule would require a domestic corporation that is a U.S. shareholder of a CFC to include its pro rata share of the accumulated deferred foreign income in gross income. But a deduction of an applicable percentage of this mandatory inclusion would be permitted, resulting in a 20% effective tax rate. An FTC would be available only for taxes paid with respect to the taxable portion of included income, i.e., if 75% of foreign income was subject to tax, only 75% of the FTCs could be used by the taxpayer. And an increase in the tax liability of a U.S. shareholder as a result of the mandatory inclusion would generally be payable in installments over eight years.
10% U.S. Shareholders
The Discussion Draft modifies the definition of a 10% U.S. shareholder to include not only U.S. persons that own 10% of voting power, but also those that own 10% by value. It also eliminates the requirement that a foreign corporation must be a CFC for 30 days during the year before the subpart F income inclusion rules apply. Under the Discussion Draft, the subpart F rules apply for a foreign corporation that is a CFC at any point during the year.
Foreign Tax Credit Proposals
The Discussion Draft proposes to reform current FTC provisions by repealing (1) the deemed-paid credit rule with respect to dividends received by a domestic corporation which owns at least 10% of the voting stock of a foreign corporation, and (2) the section 909 “anti-splitter” rule. The new deemed-paid credit rule would effectively prevent a taxpayer from taking into account CFC taxes before the taxable year in which the related CFC income is included in the taxpayer’s income under subpart F.
Elimination of “Check-the-Box” for Certain Controlled Entities
The Discussion Draft proposes to eliminate the “check-the-box” election for an entity wholly owned either by a single CFC or by two or more members of an expanded affiliated group, one of which is a CFC. Such an entity would be treated as a corporation for U.S. tax purposes. This proposal would not apply to an entity wholly owned by one or more domestic entities.
According to the Joint Committee Explanation, this proposal would “limit a number of techniques that have been used to circumvent subpart F, or to otherwise alter the application of the foreign tax credit rules, the transfer pricing rules, and other international tax provisions.”
The Discussion Draft proposes to modify rules related to Passive Foreign Investment Companies (PFICs) by (1) requiring a U.S. person who owns non-publicly traded PFIC stock to recognize interest income based on a deemed rate; (2) modifying the current mark-to-market rules applicable to marketable stock of a PFIC; (3) repealing the current asset test for determining whether a foreign corporation is a PFIC; (4) reducing the income test threshold for a PFIC from 75% to 60%; and (5) requiring any U.S. person who holds certain PFIC stock on the last day of the 2014 taxable year to treat the PFIC stock as sold on that day for fair market value.
Sourcing Rule Proposals
The Discussion Draft proposes four sourcing rule changes: (1) accelerating by six years the effective date of the election to allocate interest on a worldwide basis to December 31, 2014; (2) repealing fair market value interest expense allocation by members of U.S. affiliated groups; (3) sourcing income from the sale of inventory within the U.S. when a taxpayer’s office or fixed place of business within the U.S. is a material factor in the sale; and (4) disregarding certain asset acquisitions for purposes of computing the FTC.
Proposals to Prevent Base Erosion
The Discussion Draft includes proposals to prevent base erosion and profit shifting (BEPS), including: (1) curtailing BEPS through the transfer of intangible property for purposes of sections 367(d) and 482 by revising the definition of intangible property and providing authority to the Commissioner to require certain valuation methods of such property; (2) instituting a general rule of non-deduction and non-inclusion for insurance companies related to non-taxed reinsurance premiums and amounts paid allocable to those premiums (this is akin to proposals from Rep. Richard Neal (D-Mass.)); (3) treating as effectively connected to a U.S. trade or business the gain or loss on the sale of a partnership interest by a foreign person to the extent the seller is considered to be engaged in a U.S. trade or business by reason of its membership in the partnership; (4) imposing, subject to current treaty arrangements, a 30% gross basis withholding tax on payments, including interest income, arising from corporate obligations held by non-resident aliens and foreign corporations who are otherwise exempt from the withholding tax under present law; and (5) disallowing deductions for any related party payment arising in connection with a “base erosion arrangement.” For purposes of proposal (5), a “base erosion arrangement” is any transaction or series of transactions, or other arrangement, that reduces the amount of foreign income tax paid or accrued and that involves a (i) hybrid transaction or instrument, (ii) a hybrid entity, (iii) an exemption arrangement, or (iv) a conduit financing arrangement.
The Discussion Draft also proposes to: (1) repeal the domestic international sales corporation (DISC) rules; (2) repeal the dual consolidated loss rules; (3) modify the tax on foreign investments in U.S. real property interests including specific rules applicable to real estate investment trusts (REITs) and regulated investment companies (RICs); and (4) exclude dividends from REITs and RICs from the 10% qualified shareholder dividends received deduction under section 245.
Baucus’ staff requests comments from taxpayers on “all aspects” of the Discussion Draft as well as other areas of international business tax reform. Comments are requested by January 17, 2014, although they will be accepted at any time.