The circus that is US politics has thrown up perhaps its strangest tax reform proposal yet. And it is one which, if enacted, could have serious consequences for Australian businesses. Think: the US version of the MAAL or DPT.
On 2 November 2017, the Republicans in the US House of Representatives released the text of the long-awaited tax reform Bill, the Tax Cuts and Jobs Act. The Bill contains several measures which could affect Australian businesses with US operations (for example, there are two different rules limiting the deductible interest of US subsidiaries) but the most striking is the proposal for a 20% gross-basis tax imposed on a US company making payments to a related foreign company from 1 January 2018.
The 20% gross tax would apply to, ‘payments … made by a US corporation to a related foreign corporation that are deductible, includible in costs of goods sold, or includible in the basis of a depreciable or amortizable asset …’ There is an exception for interest and some commodity transactions. But any payment by a US company that is, for example, a royalty, lease rental, a deductible swap payment, reimbursement of an expense, a contribution to a shared cost (such as advertising), the cost of trading stock, the cost of a machine or buying a patent - basically, any payment made by a US company other than a dividend, interest, the price of some commodities or a capital asset - is exposed.
The rule would only apply if the payments are made by the US company to ‘a related foreign corporation’ and if the total payments made by the US company to related companies exceed USD100m in a year.
So consider the outcome if, say, Gadget (US) Inc buys its stock from Gadget (Aust) Ltd. Gadget (Aust) would collect only 80% of the gross proceeds from selling to its US affiliate because Gadget (US) must remit 20% of the gross payment to the IRS. Gadget (Aust) may claim that it is being taxed by the US contrary to the treaty but the US has at least two answers: the tax is (formally) imposed on the resident payer not the non-resident investor, and in any event it is (called) an ‘excise tax’ rather than an income tax and so is not a ‘covered tax’ for the purposes of the treaty.
There is, however, some ‘good news.’ The proposal contains two ways out. The tax will not be charged for inter-company services where the US company pays just the supplier’s costs with no mark-up (though whether the revenue authorities in the seller’s jurisdiction will be happy with this could be doubted).
Secondly, instead of losing 20% of its receipts, the related foreign corporation can elect to treat the payments it receives as income effectively connected with the conduct of a trade or business in the US (in which case the payer will be immune from having to pay the excise tax). Making this election will, however, expose the foreigner to US tax at the corporate rate (currently 35% but maybe 20% in the future) on the net profit. So the foreigner can choose: suffer tax of 20% on its gross receipt, or pay tax itself at the US corporate rate on the net profit. For this purpose, the net profit earned in the US will be determined by ‘profit margins reported on the group’s consolidated financial statements for the relevant product line.’
This option is another possible answer to the treaty violation argument: the design of the tax will basically force the foreign company to make the election, but once it has done so, the foreign company is now deemed to have a PE in the US to which the income is effectively connected and so the tax can be sustained in the face of article 7 of a treaty. Whether US domestic law can deem treaty requirements to be met is doubtful (unless the US makes it clear in the law that it overrides US tax treaties). And whether this formula for calculating the net profit correctly computes the amount of profit that the PE would make if dealing at arm’s length is also debatable.
Needless to say this proposal has already generated some angry responses: that it is inconsistent with international tax norms, it offends treaty rules and will ultimately provoke retaliatory measures by other countries – all criticisms made against Australia’s MAAL and DPT. In fact, maybe this proposal could well be viewed as US retaliation against the unilateral measures already taken by the UK, Australia, India and others.
Perhaps the best news is that the prognosis for the Bill is poor: Bloomberg’s assessment is ‘the draft House tax plan is going nowhere in the Senate as written.’ On the other hand, this proposal is prominently labelled as a measure for the Prevention of Base Erosion and it is one of the few revenue-raising measures in the Bill (it is estimated to raise USD154bn over 10 years). If some Bill can eventually be enacted through the chaotic US political system, this provision may yet form part of it.