The Obama Administration recently unveiled initiatives to reform international tax laws which, if enacted, could reduce U.S.-based multinational companies' ability to compete with certain foreign companies. Scheduled to take effect in 2011, the Administration's proposals are projected to raise taxes by $210 billion over the following ten years and significantly increase the effective tax rate of U.S. corporations with foreign operations. It is critical that U.S. companies have the opportunity to continue to engage in and rely upon sound tax planning to remain competitive internationally. In view of these proposals, U.S. businesses must be prepared to effectively advocate for their interests in the tax reform debate that has been launched in Washington, D.C.
Four key initiatives should be of concern to U.S. companies with international operations:
1. Modification of the "Check-the-Box" Rules
Under current "check-the-box" rules, U.S. companies can elect to treat certain foreign subsidiaries as disregarded entities and transactions between disregarded entities and their direct owners are not recognized for U.S. federal income tax purposes. Under the Administration's proposals, certain transactions with these currently disregarded entities would be recognized and generate passive income subject to U.S. tax on a current basis.
2. Deferral of Deductions Related to Foreign Operations
The Administration is also seeking to defer deductions for ordinary and necessary business expenses (other than research and experimentation expenditures) until the related foreign source income is subject to U.S. tax. Contending that some U.S. businesses shift income overseas, the reforms would prohibit U.S. companies from taking current deductions related to foreign operations against U.S. source income. For example, marketing and sales deductions generated in the United States could not be claimed until the related foreign manufacturing income is recognized. The possible tax effect of this initiative for U.S.-headquartered companies with overseas operations is the possible deferral of significant ordinary and necessary business expense deductions, increasing current U.S. tax liability.
3. Crackdown on Tax Havens
A crackdown on the abuse of tax havens is also in the works. Currently initiatives are already under way within the G-20 to impose sanctions on countries that fail to implement information exchange standards relating to tax havens. To implement this plan, the Administration proposes a comprehensive package of disclosure and enforcement measures to be imposed on financial institutions. The package would withhold taxes on amounts paid to institutions that fail to adequately share information with U.S. authorities. Foreign financial institutions with U.S. dealings would be required to sign an agreement with the U.S. Internal Revenue Service (IRS) to become a "Qualified Intermediary" and share information with the IRS about U.S. customers. Failure to share information would lead to a presumption that the financial institution is facilitating tax evasion and taxes would be withheld on payments to their customers. The reforms would also increase reporting standards for foreign investments and extend the statute of limitations for enforcement.
In order to provide additional resources to enforce the new rules, the Administration has allocated funding in the current budget for 800 new IRS employees devoted to international tax enforcement.
Although proper enforcement against recent tax abuses by U.S. persons "hiding" otherwise reportable foreign source income in tax haven schemes is to be applauded, it is unclear whether the increased U.S. tax reporting obligations are likely to be effective and efficient.
4. Plans to Restrict Foreign Tax Credit Utilization
The Administration is further concerned that the reduction of foreign tax credit limitation categories to passive and general baskets (under the American Jobs Creation Act of 2004) has enhanced U.S. taxpayers' ability to "cross-credit" to reduce residual U.S. tax on foreign source income. It is also concerned with the ability of U.S. multinational companies to use hybrid structures to separate foreign taxes from associated foreign source income. It intends to introduce a plan to eliminate these abilities for U.S. taxpayers. It is not clear exactly how the Administration's proposal would effect foreign tax credit pooling, but it is clear that any further restrictions on foreign tax credit utilization likely will increase the effective tax rates of U.S. multinational companies vis-à-vis foreign competitor corporations whose home countries do not tax foreign source income or whose home countries do impose a tax on foreign source income but do not impose such strict limitations on the use of foreign tax credits.
Looking Forward: Engaging in the Policy Debate
The proposed reforms summarized above are merely the opening salvo in what promises to be a critical debate about the future of U.S. competitiveness in the global economy. As a result, U.S. companies with international operations should carefully analyze these proposed reforms and monitor any future proposals. Our tax policy group, which has participated in advocacy efforts relating to every federal tax bill proposed since 1981, fully expects this debate to continue within the federal landscape for some time to come. However, experience tells us there is no better time than the present to advocate for sensible policies in order to ensure future competitiveness within the global marketplace.