A Model of Reality for President Obama (and Senator Dorgan) to Use in Evaluating Proposals for U.S. International Tax Reform

By Herman B. Bouma, Esq. Buchanan Ingersoll & Rooney PC, Washington, DC

During the 2008 presidential campaign, candidate Obama frequently stated (both on the stump and in the Presidential debates) that he would repeal “tax breaks and loopholes for shipping U.S. jobs offshore.” The references to tax breaks (plural) and loopholes (plural) suggested he had in mind at least four provisions of the Internal Revenue Code. However, it was never clear, at least to this author, as to what he was referring. The language communicated some concern with “deferral” (i.e., deferral of U.S. income tax on income earned abroad by foreign subsidiaries of U.S. corporations) but deferral certainly cannot be considered a tax break intended to encourage persons to ship U.S. jobs offshore, nor a loophole. After all, deferral is a very broad principle and results in reduced U.S. income tax on all kinds of operations conducted abroad, even if they do not involve U.S. jobs shipped offshore.

President Obama's manifest concern with at least some aspect of U.S. international taxation, whatever that might be, was made clear in his budget released on February 26, 2009. That budget included the following, rather mysterious, line item (which was projected to raise $210 billion over 10 years): “Implement international enforcement, reform deferral, and other tax reform policies.” News reports have indicated that this is to be fleshed out in the course of the budget process.1 In addition, Peter Orszag, Director of the Office of Management and Budget, announced on March 25 that the White House is in the process of creating a Tax Reform Task Force “to recommend ways to simplify the tax code and reduce tax evasion.”2 It is clear, therefore, that in the not-too-distant future the President will be entertaining some proposals for reform of U.S. international taxation. That being the case, the following “Model of Reality” is offered to help him evaluate the merits and demerits of any such proposals that may be presented to him. The Model is also offered to Senator Dorgan (D-ND) in light of his concern with so-called “runaway plants.”3

The Model that follows may seem rather basic, but it is this author's experience that, in the political world at least, it is necessary to present concepts very simply in order to get a point across.

A Model of Reality for Evaluating Proposals for U.S. International Tax Reform

When dealing with issues involving corporations, partnerships, and “hybrid entities”, international tax practitioners (and other tax practitioners) usually think in terms of rectangles, ovals, and triangles. However, rectangles, ovals, and triangles really have nothing to do with reality, and do not help the practitioner “see” reality when dealing with the tax issues. Some model of reality is needed to help the practitioner do this and to get away from the “rectangle, oval, and triangle” mentality.

One model of reality that may be helpful in this regard is an “Indian village” model of reality. One pictures an autonomous Indian (i.e., Native American) village established at the confluence of two rivers and bounded a few miles up from the junction of the rivers by a thick forest. The Indian village, called Pawnee Village, is sovereign and self-governing and free to develop its own tax system. A resident of Pawnee Village, a brave named Brave Pawnee, has his own basket-weaving business, producing baskets in his village and selling them in the Pawnee Village market. Brave Pawnee employs a number of residents of Pawnee Village in his business.

There is another Indian village, Mohawk Village, which is also sovereign and self-governing. A resident of Mohawk village, a brave named Brave Mohawk, also has a basket-weaving business, producing baskets in his village and selling them in the Mohawk Village market.

Brave Pawnee decides to open up a basket-weaving business in a third Indian village, Sioux Village, which is also sovereign and self-governing. Coincidentally, Brave Mohawk decides to do the same thing. Thus, both Brave Pawnee and Brave Mohawk are producing baskets in Sioux Village and selling them in the Sioux Village market.

One simple use of the Model is to help one see the impact of “ending deferral” (i.e., ending deferral of U.S. income tax on income earned abroad by foreign subsidiaries of U.S. corporations). Assume the following: (1) Sioux Village imposes income tax on income “effectively connected” with a trade or business in Sioux Village and has a low rate of tax, say 10%; (2) Pawnee Village imposes residual taxation on Brave Pawnee at a 35% rate (but with a credit for taxes paid to Sioux Village); and (3) Mohawk Village imposes no residual taxation on Brave Mohawk (i.e., it has a territorial system). Obviously, with the tax advantage Brave Mohawk experiences (only paying tax at a 10% rate on his income earned in Sioux Village while Brave Pawnee pays tax at a 35% rate on his income earned in Sioux Village), Brave Mohawk could seriously underprice Brave Pawnee in the Sioux Village market, and thus Brave Pawnee would be at a significant competitive disadvantage.

For example, suppose the total production costs and operating expenses for both Brave Pawnee and Brave Mohawk in Sioux Village average 70u on a per-basket basis, where “u” is the unit of Sioux Village's currency. Also suppose a “reasonable” after-tax profit that a business person would expect to make on a per-basket basis is 20u. Brave Mohawk could derive the expected after-tax profit by charging 93u for each basket. However, in order for Brave Pawnee to derive the same after-tax profit, he would have to charge more than 100u. Thus, Brave Mohawk would have a distinct competitive advantage over Brave Pawnee in the Sioux Village market.

Another use of the Model is to help one see the impact of legislation aimed at “runaway plants” (i.e., legislation ending deferral of U.S. income tax on income earned abroad, by foreign subsidiaries of U.S. corporations, on the production of products for the U.S. market). Assume the following: (1) because of the low tax rate in Sioux Village, Brave Mohawk decides to move all of his basket-weaving production for his worldwide market to Sioux Village (and assume that low labor costs in Sioux Village make up for any additional transportation costs incurred); (2) Brave Mohawk also decides to begin selling baskets (made in Sioux Village) in Pawnee Village; (3) because of Brave Mohawk's distinct price advantage in the Pawnee Village market, Brave Pawnee begins to lose market share there; and (4) in order to remain competitive, Brave Pawnee is considering moving his basket production for the Pawnee Village market to Sioux Village. However, if Pawnee Village taxes Brave Pawnee at a 35% rate on all of his income earned in Sioux Village, then Brave Pawnee would continue to be at a significant competitive disadvantage and might not be able to compete with Brave Mohawk even if he did move his production to Sioux Village. Thus, Brave Pawnee might continue to lose market share in Pawnee Village until he eventually went out of business.

An additional advantage of the Model is that it helps the user keep in mind that there are three aspects of reality associated with a business tax unit (such as a “corporation”): (1) people and property; (2) assets and liabilities; and (3) value.

This commentary also will appear in the May 2009 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Yoder, 926 T.M., Subpart F--General, and in Tax Practice Series, see ¶7130, U.S. Persons' Foreign Activities.

1 Goldfarb and O'Toole, “Geithner and Orszag Defend Obama Tax Proposals,” 2009 TNT 40-1 (3/4/09); Ferguson, “Deferral Should Be Addressed as Part of Broader International Reform, Neal Says,” 47 BNA Daily Tax Rpt. G-6 (3/13/09).

2 Ferguson, Rothman, and Grimaldi, “Obama Calls for Tax Reform Task Force to Get Advice on Long-Term Policy Changes,” 56 BNA Daily Tax Rpt. GG-1 (3/26/09).

3 See S. 260, introduced by him in the Senate on Jan. 15, 2009. Legislation identical to S. 260 was introduced by Senator Dorgen on Feb. 4, 2009, as an amendment to Senate Amendment 98 (an amendment in the nature of a substitute to H.R. 1, American Recovery and Reinvestment Act of 2009), but was mysteriously withdrawn from Senate consideration on Feb. 5, 2009.

1 435 F.3d 555 (5th Cir. 2006), aff'g 124 T.C. 1 (2005).