Obama Embraces Some of the Rangel Plan and It's Deja Vu All Over Again for U.S. Companies

By James J. Tobin, Esq. Ernst & Young LLP, New York, NY

Yogi Berra also famously said, “You can observe a lot just by watching.”

On May 4, I observed a lot just by watching Treasury Secretary Geithner say, “In a global economy, we need American companies to compete in overseas markets, but we will no longer provide tax incentives that disadvantage American innovation and American workers.”

Continuing to watch, I then observed President Obama say that he was going to save the American people about $210 billion dollars and create jobs here by curtailing the ability of U.S. companies to “shirk their responsibilities” to pay their taxes. He also said the whole idea was to level the playing field.

What Messrs. Geithner and Obama plan to do to correct what the President called “a broken tax system, written by well-connected lobbyists on behalf of well-heeled interests and individuals,” is:

• Deny current corporate deductions for U.S. expenses deemed related to deferred foreign income;

• Change the foreign tax credit system to key off a conceptual consolidated average foreign tax amount instead of specific foreign taxes actually paid on foreign income subject to U.S. tax; and

• Revoke the check-the-box rules for most single-owner foreign entities.

The first two of these appear to come straight out of Ways and Means Committee Chairman Rangel's international tax reform plan from a couple of years ago, while the third caught pretty much everyone by surprise. The three taken together represent a dramatic curtailment of deferral, the system under which earnings of foreign subsidiaries of U.S. multinationals generally are not taxed in the United States until those earnings are distributed to the U.S. parent as a dividend; for many American companies, the combined effect would be virtually the same as complete repeal of deferral. Enactment of all three proposals, while acknowledging the need for American companies to be globally competitive, would be the economic equivalent of deliberately throwing the game. And any one of the proposals would be like requiring American companies to take the field a few players short. I'm still trying to figure out which playing field it is that is supposed to be leveled with these proposals.

Okay, so it's true, I did observe a lot just by watching. But I've also got some additional observations.

For one thing, deferral is not a four-letter word, contrary to the Administration's efforts to make it so. And territorial is not merely a term used to describe your dog's behavior. The latter term, in fact, is used to describe the tax systems of virtually all of the world's major economies, now that Japan and the United Kingdom have adopted such systems. This will leave the United States as the last one standing: the world's last major economy with a worldwide taxation/foreign tax credit system and a high corporate tax rate. The other countries with a worldwide taxation/foreign tax credit system -- China being the only true “major” among them -- all have corporate tax rates lower than 30%; 25% in the case of China.

For “deferral” to be considered sinful or a corporate giveaway implies that it is appropriate for shareholders to be including their share of income of corporations they own on a current basis. I certainly don't think that's appropriate on the stock of companies I own (of course, most of my investments are in money-losers anyhow). Rather, I think any corporate investor would expect a corporation to reinvest part of its profit to grow its business and at most pay a portion of its profit as a dividend return to shareholders. Why would our expectations of reasonable behavior in the case of foreign subsidiaries be any different from this?

Let's consider some typical fact patterns. Say a U.S. company in the retail industry is trying to grow its business in China. It seems reasonable to expect that to grow its local business, its China subsidiary may reinvest profits from store #1 to open store #2, etc. Likewise a consumer products company reinvesting profits to further establish its brands to Chinese consumers. Likewise a mining company reinvesting profits from mine #1 to develop mine #2. Apparently the “deferral as a sin” camp would think it more appropriate that the profit from store #1, brand #1, and mine #1 be taxed in the United States before the funds can be reinvested. So for China, given its 25% tax rate, that would mean a 10% U.S. residual tax under current law before the U.S. company can reinvest. The idea espoused by proponents is that the playing field should be leveled so that U.S. companies should instead equally consider opening the next store in the United States, spending more in promoting their brands in the United States, or developing the next mine in the United States. But, it seems to me that in my simple examples the target customers and the natural resource prospects are located in China, so it's hard to see why it's good policy to impose a 10% U.S. tax penalty on the U.S. company's ability to grow in that market. Certainly I can't see how anyone could say deferral is an unreasonable corporate giveaway.

The White House press release of May 4 says, “yet today, our tax code actually provides a competitive advantage to companies that invest and create jobs overseas compared to those that invest and create those same jobs in the U.S.” Seems to me the competitive opportunity in my example above is the billion-plus potential consumers in China and the overseas natural resource prospects not yet exploited. A U.S. tax penalty in accessing them would be a competitive disadvantage that unlevels the playing field.

I remain hopeful that this uncompetitive result will stimulate conversation among a good number of Members of Congress and that real debate over deferral will ensue. However, I remain concerned about the labels of “abuse” and “corporate loopholes” that are being thrown around.

Both the foreign tax credit and check-the-box proposals are being styled as anti-abuse proposals. Interestingly, both would result in enormous new complexity for the international tax system. For the remainder of this commentary, I'd like to focus on the technical implications of the foreign tax credit approach being proposed. For now, I'll defer comment on the check-the-box proposal.

Rangel Redux

Aficionados might recall a commentary I wrote in the wake of the unveiling of the Rangel international tax proposals. (“Chairman Rangel Consolidates His Thoughts on International Tax Reform,” 37 Tax Mgmt. Int'l J. 49 (1/11/08).) There, in connection with Mr. Rangel's foreign tax credit proposal -- in a section headed “Some Scary FTC Stuff” -- I noted that the Rangel approach would essentially consolidate all a group's CFCs for credit purposes with the result most commonly being fewer credits coming along with a CFC dividend.

While I did not take the Rangel proposals all that seriously at the time, I played along, going on to say, “The bill's approach of requiring year-by-year layering moves us away from the adoption of a pooling system made in the 1986 act, a change that was made in reaction to the complexity and recordkeeping difficulties of the previous layering system. Going into a consolidated layering system takes the complexities to a new level; consider that when you exhaust the post-2007 layers, you go back to the 1987-2007 pools and then, when those are exhausted, to the pre-'87 layers.”

So, while I've already noted previously that the Rangel plan would take complexities to a new level, I've taken a fresh look in light of the Obama proposal. And my current view is that the proposed foreign tax credit approach is actually too complex for anyone to get it right. And I'm referring to implementing the approach through regulations, not even the compliance aspects of applying it. The proposal would require the addition of huge new mechanics to the U.S. tax rules while maintaining most of the existing complexity of the current system, as well.

Let's consider a “simple” fact pattern to illustrate.


Current Rules

Let's say you receive a distribution from Japan sub of 60 and a distribution from Brazil JV of 40, 35 of which is a dividend for U.S. tax purposes.

Under current rules the foreign tax credit calculation would be as follows:

Dividend (60 + 35)


§78 gross up


Taxable income


U.S. tax at 35%




Excess credits


Of course, this ignores any possible currency movements in the Japanese Yen or Brazilian Real.

Obama Proposal

The result I think we would see under the Obama proposal is as follows:

Average §902 rate

Total pre-tax E&P


Total tax


Effective tax rate


U.S. FTC Calculation:

Dividend income: 60 + 35


§78 gross up

(95/255 × 95


Taxable income


U.S. tax at 35%




Residual U.S. tax


So, in this example, the effect of the proposed rule is presumably as intended -- i.e., the U.S. tax cost of repatriating profits from subsidiaries in higher-taxed locations will go up -- perhaps considerably.

But, of course, a change of this magnitude would not be so simple. What additional questions are inherent in the simple fact pattern laid out above?

• Will E&P balances continue to be maintained for each company individually or will all E&P be considered part of a consolidated pool? If the latter, then the additional 5 of distribution from Brazil JV (40 distributed − 35 out of E&P) above would also be currently taxable in the United States even though Brazil JV did not have sufficient E&P to source any additional dividend.

• If separate E&P pools will still be maintained, how will the reallocation of taxes be handled? In the above example, Japan sub had pre-tax income of 100 and paid Japanese tax of 40. However, under the consolidated pooling approach, its foreign tax paid will be considered reduced to 27. Does this mean Japan sub has additional E&P of 13? Does it also mean that Ireland sub has a reduction of its E&P? On the other hand, it could just be a change in the algorithm for §902 so that there is no longer a connection between the credits associated with a dividend and the underlying income tax expense of a particular subsidiary.

• How to do the worldwide consolidated income calculation? Will U.S. consolidated tax return concepts apply? (What fun that would be!) How to combine the earnings and profits in different currencies?

• How to deal with currency movements with respect to foreign tax paid? Should all forex rates be locked in at the time each “layer” of deemed-paid credits is computed? Will each country's taxes be considered to come out of the combined pool on a proportionate basis?

• How to deal with dividends from lower-tier CFCs up the chain? In the example, what if in year two UK sub pays a dividend to NL holdco and let's say NL holdco has some of its own income and expense in year two. Presumably, because the pooling concept is a virtual consolidation, all intercompany dividends would be eliminated. Query how dividends for pre-acquisition profits on pre-effective date earnings should be treated. Do any pre-effective date §902 credits get blended into the new FTC pool?

• Will Subpart F inclusions be subject to the same pooling provisions? Presumably yes; the maintenance of CFC-by-CFC computations for Subpart F inclusion purposes along with consolidated computations for dividend purposes would seem an impossible task.

• How to deal with §986 forex gain or loss on Subpart F inclusions when a consolidated E&P concept implies a blending of currencies for certain purposes?

• How to deal with §960 tax adjustments with respect to Subpart F inclusions as they are distributed up the chain?

• How to deal with E&P deficits? Will they be included in consolidated E&P? Could a net deficit result in a denial of any FTCs for a given year? How to deal with upper-tier deficits as profits are distributed up the chain of CFCs?

• How to deal with M&A transactions?

• What if USP sells Japan sub? Is its §1248 amount recomputed based on its proportion of consolidated foreign tax? Will the consolidated E&P pool be reduced by that amount of E&P and tax? What if the “sale” is a tax-free exchange or the actual gain is less than the recomputed §1248 amount?

• What if NL holdco sells UK sub? Will the §964(e) calculation be similarly computed as described above, and only any excess gain added to the new E&P pool?

• What if a U.S. buyer purchases the 50% ownership of Brazil JV from the unrelated foreign shareholder? How to compute its §902 pool? For any joint venture company, will there be shareholder-level E&P account pools that will track the blended §902 pool for each shareholder?

• Are the new rules intended to apply to 10-50 companies, as this example assumes?

• How will these rules be viewed with respect to our tax treaty obligations? In the above example, has the United States really given foreign tax credit relief for Japanese tax with respect to the dividend received from Japan sub? Will our treaty partners think this was the intended result of their negotiations?

The space constraints imposed on this commentary prevent me from going on and on. But one can easily imagine adding to the list of unanswered questions and inherent complexities when thinking about aspects of §367, §905, §904 separate FTC baskets, etc., etc.

As you might be able to tell, I don't think the proposal is a particularly good idea. If it is brought into law without all the technical details worked out and collateral effects considered, there will be chaos in the system. Even if these issues are all fully addressed with detailed implementation rules, we will move from what today is already an overly complicated FTC regime, with which companies struggle to comply, to one of unprecedented complexity, which few if any will be able to get right. With complexity of this magnitude, there is a risk that some may not even try very hard to get it right anymore. And it will be beyond the IRS's ability to enforce.

Setting aside technical issues such as complexity, the policy result will be to render any repatriation from overseas more costly -- even high-taxed earnings that are currently brought home will be deferred where possible, which is not presumably an intended result. I believe our foreign tax credit system puts U.S. multinationals at a big competitive disadvantage today for investments in lower-tax countries (which is most of the world!). Now with this “leveling” of the playing field that big competitive disadvantage for American companies will apply to investments in higher-tax and lower-tax countries equally.

Other than that, I'm completely in favor.

Then again, as Yogi also said, if you don’t know where you are going, you will wind up somewhere else. Hopefully that will be the case with this proposal.

This commentary also will appear in the July 2009 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Carr and Moetell, 902 T.M., Indirect Foreign Tax Credits, and Yoder and Kemm, 930 T.M., CFCs -- Sections 959-965 and 1248, and in Tax Practice Series, see ¶7130, U.S. Persons' Foreign Activities.