U.S. Territoriality – Variations on a Theme

 By Barbara M. Angus, Esq.

Ernst & Young LLP, Washington, DC1 

We are midway through 2012 and the tax extenders - the myriad provisions that are an integral part of our tax code except that they are temporary - are still expired. Looming ahead on the individual tax side is the year-end expiration of the so-called Bush tax cuts. Add to the mix the need to deal with the automatic spending cuts that will kick in on January 1st under the sequestration provisions enacted last year in connection with the raising of the federal debt ceiling (which likely will need to be raised again early in the new year). The result is what is being labeled by the inside-the-beltway crowd as the fiscal cliff or, more colorfully, taxmageddon.

This tax and spending perfect storm is the immediate priority in Washington. Well, perhaps not so immediate because this is an election year, but finding a way out of this maze is expected to be the consuming focus of the post-election lame duck session later this year. Given the magnitude of the issues involved, the December outcome is likely to be a short-term fix. Against this backdrop, and indeed in no small measure because of it, the focus on fundamental tax reform is increasing. There is talk of including in the year-end tax deal an agreed expedited process for work on tax reform legislation.  As one Hill staffer said recently, 2013 will be the key year for tax reform.

As we look ahead to next year, the discussion around the international segment of tax reform is what is most advanced, perhaps because the international tax regime is most in need of an overhaul. There is growing consensus (if one can use the word "consensus" in Washington in an election year) regarding a move to a more territorial tax approach. Of course, "territorial" is a term that is being used pretty loosely. Our European colleagues have a tendency to roll their eyes every time we Americans refer to the U.S. reform proposals, which include retention and even expansion of the Subpart F regime, as moving to territoriality. Still, we are using the word "territorial" and we are talking about competitiveness, which seems like a step in the right direction. And which makes now an exciting time for those of us who have been eagerly anticipating international tax reform.

House Ways and Means Committee Chairman Camp released his comprehensive discussion draft for a new U.S. international tax regime last fall in order to advance the debate, and his proposal has done just that. While things have been quieter on the Senate side of Capitol Hill, there is focus on international tax reform over there as well. Senate Finance Committee Chairman Baucus gave a speech in June that outlined the broad principles defining his view of fundamental tax reform and made several key points related to international tax.  Senator Portman has been developing a tax reform bill that is expected to broadly parallel the overall approach taken in the Camp discussion draft.

The most specific proposal to date from the Senate is the bill introduced earlier this year by Senator Enzi, who is a member of the Finance Committee. Senator Enzi's signature tax issue has long been the sales tax treatment of internet transactions and he is the lead sponsor of legislation in that area aimed at leveling the playing field for Main Street businesses. I like to think that Senator Enzi's introduction of this bill is affirmation that in today's global economy an international tax level playing field has become a Main Street business issue. As has been said in prior commentaries about the Camp proposal in this space, there is a lot to like about the Enzi bill, but there also are plenty of devils in the details.

The Enzi bill is similar to the Camp proposal in its three core elements:

  •   A new participation exemption regime structured as a 95% exemption for dividends and capital gains with respect to foreign subsidiaries;
  •   A significant expansion of the U.S. Subpart F regime with a particular focus on low-taxed intangible income; and
  •   Transition rules aimed at accelerating U.S. tax on pre-reform accumulated deferred foreign earnings of controlled foreign corporations (CFCs).

However, there are important differences between the Enzi bill and the Camp proposal. As the debate over international tax reform continues, it makes good sense to be familiar with the Enzi bill, particularly as some of the differences could have significant implications, positive or negative, in particular cases.

The most obvious difference in the Enzi bill is that it does not include a cut in the corporate tax rate (although Senator Enzi has indicated his support for a corporate rate reduction).  Given the relevance of the corporate tax rate in assessing the implications of these international reform proposals, one might want to factor in a common tax rate for purposes of comparing the Enzi bill to the Camp proposal.

An exhaustive review of the details of the Enzi bill and the parallels and contrasts with the Camp proposal is beyond the scope of this commentary. The remainder of this discussion will focus on the so-called anti-base-erosion rules and the transition rule treatment of accumulated earnings, two components of international reform that have attracted considerable critical attention since the Camp proposal was introduced last fall but that have begun to have something of an air of inevitability about them.

The element of the Camp proposal that has been most controversial is the approach to addressing what the technical explanation describes as "base erosion caused by shifting of intangible property and its related income." The Camp proposal includes three alternative options, each of which is an expansion of Subpart F through the creation of a new category of CFC income subject to immediate U.S. tax. In the context of a participation exemption system, the capture of foreign earnings with Subpart F is more dramatic than under today's worldwide tax system as it represents the difference between current U.S. taxation and permanent U.S. tax exemption. The reaction to these alternative options and their targeting of income from intangibles has been heated, which is not surprising given the growing role of technology in the modern global economy.  For some U.S.-based multinationals, the impact of these provisions could be so great as to swamp the potential benefit of an otherwise territorial tax regime, turning some long-time advocates of territoriality for the United States into opponents.

Senator Enzi has waded into this controversy with an approach that would both contract and expand the reach of Subpart F. In an extremely positive development, the Enzi bill includes repeal of the foreign base company sales and services income rules (and also would make permanent the CFC look-through rule and the Subpart F active financing exception). This is welcome recognition that the foreign base company rules, with their focus on where foreign activity occurs, do not have the same role to play under a territorial tax regime that generally exempts foreign earnings from U.S. tax. In this regard, Chairman Camp's staff has indicated that revision of Subpart F is still under consideration; hopefully, consideration will be given to a similar approach in this area.

This scaleback of the existing Subpart F rules would be combined in the Enzi bill with an expansion of the reach of Subpart F through an anti-base-erosion provision that contains elements of the Camp proposal's Option B (which broadly covers low-taxed earnings) and Option C (which applies a carrot-and-stick approach to foreign intangible income based on whether it is earned by a U.S. affiliate or a CFC). Under the Enzi bill, a new category of Subpart F income would be created for income that is subject to a foreign effective tax rate less than or equal to half the U.S. corporate tax rate (which under the Enzi bill would be a threshold of 17.5% or, using the Camp proposal's 25% corporate tax rate, would be a threshold of 12.5%). An exception is provided for income attributable to the CFC's conduct of an active trade or business in a foreign country (note that the focus here is on any foreign country not just the CFC country of incorporation), provided that the CFC has a fixed place of business in such country and officers and employees who are physically located in such place of business conduct (or significantly contribute to) activities that are substantial in relation to the activities necessary for the active conduct of such business. The bill's explanation indicates that activities taken into account for this purpose include procurement, manufacturing, distribution, and sales and marketing.  This active business exception compares favorably to the analogous exception in the Camp proposal's Option B in that it reflects a more modernized approach for defining an active business. The approach builds on standards developed in the manufacturing context in the substantial contribution regulations under the foreign base company sales income rules (although it continues those regulations' focus on "people functions" that some have viewed as inappropriate in today's technological age).

Before you start feeling too good about this provision, there is a catch. The Enzi bill includes an exception to the active business exception that captures intangible income.  "Intangible income" is defined broadly as income from the disposition of property, or the provision of services, in which intangible property is used directly or indirectly, to the extent attributable to such intangible property. So determining intangible income would require a bifurcation of income streams with a portion of sales or other income taken into account to the extent considered attributable to an intangible. And "intangible property" is defined using the broad definition in §936(h). Thus, under the Enzi bill, all intangible income of a CFC is treated as if it were not active business income, regardless of the functions performed and risks borne outside the United States. All intangible income of a CFC that is subject to foreign tax at not more than half the U.S. corporate tax rate would be subject to immediate U.S. tax at the full U.S. corporate tax rate.

For companies with significant intangible income earned by CFCs, this Enzi bill approach is as big a concern as the Camp proposal options (and, based on the higher foreign tax rate threshold of 17.5% that results from the bill's retention of the current U.S. tax rate, would be of even greater concern). Like the Camp proposal's Option C, the Enzi bill includes a provision that would provide a reduced rate of tax (half of the U.S. corporate tax rate, again 17.5% using the current rate) on certain foreign intangible income earned by a U.S. company. However, the location of intangible property in a CFC is not simply a tax-planning ploy, and in many cases foreign intangibles have been developed or acquired outside the United States and thus would not be eligible to benefit from this "carrot" provision. Moreover, all of these approaches targeting intangible income represent attacks on the widely-agreed arm's-length standard of transfer pricing, which is a recipe for international disputes and potential double taxation.

As with the Camp proposal, it is important to evaluate the two intangible-related provisions in the Enzi bill, together with the other proposed changes to Subpart F and the participation exemption provisions, in light of a business's current and expected future mix of income to assess the impact of this approach. The presence of this anti-base-erosion provision in the Enzi bill underscores the negative focus on foreign intangible income that likely will continue to permeate the debate on international tax reform.

Let us turn now to the approach to transition in the Enzi bill. As transition is the first thing that happens under reform, it is naturally taxpayers' most immediate concern, especially when it involves a toll charge to get to the reformed regime. The Enzi bill starts from a deemed inclusion of deferred foreign earnings at a reduced U.S. tax rate that is similar to the Camp proposal; there are differences that may mitigate some of the issues regarding the implications of the Camp proposal's provision but they create issues of their own.

Under the Enzi bill, the transition rule deemed inclusion of pre-reform accumulated earnings is elective, at least nominally so. Where the election is made, the deemed inclusion is subject to a 70% deduction, yielding an effective tax rate of 10.5% for the earnings included under this provision as compared to the 5.25% effective rate under the Camp proposal. In contrast to the Camp proposal, no foreign tax credits are allowed against the U.S. tax on the portion of the earnings that is includible under this provision.  Thus, amounts includible under the Enzi bill provision are subject to U.S. tax without offset for foreign taxes that were paid on such earnings.

Unlike the Camp proposal, this provision is elective. The taxpayer can choose the portion of a CFC's income that is deemed to be included in income under this one-time provision.  To the extent that this election is not made for all accumulated deferred earnings of a CFC, subsequent distributions are treated as coming first from pre-reform earnings not eligible for the 95% exemption under the new participation exemption regime. Such distributions are taxed under the current international tax rules, with offset for foreign tax credits including §902 deemed-paid credits.

The Enzi bill transition rule provides taxpayers more flexibility than the approach in the Camp proposal. However, the price tag for that flexibility includes an effective tax rate on pre-reform earnings for which inclusion is elected that is at least double the rate under the Camp proposal and higher than that if the denial of foreign tax credits is taken into account. While taxpayers can forgo the deemed inclusion altogether under the Enzi bill (and thereby avoid the potential liquidity issues), choosing to continue deferral means inclusion at the full U.S. tax rate when distributed, delay of effective entry into the new participation exemption regime, and the complexity of running two parallel systems for what could be many years into the future. The result could be continuation of the lock-out effect that the move toward territoriality is intended to address. Moreover, there could be some competitive effects as U.S.-based multinationals effectively enter the new world of territoriality at different times depending on their pre-reform earnings history and the elections they make. Still, choice is generally a good thing.

Under both the Camp proposal and the Enzi bill, the key driver in the cost of transition is a CFC's accumulated earnings.  And the measure is earnings and profits (E&P) for U.S. tax purposes, which may well be higher than retained economic profits. (See Tobin, "Off to Camp?" 41 Tax Mgmt. Int'l J. 96 (2/10/12).) The bottom-line message with respect to the transition inherent in international tax reform: companies would be well-advised to act now to get their E&P data in order and to consider steps to reduce balances of accumulated pre-reform earnings.

As noted in the opening, this is an exciting time to be an international tax practitioner. We are on the cusp of transformational international tax change. I am confident we will see it in my professional lifetime - indeed, letting the record reflect that I'm a little younger than my colleague who is a regular commentator in this space, I am confident he will see a new U.S. international tax regime well before he sees retirement. There is lots of hard work yet to do and now is the time to get involved. The major themes are sufficiently similar across the proposals being advanced by lawmakers to allow a qualitative and quantitative assessment of the implications of reform. The differences in detail from proposal to proposal provide a basis for discussion regarding optimal approaches. The staffs who are designing the legislation are receptive to constructive comments.  Being proactive now is key to helping the policymakers move international tax reform in the right direction. And focusing now is key to taking the right steps to be ready for reform when it arrives.

This guest commentary also will appear in the August 2012 issue of the  Tax Management International Journal.  For more information, in the Tax Management Portfolios, see Isenbergh, 900 T.M., Foundations of U.S. International Taxation,  and in Tax Practice Series, see ¶7110, U.S. International Taxation: General Principles.

 1 The views expressed herein are those of the author and do not necessarily reflect those of Ernst & Young LLP. This guest commentary is in place this month of the regular commentary by James T. Tobin.