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By James J. Tobin, Esq. Ernst & Young LLP New York, New York
I'm excited about the prospect of major international tax reform, which is looking more and more likely to me. The House Republican Tax Reform Blueprint would represent massive changes. Border adjustability would be a true disruption and cause many companies to rethink their business models. But if it is projected to raise lots of revenue there will naturally be lots of lobbying and pushback, so I'm not so sure about that proposal. On the other hand, I do think we need to and will move to a territorial tax system, which will likely come with a transition tax on deferred foreign earnings. The transition tax would pay for the move to the territorial tax system and have the added benefit of unlocking large amounts of cash trapped offshore.
Because a logical starting point for drafting a transition tax would be the proposal included in legislation championed by former House Ways and Means Committee Chairman Dave Camp (R-Mich.), the Tax Reform Act of 2014, I decided to revisit that proposal (hereafter referred to as Camp II) to determine what I do and do not like about it. (And maybe I didn't take that proposal seriously enough at that time to appreciate all of its subtleties — but it seems like I need to know them now.)
So let me go through the basics of the Camp II transition tax proposal and then make a few comments. As we all know the proposal calls for a mandatory tax on deferred foreign earnings — not just a tax on optional cash repatriation like old §965. (In fact Camp II uses §965 again for the new provision — no point wasting a good Code section that's available.) The mandatory tax applies to deferred foreign earnings accumulated by controlled foreign corporations and §902 (10/50) companies in tax years ending after December 31, 1986. The taxing mechanism is a one-time subpart F inclusion for the deferred earnings amount. But in order to provide a reduced tax rate for the deemed inclusion, a deduction is allowed. A 75% deduction is allowed with respect to deferred earnings which are represented by cash or other specified liquid assets producing an effective tax rate of 8.75% and a 90% deduction is allowed for remaining deferred foreign earnings producing an effective rate of 3.5%. Any foreign tax credits related to the deductible portion of the deferred earnings inclusion are disallowed but underlying foreign tax credits related to the nondeductible portion of earnings would be available to offset the toll charge. Any existing foreign tax credit carryovers and net operating losses are also available to offset the transition tax, apparently without limitation.
A very positive aspect of Camp II, which had not been in Chairman Camp's previous toll charge proposal, was the offset of deferred foreign earnings deficits (again earned in tax years ending after December 31, 1986) against positive deferred earnings balances, thus reducing the transition tax. The mechanism for doing so is quite complicated. All deficits allocable to the U.S. shareholder in the CFCs or §902 group companies are aggregated and then allocated proportionally to each CFC or §902 corporation of that U.S. shareholder which had positive deferred earnings.
Camp II was released for public comment in February 2014. The earnings and profits measurement date for the toll charge proposal by Camp II was the last day of the last taxable year of each deferred foreign income corporation beginning before January 1, 2015. The total toll charge inclusion would be the aggregate attributable post-1986 E&P net of aggregate attributable deficits. This aggregate net amount would represent the total subpart F inclusion. Note the amount would be unreduced by any dividend distributions during that year — such dividends would essentially be treated as previously taxed income distributions of the subpart F inclusion. If such a quick effective date were chosen for current tax reform and it passed this year, for calendar year companies 2017 would be the E&P measurement and subpart F inclusion year.
There was a deferred payment election available for paying the toll charge. Regular taxpayers could elect to pay in eight installments: 8% of the liability in each of the first five years and 15, 20, and 25% for years 6 through 8. Pretty generous. And Subchapter S shareholders could defer payment indefinitely until there was a triggering event with respect to the S corporation or its shareholder.
So those are the basics. Pretty complicated. Lots of money at stake and a tremendous amount of computational work to do in potentially a very short time. Let's see how close to Camp II the rules turn out to be. Here are some observations on aspects of the proposal, many of which I hope get fixed or clarified before we have a final rule.
So overall one hopes that we get clarification in lots of areas assuming the toll charge does get enacted. Seems that will practically need to happen in the statute or legislative history as it will be awfully hard for the IRS to give guidance on open points quickly enough to help taxpayers since all reporting will likely be required within about one year after the law is enacted.
I complained about the toll charge proposal in Camp I, in part because I didn't see it coming. I know of no other country that extracted a similar entry fee upon converting to territorial. A toll charge at all — even at a reduced rate — on earnings fully redeployed in the foreign business seems like a pure revenue grab and not a principled transition approach. But I am at least thankful for the lower split rate. How about zero for non-cash equivalent E&P?
But it seems to me the revenue targeted from a toll charge is now largely committed or spent so I doubt it will be abandoned. And since it could happen quite quickly companies will need to get prepared. In my experience, permanently reinvested foreign earnings numbers are often a bit “soft.” So lots of effort may be needed to firm them up and start addressing all of the obvious complications. And the IRS will certainly have its hands full in dealing with the complex issues and reviewing the calculations of every multinational company in America!
|PANEL OF CONTRIBUTORS|
|Thomas S. Bissell, CPA Celebration, Florida||David Ernick, Esq.PricewaterhouseCoopers LLPWashington, D.C.||Edward Tanenbaum, Esq.Alston & Bird LLPNew York, New York||Robert E. Ward, Esq. Ward Chisholm, P.C. Bethesda, Maryland|
|Kimberly S. Blanchard, Esq.Weil, Gotshal & Manges LLPNew York, New York||Gary D. Sprague, Esq. Baker & McKenzie LLPPalo Alto, California||James J. Tobin, Esq.Ernst & Young LLPNew York, New York||Lowell D. Yoder, Esq.McDermott Will & Emery LLPChicago, Illinois|
|This section features brief commentary written on a rotating basis by leading international tax practitioners.|
Copyright © 2017 Tax Management Inc. All Rights Reserved.
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