By Philip D. Morrison, Esq.
Deloitte Tax LLP, Washington, DC
As most readers will agree, Ways & Means Committee Chairman Camp should be heartily applauded for proposing a realistic territorial system of taxation for foreign income of American taxpayers. The United States has been increasingly out of step with other OECD members on this point and adoption of such a proposal would help put American-flagged businesses on a more equal footing with foreign-flagged businesses.
Chairman Camp is also to be applauded for refraining from including in his proposal a denial of deductions for interest allocated or attributed to exempt foreign income. While there might be theoretical justification for some such denial, the imbalance it would create between highly-leveraged multinationals and those that do little borrowing would be unfortunate. It would also be out of line with all other OECD countries' territorial systems. Instead, the 5% "haircut" (only 95% of foreign earnings would be exempt under the proposal) indirectly addresses this concern in a simple way that many other countries have adopted.
However, as other Tax Management commentators have pointed out, in certain details Chairman Camp's proposal needs some tweaking. Perhaps the most serious concern is the significant, and complex, expansion of Subpart F that is proposed. Under the heading of "prevention of base erosion," the discussion draft includes three alternatives. Two of the alternatives raise the question as to whether the economic activity that produces income from intangibles should be subject to tax twice. Those same options also would create a level of complexity that will make compliance and administration nearly impossible.
Under Option A of the discussion draft's Subpart F alternatives, income derived by a controlled foreign corporation (CFC) from outside its country of incorporation would be currently subject to tax in the United States if: (1) the income is from the use of U.S.-transferred or co-developed intangible property; (2) the income exceeds 150% of certain costs allocated to the income other than interest expense and taxes and indirect expenses; and (3) the income is taxed in a local jurisdiction at a foreign effective tax rate of 10% or less.2 (Option B is an even broader expansion of Subpart F requiring all income of a CFC to be currently taxed in the United States if the income is derived outside the CFC's country of incorporation and it is subject to a foreign effective tax rate of 10% or less.) Option C would tax currently CFC income that is attributable to intangible property and subject to a foreign effective tax rate of less than 13.5%.3 However, in a separate provision, a 40% deduction is allowed with respect to both foreign intangible income of the U.S. corporation itself, and any Subpart F inclusions of CFC intangible property income that is foreign intangible income - and such income is limited to the sale of property or provision of services in foreign markets.
The proposed Options A and C would negatively impact the ability of U.S. companies to use intellectual property in the course of active business operations conducted outside the United States. That impact will weaken their competitiveness as against other similarly situated foreign-owned businesses operating in the same markets. As far as this commentator is aware, in no other country must income attributable to sales and services performed by CFCs be subject to bifurcation between intangible-related returns and non-intangible-related returns.
By taxing otherwise exempt income attributable to intangibles, Options A and C also characterize as base erosion the ordinary and necessary use of one of the most important inputs to products and services in any number of industries. Heretofore, when U.S. companies export technology integrated in products and services that are made and delivered by their CFCs, that has not been characterized as base erosion. Companies use intellectual property to generate sales and services profits offshore because that is where they must operate to meet the needs of their global customers.
Under current law, a CFC must pay an arm's-length transfer price for the right to use intellectual property. If the intellectual property is owned by a U.S. parent or affiliate of the CFC, significant attention is devoted to determining this price under §482 and the complex regulations and case law interpreting it. This substantial body of law prevents the erosion of the U.S. tax base when U.S.-developed intangibles are sold or licensed to CFCs. To eliminate, in the name of preventing base erosion, the proposed exemption for income from active business operations that use those intangibles is tantamount to declaring this enormous body of law and experience so flawed as to be useless. The arm's-length standard, however, is a cornerstone of international taxation for the members of the OECD. If it is as flawed as these Subpart F proposals imply, the United States should work within the OECD to repair it in a way that our competitors might also choose. We should not simply add a very rough, unfair, and unique-to-the-United States "patch" on top. For intangible intensive businesses, such a patch has the potential for undoing all the competitive good that a territorial system would otherwise do.
In a sense, these "base erosion" intangibles options may result in double U.S. taxation of intangible income. First, the transfer of intangible assets to a CFC is taxable to a U.S. transferor. Whether this transfer occurs via sale or license, the transfer price is supposed to reflect the intangibles' value. And under §482's "commensurate with income" principle, the price must also reflect the profits attributable to the intangibles while being exploited, not just a static guess at their value upon initial transfer. Second, under these Subpart F options, income earned by the CFC from use of the intangibles in manufacturing, making sales, or providing services would be subject to another U.S. tax as Subpart F income. Yes, that second income is a different item at a different level of production, but in a territorial system that otherwise exempts 95% of the income of CFCs from manufacturing and selling goods or providing services, this is a harsh penalty for the U.S. shareholder that is also licensor or seller of the intangible, at least when the foreign tax credit is inadequate to prevent additional U.S. tax. The need for a foreign tax credit for such income also seriously reduces the simplification that might otherwise be achieved by a territorial system.
The intangible income options also raise complexity concerns that will severely impact already strained compliance and administration resources (both private and at the IRS). These options would require taxpayers to determine the amount of sales and services income of a CFC that is attributable to intangible property. This measurement of intangible income requires taxpayers to "unscramble the economic egg" by separating the amount of revenue and expenses attributable to intangible property from the income of the CFC derived from a return on capital, services, or manufacturing or marketing activities. Requiring segregation of the return from intellectual property will result in significant controversy during the examination process as taxpayers and the IRS attempt to subdivide the returns on transactions. Such a theoretical subdivision of income from a single transaction is considerably more complex than adjusting the transfer prices for actual transactions based on other, actual transactions among uncontrolled taxpayers. The regulations that will be required to explain how this might be done will be at least as voluminous and complex as the current §482 regulations.
Finally, these intangibles options penalize success and risk-taking. Option A does this directly - if one's return on costs is too high, the return might lose its exemption from tax. Don't be too successful, this proposal declares, or you will be taxed. Option C can be expected to achieve the same thing, albeit indirectly. Determining an appropriate arm's-length return for unique intangibles is already an enormous challenge under §482. In dividing sales and services income into intangible and non-intangible pieces, it should be assumed that regulations would likely assign a "normal" (i.e., small) return to factors such as the use of capital and manufacturing, and assign what will likely be a large residual (for any risky and very successful business) to intangibles.
When Congress and those who influence it turn their attention to the details of the territorial proposal, they should abandon using territoriality as an excuse to create a super Subpart F. Section 482 and the arm's-length standard, supplemented by the very powerful "commensurate with income" addition for intangibles, are adequate tools for policing this area.
This commentary also will appear in the February 2012 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Yoder, 928 T.M., CFCs-Foreign Base Company Income (Other than FPHCI), and in Tax Practice Series, see ¶7150, U.S. Persons-Worldwide Taxation.
* With special thanks to Tim Tuerff and others at Deloitte Tax who contributed to the preparation of Tim's Nov. 17, 2011, testimony before the Ways & Means Subcommittee on Select Revenue Measures.
2 All of the excess intangible income would be Subpart F income if the effective tax rate on the intangible income was 10% or less, and none of the income would be treated as Subpart F income if the effective tax rate was 15% or more, with a sliding scale applicable to income subject to a rate between 10% and 15%.
3 This rate is determined assuming a 25% maximum tax rate, a deemed deduction of 40%, and a high-tax safe harbor under §954(b)(4) of 90% of the maximum tax rate imposed under the Code. These provisions create a high-tax exception to Subpart F income where the income from intangibles is subject to a 13.5% foreign effective tax rate.
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