Off to Camp?

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By James J. Tobin, Esq.  

Ernst & Young LLP, New York, NY*

I was certainly pleased to read the headlines of Ways and Means Committee Chairman Camp's proposal released in October.  A realistic proposal for the United States finally to follow most of the rest of the world and adopt a territorial tax regime seems like a step in the right direction. A 25% proposed corporate tax rate and a 95% dividend, branch, and capital gain exemption would be a huge boon to the competitive position of U.S. multinationals globally. The resulting U.S. tax take on qualifying foreign income would be very much in line with other developed country tax systems.  This would leave only certain developing countries burdened by the complexity and anti-competitiveness of a worldwide, foreign tax credit regime. So perhaps China, Brazil, and India will need to worry more about the competitiveness of their multinational corporations and our U.S. multinationals could enjoy a bit of a head start toward a level tax playing field with the rest of the developed world. But needless to say, the devil is in the details and there are a number of devils or potential devils to worry about:

  •   The full inclusion of 15% of all existing earnings and profits (E&P) sounds like the original §965 repatriation holiday so at first blush maybe not too bad as a price for admission into this new territorial tax regime. However, the all part is the problem, coupled as well with the fact that this "holiday" is mandatory.  Under APB 23, U.S. multinationals don't have to provide residual U.S. tax on foreign subsidiary earnings to the extent such earnings are permanently invested overseas. Most " permanently invested" earnings overseas have indeed been invested - in factories, buildings, inventories, acquisitions, etc. So unlike in 2005 when only amounts actually remitted were taxed at the beneficial rate, these retained earnings can't be repatriated but nevertheless would be subjected to U.S. tax under this transition rule. A further problem arises because E&P for U.S. tax purposes is often higher than retained profits of a controlled foreign corporation (CFC) group due to taxable reorganizations or other asset transfers within the foreign group or other E&P differences. So the taxable deemed repatriation could include "phantom" earnings from an economic or financial accounting perspective - while the earnings might not be real and the repatriation would not be real, the tax would be plenty real.  A 5.25% tax (35% × 15%) on the full amount of U.S. E&P would be a huge upfront cost to most U.S. multinationals. The client I spoke to most recently about this had over $5 billion of foreign E&P but less than $500 million of excess liquidity overseas.  I understand we need some "pay fors" on the road toward a more competitive international tax system, but this seems like too high a toll to me. I am hopeful that as the proposal advances this toll charge provision will be scaled back and further refined to address these practical issues.
  •   The shape and scope of anti-deferral rules in a territorial world is an acknowledged open area in the proposal. In my view, a full retention of our current Subpart F rules would be unnecessary. Clearly, retention of anti-abuse rules for truly passive income would be appropriate.  However, conceptually it seems to me that foreign base company income other than foreign personal holding company income (FPHCI) should be eliminated from Subpart F. The theoretical foundation of a territorial regime is that the home country provides an exemption for foreign business profits. In such a world, I see no reason to worry whether a CFC is dealing with customers in its country of incorporation or where outside the United States a CFC manufactures its products.  Likewise, the CFC look-through rule should be maintained and made permanent. Subjecting foreign-to-foreign transactions that might produce foreign tax savings to U.S. taxation under Subpart F is a vestige of the tax-policeman-of-the-world mentality which viewed with suspicion non-U.S. tax planning and thus impeded the competitiveness of U.S. multinationals to no discernible benefit (and potential real detriment) to the U.S. fisc. The increased sophistication - even aggression - of foreign tax authorities over recent years is clear demonstration that the United States can safely abandon its global tax policeman role and narrow the scope of the future incarnation of Subpart F to what is necessary to protect our U.S. tax base.
  •  The three options that have been provided ostensibly to protect the U.S. tax base are all obviously worrying. The starting point for these options is the original excess returns proposal put forth by the Obama Administration. All three in my view are attacks on the fundamental principle of the arm's-length standard of transfer pricing of which I am an on-the-record defender.1 In a territorial world, particularly if the non-FPHCI foreign base company rules are eliminated as they should be, I can see that some kind of anti-abuse provision might be inevitable. However, in my view, all three of these options go too far. I'll leave it to other commentators to weigh in on the details. But it seems to me the fatal flaws are the underlying assumptions that all ownership of valuable intangibles always starts with and somehow rightfully belongs to the United States and that a low rate of foreign tax is somehow inappropriate (the tax policeman of the world again!). As to intangible income, this ignores the reality that R&D, brand development, customer goodwill, etc., occur globally and often relate to IP rights purchased in connection with foreign acquisitions. The IRS certainly recognizes this in the case of U.S. subsidiaries of foreign groups. Fortunately, these are presented as options for discussion, and the discussion should focus on recognition of the reality of global IP development such that the scope of these approaches is significantly scaled back and more finely targeted.

There are lots of other details that are worthy of comment. But the particular aspect I want to focus on in a bit more detail now is the treatment of 10/50 companies (qualifying §902 corporations that are not CFCs). The rule as proposed is that all 10/50 companies would be included in the mandatory full E&P inclusion provision but their treatment as CFCs going forward in order to be eligible for the 95% exemption would be optional (at least nominally).  So let's think about what that means.

Under the deemed full inclusion transition rule, the same as for CFCs, there would be the 5.25% cost to the U.S. shareholder on its share of the 10/50 company's E&P. As for 100%-owned CFCs, the E&P-versus-liquidity problem mentioned above would exist.  However, the problem would be more acute in the case of 10/50 companies because, by definition, the U.S. shareholder would not control the entities and therefore would not be able to ensure a dividend distribution to fund the U.S. tax bill. A further common problem is that a 10/50 company will not have been as sensitive to U.S. E&P rules over its history. As a result, often there will be large pockets of U.S. E&P with respect to taxable reorganizations and intergroup restructurings that don't represent real earnings but would potentially result in an immediate U.S. tax hit under this provision. Access to the E&P details would also be challenging in many cases due to the lack of control. While typically there would be some expectation of cooperation in this regard because deemed-paid foreign tax credit information is needed under current law, not all 10/50 companies pay dividends currently and it would be rare that full E&P information would be available for an entire group of 10/50 companies. This is particularly true when one thinks about the spectrum of 10/50 companies owned by many global groups. Perhaps for 50/50 joint venture companies the required information typically would be available. But for holdings at closer to the 10% level, with controlling foreign interests or public listing, it may be nearly impossible to comply.

The election into the 95% exemption for 10/50 companies is even more troubling. In order to be eligible for the exemption, a U.S. group must elect for all of its 10/50 companies to be CFCs. The good news is that dividends in the future from the 10/50 companies would be eligible for the exemption. The bad news is that the Subpart F rules would fully apply to all of those subsidiaries, presumably including whichever of the three alternative anti-avoidance options, if any, is incorporated. Perhaps if my suggestion above to eliminate the non-FPHCI foreign base company rules and maintain CFC look-through is adopted, this would be somewhat more workable.  Even then, as with respect to the transition rule E&P inclusion, there would likely be significant difficulties in getting access to the necessary information for all 10/50 companies. But if all aspects of existing Subpart F plus a new anti-abuse provision would need to be applied, compliance would be extremely challenging. And the rationale for considering these categories of income to be "tainted" where a U.S. shareholder does not control the foreign business is even more questionable. Think about a three-way joint venture between U.S., U.K., and German multinationals where all three shareholders would benefit from dividend exemptions with respect to the venture but only the U.S. shareholder would have to worry about foreign base company sales income and potentially a new inclusion of some sort with respect to intangible income. That doesn't sound like a level playing field and potentially would be even worse than current law.

However, the good news you say is that it's only an election! If you can't comply with the information requirements of Subpart F or if the cost is too high, then you just won't elect.  Not so fast. Two problems here. First, remember the election is all or nothing. So if there is just one 10/50 company where it would not be possible to obtain the necessary information, none of the 10/50 companies would be eligible for the election. Second, the bigger problem is that the proposal also would repeal §902 across the board and not just for foreign companies that are under the participation exemption regime. So while not electing into the 95% exemption would avoid the application of Subpart F to your 10/50 companies, any dividends from those 10/50 companies in the future would be fully subject to double taxation. Likewise, the 95% capital gain exemption would only apply to electing 10/50 companies, so no election would mean no capital gain exemption. Therefore, the election as drafted seems to be mandatory as a practical matter. So you would have to elect, but maybe you wouldn't be able to comply when you did elect?

Knowing how complex this all is, Chairman Camp's team was smart to release the proposal as a discussion draft to get the dialog going. There are many issues that need to be grappled with in making the move to a territorial system that accomplishes the competitive objectives at which the proposal is aimed. The prospects of getting there seem better than ever given the growing political support for reform, the continuing adverse economic impact of the so-called lock-out effect in the current system, and now the contribution of a serious and reasonable starting point discussion draft from the Ways and Means Committee. I suspect we will all have a bit of time to engage in discussion of the details. But it is no longer too early to get started on that process. Which is music to the ears of this international tax guy.

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 Isenbergh, 900 T.M., Foundations of U.S. International Taxation,  and in Tax Practice Series, see ¶7110, U.S. International Taxation - General Principles.

  * The views expressed herein are those of the author and do not necessarily reflect those of Ernst & Young LLP. 

   1 See, for example, my commentary "U.S. Taxation of Intangible Property - Yet Another Stick but Still No Carrots?" 39 Tax Mgmt. Int'l J. 408 (7/9/10).

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