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By David Ernick, Esq.
PricewaterhouseCoopers LLP, Washington, DC
As the Organisation for Economic Co-operation and Development (OECD) passes the halfway point in its joint project with the G20 to address base erosion and profit shifting (BEPS) concerns, it is worth pausing to examine what the consequences of some of the proposed changes may be. Much of the focus of the project from the U.S. Treasury Department's perspective has been on preventing "stripping" of the U.S. tax base by U.S. multinational enterprises (MNEs).1 Equally important, however, should be the prevention of stripping of the U.S. tax base by other countries, and avoidance of anti-BEPS "solutions" that facilitate or subsidize that result.
Certain outcomes of the BEPS action plan proposed by foreign countries have come under scrutiny because of their potential to facilitate the ability of foreign countries to increase their taxation of U.S. MNEs.2 Additionally, as the potential options that the U.S. government may propose to deal with BEPS issues start to come into focus, attention should be paid to whether the effect of these potential "BEPS solutions" would be a direct revenue loss to the United States, as a result of U.S. rules that subsidize the imposition of foreign taxes on U.S. MNEs. A brief detour into the history of the estate tax helps to illuminate that issue.
Briefly, the federal estate tax is imposed on the transfer of property at death and is calculated by reference to the size of the decedent's estate. The determination of the amount of tax starts with the "gross estate"; certain deductions are then allowed to arrive at the "taxable estate." To that amount is added the total of all taxable gifts made by the decedent before death. Although a graduated rate schedule previously applied, because of the interaction of a credit, which offsets tax otherwise imposed at lower rates, and a ceiling on maximum rates, for years after 2012 the estate tax is imposed at a flat 40% rate for amounts above the "applicable exclusion amount" (which for 2015 is $5,430,000).
Among the credits allowed against the estate tax was, until recently, a credit for state "death taxes" that effectively acted as a federal subsidy for the imposition of the state death taxes, as the effect of the credit "was simply to divert to the states tax money that would otherwise find its way to the federal fisc."3 For decedents dying before January 1, 2005, now-repealed §2011 allowed for a limited credit against the federal estate tax due for any state death taxes paid on property included in the federal gross estate.4
The credit was commonly known as a "pick-up tax" or "sponge tax," as it allowed states to impose death taxes to simply "soak up" and collect taxes that otherwise would have been paid to the federal government.5 Because the state death taxes paid could be credited against federal estate taxes, the state taxes did not increase total taxes imposed upon a decedent's estate. The effect of the credit was simply to shift revenue from the federal government to state coffers. Not surprisingly, some states responded to this subsidy by enacting death taxes up to the maximum amount that would be covered by the federal credit. From the states' perspectives, there was no reason not to "soak up" as much of the federal revenue as possible without increasing the total taxes imposed upon the decedent's estate.6
What does this all have to do with BEPS? Analysis of the former §2011 credit for state death taxes is useful because of the remarkable similarity of its effect as a subsidy to the possible effect in practice of some of the solutions to BEPS issues which may be proposed by the United States. To the extent the United States advocates as part of the BEPS project for changes to international tax rules that are similar to those in the Administration's FY 2015 Budget and the President's Framework for Business Tax Reform, concerns should arise regarding revenue transfers from the U.S. fisc to foreign countries.
For example, consider the Administration's proposal to impose a "minimum tax" on the income earned by the foreign subsidiaries of U.S. companies, regardless of whether or not those earnings are repatriated to the United States.7 Suppose the United States were to impose a 15% "minimum tax;" what would the effect be? Generally, the foreign tax credit granted by the U.S. might be considered a subsidy to foreign countries to the extent it allows them to impose tax, without any marginal increase in total tax paid, on income up to the amount of tax that would otherwise be imposed by the United States. However, when U.S. taxation of earnings of foreign subsidiaries can be deferred indefinitely, the effect of the subsidy disappears, as in that case imposition of a foreign tax on that income increases total tax paid.
The effect of the subsidy reappears, however, in the case of a minimum tax that eliminates the ability to defer U.S. taxation, to the extent of the minimum tax rate. In that case, an incentive exists for foreign governments to impose tax on the earnings of foreign subsidiaries of U.S. companies up to the amount of the minimum tax, because there is no increase in the amount of total tax imposed. In the example, a foreign government could impose its taxes up to a 15% rate8, because there would be no negative effect on business investment by U.S. companies for doing so. The U.S. company would face taxes on the earnings of its foreign subsidiaries at a 15% rate, regardless of whether the taxes were collected by the United States or by a foreign country. Similar to how former §2011 subsidized imposition of state death taxes, a federal minimum tax would (completely) subsidize imposition of foreign taxes on the earnings of foreign subsidiaries of U.S. companies, up to the amount of the minimum taxes. Foreign governments would be incentivized to impose "sponge taxes" that "soak up" and collect taxes that otherwise would have been paid to the U.S. government.
Other proposals from the Administration's FY 2015 budget proposal would also have the same effect as a sponge tax. Action 2 of the BEPS Action Plan seeks to neutralize the effects of hybrid mismatch arrangements, which arise because of differences in the characterization of an entity or arrangement under the laws of two or more tax jurisdictions that result in a mismatch in tax outcomes. Some observers have criticized these types of arrangements as serving no purpose other than to produce so-called "stateless" or "nowhere" income. The Administration's FY 2015 budget proposal would attack these types of arrangements by, for example, denying a U.S. deduction to a taxpayer that pays interest or royalties to a related party when there is no corresponding inclusion in income in the payee's jurisdiction, or where the taxpayer is also entitled to a deduction for that same payment in a foreign jurisdiction.9 That is indeed the approach taken in the September 2014 OECD/G20 report, Neutralising the Effects of Hybrid Mismatch Arrangements.10
From a U.S. perspective, this proposal would likely "neutralize" the hybrid mismatch arrangements to which it applied, but at the potential cost of shifting tax revenues from the United States to other countries. In the example given, rather than allowing the denial of a U.S. deduction to a taxpayer that pays interest or royalties to a related party, a foreign government would be incentivized to simply "pick up" the tax that would otherwise flow to the United States by requiring an inclusion in income in the payee's jurisdiction or disallowing a deduction for the same payment in a foreign jurisdiction. From a U.S. tax policy perspective, even if it is accepted that hybrid mismatch arrangements are a problem that needs to be addressed, it is difficult to see why the solution to that problem should be to force U.S. companies to pay higher levels of foreign tax than would otherwise be the case.11
To a similar effect would be the Administration's "excess returns" proposal to expand Subpart F to prevent income shifting through transfers of intangibles to low-taxed affiliates:The proposal would provide that if a U.S. person transfers (directly or indirectly) an intangible asset from the United States to a related CFC (a "covered intangible"), then certain excess income from transactions connected with or benefitting from the covered intangible would be treated as subpart F income if the income is subject to a low foreign effective tax rate. In the case of an effective tax rate of 10 percent or less, the proposal would treat all excess income as subpart F income, and would then phase out ratably for effective tax rates of 10 to 15 percent. For this purpose, excess intangible income would be defined as the excess of gross income from transactions connected with or benefitting from such covered intangible over the costs (excluding interest and taxes) properly allocated and apportioned to this income increased by a percentage mark-up. For purposes of this proposal, the transfer of an intangible asset includes by sale, lease, license, or through any shared risk or development agreement (including any cost sharing arrangement)). This subpart F income will be a separate category of income for purposes of determining the taxpayer's foreign tax credit limitation under section 904.12
Because this would be a Subpart F provision, it would apply only to penalize U.S. MNEs and it would do so by raising foreign, not U.S., taxes. Foreign taxes imposed on the CFC at a 15% effective tax rate would completely avoid the penalty and still be lower than the U.S. taxes otherwise imposed by the potential Subpart F inclusion. Once again, the net effect would be a subsidy by the United States of the imposition of foreign taxes on U.S. MNEs.
The Administration's excess returns proposal is also apparently the basis for part of a proposal the United States has made as part of the BEPS project to address the so-called "cash box" problem in transfer pricing. To address this problem, a "primary rule" would apply, similar to the excess returns proposal, to require an income inclusion under CFC rules in the parent company jurisdiction. If the CFC's parent jurisdiction does not have CFC rules, then a "secondary rule" would give the source country jurisdiction to tax the CFC's excess returns.13 Interestingly, the description of the proposal seems to explicitly acknowledge the incentive for foreign countries to enact sponge taxes to "pick up" tax revenue that would otherwise flow to the United States.14
From a U.S. perspective, some observers might find it difficult to discern what policy rationale justifies anti-BEPS measures that ensure foreign governments collect a certain amount of tax from U.S. companies, and even more difficult to understand measures that effectively result in U.S. subsidies of such foreign tax collections. One rationale simply may be that allowing U.S. companies to operate in low-tax jurisdictions undermines investment in the United States.15 These observers might find that rationale flawed though, since they would say it is essentially an argument against tax competition – all other things being equal, imposition of lower taxes will always attract trade and investment, and it does not matter whether lower taxes are attained through means of measures designed to narrow the tax base or a simple reduction in the statutory corporate tax rate; economically the effect is the same. Imposing a sponge tax, however, seems to be a blow against tax competition and the "race to the bottom." In practice, the effect of a minimum tax, for example, would be to prevent other countries from competing for business with the United States at a rate below wherever the minimum tax level is set. If that is the goal, however, it must be weighed against the fact that it would disadvantage U.S. MNEs with respect to their foreign competitors not subject to the rule and would effectively be a U.S. subsidy of foreign tax collections. Dampening tax competition in such a manner could come at a high cost to U.S. MNEs and the U.S. fisc.
The similarity of some of the proposed anti-BEPS solutions to the sponge tax imposed by the former §2011 credit for state death taxes raises important issues to be considered as the BEPS project moves inexorably to its conclusion. Although everyone seems to agree that the existing international tax rules are flawed and should be updated to better reflect changes in the economy and business practices, it should be remembered that the current system is the result of a series of difficult compromises and that all alternatives will have pros and cons that should be carefully considered, in order to avoid unintended consequences. And, more importantly, certain of the BEPS "solutions" espoused so far would disproportionately impact U.S. MNEs and have the effect of a direct federal transfer of tax revenue to foreign governments – sponge taxes which "divert to [foreign governments] tax money that would otherwise find its way to the federal fisc" should be avoided.
This commentary also will appear in the January 2015 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see DuPuy and Dolan, 901 T.M., The Creditability of Foreign Taxes -- General Issues, Carr and Moetell, 902 T.M., Indirect Foreign Tax Credits, Yoder & Kemm, 930 T.M., CFCs — Sections 959-965 and 1248, and in Tax Practice Series, see ¶7150, U.S. Persons -- Worldwide Taxation.
Copyright©2015 by The Bureau of National Affairs, Inc.
1See Testimony of Robert B. Stack, Deputy Assistant Secretary (International Tax Affairs), U.S. Department of the Treasury, Before the Senate Finance Committee, July 22, 2014, available at http://www.finance.senate.gov/imo/media/doc/Testimony%20of%20Robert%20Stack.pdf.
2 For example, country-by-country reporting may provide a tool to foreign countries to make transfer pricing adjustments consistent with a formulary apportionment approach and tax more income from U.S. MNEs than would be possible under arm's-length pricing. With respect to the report on preventing the artificial avoidance of permanent establishment (PE) status, in a country such as the United States that does not use a territorial system and therefore taxes U.S. corporations on their worldwide income, expanding what constitutes a PE has no relevance to stateless income or shifting of income to low-tax jurisdictions but simply shifts the primary right of taxation from the residence state (the United States) to the source state. Similarly, proposals in the initial discussion draft of the report on addressing the tax challenges of the digital economy with respect to creating a "virtual PE" or a "significant digital presence PE" could have made it easier for other countries to find permanent establishments of U.S. technology companies, and then attribute significantly more profits to those permanent establishments than under traditional rules.
3 Stephens, Maxfield Lind & Calfee, Federal Estate & Gift Taxation (2014), §12.04.
4Id. at §3.03.
5See Congressional Research Service Report, Federalism Through Tax Interdependence: An Overview (Jan. 25, 2001) ("Under the pick-up tax mechanism the state tax is set equal to the maximum federal credit allowed, [and] the federal government credits the decedent's federal estate tax bill by the exact amount of the state death taxes paid. The credit for state death taxes is theoretically indistinguishable from a direct federal transfer to the states.").
7See generallyThe President's Framework for Business Tax Reform, available at http://op.bna.com/dt.nsf/id/sdoe-8rqmge/$File/The-Presidents-Framework-for-Business-Tax-Reform-02-22-2012.pdf.
8 However, to be eligible for foreign tax credits in the U.S. the foreign tax would have to be generally applicable and could not be explicitly structured as a "soak-up tax," as state death taxes were imposed in response to former §2011, because of the restrictions in Reg. §1.901-2(c).
9See generallyGeneral Explanations of the Administration's Fiscal Year 2015 Revenue Proposals, available at http://www.treasury.gov/resource-center/tax-policy/Documents/General-Explanations-FY2015.pdf; see also Testimony of Robert B. Stack, Deputy Assistant Secretary (International Tax Affairs), U.S. Department of the Treasury, Before the Senate Finance Committee, July 22, 2014, available at http://www.finance.senate.gov/imo/media/doc/Testimony%20of%20Robert%20Stack.pdf:In addressing stripping of the U.S. base, it is also important to consider so-called "hybrid arrangements," which may allow taxpayers to claim U.S. deductions with respect to payments that do not result in a corresponding income item in the foreign jurisdiction. These arrangements serve little function other than to produce stateless income and could easily be reined in. To neutralize these arrangements, the Administration's FY 2015 budget proposal would deny deductions for interest and royalty payments made to related parties under certain circumstances involving hybrid arrangements. For example, the proposal would deny a U.S. deduction where a taxpayer makes an interest or royalty payment to a related person and there is no corresponding inclusion in the payee's jurisdiction, or where the taxpayer is able to claim a deduction with respect to the same payment in another jurisdiction.
10 Available at http://www.oecd-ilibrary.org/docserver/download/2314261e.pdf?expires=1416191955&id=id&accname=guest&checksum=832624DF67D316DA112D27C4C302ACA9.
11 For a comprehensive critique of attempts to combat "hybrids" and other forms of international tax arbitrage, see H. David Rosenbloom, The David R. Tillinghast Lecture: International Tax Arbitrage and the "International Tax System," 53 Tax L. Rev. 137 (citations omitted):The objection to addressing international tax arbitrage is not merely limited to the difficulty of doing so in a rational and feasible way. The broader objection is that there does not appear to be any clear reason why U.S. tax policy should take account of the fact that the taxpayer or a related party enjoys benefits under the tax laws of another country with respect to income or activities not subject to U.S. taxation. The treatment of that income or those activities is not obviously our business, and there is no clear reason why we should make it our business—any more than the rules of that other country applicable to its own citizens and residents on its own soil with respect to anti-competitive behavior, corrupt practices, or the price of water….
Treasury and the Service have been severely criticized for attempting … to backstop the tax systems of other countries, thereby causing U.S. enterprises to pay a higher level of foreign tax than they otherwise would. Some view this as a sharp about-face of U.S. policy, making little sense for the U.S. fisc.
As a general matter, it is hard to see why it is a function of U.S. tax authorities to ensure that foreign governments collect any particular amount of tax, either generally or from U.S. companies and their affiliates. This is not a way to keep U.S. foreign tax credits to a minimum. It is not a way to encourage the foreign success of U.S. enterprise.
12General Explanations of the Administration's Fiscal Year 2015 Revenue Proposals, available at http://www.treasury.gov/resource-center/tax-policy/Documents/General-Explanations-FY2015.pdf; see also Testimony of Robert B. Stack, Deputy Assistant Secretary (International Tax Affairs), U.S. Department of the Treasury, Before the Senate Finance Committee, July 22, 2014, available at http://www.finance.senate.gov/imo/media/doc/Testimony%20of%20Robert%20Stack.pdf:Additionally, it has been well documented that shifting intangibles outside the United States is a key avenue through which U.S. base erosion occurs. The principal means of shifting intangible income is to undervalue intangible property transferred offshore or to take advantage of perceived loopholes in our definition of intangibles. Once this intellectual property is offshore, the income that it produces can accrue in low- or no-tax jurisdictions, outside the scope of U.S. taxation. The Administration's FY 2015 Budget contains a number of proposals that would discourage the corporate tax base erosion that occurs via intangibles transfers. One of those proposals would clarify the definition of intangible property to address taxpayer arguments that certain value does not fall within the current definition and therefore may be transferred offshore without any U.S. tax charge. Another proposal would modify our subpart F rules to tax currently certain excess returns of a controlled foreign corporation from intangibles transferred to it by a U.S. person….
13 It is not clear why a "secondary rule" is necessary to give the source country jurisdiction to tax any of the CFC's returns. Also, the "primary rule" seems to include the same subsidization of foreign taxes as in the Administration's excess returns proposal; it would be difficult to eliminate the subsidy effect of such a rule, unless the "primary rule" could apply to re-source the CFC's excess returns in the residence country, for example.
14U.S., OECD Seek to Smash "Cash Box" With Coordinated Effort on Intangibles, 22 Bloomberg BNA Transfer Pricing Rep. 898 (Nov. 13, 2014) (quoting Treasury official's description of the proposal: "Having a coordinated rule among countries to neutralize the effect by such means as allowing other countries to pick up what isn't taxed can eliminate the problem.").
15See, e.g., The President's Framework for Business Tax Reform, available at http://www.treasury.gov/resource-center/tax-policy/Documents/The-Presidents-Framework-for-Business-Tax-Reform-02-22-2012.pdf:Because of deferral, U.S. corporations have a significant opportunity to reduce overall taxes paid by shifting profits to low-tax jurisdictions—either by moving their operations and jobs there or by relying on accounting tools and current transfer pricing principles to shift profits there. There is ample evidence that U.S. multinationals' decisions about the choice of where to invest are sensitive to effective tax rates in foreign jurisdictions…
There is considerable debate as to how to reform the international tax code. One proposal is to switch to a pure territorial system under which all active foreign income would either be taxed little or not at all in the United States. However, the Administration believes that a pure territorial system could aggravate, rather than ameliorate, many of the problems in the current tax code. If foreign earnings of U.S. multinational corporations are not taxed at all, these firms would have even greater incentives to locate operations abroad or use accounting mechanisms to shift profits out of the United States. Furthermore, such a system could exacerbate the continuing race to the bottom in international tax rates.
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