Winners and Losers in the Quest for a U.S. Territorial Tax System

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By Jim Ditkoff, Esq.  

Danaher Corporation, Washington, DC

Under the current U.S. international tax system, a U.S. taxpayer that chooses to conduct its overseas business through controlled foreign corporations (CFCs) will generally not be taxed on the operating incomeof those foreign subsidiaries unless and until the U.S. taxpayer receives a distribution (normally of "cash," i.e., currency or on-demand bank payables) from a CFC and the distribution is taxed as a dividend because it is treated as a distribution of earned value - earnings and profits (E&P) - of the CFC. Those interested in moving the United States to a territorial tax system (which most other countries have) desire a territorial system so that U.S. taxpayers may receive distributions from CFCs (perhaps for investment in the United States) without being subject to U.S. tax. What can be wrong with that?

Under the current system, U.S. taxpayers can pick and choose the foreign E&P that is deemed distributed and only the most unsophisticated taxpayers pay residual U.S. tax on dividend distributions from CFCs. Instead, most U.S. taxpayers repatriate only high-taxed E&P and leave the low-taxed E&P sitting offshore until the next incarnation of §965. If there is no U.S. tax on foreign E&P when distributed, it can be repatriated freely, hopefully for investment in the United States.

The problem is how to transition to such a system.  The easy way is to say that the operating income of CFCs earned in taxable years beginning after the legislation's effective date may be repatriated tax-free, or maybe 95% tax-free like the territorial regimes in France and Germany, and current law will continue to apply to pre-effective-date E&P. This is nothing more complicated than the pooling of post-1986 E&P that is currently required of all CFCs.

But Congress does not like the easy way. So Ways & Means Committee Chairman Dave Camp (R-MI) has proposed an immediate 5.25% tax on pre-effective-date accumulated E&P of CFCs to pay for a lower U.S. corporate tax rate and a 95% exemption on the repatriation of both past and future foreign E&P.

There is nothing wrong with giving taxpayers an option to pay a current tax in order to enjoy a future tax savings, but mandatory ex post facto taxation is never a good idea. And it is an especially bad idea where one group of taxpayers is being asked to pay a retroactive tax in order to finance future tax savings for a different group of taxpayers. I like having the option to convert my traditional IRA into a Roth IRA by paying a current tax, but I would be very unhappy if I were forced to make that conversion. And I would be especially unhappy if I had to pay a tax to give somebody else a tax-free Roth IRA!

That's the problem with this proposed legislation.  The beneficiaries of a 95% exemption on the repatriation of offshore cash are not necessarily the same people who have accumulated foreign E&P. E&P is not cash. It is not even retained earnings for financial accounting purposes. E&P can be eliminated with a §338(g) election or increased by an inter-company sale, with no effect on cash or retained earnings, while retained earnings decline when a company's purchased goodwill is "permanently impaired" and disappear altogether when a company is acquired. But purchase accounting affects neither cash balances nor E&P, and E&P is not reduced when a company invests all of its cash in the expansion of its business.

So taxing accumulated foreign E&P to finance a reduced tax on the repatriation of foreign cash is a classic "Rob Peter to pay Paul" strategy, and, before we endorse it, we ought to see who Peter and Paul really are.

A Tale of Two Taxpayers  

Paul's Corporation sells consumer products.  Its manufacturing processes are relatively simple, and the value drivers are marketing and patents. So Paul argues with the IRS about whether the CFC "manufacturers" of its products, who tend to be located in tax havens like Ireland and Switzerland, are paying sufficient royalties to the U.S. owners of the relevant trademarks and patents. But the gross margins on Paul's products are extremely high, and Paul has no need to invest in sophisticated foreign manufacturing operations. So its unrepatriated (and largely untaxed) foreign profits tend to sit in bank accounts in Bermuda or the Cayman Islands.

Peter's Corporation manufactures a wide variety of sophisticated industrial products all over the world. Some of its foreign manufactured products are sold in the United States, and some of its U.S. manufactured products are sold overseas. So its arguments with the IRS concern transfer pricing. Specifically, the IRS thinks that Peter's foreign sales subsidiaries are making too much money on their U.S. manufactured products and that Peter's U.S. sales subsidiaries are not making enough money on their foreign manufactured products. But because Peter operates and sells in countries that no one would regard as tax havens, the foreign tax inspectors predictably take the opposite view.

Another consequence of the fact that Peter conducts sophisticated manufacturing operations all over the world is that it has both high-taxed and low-taxed foreign E&P and many opportunities to expand its foreign operations through acquisitions and the construction of new manufacturing facilities. So while Peter has lots of foreign E&P, it has very little foreign cash. Its high-taxed foreign earnings have been repatriated to finance business expansion in the United States, and its low-taxed foreign earnings have been used to finance business expansion overseas.

This explains why Paul's Corporation took full advantage of §965 and is actively lobbying for its re-enactment, even though it created no new U.S. jobs with the funds repatriated the first time around, and it has more offshore cash now than it did when §965 expired. This also explains why Peter's Corporation is largely indifferent to the enactment of a temporary or permanent tax holiday on the repatriation of foreign cash. Peter simply doesn't have any excess foreign cash to repatriate! But it doesn't explain where Peter is going to get the cash to pay Congressman Camp's retroactive 5.25% tax on all of its accumulated foreign E&P or why Peter should pick up the tab for Paul's taking cash out of Bermuda.

Is there something particularly praiseworthy about peddling consumer products and something particularly disreputable about manufacturing industrial products? If not, Congress should not be changing the rules in the middle of the game. Both Peter and Paul can react to changes in the U.S. taxation of future foreign E&P, but they should neither benefit from nor be blind-sided by retroactive changes in the U.S. taxation of foreign E&P.

Finding a Better Way  

Nobody thinks that Congress is considering a retroactive tax on accumulated foreign E&P out of sheer vindictiveness.  It is obviously a question of raising revenues to pay for a new territorial tax system that will end the "lock-out effect." However, there are at least two better ways to solve that problem. The first is to base the transitional tax on the net cash of CFCs on their last pre-effective-date year-end balance sheets. After all, it is cash, not E&P, that builds factories and creates jobs in the United States, and all of the rhetoric on this issue has focused on "trapped cash," not E&P. Moreover, every CFC is required to file an annual Form 5471 with a balance sheet disclosing its cash and short-term debt on separate lines. And anybody who thinks that it will be easier for the IRS auditors to determine a CFC's E&P than it is to determine that CFC's cash has not read the §312 regulations lately. This would still be a retroactive tax, but it would at least be consistent with the stated policy objective.

The other way is to tax a portion of the future operating income of all CFCs, whether or not those earnings are repatriated, and to then treat all of the post-effective-date income of those CFCs as previously taxed income (PTI). I leave it to others to figure out how much of that foreign income needs to be taxed in order to achieve revenue neutrality on a purely prospective basis, but surely there is a percentage that works. And even if a significant portion of the CFC's future operating income must be taxed, at least there will be no retroactive taxation. Then, if Congress thinks it appropriate to create incentives for the voluntary repatriation of pre-effective-date foreign E&P, it can do so without penalizing corporations who acted in good faith reliance on existing law.

Of course, I realize that U.S. taxation of some portion of a CFC's operating income, whether it is a prospective tax on future E&P or a retroactive tax on unrepatriated foreign cash or E&P, needs to help pay for the proposed reduction in the U.S. statutory corporate tax rate, as well as the elimination of U.S. tax on repatriation. And that is fine. A lower corporate tax rate benefits everybody. But as the great tax reform of 1986 demonstrated, the best way to lower tax rates is through base broadening. So before we decide what percentage of future operating profits of CFCs needs to be taxed in the United States, we ought to see what the repeal of §199 and the R&D credit can accomplish. And maybe, just maybe, we ought to look at the "income-stripping" rules that some European countries have enacted, like the limitation of the deduction for net interest expense to 30% of EBITDA (earnings before interest, taxes, depreciation, and amortization), again on a prospective basis.

The point is that corporations, like people, can adjust their plans to deal with prospective changes in the law.  But nobody should be taxed or penalized ex post facto.  Retroactive taxation is a breach of faith with the taxpayer that no policy objective, however benign, can possibly justify.

This commentary also will appear in the December 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 taxation of passive foreign income is a different matter, and most proposals for a U.S. territorial tax system for corporations assume that U.S. taxation of foreign personal holding company income would continue to apply. Many foreign territorial tax systems, including those in Australia, Canada, Denmark, France, Germany, Japan, the Netherlands, and Sweden (to name just a few), tax some type of passive income of subsidiaries. But the idea expressed in §954(d) and (e) - that an active foreign sales or service subsidiary of a U.S. parent should be subject to U.S. tax on its cross-border sales and services - seems to be an anomaly of U.S. tax law, and it remains unclear why the U.S. Treasury would want a U.S. manufacturer to have four separate sales and service subsidiaries in Scandinavia where one might suffice.

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