Recent Legislative Proposals to Curb Erosion of the U.S. Tax Base

Transcription

1 Recent Legislative Proposals to Curb Erosion of the U.S. Tax Base By Theresa Androff Introduction One can hardly open any newspaper today without reading about politically charged tax reform. International tax reform, in particular, has been thrust to the center of public debate in the United States, due partly to changes in the global economy, but also as a reflection of an emerging international focus on base erosion and profit shifting. Discussion drafts and legislative proposals have emerged from Capitol Hill along with the Administration s recent budget proposals to reform the U.S. international tax system. Concurrently, the Organisation n for Economic Co-operation and Development (OECD), at the direction of the G20, has embarked on a grand Base Ero- sion and Profit Shifting (BEPS) project aimed datco combating multinational tio corporations perceived manipulation of the tax gaps between national laws by shifting profits to low-tax jurisdictions and eroding the tax base of their residence country. In response to the concerns regarding base erosion, the shifting of profits out of the United States tax base and recent developments in the international community, several legislative responses have been proposed to reform the U.S. international tax system. This article examines two legislative proposals and President Obama s budget proposals aimed at protecting the U.S. tax base and assesses their compatibility with the OECD BEPS project. The Obama Administration s Proposals THERESA ANDROFF is a Tax Associate at Miller & Chevalier Chartered in Washington, D.C. President Obama s fiscal 2015 budget proposal reintroduces 10 international proposals from prior budgets and introduces six new international proposals designed to reduce incentives to shift income and assets overseas. 1 Of particular interest to the base erosion debate are the Administration s proposals to restrict interest expense deductions for foreign and U.S. multinationals and its proposals targeting potential income shifting associated with transfers of intangible assets. NOVEMBER DECEMBER T. ANDROFF. 15

2 RECENT LEGISLATIVE PROPOSALS TO CURB EROSION OF THE U.S. TAX BASE Defer Deduction of Interest Expense Related to Deferred Income of Foreign Subsidiaries This proposal would defer the deduction of interest expense that is properly allocated and apportioned to stock of a foreign corporation that exceeds an amount proportionate to the taxpayer s pro rata share of income from such subsidiaries that is currently subject to U.S. tax. 2 The proposal would restrict the deduction of interest expense only with respect to income of foreign subsidiaries that is eligible for deferral, and not to foreign-source income currently taxed in the United States, such as income earned through branches. The amount of a taxpayer s interest expense that is properly allocated and apportioned to stock of a foreign corporation would generally be determined under the principles of current regulations. Interest expense deferred under the proposal would be deductible in a later tax year. The international tax proposals of the Obama Administration, Chairman Camp and former Senator Baucus evidence ean apparent momentum behind du US U.S. international na tax reform, as well asac consensus nsus that base erosion on is sasgni significant concern cern that should be addressed by any international tax reform proposal. Restrict Deductions for Excessive Interest of Members of Financial Reporting Groups Under current law, Code Sec. 163(j) 3 denies U.S. tax deductions for interest paid by a corporation to a related party when: 1) the corporation s debt-to-equity ratio exceeds 1:5, and 2) net interest expense exceeds 50 percent of the corporation s adjusted taxable income. Such disallowed interest expense may be carried forward indefinitely for deduction in subsequent year. Additionally, the corporation s excess limitation for a tax year ( i.e., the amount by which 50 percent of adjusted taxable income exceeds net interest expense) may be carried forward to the three subsequent tax years. The Administration proposes to expand Code Sec. 163(j) to address the ability to capitalize U.S. operations with debt and equity in a way that results in disproportionate leveraging of the U.S. operations as compared to the group s operations outside the United States. Th is proposal applies to members of a group that prepares consolidated financial statements. A member s U.S. interest expense deduction generally would be limited to the member s interest income plus the member s proportionate share of the group s interest expense based on its contribution to the group s total earnings. If a member fails to substantiate their proportionate share of the group s net interest expense (or so elects), its interest deduction would be limited to 10 percent of the member s adjusted taxable income (as defined in Code Sec. 163(j) ). Under the proposal, U.S. subgroups are treated as a single member of a financial reporting group and are defined as any U.S. entity that is not owned directly or indirectly by another U.S. entity, and all members owned by that entity. Tax Currently Excess Returns Associated with Transfers of Intangible Property In addition to these proposals targeting base erosion through earnings stripping, p the Administration has also set its sights on the use of transfers of intangibles to low-taxed affiliates ates to achieve profit shifting. The Administration proposes oses an expansion n of subpart F to include excess ess income from intangibles ibl stransferred to low-taxed affiliates in order to reduce the incentive for taxpayers to engage in these transactions. 4 Specifically, the President s proposal provides that if a U.S. person transfers (directly or indirectly) an intangible asset from the United States to a related CFC, then certain excess income from the 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. 5 In the case of an effective tax rate of 10 percent or less, the proposal treats all excess income as subpart F income and phases out ratably for effective tax rates of percent. Excess intangible income is the excess of gross income from transactions involving the covered intangible over the costs properly allocated and apportioned to this income increased by a percentage mark-up. For purposes of the 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). 16 INTERNATIONAL TAX JOURNAL NOVEMBER DECEMBER 2014

3 Limit the Shifting of Income Through Intangible Property Transfers The Administration has proposed changes to the definition of intangible property in order to expand the scope of provisions such as Code Secs. 482 and 367(d), which tax outbound transfers of intangibles. This proposal is intended to resolve controversies that arise concerning the value of transferred intangibles. The Administration s proposal provides that the definition of intangible property under Code Sec. 936(h)(3)(B) (and therefore for purposes of Code Secs. 367(d) and 482 ) also includes workforce in place, goodwill, going concern value and any other item owned or controlled by a taxpayer that is not a tangible or financial asset with substantial value without an individual s services. 6 The proposal also provides that where multiple intangible properties are transferred, or where intangible property is transferred with other property or services, the Commissioner of the IRS can value the property or services on an aggregate basis where that achieves a more reliable result. Further, the proposal would provide that the Commissioner may value intangible property taking into consideration the prices or profits that the controlled taxpayer could have realized by choosing a realistic alternative to the transaction undertaken. Chairman an Camp s Tax Reform Act of 2014 In February 2014, Chairman of the Ways & Means Committee David Camp released a discussion ndraft for comprehensive income tax reform. 7 His draft establishes a participation exemption system for foreign income effectuated by a 95-percent deduction ductio for the foreignsource portion of dividends received from certain foreign corporations by domestic corporations that own at least 10 percent of those foreign corporations. 8 The discussion draft represents a move from the U.S. s current worldwide, or residence-based international tax system, to a territorial system. In addition to the adoption of a participation exemption, however, Chairman Camp included two base erosion proposals which modify the subpart F rules relating to intangible property and limit interest expense deductions for heavily leveraged U.S. companies. Foreign Intangible Income Subject to Tax at a Reduced Rate; Intangible Income Treated as Subpart F Income Under Camp s proposal, a U.S. parent of a foreign subsidiary would be subject to current U.S. tax on a new category of subpart F income, foreign base company intangible income (FBCII). 9 FBCII equals the excess of the foreign subsidiary s gross income over 10 percent of the foreign subsidiary s adjusted basis in depreciable tangible property. Although such income would be subject to current U.S. tax, all foreign intangible income would be eligible for a reduced rate. The reduced rate is achieved by permitting a deduction equal to a percentage of the foreign subsidiary s FBCII that relates to property that is sold for use, consumption or disposition outside the United States, or to services provided outside the United States. The deductible percentage of FBCII and foreign intangible income would be 55 percent for tax years beginning in 2015 and would phase down to eventually 40 percent in years beginning in 2019 or later, resulting ultimately in a rate of 15 percent on foreign intangible income. Chairman Camp and the Ways & Means Staff reason in the draft s section-by-section description that the neutral tax treatment of income attributable to intangible property, regardless of where such property is located, will remove tax incentives to locate intangible property in low- or no-tax jurisdictions. 10 The proposal also provides a reduced U.S. tax rate on such income to the extent derived from foreign customers, in recognition that it is difficult to identify precisely when the allocation of income to intangible property in foreign jurisdictions results in erosion of the U.S. tax base. Denial of Deduction for Interest t Expense of US U.S. Shareholders h which hare Members of Worldwide Affiliated Groups with Excess Domestic Indebtedness Chairman Camp s proposal reduces the deductible interest expense of a U.S. parent of one or more foreign subsidiaries in circumstances indicating that the U.S. parent is excessively leveraged as compared to the worldwide group. In particular, the proposal would reduce deductible net interest expense of the U.S. parent by the lesser of the extent to which: 1) the indebtedness of the U.S. parent (including other members of the U.S. group) exceeds 110 percent of the combined indebtedness of the worldwide affiliated group, or 2) net interest expense exceeds 40 percent of the adjusted taxable income of the U.S. parent. 11 This provision is intended to prevent U.S. companies from generating excessive interest deductions in the U.S. on debt that is incurred to produce exempt foreign income in a dividend-exemption system. 12 The provision recognizes standard nontax business practices that involve parent NOVEMBER DECEMBER

4 RECENT LEGISLATIVE PROPOSALS TO CURB EROSION OF THE U.S. TAX BASE corporations incurring debt to finance the acquisition or establishment of foreign subsidiaries by 1) allowing the U.S. group to have 10 percent more leverage than the worldwide group and 2) providing an indefi nite carry-forward of disallowed interest expense. Former Chairman Baucus s Discussion Drafts for International Tax Reform On November 19, 2013, former Senator Max Baucus released his proposed international tax reform in the form of three legislative discussion drafts while Chairman of the Senate Finance Committee. Two of the drafts present options billed as Option Y and Option Z for taxing income from products and services sold into foreign markets as the income is earned, and the third presents proposals that could accompany either option. 13 Chairman Baucus s Option Y adopts a participation exemption system, and Option Z retains current taxation on CFC income, moving towards a minimum tax. The common draft includes specific provisions to address base erosion, including limitations on income shifting through intangible property transfers s and the denial of deductions for some relatedparty payments. 14 Limitations on Income Shifting ing Through Intangible Property Transfers rs Baucus s proposal addresses recurring definitional and methodological issues that have arisen in controversies involving transfers of intangible ngib property, r similar to President Obama s budget proposals. Baucus s provision revises the defi nition of intangible property in Code Sec. 936(h)(3)(B), but does not modify the basic approach of the existing transfer pricing rules with regard to income derived from intangible property. The definition is amended to specify that workforce in place, goodwill and going concern value are intangible property. 15 The provision also clarifi es the Commissioner s authority to specify the method to be used to determine the value of intangible property, both with respect to outbound restructurings of U.S. operations and to intercompany pricing allocations. In the case of transfers of multiple intangible properties in one or more related transactions, the valuation of such intangible is explicitly permitted if the Commissioner determines that an aggregate basis achieves a more reliable result than an asset-by-asset approach. Denial of Deductions for Related-Party Payments Arising in a Base Erosion Arrangement This provision disallows deductions for any related-party payment arising in connection with a base erosion arrangement. 16 A base erosion arrangement is defi ned as any transaction or series of transactions that reduces the amount of foreign income tax paid or accrued, involving either: 1) a hybrid transaction or instrument, 2) a hybrid entity, 3) an exemption arrangement or 4) a conduit financing arrangement. A hybrid transaction or instrument is an instrument, transaction or series of transactions that the issuer treats as debt for purposes of income tax and that the holder treats as other than debt (including as an acquisition of property) for purposes of any income tax. A hybrid entity is any entity treated as fiscally transparent for income tax purposes if the entity is not treated fiscally transparent for purposes of any other income tax. An exemption arrangement is any provision of foreign income tax law that has the effect of reducing the generally applicable statutory rate of foreign income tax by 30 percent or more. Finally, a conduit financing arrangement is an arrangement under which one party (the financing entity) advances money or property or grants the right to use property to another entity (the financed entity) indirectly through the involvement of one or more intermediate entities if there are financing transactions linking these e entities ies and they are related parties. A financing transaction involves debt, a lease or license, or any other transaction action in which a person makes an advance of money, property or rights to property to a person obligated to repay or return a substantial portion of that money or other property. Recent U.S. International Tax Proposals Compared To varying degrees, each proposal alters the timing and scope of U.S. taxation of foreign income of U.S. multinational companies. Former Chairman Baucus s proposal does not address intangible income, while President Obama s and Chairman Camp s proposals both provide special rules for the taxation of intangible income. The Administration s budget proposals tax a U.S. person on the excess income from transactions with an intangible transferred by the U.S. person to a related CFC, and Chairman Camp s provides current U.S. taxation at a preferential rate of CFC earnings in excess of a 10 percent return on the CFC s investment in tangible, depreciable 18 INTERNATIONAL TAX JOURNAL NOVEMBER DECEMBER 2014

5 property. President Obama and former Senator Baucus s plans both propose modifications to the intangible definition to aid the Treasury in transfer pricing administration, while Chairman Camp s does not address the classifications in the same way. Regarding excessive interest deductions, both Chairman Camp and President Obama propose to limit, restrict or defer such deductions in order to curb the perceived abuses associated with excessive leveraging of U.S. operations. Former Senator Baucus s draft does not address interest deductions as a base erosion provision, but proposes denying deductions associated with base erosion arrangements. Compatibility with the OECD s BEPS Action Plan Outside of the United States, base erosion and profitshifting issues also dominate tax policy discussions. In July 2013, at the request of G20 Finance Members, the OECD launched an Action Plan on Base Erosion and Profit Shifting (BEPS), identifying 15 specific actions needed to equip governments with the domestic and international instruments to tackle perceived abuses associated with tax planning by multinational enterprises. Particularly, the project examines whether current tax rules allow for the allocation of taxable profits to locations different ent from those where the actual business activity takes place and what can and should be done to change this if they do. 17 The OECD s BEPS deliverables touch on the concerns addressed dressed by the proposals for U.S.. international nal tax reform rm described dab above. Especially relevant are action items two, four and eight, which provide recommendations regarding the design of domestic rules to limit base erosion via hybrid mismatching arrangements, interest deductions and changes to the transfer pricing rules involving intangibles, respectively. The BEPS action plan has an ambitious timeline, with the first deliverables released in September 2014, and the remaining elements, including items four and eight, due to be released by April It is unclear whether U.S. international tax reform will temporally precede or follow the remaining BEPS s deliverables; however, it is clear that any international tax reforms in the United States should be compatible with the final BEPS actions. Action 2 Neutralizing the Effects of Hybrid Mismatch Arrangements Action item two of the BEPS Action Plan calls for the development of model treaty provisions and recommendations regarding the design of domestic rules to neutralize the potential double nontaxation effect of hybrid instruments and entities. Part I of the Action two deliverable released in September 2014 recommends hybrid mismatch rules that seek to align the tax treatment of an instrument or entity with the tax outcomes in the counterparty jurisdiction, but otherwise do not disturb the tax or commercial outcomes. Specifically, the report recommends that domestic laws deny a deduction for a payment that is not includible in another jurisdiction, prevent exemption or nonrecognition for payments that are deductible by the payer, and deny a deduction for a payment that is not includible in ordinary income by the recipient (and is not subject to taxation under CFC or similar rules). U.S. Treasury Deputy Assistant Secretary (International Tax Affairs) Robert Stack, commenting on the deliverables noted that the U.S. Treasury succeeded in shifting the discussion to identifying abusive arrangements and determining how to address them, rather than attacking all hybrid mismatch arrangements as some tax administrators wanted. 19 This narrowing of the focus onto related-party and structured arrangements may alleviate some of the administrative burden posed by the hybrid mismatch rules. Former Senator Baucus s proposal to disallow deductions for related-party payments arising in a base erosion arrangement corresponds with the recommended domestic hybrid mismatch rules contained in the OECD s action item two. Action 4 Limit it Base Erosion via Interest Deductions and Other Financial ial Payments The Action four working group is tasked with developing best practices in the design nofru rules to prevent base erosion through the use of interest expense, for example, through the use of related- and third-party debt to achieve excessive interest deductions or to finance the production of exempt or deferred income. 20 Their work will evaluate the effectiveness of different types of limitations and the expected output is recommendations for the design of domestic rules and minimum standards in these areas. Chairman Camp and President Obama s proposals regarding interest deductions both fit into the Action four framework. Action 8 Assure that Transfer Pricing Outcomes are in line with Value Creation: Intangibles Action eight aims to develop rules to prevent BEPS by moving intangibles among group members and involves: 1) adopting a broad and clearly delineated definition of intangibles; 2) ensuring that profits associated with the transfer and use of intangibles are appropriately allocated in accordance with value creation; 3) developing transfer NOVEMBER DECEMBER

6 RECENT LEGISLATIVE PROPOSALS TO CURB EROSION OF THE U.S. TAX BASE pricing rules or special measures for transfers of hardto-value intangibles and updating the guidance on cost contribution arrangements. Some work on Action eight was included with the first set of deliverables, but much of the report was bracketed to allow for further development. U.S. government officials have commented that the Action eight group first worked to develop definitions and provide clarity because there was momentum toward writing the rules in a way that was vague enough to enable tax authorities to grab a slice of the intangibles. 21 The group prioritized defining who owns the intangible, how they value the intangible, what is an intangible and how to ascribe a profit to it in a very detailed way. Treasury economist Michael McDonald commented that remaining work in this area requires consensus on four unresolved issues pertaining to hard-to-value intangibles, cash boxes, residual returns and risk and recharacterization. 22 Given that consensus surrounding these issues has yet to emerge, it is difficult to predict the extent to which U.S. base erosion proposals will be consistent with the BEPS process in this regard. Conclusion The international tax proposals of the Obama Administration, Chairman Camp and former Senator Baucus evidence an apparent momentum behind U.S. international tax reform, as well as a consensus that base erosion is a significant concern that should be addressed by any international tax reform proposal. The specific proposals take different shapes, and it is possible that we will see other variations as well, particularly as the OECD BEPS project moves forward and continues to develop its recommendations. The proposals share some common elements, such as a focus on interest deductions and income from intangibles, and to the extent that these elements garner bipartisan support, taxpayers may be well advised to give them serious consideration. ENDNOTES 1 Administration's Fiscal Year 2015 Revenue Proposals; see 73 TAX NOTES INT'L 846 (March 10, 2014). 2 Department of the Treasury, General Explanations of the Administration's Fiscal Year 2015 Revenue e Proposals osals at 45 (March 2014) [hereinafter Green Book ]. 3 All l Code Sec. references enc are to the Internal Revenue e Code of 1986 as amended and the regulations thereunder. 4 Green Book at Green Book at t45. 6 Green nbook at t47. 7 Chairman Dave Camp, Tax Reform Act of 2014 (February 26, 2014) [hereinafter TRA of 2014 ]. 8 TRA of 2014, Sec TRA of 2014, Sec end and t 10 U.S. House of Representatives Ways & Means Comm., TRA of 2014 Discussion Draft Sectionby-Section, TRA of 2014, Sec U.S. House of Representatives Ways & Means Comm., TRA of 2014 Discussion Draft Sectionby-Section, U.S. Senate Comm. on Finance, Baucus Works to Overhaul Outdated Tax Code (Nov. 21, 2013) available ai le at newsroom/chairman/release/?id=f946a9f3- ea d296-42ad-bae4-bcf451b34b14 4-bcf4 b Chairman Max Baucus, International Tax Reform Discussion Draft Common (November 9, 2014) [hereinafter Common Discussion Draft ]. 15 Common Discussion Draft, Sec Common Discussion Draft, Sec OECD, Addressing Base Erosion and Profit Shifting, February 2013; OECD, Action Plan on Base Erosion and Profit Shifting, July 2013 [hereinafter BEPS Action Plan ]. 18 OECD, OECD Issues Revised Calendar for Stakeholder's Consultation (October 1, 2014), available at 19 Margaret Burow, Practitioners tio and Treasury Share Reactions to OECD's BEPS Recommenda-tions, 2014 WTD (September 22, 2014). 20 BEPS Action Plan, Action Kristen A. Parillo, Stack Explains BEPS Reports, 75 TAX NOTES INT'L 993 (9/22/2014). 22 Kristen A. Parillo, More Work Remains on BEPS Deliverables, U.S. Treasury Officials Say, 2014 WTD (9/25/2014). This article is reprinted with the publisher s permission from the INTERNATIONAL TAX JOURNAL, a bimonthly journal published by CCH, a part of Wolters Kluwer. Copying or distribution without the publisher s permission is prohibited. To subscribe to the Journal of INTERNATIONAL TAX JOURNAL or other CCH Journals please call or visit CCHGroup.com. All views expressed in the articles and columns are those of the author and not necessarily those of CCH, a part of Wolters Kluwer or any other person. 20 INTERNATIONAL TAX JOURNAL NOVEMBER DECEMBER 2014