Re: Chairman Baucus International Tax Reform Discussion Draft

Transcription

1 January 17, 2014 The Honorable Max Baucus Chairman Committee on Finance United States Senate Washington, DC Re: Chairman Baucus International Tax Reform Discussion Draft Dear Chairman Baucus: The Organization for International Investment ( OFII ) is pleased to submit the following comments regarding the Chairman s staff discussion draft addressing international tax reform released November 19, 2013 (the discussion draft ). OFII is a business association of U.S. subsidiaries of global companies, a business community which plays a major role in U.S. job creation and economic growth. OFII works to ensure fair and non-discriminatory treatment for its member companies and advocates for policies which increase U.S. competitiveness in attracting foreign direct investment (FDI). U.S. subsidiaries of global companies generate precisely the types of high-value jobs and economic activities that should be encouraged through fundamental tax reform. According to the most recent U.S. government statistics, U.S. subsidiaries employ 5.6 million Americans, including over two million manufacturing workers or 17 percent of the manufacturing workforce, generate 6.3 percent of U.S. private sector GDP, and undertake 14.4 percent of all U.S. non-residential capital investment. With a combined annual payroll of $438 billion and average employee salary at $77,632, these companies provide well-paying U.S. jobs at salary levels substantially higher than the economy-wide average. Additionally, this business community comprises a significant portion of the U.S. corporate tax base; according to the most recently published IRS data, foreign-owned companies pay approximately 14 percent of total U.S. corporate income taxes. OFII believes tax reform is a unique opportunity to make the United States significantly more competitive as a location for business investment in a challenging global environment. OFII strongly supports a significant reduction in the U.S. corporate income tax rate, elimination of unnecessary complexity and administrative burden, and the establishment of a more transparent tax code that will provide the stability and

2 certainty critical to long-term business planning. In pursuing these goals, it is essential that any changes to the tax code be carried out in a non-discriminatory manner that encourages global investment in the U.S. economy. We are pleased to provide comments on how the proposals in the discussion draft would impact U.S. subsidiaries of global companies and U.S. competitiveness for global investment more broadly. As discussed in more detail, our comments on the discussion draft focus on the following areas: 1. The proposed denial of deductions for certain related party transactions that have the effect of reducing foreign tax (section 85 of the provisions common to options Y and Z). 2. The potential expansion of thin capitalization rules. 3. The proposed repeal of the portfolio interest exemption for U.S. corporate debt obligations (section 84 of the provisions common to options Y and Z). 4. The proposal to modify the rules regarding foreign investments in United States real property (section 93 of the provisions common to options Y and Z). 5. The proposal to deny deductions for reinsurance premiums paid to affiliated corporations in certain circumstances (section 82 of the provisions common to options Y and Z). 2

3 1. Denial of deductions for certain related party transactions that have the effect of reducing foreign tax a. Background Current law generally permits the deduction of ordinary and necessary business expenses, including payments for services, raw materials, and other payments in the ordinary course of business. To be deductible, such payments must meet arm s length standards when made to related parties. The arm s length standard generally requires that payments between related parties should reflect terms that are consistent with terms that two unrelated parties, acting at arm s length, would agree to. In addition, the ability to deduct interest is subject to a number of limitations, especially in the context of interest paid to related foreign parties. In addition, certain payments by U.S. persons to foreign persons (related or unrelated) are subject to a gross 30 percent U.S. income and withholding tax. This income and withholding tax may be reduced under a relevant U.S. income tax treaty. The ability to reduce the 30 percent income and withholding tax under a treaty is subject to a number of limitations and anti-abuse measures, including limitation on benefits provisions contained in most U.S. income tax treaties (several of which focus on whether the foreign recipient of the income reduces its tax base in its residence country) and complex regulatory and common law anti-conduit rules. 1 b. Summary of Proposal The discussion draft would disallow any deductions for related party payments arising in connection with a base erosion arrangement that reduces the amount of foreign income tax paid or accrued. A base erosion arrangement which reduces the foreign income tax paid or accrued includes an exemption arrangement (a provision of a foreign income tax law which has the effect of reducing the generally applicable statutory rate on income derived by the person by 30 percent or more with respect to specific items or activities), a hybrid transaction or instrument (e.g., an instrument characterized as debt for purposes of one country s tax law but not as debt for purposes of another 1 These rules are anti-abuse measures to prevent foreign persons from using intermediary companies to obtain treaty benefits for certain types of U.S. payments that would be subject to U.S. tax if the payment had not involved the intermediary company. For example, interest payments made by a U.S. subsidiary to a parent company located in a non-treaty jurisdiction would be subject to a 30 percent U.S. income and withholding tax. If the parent lends to an affiliate located in a country that has a tax treaty with the United States, and the affiliate on-lends to the U.S. subsidiary, the U.S. subsidiary could seek to qualify the payment of interest for treaty benefits; however, the U.S. anti-conduit rules would look to the parent as the ultimate source of funds for purposes of determining whether reduction of the 30 percent U.S. tax is available. 3

4 country s tax law), a hybrid entity (e.g.,, an entity treated by one country as a corporation and by another country as fiscally transparent), or a conduit financing arrangement (an arrangement in which certain financing activities are undertaken through one or more intermediate entities). The Chairman s request for comments indicates that this provision is intended to address U.S. base erosion by foreign multinationals by broadly denying deductions in such related party transactions that have the effect of reducing foreign tax. c. Comments on Proposal The proposal would broadly deny deductions for ordinary business transactions. The proposal would deny deductions for business transactions between related parties undertaken in the ordinary course of conducting a global enterprise that are consistent with the arm s length standard. OFII is concerned that the proposal would apply to any type of deductible payment, including payments by U.S. subsidiaries for the purchase of materials or for services that are integral to the operation of the business, and would deny a deduction from U.S. taxes over a reduction in foreign taxes. For example, it is fairly common for multinationals to operate shared service centers and other centralized business functions for the benefit of the group, including group headquarters and service functions, group procurement functions, group treasury, financial, holding, and cash management functions, or centralized development or licensing of patented property to the entire group (including the United States) for ongoing business needs. A country may encourage such types of shared business center functions in the form of a reduced tax rate or other tax incentives. A country may also offer targeted industries tax incentives, such as a temporary reduction in a company s tax rate in exchange for doing business in that country. These measures, which are also common in U.S. tax policy, are used by countries in furtherance of tax policies as an efficient means of encouraging specific types of activities that enhance the local economy. Under the proposal, a U.S. subsidiary would be denied deductions for payments to such affiliated enterprises merely because the local country has provided a reduced tax rate for such business activities. 2 The deduction denial would thus broadly impose significant and unnecessary damage on business transactions, increasing the cost of doing business in the United States. This will lead to decreased investment in 2 These types of payments may fall under the exemption arrangement category of the proposal. While there is an exception in the proposal for any provision of foreign income tax law that requires economically significant expenditures in order to obtain the benefit provided, it is unclear under what circumstances such an exception would apply. 4

5 operations of U.S. subsidiaries and, therefore, to a reduction in U.S. jobs. deduction denial would thus have a detrimental impact on the U.S. economy. The Moreover, the deduction denial would invite other countries to retaliate against U.S. companies doing business in their jurisdictions by denying deductions for tax incentives the United States provides on similar related party payments. The proposal ignores U.S. and international standards. The discussion draft would effectively ignore and override the internationally recognized arm s length standard that has historically respected transactions between U.S. subsidiaries and related parties as long as those transactions are undertaken on an arm s length basis. This standard, which the United States has promoted around the world, provides a limit on the amount of related party payments that are allowable as a deduction under U.S. law. In addition, the discussion draft ignores the impact of U.S. income and withholding tax rules. Many types of related party payments for which deductions would be denied under the proposal are also subject to a 30 percent withholding tax, unless reduced or eliminated under a U.S. income tax treaty. U.S. bilateral income tax treaties reduce instances of double taxation and guard against double non-taxation in abusive situations. For payments made by U.S. subsidiaries to related parties seeking to claim treaty relief from U.S. withholding tax, well developed limitation on benefits rules in U.S. income tax treaties (including rules addressing foreign base erosion 3 ), and well developed anti-conduit rules, apply as anti-abuse measures to limit treaty relief from the U.S. withholding tax. 4 The denial of deductions on payments that would also be subject to U.S. withholding tax under these rules would result in double taxation. This double taxation would be inevitable for payments made to non-treaty eligible persons, as the discussion draft would effectively increase the U.S. tax burden on such related party payments from 30 percent to 65 percent as a result of the deduction denial and the imposition of full withholding taxes. We also note that the proposal effectively 3 To qualify for the benefits of a U.S. income tax treaty with respect to income from the United States, a resident of the treaty company must generally satisfy one of several provisions of the treaty s limitation on benefits article. Several of these tests, including the ownership/base erosion test and the derivative benefits test, specifically deny treaty benefits where the recipient of the income erodes more than a certain amount of its tax base in its residence country through deductible payments. See, e.g., 1994 Income Tax Convention between the United States and France, amended by Protocols in 2004 and 2009, Article 30(2)(e) and (3); 1989 Income Tax Convention between the United States and Germany, amended by Protocol in 2006, Article 28(2)(f) and (3). 4 The deduction denial for conduit financing arrangements contained in the discussion draft is effectively duplicative of existing rules for conduit financing arrangements in the withholding tax context (see., e.g., section 7701(l) and Treas. Reg. sec ), which highlights the over-breadth of the proposal. 5

6 results in a tax on the gross income of the recipient, as no deduction is allowed for expenses related to earning the income and accordingly represents an abrogation from the long-standing principle of taxing net income. The proposal would violate U.S. treaty obligations. As the Chairman s request for comments indicates, the proposal is targeted at non-u.s. multinationals. The U.S. Congress has generally, but not uniformly, been respectful of the commitments the United States makes to its trading partners under U.S. income tax treaties. The proposal would violate treaty nondiscrimination provisions in that the proposal, in practice, would place greater tax burdens, or related requirements, on foreign persons investing in the United States economy than would apply to similarly situated U.S. persons. The proposal may prompt retaliatory action by treaty partners and erode international confidence in the United States as a treaty partner. Unilateral measures will lead to double taxation. The United States is an active participant in the OECD project on base erosion and profits shifting, a fundamental goal of which is to develop agreed upon international standards for addressing base erosion and profit shifting. There is a broad consensus that adopting unilateral measures before an international consensus is developed is undesirable. 5 The OECD Action Plan, states the following: Inaction in this area would likely result in some governments losing corporate tax revenue, the emergence of competing sets of international standards, and the replacement of the current consensus-based framework by unilateral measures, which could lead to global tax chaos marked by the massive re-emergence of double taxation. The deduction denial proposal in the discussion draft is likely to have just that effect. There is a significant risk of double taxation, and reduced investment, where broad proposals are unilaterally applied. The discussion draft s proposal would create novel and uncertain standards that would cast a pall over many common cross-border transactions that are consistent with the arm s length standard. 2. Potential expansion of thin capitalization rules a. Background U.S. subsidiaries of foreign businesses are currently subject to unique interest limitations under Internal Revenue Code section 163(j), which was intended to prevent base erosion through excess interest expense. Section 163(j) limits deductions of 5 OECD Action Plan on Base Erosion and Profit Shifting, issued July 19,

7 interest on loans from a foreign related party, such as a non-u.s. parent company, even if the terms of the loan meet the arm s length standard. It also imposes limitations on deductions of interest paid to an unrelated lender, such as a U.S. bank, when the loan is guaranteed by a related party (e.g., a parent or affiliate company). This is true in spite of the fact that a loan from a U.S. lender is tax revenue neutral (i.e., the interest deducted by the U.S. borrower is taxable income for the U.S. lender) and presents no opportunity for the kind of base erosion section 163(j) was intended to prevent. Such restrictions which currently apply in practice only to U.S. subsidiaries can increase the cost of capital for investment. b. Summary of Proposal The discussion draft includes a proposal to limit interest deductions for interest expense allocable to exempt income of a controlled foreign corporation (section 21 of both options Y and Z). In addition, the Chairman has requested comments regarding whether present law thin capitalization rules should be tightened and expanded to apply to interest on all debt owed by a domestic corporation. c. Comments on Proposal The ability to deduct interest as an ordinary and necessary business expense is a longstanding principle of U.S. corporate income tax policy. All companies small, medium, and large use debt as a basic and necessary tool to finance investment and fundamental business activities. The United States, like all OECD countries, allows interest to be deducted as a normal business expense. The use of debt in conjunction with equity investments optimizes the overall cost of an investment and therefore the return on investment, helping to fuel positive economic activity that grows economies. The deduction for interest expense reduces the after-tax cost of debt finance and thus lowers the cost of capital for all businesses operating in the United States, making investment here more attractive. As a general matter, the cost of capital sets the hurdle rate that the return on an investment opportunity must exceed in order to pay the returns required by bondholders and shareholders. The higher the cost of capital, the higher the hurdle rate and the lower the amount of investment a firm can profitably undertake. Changes in tax law that would increase the cost of capital carry the risk of reducing domestic investment, employment, wages, and economic growth. One key source of investment financing for a subsidiary company is its global parent company. In addition to equity investment, a parent company can provide a loan to its subsidiary or guarantee a loan from an unrelated third party, such as a bank. In any case, the parent company plays a critical role in ensuring the subsidiary has access to 7

8 the funding it needs to carry out its business activities everything from meeting payroll to buying new equipment to building a new factory. Without the flexibility of raising capital through intercompany debt finance, the United States would become a far less competitive environment for investments especially for global businesses with a wide array of choices for where to place their investments. The Treasury Department has periodically reviewed data on U.S. subsidiaries in relation to section 163(j). These studies, including one in 2007, found no evidence of earnings stripping by traditional foreign-based corporations with U.S. subsidiaries. Furthermore, a subsequent 2008 Treasury study found that U.S. subsidiaries and U.S.- headquartered corporations were largely on par in their levels of debt and profitability. In short, multiple studies and many years of IRS data provide no evidence of a need to further tighten current rules governing interest deductibility for U.S. subsidiaries. As such, we do not believe that placing further limits on section 163(j) for U.S. subsidiaries of foreign multinational companies are warranted. In addition, U.S. law should apply in a non-discriminatory manner to encourage investment in the United States. 3. Repeal of the portfolio interest exemption for U.S. corporate debt obligations a. Background Interest paid by U.S. corporations to foreign persons generally is subject to a 30% income and withholding tax. A portfolio interest exemption from this tax was enacted by the Deficit Reduction Act of 1984 in order to encourage investment of capital in the United States from foreign investors. The exemption provides that no U.S. federal income tax is imposed on interest received by foreign individuals and foreign corporations from portfolio debt instruments. Debt issued by both U.S. companies and the U.S. government can qualify for the portfolio interest exemption. However, the exemption is not available if the recipient of the interest is related to the debtor paying the interest, 6 if the interest on the debt is contingent interest, or if the recipient of the interest is a bank that has received the interest on an extension of credit made in the ordinary course of such bank s trade or business. In addition, the debt instrument must be in registered form. 6 For this purpose, a person is generally related if the person receiving the interest is at least a 10 percent shareholder in the person paying the interest, after applying certain ownership attribution rules. 8

9 b. Summary of Proposal The proposal would repeal the portfolio interest exemption for interest paid on U.S. corporate debt, while leaving in place the portfolio interest exemption for interest paid by the U.S. government. c. Comments on Proposal The proposed repeal of the portfolio interest exemption for corporate debt paid to foreign persons will have severe impacts on U.S. subsidiaries ability to access foreign capital markets. The effect of the proposal would be to increase the cost of capital for U.S. corporations, and to severely limit international investment in U.S. corporate debt obligations. Residents of treaty countries would be unlikely to purchase public debt issued by U.S. subsidiaries, as the mechanics of issuing public debt in a treaty context would be nearly impossible to administer. 7 In addition, excluding investors from other emerging countries such as in Latin America and Asia would also limit potential sources of increased investment in the United States. The repeal of the portfolio debt exemption also has a serious impact on non-u.s. multinationals that finance their U.S. subsidiary operations with publicly issued debt offered in its home market. It may be efficient for the foreign parent to issue public debt and to lend funds to its group affiliates including its U.S. subsidiary. U.S. anticonduit rules can effectively treat the public borrowing and internal lending as if the U.S. subsidiary had accessed the foreign market directly. However, since the public debt has actually been issued by a foreign corporation, being able to obtain U.S. tax certifications from the public debt holders is not likely. Under current law, public debt issued by the foreign corporation that would qualify for the portfolio debt exemption had they been issued directly by the U.S. subsidiary generally do not raise conduit concerns. However, if the portfolio debt exemption is repealed, a foreign corporation would face possible denial of treaty benefits for its loans to its U.S. subsidiary even though accessing the public debt markets is a customary business practice for the foreign corporation. 7 Investors seeking to claim exemption from tax on interest under a U.S. income tax treaty would generally be required to provide tax ownership certifications to the U.S. payor, which may often need to be carried through a number of foreign intermediaries. In the context of publicly held corporate debt, where there are multiple exchanges of the debt on a daily basis, obtaining all of the required tax certifications with respect to interest payments would be nearly impossible. 9

10 4. Modification of the rules regarding foreign investments in United States real property (FIRPTA) a. Background In general, foreign persons are not subject to tax when disposing of stock in a U.S. corporation for capital gain. Special rules provide that foreign persons that dispose of interests in real property located in the United States are taxed on such disposition as if they were engaged in a trade or business in the United States. These rules are known as the FIRPTA rules. The FIRPTA rules apply when a foreign person disposes of a direct interest in U.S. real property, but they also apply when a foreign person disposes of a stock interest in a U.S. corporation the assets of which predominantly consist of U.S. real property interests. However, for these purposes, a stock interest in a U.S. corporation is not treated as a U.S. real property interest if the corporation is regularly traded on an established securities market and if the person disposing of the interest does not hold (and has not held in the past five years preceding the disposition) more than 5 percent of the stock of the corporation. b. Summary of Proposal The discussion draft would make a number of modifications to the FIRPTA rules, including an exemption from tax for gains on the disposition of U.S. real property interests owned by foreign pension funds, and an increase in the exemption for dispositions of publicly traded companies from 5 percent to 10 percent in the case of dispositions of interests in regularly traded U.S. real estate investment trusts ( REITs ). c. Comments on Proposal OFII welcomes the measures in the proposal for modification of the tax rules on foreign investment in U.S. real property interests to minimize adverse impacts on access to foreign capital for U.S. real estate investment. However, the proposal does not fully address impediments to foreign investment in U.S. real estate. We recommend that the Committee incorporate the broader FIRPTA reforms of the Real Estate Investment and Jobs Act of 2013 ("S. 1181") (including the look-through provisions of the 5 to 10 percent FIRPTA exemption for collective investment vehicles) and the broader exemption for foreign pension funds contained in President Obama's Fiscal Year 2014 Budget, to alleviate punitive taxes and encourage greater investment in U.S. real estate. 10

11 5. Denial of deductions for reinsurance a. Background Reinsurance is a commonplace business transaction in the insurance industry in which one insurance company, in exchange for a premium, indemnifies another insurance company for losses that it may sustain under one or more insurance policies it has issued. Reinsurance generally enables insurance companies to limit their risk of loss. It also allows members of an affiliated group of insurance companies to diversify their risk portfolios and to quickly deploy capital where it is needed within the group. Affiliate reinsurance effectively mitigates the information asymmetry between the insurers and reinsurers and it allows risk and capital to be moved more quickly and easily within the insurance group in response to changing market conditions. These aspects in turn benefit the consumer market by reducing the costs of insurance and, in the event of losses arising from catastrophic events such as hurricanes, decreasing the likelihood that an insurance company will be overwhelmed by losses and unable to honor its contractual obligations, effectively shrinking insurance capacity. Current law generally permits the deduction of ordinary and necessary business expenses, including reinsurance premiums paid to both affiliated and unaffiliated reinsurers. Amongst related persons, these deductions are limited under sections 482 and 845 to the extent made above arm s length prices or are considered abusive. Reinsurance premiums paid with respect to U.S. risks to foreign insurance companies are subject to a federal excise tax, which is imposed on a gross basis. Several U.S. tax treaties provide an exemption from this tax and include well developed anti-conduit rules to ensure that the benefit of the exemption does not flow to companies resident in countries without a similar exemption. b. Summary of Proposal The discussion draft would disallow insurance companies a deduction for reinsurance premiums and other amounts with respect to the reinsurance paid to their foreign affiliates (and not subject to U.S. federal income tax) with respect to risks other than life insurance risks. The proposal would also exclude from such companies taxable income items of income, such as return premiums, ceding commissions, reinsurance recovered and other amounts properly allocable to the non-taxed premiums paid. The proposal provides an election for an affiliated foreign reinsurer to be subject to U.S. tax on reinsurance premiums paid to it that would be otherwise subject to a deduction disallowance and deemed net investment income allocable to such premiums. If the 11

12 election is made, the excise tax, reinsurance premium deduction disallowance and corresponding income exclusion does not apply. 8 c. Comments on Proposal The proposal would violate U.S. treaty obligations. The proposal would violate numerous treaty provisions, which may prompt retaliatory action by treaty partners and erode international confidence in the United States as a treaty partner. Specifically, by denying corporate deductions for premium amounts paid to foreign reinsurance companies, the proposal would violate treaty prohibitions on taxes that discriminate on the basis of foreign ownership and on discriminatorily disallowing deductions. Additionally, by denying a deduction for impacted premium amounts, the proposal would result in imposing the economic equivalent of a full corporate tax on foreign insurance companies premium income, thereby violating U.S. obligations under tax treaties with respect to mitigating double taxation and ceding taxing authority to the residence state in the absence of a U.S. permanent establishment. The proposal ignores U.S. standards. While the proposal seeks to address perceived abuses through reinsurance transactions with foreign affiliates, section 482 already provides a mechanism to ensure reinsurance transactions are priced on arm s length terms. Further, section 845 provides a more particularized mechanism, exclusively applicable to reinsurance transactions. It operates as an anti-abuse provision that grants the Service the authority to allocate, recharacterize, or adjust the income of the parties to an affiliated reinsurance transaction where necessary to properly reflect the proper amount, source, or character of that income. Section 845 is the proper tool to address related party reinsurance transactions. The proposal would violate fundamental U.S. tax principles. The proposal would place artificial limitations on the deductibility of business expenses. This violates the fundamental concept of U.S. tax policy that the cost of doing business is deductible in arriving at the taxable income of a taxpayer. This will also lead to decreased foreign investment in the United States and have a detrimental impact on the U.S. economy. Importantly, reinsurance premium payments are an ordinary, necessary, and significant business cost incurred by insurance companies. It is no more appropriate to arbitrarily 8 The proposal is similar to prior reinsurance proposals offered by Congressman Neal and the Obama Administration. See, e.g., See, e.g., H.R. 2054, 113th Cong. (2013); Dep't of the Treasury, General Explanations of the Administration's Fiscal Year 2014 Revenue Proposals, at 52 (Apr. 2013). For additional discussion of the potential adverse impacts of a similar prior proposal, please see our comment letter, dated February 27, 2009, available at 12

13 limit the deductions for such a basic cost of doing business than it would be to disallow manufacturing costs for an automobile producer. 6. Conclusion OFII and its member companies appreciate the Committee s efforts to reform the U.S. corporate tax code. We believe tax reform is a critical opportunity to strengthen our economy and make the United States the most attractive place in the world for investment. Thank you for the opportunity to provide feedback on the discussion draft. We hope to be a resource to the Committee on issues impacting global investment in the United States. Sincerely, Nancy McLernon President & CEO Organization for International Investment cc: The Honorable Orrin Hatch Ranking Member Committee on Finance United States Senate Washington, DC