Planning and Policy Issues Raised by the Structure of the U.S. International Tax Rules

1. Planning and Policy Issues Raised by the Structure of the U.S. International Tax Rules Daniel Shaviro NYU Law School

2. Broader context Chapter 2 of book-in-progress currently entitled “Fixing the U.S. International Tax Rules.” (Livelier suggestions welcomed.) Initial conception: “Current Intellectual State of the Play in U.S. International Tax Policy Debate.” Get past the “alphabet soup” of CEN / CIN / CON; address new research (e.g., finding outbound investment to be a complement not a substitute for home investment). “Alphabet soup” debate is fundamentally flawed - why only 1 margin; how do we link WW and national welfare. A better focus: market power in imposing WW residence-based tax, analogy to standard/optimal tariffs, prisoner’s dilemma if WW & unilateral diverge.

3. More on the broader context Project then expanded to include specific reform proposals. Proposal 1: exemption but with transition tax; fix source rules without regard to residence. No subpart F! Rationale: weakness of corporate residence concept; no windfall for prior outbound investment; fixing source rules for ALL multinationals obviates any need for subpart F. Proposal 2: If stuck with ceasefire-in-place, enact burden-neutral repeal of deferral & foreign tax credit, with outbound rate declining to (say) 5%. Rationale: eliminate distortions & incentive problems from deferral & FTC planning; existing burden on outbound stays about the same.

4. Ch 2: Planning & Policy Issues from the U.S. Rules’ Main Building Blocks Two key facts about U.S. international tax rules: (1) Horrible ratio of tax planning & compliance costs to revenue raised; huge behavioral responses (e.g., 2005 dividend tax holiday) for a modest yield. Fixing this is necessary, but not sufficient, to support current law (& its mode of compromise between WW & exemption). (2) Huge economic changes since rules took current form in 1962 - globalization, etc., indicate greatly reduced U.S. market power to impose tax burdens.

5. Plan of Chapter 2 Examine the 5 key features of U.S. international tax law to help evaluate means of compromise / placement between the WW & exemption poles. E.g., look at planning responses, importance / feasibility of underlying goals, can rules be reformulated to work better. The 5 key features are: (1) corporate residence rules, (2) source rules, (3) FTCs with limits, (4) deferral, (5) subpart F.

6. Corporations as Taxpayers Corporations as separate TPs: domestically, this only matters due to rates, etc., & double taxation. But internationally, the chief reason why 1962-era thinking (which failed to recognize its importance) no longer prevails. If all corporate income could be & were taxed to individuals on a flow-through basis, capital export neutrality (CEN) & possibly national neutrality (NN) would remain intellectually dominant. Corporations: (a) residence isn’t normatively meaningful & is highly elective (at least up-front), (b) no budget constraint if can attract new equity, (c) boundaries between “persons” not fixed.

7. (1) Corporate residence US: defined via place of incorporation. This definition has been surprisingly successful historically, reflecting home equity bias. Despite tax disadvantages of US WW regime, US companies have > $10 trillion foreign assets, > $1 trillion unrepatriated foreign earnings. To a degree, this equity is now “trapped.” Anti-inversion rules prevent pure tax plays; require some degree of real ownership change. But underlying market power is increasingly a thing of the past.

8. Change the residence definition? Other countries often look to HQs, “real seat,” etc. A changed US definition might reduce electivity – but enough? And suppose HQs have positive externalities. Also, why tax outbound investment by “US companies”? For shares owned by US individuals, depends on efficiency tradeoffs at multiple margins (with underlying constraint of limited market power to burden US incorporation). For shares owned by foreign individuals, nationally beneficial to impose tax burdens IF have market power from value of US incorporation – but why base the levy on outbound investment?

9. (2) Source rules Important for both inbound & outbound investment (the latter, due to FTC limit). Meaningful economic content is limited even for active business income, verging on non-existent for portfolio income. Active income: “transfer pricing is dead” (Sullivan 2008); formulary apportionment a hot topic but no panacea. Another big problem is intra-group debt (a key motivation for some recent US inversions). US earnings-stripping rules are weak, reflecting reliance on subpart F to do the job for US companies.

10. Defining source for active business income Unavoidable, despite incoherence, unless we shift to purely WW tax on individuals (with no or unlimited FTCs). Arguably, source rules should be corporate residence-neutral. Multinationals have income-shifting opportunities (& risk of penalty) that businesses in just 1 country may lack. If don’t get it “right,” cross-border enterprise is tax-subsidized or tax-penalized. This is likely to be inefficient UNLESS subsidy can be rationalized as targeted tax competition for mobile investment. BUT – does it increase, or merely reallocate, home investment?

11. Source of passive income Formalistic rules (residence of corporate entities, “cubbyhole” approach to defining financial instruments) invite avoidance. Thus, e.g., “only fools pay [US] withholding taxes on dividends today” (Kleinbard 2007) given total return swaps. Luckily, this is no big deal given the lack of motivation for taxing foreigners on inbound investment (although note that inbound is being defined in terms of corporate residence). Small open economy scenario (where investors can demand the WW after-tax rate) suggests limited or no ability to impose tax burdens on foreigners via tax on inbound.

12. (3) Foreign tax credits with limits Worst rules in US int’l taxation? Key to the horrendous tradeoff between planning costs & revenue, bad marginal incentives. Analysts tend to miss this because they assume the only alternative (exemption aside) is unmitigated double taxation. But one should distinguish between relevant margins (investing outbound vs. economizing on foreign taxes paid). Analysts also tend to assume one must have FTCs with limits OR unlimited FTCs. Unclear why 100% & 0% should be the only permitted marginal reimbursement rates (MRRs). (Good political economy, but bad economics)

13. Effective MRRs > 100%? Although the MRR is nominally “just” 100%, TPs can actually profit from paying more foreign taxes. Suppose FTC claims arose whenever one wrote the check. Then “excess-limit” companies would profit from being paid $1 to pay someone else’s $100 foreign tax. While claims aren’t freely transferrable in this way, withholding taxes can come pretty close (e.g., on cum dividend stocks). Addressed in the US via economic substance rules, but the problem is more fundamental.

14. (4) Deferral Doctrinal in origin from separate corporate entities, but retained in the US since 1962 as a deliberate policy choice. Bad rules in the same sense as FTCs – rationalized by effect (all else =) on tax burden for outbound investment, but (a) other means available for that, (b) bad effects at another margin. Central role (with FTC limits) in bad ratio of planning costs to revenue – note Kleinbard on the CFO as “master blender.” New view (Hartman 1984): if repatriation tax at a fixed rate is inevitable, no lock-in of overseas investment. BUT: rate may change, more tax holidays?, cross-crediting may create varying rates, note also accounting considerations. Transition issue …

15. (5) Subpart F Two main categories: (a) passive income, (b) overseas tax planning (such as “base companies” in tax havens). Intra-group interest is formally (a) but substantively (b). Use without subpart F greatly eased by check-the-box rules. (More on this Friday at CBT Summer Conference.) Many view the case for taxing (a) as stronger than that for (b) – including HM Treasury at one stage of current reform process. But I question this, if source (and earnings-stripping) rulescan be used to limit use of intra-group interest by all (not just resident) multinationals.

16. Arguments for applying subpart F to passive income but not base companies (i) Prevent income tax avoidance by individuals – But this can be accomplished by PFIC & FPHC-type rules. (ii) Why encourage corporate groups to place passive assets in CFCs? – Fair enough, but note subpart F’s residence distortion. (iii) Make deferral costlier for firms with mature CFCs – But this is normatively ambiguous even if one favours more WW tax. (iv) Why not allow base companies to save foreign taxes? – OK (reflecting problems with FTC), but same concern applies to foreign source passive income. (v) Can’t source countries address base companies? – They may not want to, we may be glad they don’t, same issue for passive.

17. And in conclusion … (1) Things don’t look good for a WW residence-based corporate tax – but why give transition windfall for old investment? (2) Source is a huge problem but unlikely to go away. Use residence-neutral rules, aim for neutrality as to cross-border ownership (issues of targeted tax competition aside). (3) Deferral and FTCs/limits are bad rules. Repealing without other changes would vastly increase tax burden on outbound – but why should the choices be thus limited? (4) In a residence-based corporate tax with deferral or partial exemption, the case for taxing passive income may be no or little stronger than that for taxing overseas tax planning.