The Obama Administration’s Tax Reform Proposals Concerning Controlled Foreign Corporations

1. The Obama Administration’s Tax Reform Proposals Concerning Controlled Foreign Corporations Daniel Shaviro NYU Law School

2. U.S. political background What common features for U.S. politics of (a) international taxation and (b) the death penalty? The U.S. international tax ceasefire-in-place reflects 3 competing political elements: 1) Pro-worldwide: tax reform/base-broadening on progressivity grounds (!), plus fear of job flight / runaway factories. 2) Pro-exemption: “competitiveness” & interest group politics. 3) Pro-foreign tax credit: popular aversion to “double taxation,” reinterpreted by academics as concern for worldwide efficiency (via CEN). End result: hard to move either way; huge tax planning costs relative to revenue raised.

3. Has anything changed politically? U.S. politics is VERY slow to notice WW trends (e.g., rising tax competition, other countries’ shift towards exemption). Interest group politics is (if anything) more pervasive than ever, seemingly good news for the pro-exemption side. BUT – in overall U.S. politics the rightward shift of 2000-2008 has been more than reversed (for reasons having nothing to do with U.S. international taxation). This potentially favors the pro-worldwide side even though, on this issue standing alone, there has been no shift to the left.

4. Behind the Obama Administration’s proposals Addressing “tax breaks” for “runaway factories” was a campaign talking point – & there are desperate revenue needs, few politically appealing targets. Hence, no surprise to see a proposal purporting to raise $200 billion through 2019, with a focus on controversial tax planning. In the short run, proposal is (mostly?) going nowhere: higher priorities, lack of Treasury tax staff, Congressional opposition. But clearly an important marker that will influence subsequent legislative debate.

5. The main proposals for CFCs The Administration’s proposals are partly aimed at evasion by individuals. But for US multinationals, 3 main elements: 1) Deduction disallowance (estimated $60B, 2011-2019). 2) Foreign tax credit: pooling & other changes ($43B). 3) Disregarded entities / subpart F ($86.5B !?). The Administration thus hopes to raise $189.5B on U.S. outbound over 9 years ($21B/year), as compared to $16B paid in 2004 on foreign active earnings.

6. (1) Deduction disallowance Current law: complicated “WW interest allocation” treats some interest expense incurred in U.S. as foreign source. Similar approaches for, e.g., domestic HQ & 50% of R&D expenses. BUT – no deductions are directly disallowed by reason of being treated as foreign source. Only effect is on FTC limit. Result: same as deduction disallowance for excess-credit U.S. firms, but no effect on other U.S. firms. Administration proposes to disallow deductions for all U.S. firms where allocated/apportioned to deferred CFC income. Akin to partial, uneven, indirect repeal of deferral.

7. Effects of deduction disallowance Proposal would affect multiple margins – not just, say, where invest fixed capital (CEN) or who owns a given asset (CON). Discourages U.S. firms’ ownership of foreign operations (bad) but also indirectly reduces tax value of avoiding repatriation (good). When deduction-source rules are “correct” (matching TPs’ true marginal decisions), note scenario with good incentive effects: Say I’d otherwise spend $100 in the U.S. ($65 after-tax) to earn $90 in Singapore ($73.80 after-tax, no residual U.S. tax). But: in practice, will also discourage outlays to generate purely U.S.-source income (as well as high-taxed foreign income). AND it’s overkill absent any Singapore deduction.

8. (2) Foreign tax credit changes The principal change: “pooling” approach to indirect FTC from CFC repatriations. Suppose CFC-A has $1M earnings & paid $300K foreign taxes, while for CFC-B it’s $1M, $100K. Current law: indirect FTCs depend on choice of CFC – so $100K dividend could generate either $30K or $10K in credits (ignoring gross-up). Proposal – FTCs depend on average ratio of all foreign taxes to CFC earnings (here, 20%). Effects: ends “master-blender”-style repatriation matching (good), discourages outbound ownership (bad), discourages repatriation (bad).

9. (3) Use of check-the-box to avoid subpart F Background: subpart F treats CFC passive income as a U.S. deemed dividend – including interest from intra-group loans. Hence, if Acme’s German sub pays interest to Caymans sub, German tax savings negated by extra U.S. tax. In 1996, U.S. – without considering international implications – simplified its entity classification rules, permitting “disregarded entities.” U.S. companies quickly realized that they could now avoid sub-part F in the above scenario, via Caymans disregarded entity. Proposal would bar disregarded entity status in such cases.

10. Check-the-box proposal, cont. U.S. Treasury could amend the regulations without Congress, but note political & budgetary accounting obstacles. Clearly a good proposal IF one sufficiently (a) likes the subpart F policy of impeding overseas tax saving or (b) dislikes large unintended policy changes from the regulatory process. Effects: discourages outbound ownership (bad), discourages overseas tax saving given one’s investment pattern (bad).

11. The bottom line? Overall direction of greater WW tax on U.S. firms: I’d say wrong & futile, with other countries going the other way & rising ease of avoiding use of U.S. entities. Political prospects seem dim, unless broader U.S. trends give those who favor greater WW taxation discretionary political capital that they choose to spend this way. Inducements to wasteful tax planning, on margins other than who owns non-U.S. assets, are eased in some cases, worsened in others. My own preferred reform directions: (1) exemption without transition windfall OR (2) burden-neutral improvement of the ceasefire-in-place AND (3) residence-neutral improvement of domestic source rules.