President Obama has proposed far-reaching reforms to the taxation of foreign income of US multinational corporations and individuals in his proposal entitled "Leveling the Playing Field: Curbing Tax Havens and Removing Tax Incentives for Shifting Jobs Overseas."
The overall purpose of the proposal, announced on May 4, 2009, is to restore fairness and balance to the US tax code. The proposal has two central components: (1) reforms to ensure that the US tax code does not encourage job creation offshore versus in the United States; and (2) reduction of the amount of taxes lost to tax havens, through closing of unintended "loopholes" that allow companies to legally defer US taxation on foreign source income or through tax evasion. These initiatives, combined with other international tax reforms that will be unveiled in the Administration’s full budget later in May, are projected to raise $210 billion over the next 10 years.
The proposals affect US multinational corporations and individuals who engage in cross-border transactions, the most significant of which are (1) a deferral on deductions other than research and experimentation expenditures (R&E) related to the foreign operations of US companies; (2) increased limitations on the ability of a US taxpayer to utilize foreign tax credits; (3) repeal of the "check-the-box" election to treat "certain" foreign subsidiaries as disregarded entities for US tax purposes; (4) a permanent extension of the tax credit for R&E expenditures in the United States and (5) a series of new rules (encompassing enhanced information reporting, tax withholding, strengthened penalties, and shift in the burden of proof) to make it more difficult for US individuals to use offshore accounts to evade US tax. These proposals are summarized below.
It should be noted that some of the proposed changes could have been made administratively, by the Obama Treasury Department. By making these proposals legislatively, the Obama Administration may include any resulting revenue in its budget.
II. The Administration's Proposals
A. Replacing Tax Advantages for Creating Jobs Overseas with Incentives to Create Jobs at Home
Revenue Raised: The Administration would raise $103.1 billion by removing tax advantages for investing overseas, and would use a portion of these resources to make permanent the R&E tax credit for investment within the United States.
- Reform Deferral Rules to Curb a Tax Advantage for Investing and Reinvesting Overseas. Under this proposal, with the exception of R&E expenditures, a US company would be required to defer deductions associated with offshore investments until offshore profits are repatriated and taxed in the United States.
This provision would take effect in 2011, raising $ 60.1 billion from 2011 to 2019.
- Closing Foreign Tax Credit Loopholes. This proposal has two components: (1) a taxpayer’s foreign tax credit would be determined based on the amount of total foreign tax that a taxpayer actually pays on its total earnings; (2) a foreign tax credit would no longer be allowed for foreign taxes paid on income not subject to US tax.
This provision would take effect in 2011, raising $43.0 billion from 2011 to 2019.
- R&E Credit to Become Permanent. The R&E credit, which is scheduled to expire at the end of 2009 would become permanent.
This provision would take effect from 2010 and would cost $74.5 billion over 10 years, which will be paid for by reforming the treatment of deferred income and the use of foreign tax credits.
B. Overseas Tax Havens
Revenue Raised. The Administration’s proposal would raise a total of $95.2 billion over the next 10 years through efforts to get tough on tax havens.
- Eliminate Loopholes for "Disappearing" Offshore Subsidiaries. This provision would eliminate the ability of a taxpayer to electively treat certain eligible foreign entities as a disregarded entity or "tax nothing," under the "check-the-box" regulations and require that such entity be treated as a corporation for all tax purposes. The stated purpose of this proposal would be to "level the playing field between firms that invest overseas and those that invest at home."
This provision would take effect in 2011, raising $86.5 billion from 2011 to 2019.
- Cracking Down on the Abuse of Tax Havens by Individuals. These proposed changes contain what the Administration describes as a “comprehensive package” of disclosure and enforcement measures to make it more difficult for wealthy individuals to evade taxes through offshore accounts. The provisions would enhance information reporting, increase tax withholding, strengthen penalties, and shift the burden of proof to make to more difficult for US taxpayers with foreign-accounts to evade US taxes, while also strengthening the enforcement tools necessary to “crack down” on tax haven abuse. These proposals would be in addition to the initiatives taken within the G-20 to impose sanctions on countries judged by their peers not to be adequately implementing internationally accepted exchange of information standards.
These provisions are estimated to raise $8.7 billion over 10 years.
- Strengthen the "Qualified Intermediary" (QI) System. "The core of the Obama Administration's proposals is a tough new stance on investors who use financial institutions that do not agree to be qualified intermediaries." (A QI is a foreign financial institution that has contractually agreed with the IRS to undertake certain US withholding and reporting responsibilities and has agreed to audits by an external auditor.) The overall thrust of the proposal is to correct shortcomings in the current QI program that have hindered US tax enforcement and seemingly mandate that all foreign financial institutions with US dealings to become a QI in order to avoid harsh new rules that would make their financial intermediation as a non-QI economically uncompetitive.
- Impose Significant Withholding Tax on Transactions Involving Non-QIs. The Administration would require US financial institutions to withholding 20 percent to 30 percent of payments of US source income to individuals who use non-QIs. An investor would have to disclose its identity and demonstrate that he or she is complaint with U.S tax law in order to obtain a refund of the tax withheld.
- Create a Legal Presumption against Users of Non-QIs. The Administration’s plan would create a rebuttable evidentiary presumption that any foreign bank, brokerage, or financial account held by a US citizen at a non-QI contains sufficient funds to require filing of a Foreign Bank and Financial Account Report (FBAR) --disclosing ownership of financial accounts in a foreign country containing over $10,000, and that any failure to file an FBAR is willful if an account at a non-QI has a balance of greater that $200,000 at any point during the calendar year. These presumptions would make it easier for the IRS to demand information and pursue cases against non-compliant US taxpayers.
- Limit QI Affiliations with Non-QIs. The Treasury Department would have authority to issue regulations requiring that a financial institution may be a QI only if all commonly-controlled financial institutions are also QIs. This would prevent financial firms from using affiliated non-QIs for illegitimate purposes.
- Provide the IRS with the Legal Tools Necessary to Prosecute International Tax Evasion. This proposal has four components:
- Double penalties when a taxpayer fails to make a required disclosure of foreign financial accounts;
- Extend the statute of limitations for international tax enforcement to six years after the taxpayer submits the required information;
- Increase the reporting requirements on international investors and financial institution, especially QIs.
- QIs would required to report information with respect to their US customers to the same extent as required by US financial institutions
- US customers at QIs no longer would be allowed to use foreign entities to avoid disclosure of their identity.
- US investors would be required to report transfers of money or property made to or from non-QIs foreign financial institutions on their income tax returns
- Financial institutions would face enhanced information reporting requirements for transactions that establish a foreign business entity or transfer assets to and from foreign financial accounts on behalf of US individuals.
- New IRS Hires. The IRS would be provided with funds to support the hiring of nearly 800 new employees devoted specifically to international enforcement.
III. Initial Observations
- General. With respect to all of the proposals, significant detail will have to be developed before potentially affected taxpayers can evaluate how the proposals would apply in specific circumstances.
- Reform of Deferral Rules
- The Administration does not propose deferral of taxation of active income. Rather, it requires that repatriation of profits before expenses (other than R&E) can be deducted on a federal tax return.
- This proposal has been characterized by some as “forced repatriation,” which may place US multinationals in an uncompetitive position.
- It is not clear how taxpayers are to determine when an expense “supports their offshore investments” and, thus, would be currently disallowed.
- Similar to other of the Administration’s proposals, it appears that this proposal is motivated in part by a desire to combat tax “arbitrage,” whereby an expense may be deductible prior to a corollary inclusion of income.
- It should be noted that current law has recognized the tax arbitrage possibilities in a US taxpayer incurring deductible expenses in connection with foreign investments and adopted foreign tax credit limitation rules (i.e., the overall foreign loss rules and certain allocation and apportionment rules to prevent perceived abuse).
- Foreign Tax Credit Proposals
- The Administration proposes that (1) the amount of foreign tax credit would be determined based on the amount of total foreign tax actually paid on total foreign earnings and (2) the foreign tax credit would not be allowed for foreign taxes paid on income not subject to US tax.
- The full intent behind the first proposal is unclear, but it may be aimed at “blending” all foreign earnings and associated foreign tax credits.
- The second proposal appears to be a codification of certain current regulatory proposals relating to the so-called “technical taxpayer” rule, much debated in recent years.
- Repeal of “Check-the-Box” Rules
- This proposal appears directed at the use of entities that are treated as disregarded entities of tax haven entities in order to pay dividends or local-tax deductible payments, such as interest, royalties or services fees to the tax haven entity in a manner whereby, with respect to deductible payments, the paying entity obtains a local tax deduction but the recipient entity incurs no local tax and is not subject to the US anti-deferral rules. This type of planning involves tax “arbitrage”
- Query the abuse in this planning situation, which is intended to enable a US taxpayer to base erode local taxes without a concurrent income inclusion?
- In that regard, it is unclear whether or to what extent the Administration may have been influenced by earlier efforts to limit the “heck-the-ox” regulations (e.g., Notice 98-11).
- While the proposal contains few details, there are some hints that it might be applied only to “certain” foreign entities – namely those related to, or organized in, “tax havens” – but it is far from clear whether the final form of the proposal will be narrowly tailored in this fashion.
- It does seem clear that the proposal is projected by the Administration to result in a significant expansion of the current US tax liability of US-based multinationals.
Permanent Extension of R&E Credit
The permanent extension of the R&E credit is intended to initiate new research projects that will improve productivity, raise standards of living, and increase US competitiveness, and as emphasized in the proposals, provide an important incentive for businesses to create new jobs.
IV. Possible Political Implications
Congressional Democrats are likely to welcome the President's tax proposals, especially given that many of them were previously proposed by senior legislative tax writers (for example, the proposal to match domestic deductions for overseas operations to the repatriation of that income was proposed two years ago by House Ways and Means Committee Chairman Charles Rangel (D-New York)). There is also likely to be some relief in Congress that the President has limited his proposals to practices deemed "abusive" rather than an outright attack on the concept of deferral, which appeared to be the position he took during the presidential campaign. Congressional Republicans are expected to attack the proposals as unwarranted tax increases during a recession which will hurt US competitiveness overseas.
Congress this fall will need to raise upwards of $1 trillion to offset the cost of enacting comprehensive health care reform, the President's top legislative priority, and these proposals are likely to be considered very seriously given that they raise $210 Billion. However, there is likely to be a spirited debate over whether they will help or hinder international trade and competitiveness of US companies. The President is expected to release additional tax proposals later in the week, including possibly other international proposals.
The debate on these and other international tax proposals will dominate the tax debate in Congress for much of the year with the possibility that some Members of Congress will in fact propose more aggressive restrictions on the use of US controlled foreign corporations and curbs on other practices that go beyond what the President has proposed. Over the summer, a great many multinational corporations and financial institutions are likely to become directly engaged in the legislative process and make their case directly to lawmakers.