Corporate Tax Changes Will Lead to International Tax Battles

December 14, 2017 2:30 PM
Photo Credit: 
REUTERS/Aaron P. Bernstein

With its plan to reduce the corporate tax rate and enact temporary expensing of capital outlays, Congress is poised to put US firms on a better competitive footing than many of their rivals based in Europe, Japan, and other advanced countries. But the Republican leadership is taking other steps to deter US firms from moving their operations to low-tax countries or transferring valuable patents, copyrights, and trademarks to such countries. Some of these actions will disrupt global supply chains and are certain to provoke protests and possible retaliation among US trading and investment partners, and possibly even legal action at the World Trade Organization (WTO).

The Tax Cuts and Jobs Act of 2017 (TCJA), which congressional leaders want to pass before Christmas, would lower the statutory corporate tax rate from 35 percent to 21 percent. This reduction, along with temporary expensing of capital outlays, is projected to cost $1.35 trillion over 10 years.

The TCJA also embraces the concept of territorial taxation—taxing corporate earnings properly attributed to activity in the United States but not earnings generated abroad. This change would align US tax law with the practice of most of its major trading partners. But to compensate for any lost revenue from that step, the legislation would extract a substantial amount of tax revenue from pre-2018 unrepatriated earnings held abroad by subsidiaries of US-based multinational corporations (MNCs). By some estimates, these corporations have parked $2.6 trillion overseas to avoid paying taxes when funds are repatriated to the United States. The TCJA would raise over $200 billion by taxing the cash and equivalent portion at about 14 percent and the reinvested portion at 7 percent.

The “excise” tax is the most objectionable feature in the legislation and possibly the most unworkable.

For post-2017 foreign earnings, the TCJA adopts what is called a “participation exemption” approach: Dividends from foreign subsidiary corporations will be generally exempt from US taxation—but with important exceptions. Congress feared that a pure territorial system would encourage US firms to locate facilities in low tax countries to serve the American market, purchase inputs from related firms in low tax countries, or continue to transfer patents, copyrights, and trademarks to such countries. So the legislation tentatively carves out certain exceptions to its territorial system. But these exceptions are what threaten tax battles if included in the final TCJA package.

  • In the House version of the TCJA, foreign firms that are affiliated with a US multinational and that sell goods and services (including royalties for the use of intellectual property) to their US parent, subsidiary, or sister firms must report the income earned as US “effectively connected income.” This income would then be subject to US “excise” taxation, while allowing a credit for 80 percent of foreign taxes imposed on the same income.[1] Alternatively, the US purchasing firm will be denied a deduction for such payments—generally a more burdensome prospect. The “excise” tax is projected to raise $88 billion over 10 years. But this excise tax idea is already stirring controversy. If enacted, it would discourage supply chain purchases and sales between related firms, at a time when much international trade is now related to components in vast supply chains. The legislation would thus punish firms reliant on purchases from affiliate companies overseas, effectively encouraging them to make these purchases from US-based affiliates or other companies. It would also encourage purchases between US firms and unrelated foreign firms, undercutting the general idea of keeping operations at home. This legislation discards the widely accepted “arm’s length” principle—in other words, the market price of the same transaction between unrelated firms—for determining what income is in the tax base of country A and what is in the tax base of country B. The “excise” tax is the most objectionable feature in the legislation and possibly the most unworkable.
  • The House version imposes the corporate tax on half of “high returns” earned abroad by a foreign subsidiary, technically known as a “controlled foreign corporation” (CFC). “High returns” are defined as returns more than 7 percent, plus the federal funds interest rate, calculated by reference to the adjusted basis of tangible property owned by the CFC. Given the half feature, with a federal corporate rate of 21 percent, “high returns” would be taxed at 10.5 percent, with no credit for foreign taxes paid. This provision is supposed to discourage US MNCs like Apple and Google from locating profitable intellectual property in low tax jurisdictions. It would raise $77 billion of US tax over 10 years. This is a plausible way of raising some revenue on future foreign earnings, but the denial of a credit for foreign taxes paid on the same income will raise hackles abroad.
  • The Senate version instead imposes a new “base erosion and anti-abuse tax” (BEAT). If cross-border payments to related firms reduce a US firm’s tax liability to less than 10 percent of its US “modified taxable income,” the BEAT would apply. After 2025, the key percentage rises to 12.5 percent. “Modified taxable income” is calculated by excluding deductions for payments to related foreign firms and US tax credits (e.g., for R&D). The BEAT is supposed to raise $135 billion over 10 years. But the mechanics of the BEAT are unbelievably complex—a gift to tax lawyers—and probably violate US tax treaties with foreign countries.
  • On the other hand, and distinct from the House version, the Senate version creates something like a “patent box” for US corporations that derive intangible income from abroad. Under this provision, the US corporation is taxed at a preferential rate of 13.1 percent on “foreign-derived intangible income.” The idea is to encourage US firms to originate and retain their intellectual property in the United States. The revenue cost is estimated at $64 billion over 10 years. This measure would go far to persuade US firms to keep their intellectual property at home, but because licensing fees generated in the United States would be taxed at a higher rate than licensing fees generated abroad, it raises the specter of an export subsidy prohibited by the WTO.

Whether or not these complicated exceptions accomplish their stated goals, they have already raised hackles among European trading and investment partners. On December 11, five European finance ministers wrote Treasury Secretary Steven Mnuchin (with copies to congressional leaders) objecting to the provisions described above. The ministers cite WTO trade rules that require national treatment of imports—in other words, the same tax treatment as applied to domestically produced goods. They also cite tax treaties that apply the arm’s length principle to determine each country’s tax base for related party transactions. The ministers go on to cite WTO rules that prohibit export subsidies—this with reference to the preferential 13.1 percent rate on intangible income from abroad.

As of December 14, it’s not publicly known what combination of House and Senate versions will be written into the final bill. But it seems certain that Congress will not tailor the TCJA to meet all the objections raised by European ministers. However, Congress should certainly drop the “excise” tax. Not only is the tax highly vulnerable to a WTO challenge and a clear violation of tax treaties, but if enacted it will also invite mirror image taxes in Europe and around the world.

Note

1 The characterization of the new tax as an “excise” tax is odd, since it is quite different from familiar excise taxes on alcohol or tobacco.