Fundamental international tax reform on the horizon

Obama administration’s FY 2016 budget proposal

There has been much heated debate on international tax reform and no one doubts that changes are imminent. The Organization for Economic Co-operation and Development (OECD), currently made up of 34 countries including the United States, has been discussing how to combat base erosion and profit shifting (BEPS) and implement fundamental changes to the international tax landscape. On this side of the Atlantic, the Obama administration on Feb. 2, 2015, released its fiscal year 2016 budget along with The US Department of Treasury’s release of the General Explanation of the Administration’s Fiscal Year 2016 Revenue Proposals (the Greenbook). The discussion below provides a high-level overview of the proposed changes.

The Budget of the United States Government, Fiscal Year 2016 (the budget) echoes the administration’s ongoing support for business tax reform that would lower the top US corporate income tax rate to 28 percent (with a 25 percent rate for income generated by domestic manufacturing operations). For US corporations with subsidiary operations abroad, the focus of the administration appears to have shifted from outbound intellectual property transfers and base erosion to minimum and transition tax concepts that, if implemented, would represent a significant change to the US international tax system.

The administration’s proposal generally calls for (i) a 100 percent exemption on dividends from controlled foreign corporations (CFCs), (ii) a 19 percent worldwide minimum tax on foreign earnings, and (iii) a 14 percent tax on pre-effective date earnings of CFCs as a one-time transition tax into the new regime (transition tax). The international tax proposals in the budget would generally be effective for either tax years beginning after Dec. 31, 2015 or transactions occurring after that date. The main exception is effective on the date of enactment as the transition tax, which will apply to earnings for tax years beginning before Jan. 1, 2016.

While the administration’s budget contains over twenty proposed changes that impact the international tax provisions of the tax code, the focus of this article is to discuss the aforementioned transition tax and minimum tax on foreign earnings.

New proposals

Impose 19 percent minimum tax on foreign income of US companies and CFCs

Subject to the rules of Subpart F, US multinational companies generally defer US tax on the profits earned by their foreign subsidiaries until those profits are repatriated back to the United States. The Greenbook asserts that the ability to defer US tax on CFC earnings until the profits are repatriated provides an incentive for US multinationals to shift profits abroad and discourages them from repatriating foreign earnings.

The budget proposes to supplement (not replace) the existing Subpart F regime with a per-country minimum tax on the foreign earnings of US corporations and their CFCs. The minimum tax would apply to a US corporation that either (i) is a United States shareholder of a CFC, or (ii) has foreign earnings from a branch or from the performance of services abroad. The administration’s proposal would subject those foreign earnings to current US federal income tax at a rate (not below zero) of 19 percent less 85 percent of the per-country foreign effective tax rate, termed the “residual minimum tax rate”. Since this minimum tax on foreign earnings is intended to effective cause current US tax on all foreign earnings, the budget proposals would provide for a 100 percent exemption for dividends received from CFCs.

The country to which foreign earnings and taxes are assigned would be determined based on tax residence under foreign. Earnings and taxes of a single CFC may be further allocated to multiple countries if the CFC has earnings subject to tax in multiple countries. In such cases, all of the earnings and associated taxes would be assigned to the highest-tax country. For example, if a CFC incorporated in high-tax Country A has a permanent establishment in low-tax Country B, and both Country A and Country B tax the permanent establishment’s earnings, the earnings and all the associated taxes would be assigned to Country A.

The foreign effective tax rate would be calculated by aggregated all foreign earnings and associated foreign taxes assigned to a country for the sixty months preceding the current tax year-end of the US corporation or CFC. The relevant foreign taxes are those that would be creditable under the principles of section 901 during the 60-month period. The relevant foreign earnings would generally be determined under US tax principles, except that they would include disregarded payments deductible elsewhere and would exclude dividends from related parties and payments on certain hybrid arrangements.

The mechanics for calculating the minimum tax for each particular country is explained in the Greenbook. This would involve multiplying the applicable minimum tax rate (described above) by the minimum tax base for that country. A US corporation’s tentative minimum tax base with respect for the year would be the total foreign earnings assigned to that country. This tentative minimum tax base would be reduced by an allowance for corporate equity (ACE). The ACE would equal a risk-free return on equity invested in active assets (i.e., those that do not generate foreign personal holding company income such as dividends, rents, and royalties) determined without regard to any look-through rule or check-the-box election. The ACE is generally intended to exempt from the minimum tax a return on actual business activities.

This proposal, if implemented in its entirety, would be imposed on current foreign earnings regardless of whether or not they are repatriated to the United States in the current year. Therefore, all foreign earnings could then be repatriated without further US tax (thus the reason the budget proposal provides for a 100 percent exemption on dividends paid by CFCs). Therefore, US income tax would be imposed on a CFC’s earnings either immediately (under Subpart F or the minimum tax) or not at all (if all CFC income was subject to sufficient foreign tax or was exempt after applying the ACE).

This proposal, if implemented, would also impact several other areas in the international tax provisions in the tax code. While a detailed description of these items is outside the scope of this article, it should be noted that these changes would include (i) the repeal of section 956 rules on CFC investments in US property and section 959 previously tax income rules for US corporate shareholders, and (ii) treating a US corporation’s foreign branch like a CFC such that if a foreign branch used its owner’s intangibles, the branch’s royalty payments to its owner would be recognized for US tax purposes.

14 percent transition tax on accumulated foreign earnings

In connection with the transition to the minimum tax on foreign earnings discussed above, the budget proposes to impose a one-time 14 percent transition tax on earnings accumulated in CFCs and not previously subject to US tax, payable over five years. The transition tax would allow a credit for the amount of foreign taxes associated with such earnings multiplied by the ratio of the one-time tax rate to the maximum US corporate tax rates for 2015 (14 percent/35 percent, or 2/5). The accumulated earnings to which the transition tax applies would then be repatriated without any additional US tax liability.

It should be noted that unlike former Rep. Camp proposal’s version of this rule, the budget proposal would not provide a lower rate for earnings that have been reinvested in business assets. Therefore, this could significant issues for companies that have used their CFCs’ earnings to develop and expand overseas operations and do not have liquid assets available for paying the tax.

Conclusion

The administration’s budget includes new proposals that would significantly change the way US corporations with operations abroad would be taxed. Most significantly (and the focus of this article) is the proposal to impose a new 19 percent minimum tax on foreign earnings, as well as the companion proposal to impose a one-time 14 percent transition tax on previously untaxed earnings.

It should be noted that, while not discussed in this article, the budget also contains several international tax proposals aimed at addressing concerns similar to those addressed by the OECD BEPS project. For example, the budget contains several provisions aimed at curbing the use of hybrid entities and arrangements and excessive interest expense and addresses the taxation of digital goods and services, all of which are BEPS-related concerns.

While these proposals are by no means guaranteed to become law in the current year as they represent only the first step in introducing tax reform proposals, it is important that tax executives at least be aware of these proposals so they can evaluate the potential effect on their companies’ overall tax strategy. As Congress continues work on the development of a comprehensive tax reform package, the international tax proposals contained in the budget, which scored as raising significant revenue in the aggregate (estimated at over $500 billion over the next decade), are sure to be a likely part of the dialogue.

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