On Feb. 2, the Obama administration unveiled its fiscal year budget calling for a new minimum tax on the foreign earnings of US corporations. The proposal would trigger a one-time 14 percent tax toll on the previously untaxed foreign earnings of US multinationals and implement a minimum 19 percent tax on their ongoing offshore profits. The proposed regime would have a dramatic effect on the global tax strategies of US businesses and substantially reduce the ability of US multinationals to defer US taxation of their foreign earnings.
Further away from a territorial system
The minimum foreign tax proposal included in the fiscal year budget, along with a broader set of international tax proposals, represents a fundamental shift from the way the US tax system has been dealing with the foreign operations of US multinationals. Under current law, the foreign subsidiaries of US companies are generally not subject to federal tax as long as their earnings are not repatriated to the US. In order to prevent the indiscriminate shifting of income toward low-tax jurisdictions, a sophisticated set of rules would apply to US owners of controlled foreign corporations (CFCs) under the new rules. The current CFC regime requires US businesses to include in their current US tax base the undistributed profits of their foreign subsidiaries when such profits fall into certain limited categories of passive and highly mobile income (Subpart F income). Offshore earnings that escape these provisions may still be taxed in the US if the funds are made available to the US headquarters via loans or otherwise employed to fund US activities.
The proposed tax would affect US corporations currently subject to the CFC rules and it would complement, rather than replace, the existing CFC regime. To the extent the undistributed earnings of a foreign subsidiary escape current tax under existing rules, they would be subject to federal tax at a flat 19 percent rate. The minimum tax would also apply to the income earned by a US company through a foreign branch.
The minimum tax would be reduced by 85 percent of the foreign taxes paid by the subsidiary. Thus, profit taxed by a foreign country at a rate of 22.35 percent or more would bear no residual US tax. The effective rate of foreign tax will be determined under a five-year average computation. For this purpose the pools of foreign taxable income and foreign creditable taxes would be aggregated on a country-by-country basis. Special rules would prevent the use of hybrid arrangements to artificially inflate the effective foreign tax rate available for offset. Also, the minimum tax base would be reduced by an allowance intended to provide a “risk-free” return on the foreign investments free of US residual tax.
A companion “transitional measure” complements the proposal and deals with the profits accumulated by US multinationals in foreign low-tax jurisdictions—free of US tax—and currently kept offshore. A one-time, catch-all 14 percent tax would be imposed on such profits payable by the US owners ratably over five years. A credit for 40 percent of the taxes paid to foreign jurisdictions would be available.
How US multinationals’ global tax could look
In the world envisioned by the administration, there would be no deferral of US tax on profits kept offshore. All the earnings of a CFC would be included in the taxable base of its US shareholders on a current basis and regardless of actual distributions. US multinationals’ global tax rate on offshore earnings would be, overall, no less than 19 percent. A substantially higher global rate would apply to the “bad income” currently targeted by the CFC regime; these profits would remain subject to ordinary corporate US tax rates and eligible for credit under the existing foreign tax credit rules.
Conversely, repatriations from foreign subsidiaries would generally be exempt from US tax because all the earnings would have already been subject to tax under the 19 percent minimum tax, the current CFC inclusion provisions, or the one-time 14 percent toll.
Conventional foreign tax credit relief, with some modifications, would still be in place with respect to certain foreign source payments received by US companies such as royalties and interest. Arguably, coordination between all these layers of taxation would add complexity to an area of federal tax which has grown more and more convoluted over the years.
The stated goal of the controversial proposal is to remove the incentives for US multinationals to shift their production and profits abroad. The administration is also seeking an easy-to-administer system to crack down on US multinationals’ practices aiming at eroding the US taxable base without triggering the anti-deferral rules currently in place.
Commentators in the business community have noted that the proposed regime, weakening the competitive position of US businesses in the international landscape, could indeed offer further incentives for US multinationals to “invert,” abandoning their US residency altogether. Congressional Republicans have strongly criticized the tax increase. However, in the broader context of a reform of the corporate tax system, contemplating a reduction of the maximum corporate rates, this budget proposal may represent the first step in the negotiation toward common ground. It will be important to monitor the debate as it moves to the next stages.
While it is likely that parts of the president’s budget will be rejected by the Republican-controlled House and Senate, both President Obama and key Republican leaders have indicated they plan to focus on major tax reform legislation with this Congress.
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