On May 4th, President Obama announced a number of proposals to reform U.S. international taxation by curbing purported abuses through the use of tax havens and otherwise reducing or eliminating purported tax incentives for companies perceived to have moved jobs overseas (the "Proposal"). The Proposal is consistent with the Administration's campaign promises, as well as with prior bills introduced in Congress seeking similar reforms.
The battle lines are now drawn. Supporters of the Proposal seek to generate $210 billion in additional government revenue. Detractors are concerned about the impact these changes will have on U.S. companies with international operations and revenues - companies that are already subject to one of the highest corporate tax rates in the world. The Obama administration has stated that it is open to reducing the U.S. corporate income tax rate; however, that is not in the Proposal. Will the Proposal create jobs by incentivizing innovation through making the Research and Experimentation credit permanent? Or will the Proposal further contribute to unemployment, inability of U.S. companies to compete globally and cause a migration of investment capital from the U.S. to other parts of the world where competing countries are seeking to take the lead in innovation? Does the Proposal truly "level the playing field" as the Obama Administration states or does it unduly increase the burden on U.S. companies to compete in a global economy? Carl Guardino, CEO of the Silicon Valley Leadership Group stated, "On a Richter scale of 1 to 10, this is about a 20."
One thing is crystal clear; there will be increased scrutiny by the IRS on international tax matters. Compliance is a top priority as evidenced by the fact that the Proposal seeks funding for the IRS to hire 800 more professionals (lawyers, economists and accountants) specifically to handle increased international tax enforcement.
Congressional reaction to the Proposal has been mixed. The tenor of comments evidences a desire to balance concerns regarding illegitimate offshore shenanigans with the importance of keeping domestic businesses competitive in a global marketplace. Senate Finance Committee Chairman Max Baucus said on May 6 that although "our corporate international tax system needs reforming … further study is needed to assess the impact of this plan on U.S. businesses." Stressing the need to "make certain that our tax policies are fair and support the global competitiveness of U.S. businesses," Baucus said he looked "forward to sitting down with the Administration soon to take up these issues." Finance Committee ranking member Charles E. Grassley said that if the President is "using tax shelters as a stalking horse to raise taxes on corporations at the cost of U.S. jobs, he'll lose me." Senate Budget Committee Chairman Kent Conrad, on the other hand, supported the Proposal, saying far "too many big corporations and wealthy individuals have been using offshore tax havens to evade paying taxes that they owe. . . . This abuse has to stop."
Summary of Proposals
1. Reforming Deferral Rules to Curb Tax Advantages for Investing and Reinvesting Overseas
Currently, companies that have foreign subsidiaries are able to defer U.S. tax on the subsidiary's foreign earnings until they are repatriated. This allows U.S. companies to further invest in their international operations and markets (which over the past few years has been increasingly important to U.S. companies' revenues) on a pre-U.S. tax basis. This deferral, which is already subject to numerous and complex anti-deferral provisions, allows U.S. companies to compete effectively with their foreign counterparts who historically have had lower corporate income tax rates.
The Proposal would deny companies all deductions, such as interest expense, related to "untaxed overseas" income until the company repatriates the associated income. There would be, however, an exception for "research and experimentation" due to the Administration's view of the "positive spillover impacts of those investments on the U.S. economy." Furthermore, the Proposal would make permanent the Research and Experimentation credit.
2. Closing Foreign Tax Credit Loopholes
Currently, taxes paid to the foreign taxing authorities can generally be credited against U.S. tax liabilities. The foreign tax credit was intended to be available only for taxes paid on income that is taxable in the U.S. However, in some circumstances, it is possible to claim foreign tax credits for taxes paid on foreign income that is not subject to current U.S. tax. The Proposal would (1) require the foreign tax credit to be based on the amount of total foreign tax the taxpayer actually pays on its total foreign earnings, and (2) eliminate the ability to claim a foreign tax credit for foreign taxes paid on income not subject to U.S. tax.
3. Making R&E Tax Credit Permanent to Encourage Investment in Innovation in the United States
Currently, companies are eligible for a tax credit equal to 20 percent of qualified research expenses above a base amount, or they may take an alternative simplified research credit. The credit, however, has never been made permanent. Instead, it has been extended on a temporary basis 13 times since it was first created in 1981, and it is set to expire yet again at the end of 2009. The Proposal would make the R&E credit permanent, with funding generated through the proposed reforms to the treatment of deferred income and the use of the foreign tax credit, as explained above.
4. Getting Tough on Overseas Tax Havens and Eliminating Loopholes that Allow "Disappearing" Offshore Subsidiaries
Currently, if a U.S. company sets up a foreign subsidiary in a tax haven and one in another country, any income generated between the two subsidiaries (for example, through interest on loans) is considered "passive income" for the U.S. company and subject to U.S. tax. Through the use of the "check-the box" rules, U.S. companies can elect to treat one or more of these subsidiaries as "disregarded entities," and as a result, these subsidiaries effectively disappear for U.S. tax purposes. With the separate subsidiaries disregarded, the firm can shift income among them without reporting any passive income or paying any U.S. tax. As a result, U.S. firms that invest overseas are able to shift their income to tax havens.
The Proposal would abolish a number of tax-avoidance techniques by requiring U.S. businesses that establish certain corporations overseas to report them as corporations on their U.S. tax returns (i.e., treat "check-the-box" disregarded entities as separate corporations). The passive income shifted among these separate corporations then becomes Subpart F income subject to U.S. tax, regardless of when or if the funds are repatriated.
Currently, in regard to withholding tax for interest, dividends and royalties, the U.S. has developed a regime to combat international tax evasion. This is the "Qualified Intermediary (QI) Program", under which financial institutions sign an agreement to share information about their U.S. customers with the IRS. The regime, while effective according to the Administration, has become subject to abuse because (1) an investor can escape withholding requirements by simply claiming to being a non-U.S. person, (2) financial institutions can qualify as QIs even if they are affiliated with non-QIs, and since QIs are not currently required to report the foreign income of their U.S. customers, U.S. customers may hide behind foreign financial entities to evade taxes through QIs, and, (3) although U.S. investors overseas are required to file the Foreign Bank and Financial Account Report ("FBAR") disclosing ownership of financial accounts in a foreign country containing over $10,000, current rules make it difficult to catch those who do not file. This may be the case even when the IRS has evidence that a U.S. taxpayer has a foreign account. Legal presumptions currently favor the taxpayer. Without specific evidence that the U.S person has an account that requires an FBAR filing, the IRS cannot compel an investor to provide the report or impose penalties for the failure to do so.
The Proposal would create a presumption that institutions unwilling to be Qualified Intermediaries ("QI") are facilitating tax evasion, and the burden of proof will be shifted to the institutions and their account holders to prove they are not sheltering income from U.S. taxation. Furthermore, the Administration proposes to:
- Require U.S. financial institutions to withhold, at a rate of 20 to 30 percent, on U.S. payments to individuals who use non-QIs. To get a refund for the amount withheld, investors must disclose their identities and demonstrate that they are obeying the law.
- Create rebuttable evidentiary presumptions that any foreign bank, brokerage, or other financial account held by a U.S. citizen at a non-QI contains enough funds to require that an FBAR be filed, and that any failure to file an FBAR is willful if an account at a non-QI has a balance of greater than $200,000 at any point during the calendar year. These presumptions will make it easier for the IRS to demand information and pursue cases against international tax evaders.
- Give the Treasury Department authority to issue regulations requiring that a financial institution may be a QI only if all commonly-controlled financial institutions are also QIs. As a result, financial firms could not benefit from siphoning business from their legitimate QI operations to illegitimate non-QI affiliates.
- Improve the ability of the IRS to successfully prosecute international tax evasion by (1) increasing the penalties for failing to report overseas investments (e.g., double certain penalties when a taxpayer fails to make a required disclosure of foreign financial accounts); (2) extend the statute of limitations for international tax enforcement (e.g., set the statute of limitations on international tax enforcement at six years after the taxpayer submits required information); and (3) tighten lax reporting requirements (e.g., increase the reporting requirement on international investors and financial institutions, especially QIs.)
C. International Tax Enforcement
The Proposal seeks funding for the hiring of nearly 800 new employees devoted specifically to international enforcement. The funding would allow the IRS to hire new agents, economists, lawyers and specialists, increasing the ability of the IRS to pursue offshore tax avoidance and evasion, including transfer pricing and financial products and transactions (such as purported securities loans).
In light of these sweeping changes to the international tax provisions, companies should review their international operations and structures, as well as their international tax compliance, to determine the effect of these proposals. Whether all or a portion of the proposals will be adopted is unclear, but it is very clear that the IRS will be expanding its review of international tax matters. We are available to help companies evaluate their current international structure and provide an assessment regarding how these proposals may affect that structure.
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