One More Controversial Corporate Pay-For in H.R. 3970: Deferral of
U.S. Deductions Allocable to CFC Deferred Income
By Kenneth J. Krupsky,
Esq.
Jones Day, Washington, DC
Chairman Rangel's “Tax Reduction and Reform Act of
2007” (H.R. 3970), introduced on October 25, 2007, may or may
not be enacted, but it certainly does suggest some interesting new
ideas in U.S. international tax policy. Most of the international
corporate provisions are revenue-raisers intended as
“pay-fors” with respect to the bill's proposed reduction
of the top corporate marginal tax rate from 35% to 30.5% (as well as
repeal of the alternative minimum tax for certain
“low-income” individuals). In his follow-up letter of
November 1 to Treasury Secretary Paulson, Mr. Rangel said that
“my bill eliminates a number of narrowly-targeted provisions to
crack down on corporations that have received favorable or unfair
treatment at the expense of other taxpayers.”
One such “crack-down,” §3201 of H.R. 3970, would
disallow deductions to the extent allocable to deferred income of
controlled foreign corporations (CFCs). The Ways and Means Committee's
summary of this proposal is not a model of clarity. It says,
“Current law allows United States corporations to defer active
business income that is earned through controlled foreign
corporations. However, these corporations are allowed to take the
deductions associated with this income into account on a current
basis. This inconsistency encourages United States corporations to
shift jobs overseas and to finance these overseas activities at the
expense of taxpayers.” Note that foreign income is characterized
as “earned through,” rather than the more accurate
“earned by,” which might be read by some folks as hinting
at nefarious tax planning, engineering, conduiting, etc. Note that
deductions that the bill would disallow and defer are those
“associated with” the CFC's deferred income. The
suggestion seems to be that such deductions “should not”
be allowed to reduce the gross taxable income of the U.S. parent
corporation, presumably because they are not a cost of earning that
gross income but rather are a cost of earning the CFC's deferred
income. How could existing--including, by the way, §482--law have
gotten this mismatching of income and deductions so terribly wrong?
This proposal is estimated to raise $106.39 billion over 10 years.
How does the proposal work? Again, and quite understandably,
clarification is needed. New §975 of the Code would state that
“foreign-related deductions” for any taxable year: (1)
shall be taken into account for such taxable year only to the extent
that such deductions are allocable to “currently-taxed foreign
income”; and (2) to the extent not so allowed, shall be taken
into account in subsequent taxable years. Foreign-related deductions
shall be “allocated” to currently-taxed foreign income in
the same proportion which currently-taxed foreign income bears to the
sum of currently-taxed foreign income and deferred foreign income.
Here are the critical definitions. “Foreign-related
deductions” means the total amount of “deductions and
expenses” which would be “allocated or apportioned”
to gross income from sources without the United States for the taxable
year if both currently-taxed foreign income and “deferred
foreign income” were taken into account. “Currently-taxed
foreign income” means the amount of gross income from sources
without the United States for the taxable year (determined without
regard to repatriated foreign income for such year). “Deferred
foreign income” essentially means all earnings and profits of
all CFC (treated as if they were one CFC), less actual dividends paid
and Subpart F inclusions. The bill does not say whether the
“deductions and expenses” at issue are limited to items
otherwise currently deductible by the U.S. parent corporation, or
whether these terms also include the deductions and expenses of its
CFCs. Let's assume the former is meant. The bill does not define
“allocated or apportioned” (do we look to existing
§861?) but all in due time.
Let's take a simple example. U.S. parent corporation (USP) operates
a U.S. business in which it earns U.S.-source gross income of $500,
incurs U.S. operating expenses (let's put aside interest and R&D
to save a few brain cells) to earn that income of $300, and so has net
U.S. taxable income of $200. USP has a CFC which earns foreign-source,
non-Subpart F gross operating income of $300, incurs foreign operating
expenses to earn that income of $200, and so has net deferred income
of $100. There are no dividends paid and no Subpart F inclusions. One
way to read the bill would be to say that the $300 of U.S. operating
expenses is at issue. So that $300 amount is the
“foreign-related deductions” to the extent it would be
“allocated or apportioned” to currently-taxed foreign
income (in this case, zero) plus “deferred foreign income”
(in this case, $100). So let's assume the bill (or its legislative
history, or a later Treasury regulation) tells us to allocate the $300
in the ratio of deferred foreign income ($100) to the aggregate net
income of USP and CFC together ($200 plus $100, equals $300). This
means that 1/3 ($100/$300) of the $300, or in this case $100, is not
currently deductible on USP's U.S. tax return.
This seems to me quite a remarkable result. USP incurred $300 of
U.S. operating expenses to earn $500 of U.S. gross operating income,
and so under existing law USP is taxed on net U.S. income of $200.
Under the proposal, it seems USP is taxed on net income of $300 (i.e.,
$500 less $200). Again, the tax policy “principle” seems
to be that some of the U.S. operating deductions helped to earn (they
are “associated with”) the CFC deferred income. If these
expenses in fact helped to earn the foreign income rather than the
U.S. income, why are they deductible in the United States under
existing law? If they did not help to earn the foreign income, but
only the U.S. income, how can the bill disallow (defer) the U.S.
deduction? What happened to the matching principle?
One more query. If the U.S. expenses are thought to have helped to
earn the CFC deferred income, should not we also suppose that some of
the CFC's deferred expenses helped to earn the U.S.-source
currently-taxed income? Shouldn't we “allocate and
apportion” some of the $200 as against the $500? Perhaps
taxpayers will be permitted to demonstrate to the satisfaction of the
IRS that foreign deductions helped earn U.S. income? I suppose the
answer is no. Too bad. If Congress doesn't like deferral under
existing Subpart F, let's face up to that and change it, but let's not
impose our income tax on gross rather than net U.S. income.
This commentary also will appear in the January 11, 2008, issue
of the Tax Management International Journal. For more
information, in the Tax Management Portfolios, see Renfroe, Gannon,
Lange, Gordon, et al., 906 T.M., The Allocation and Apportionment
of Deductions, and in Tax Practice Series, see ¶7130, U.S.
Persons' Foreign Activities.
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