Recent Additions

Chairman Rangel Consolidates His Thoughts on International Tax Reform By James J. Tobin, Esq. Ernst & Young LLP, New York, NY On October 25, 2007, House Ways & Means Committee Chairman Charlie Rangel, with much fanfare, introduced H.R. 3970, the Tax Reduction and Reform Act of 2007. Immediately dubbed “the mother of all tax reform” by its creator, the bill also picked up the added moniker of “the mother of all tax increases” by its detractors. The bill is big, both in number of pages and in scope. It would eliminate the individual alternative minimum tax and reduce the corporate tax rate to 30.5%, while raising the top individual rates and, in a nod to the post-Reagan concept of tax reform, broaden the base. Simplification, though, is not part of the plan, as will become clear from a look at the international provisions. In addition to eliminating the §199 domestic production deduction, codifying the economic substance doctrine, and putting the last nail in the coffin of interest-charge DISCs, the bill also includes two international provisions we've seen before--repeal of the worldwide allocation of interest expense and a variation of Senator Doggett's treaty shopping proposal. But there are also three new provisions that are particularly interesting in that they're set within a framework of consolidation calculations with respect to the operations of a U.S. company's foreign group. These consolidation concept proposals, which would significantly impact the manner in which U.S. multinationals would be taxed on foreign income, include the following: • Disallow current deductions for expenses allocable to un-repatriated foreign income; • Require year-by-year layering with respect to foreign tax credit calculations; and • Make significant changes regarding translation of foreign E&P and taxes. The consolidation concept is revolutionary and, in addition to yielding some different and unexpected results, would appear to carry with it potentially tremendous complexities; just think about the highly complex U.S. consolidated tax rules, including such items as deferred inter-company transactions and inter-company eliminations, the effect and treatment of different currencies, and so on. And, as we'll see, many aspects of the proposal have not been fully thought out and would require a good deal more analysis by the drafters. He’s Got the Whole Worldwide in His Hands The American Jobs Creation Act of 2004 included within its own broad provisions new §864(f), allowing multinational groups to allocate and apportion interest expense on a worldwide basis at the election of the taxpayer. The provision contained a delayed effective date such that §864(f) is to apply for taxable years beginning after December 31, 2008. The Rangel bill would repeal the provision. I find it particularly interesting that Mr. Rangel is opposed to a worldwide (in effect, consolidated) approach for interest expense given his penchant for applying such an approach in the three new aspects of his international reform proposal. Perhaps much of the motivation for repealing §864(f) is the 10-year, $26 billion revenue estimate attached to the proposal. Incidentally, the original measure was scored to cost about $14 billion for the 2005-2014 period, although its delayed effective date meant the years 2005-2008 were not covered. That might (or might not) account for the difference. In any case, if I understood the black art of revenue estimating, I'd probably be sitting on a mountaintop with my legs crossed. Of course, it may be that by the time the Rangel bill is taken up, much of the revenue attributable to repeal of worldwide may be gone, since both three-year and nine-year delays have been included as raisers in other introduced bills. And Speaking of Raising Revenue--Delay of Deductions In his own commentary, Ken Krupsky has analyzed the new rules pertaining to the delay of deductions, so in the interest of avoiding redundancy, I'll try to keep my comments to venting over the implications of the proposal to disallow certain deductions currently, and the foreign tax credit and currency translation provisions and their complexity. The proposed repeal of §864(f) is child's play--not to mention small potatoes--compared with the Rangel bill's proposal to disallow current deductions for expenses allocable to un-repatriated foreign income. Estimated to raise a whopping $106 billion over the same 2005-2014 measuring period, the proposal is one that hasn't been seen before and appears extremely unwelcome. In this regard, the intent of the new rules seems clear--no deduction should be allowed for U.S.-incurred expenses relating to deferred foreign earnings until those earnings are actually repatriated--although portions of the rules are rather difficult to decipher in their current form. Under the bill, “foreign related deductions” (FRD) would be taken into account only to the extent allocable to currently taxed foreign income (CTFI). The remaining deductions would be classified as “previously deferred deductions” (PDD). FRDs would consist of all deductions that would be allocated and apportioned to gross income from sources without the United States if both CTFI and “deferred foreign income” (DFI) were currently taxable. Note that DFI is the excess of: (1) the amount that would be includible as Subpart F income if all CFCs were treated as one CFC and all (current-year) E&P of all CFCs was Subpart F income; over (2) the sum of all dividends received from CFCs plus §951(a) inclusions. In figuring what deductions are currently allowable, it would seem to be necessary to first perform the §861 allocation to identify the FRDs, i.e., all deductions that are related to foreign income--both CTFI and DFI--including, it appears, non-deferred foreign income such as third-party royalties. That amount of FRDs is then multiplied by a fraction, the numerator of which is currently taxed foreign income (CTFI) and the denominator of which is total foreign income (CTFI + DFI). The result is the portion of the FRDs that is deferred. (For additional details on this proposal, please see Ken Krupsky's commentary.) Thus, the consolidation concept comes into play here in treating all CFCs as one CFC. It seems unclear whether the approach would be to simply add up the results of all the CFCs or to do a true consolidation calculation, which could yield very different results in terms, for example, of taking into account intercompany eliminations and so forth. As noted, in figuring what deductions are currently allowable, it would appear that the concepts of §861 would be contemplated in terms of the calculation of deductions attributable to foreign income and, thus, some formulary apportionment of interest and R&D would continue, as well as the statutory groupings for SG&A and other expenses. But given the worldwide approach, query whether some of the fundamental principles of the existing apportionment regulations would be modified. In addition, with respect to deferred deductions, it is also unclear whether the eventual triggering of the delayed deductions would be done on a LIFO, FIFO, or aggregate basis with respect to income that is deferred in the CFCs. And what if your CFC group earns $100 in year 1 and loses $100 in year 2? Would losing money in essence be a deemed repatriation or are the PDDs now permanently previously deferred deductions (PPDDs?)? Some Scary FTC Stuff Here's the second area where the consolidation concept comes into play. Consistent with looking at all CFCs as a single CFC for purposes of determining DFI, as mentioned above, under new §976 it appears that foreign income taxes paid by all CFCs for the year must be pooled for purposes of determining the credit that comes along with any dividend actually paid by one or more CFCs. As a result, a credit is allowed only for the same portion of foreign taxes for the year that equals the amount of earnings repatriated by one or more CFCs over total foreign earnings, repatriated as well as deferred (CTFI + DFI). This will in many cases substantially reduce the amount of the §902 credit for the year. For example, assume: CFC1 CFC2 CFC3 Accumulated E&P 1,000 2,000 2,500 Accumulated Taxes 1,000 -0- 1,250 2008 E&P 100 200 200 2008 Taxes 100 -0- 125 Under current law, if CFC1 distributes a 100 dividend, the §902 credit would be calculated as follows: 100/1,100 x 1,100 = 100 Under proposed §976, however, under which all CFCs are considered a single CFC for this purpose, it appears that the §902 credit would be 45, calculated as follows: Total foreign income taxes [225] x (CTFI [100] over (CTFI [100] + DFI [400])) = 45 Of course, it would be even worse if there was in the above example a CFC4 that had, say, a 600 deficit in E&P in 2008 so that there was a current year loss within the “single” CFC. Under these circumstances, if CFC1 paid a 100 dividend, there might be no §902 credit at all. The bill's approach of requiring year-by-year layering moves us away from the adoption of a pooling system in the 1986 act, a change that was made in reaction to the complexity and recordkeeping difficulties of the previous layering system. Going into a consolidated layering system takes the complexities to a new level; consider that when you exhaust the post-2007 layers, you go back to the 1987-2007 pools and then, when those are exhausted, to the pre-1987 layers. Oh boy! It's also intriguing to think about the implications the proposed rules could have for acquisitions and dispositions. As noted above, under the proposed rules, when a CFC pays a dividend the effective foreign tax rate on that dividend will depend on the entire CFC group's earnings and taxes. Thus, combining with a target group of CFCs could have the effect of significantly changing the effective rate on post-acquisition dividends paid by a CFC since the annual earnings and taxes of the combined group will now be the measure for those items. And then there's the question of offsetting losses of some companies against profits of others in the consolidated calculations and the impact on the annual layers of each subsidiary, taking into account loss years and profit years, which will be great fun to contemplate! Many other questions also arise. What happens, for instance, in the case of joint venture companies owned by two different groups? Are their earnings also consolidated with those of the joint venture partners' CFC groups or are they kept separate? As noted at the outset, the drafters clearly have not yet considered all of the proposal's implications and much more thought will be needed before these aspects of the Rangel bill, at least, can be considered a serious proposal for international tax reform. Note that new Code §§975-977 would be effective for taxable years beginning after 2007. Lost in Translation? That pesky consolidation concept appears again in the Rangel bill's proposed revision of §986. Once again, the bill maintains its internal consistency, so to speak, in that the §986 change is done in a manner that parallels the new §975 and §976 proposals by requiring currency gain to be computed based on the amount that would have been included if allearnings were distributed each year. Thus, earnings are to be translated at the rates in effect in the years the income was earned, thereby in essence treating the earnings as if they had been distributed in full in those years. Thus, when distributed, it is very likely that some portion will be treated as other than a dividend. For example, assume the following: 2008 Earnings 2009 Earnings 2010 Earnings Total 2008 -- 2010 Foreign Currency (u) 100u 100u 100u 300u U.S. Dollars $100 $150 $150 $400 • Distribute 300u on December 31, 2010, which is equal to $450 if entire 300u is translated on that date • Currency gain is $50: $450 - $400 Again, let's think about this rule in the context of a complex group having, say, loss members and profit members, multiple ownership tiers, check-the-box subsidiaries with different currencies, less than 100%-owned CFCs, and acquisitions and dispositions of group members. Wow! Makes §987 concepts seem simple. (And speaking of which, what did ever happen to those proposed §987 regulations, anyway?) Foreign-Owned Companies Not Left Out--“Doggett” Provision The Rangel bill also includes a modified version of a provision that was included in the House farm bill--H.R. 2419--and crafted by Rep. Lloyd Doggett. The Rangel modification is intended to address criticism of the Doggett version based on its treaty override effects. The provision in H.R. 2419 proposed that the amount of withholding tax in the case of any deductible related-party payment “shall not be less than the amount which would be imposed if the payment were made directly to the foreign parent corporation.” By contrast, the provision included in H.R. 3970 changes this language slightly by proposing that the withholding tax in the case of any deductible related-party payment “may not be reduced under any treaty of the United States unless any such withholding tax would be reduced under a treaty of the United States if such payment were made directly to the foreign parent corporation.” It appears that as long as there is a treaty between the United States and the foreign parent's country (and the treaty lowers the relevant withholding tax), the treaty between the United States and the recipient's country will apply, even if the withholding rate in that treaty is lower. Given this change, it would appear that the “Doggett” provision would have a somewhat better chance of enactment, whether as part of the Rangel bill or otherwise. Nevertheless, it still appears to mean that a foreign “intermediary” company that is a subsidiary of a non-treaty company--say an intermediary company used to hold a foreign group's U.S. and perhaps other non-local operations--could never take advantage of a treaty between its country of residence and the United States, even though it qualified under an LOB provision. I can't imagine that our treaty partners would accept such a result. So, What Are the Odds of Passage? It seems pretty clear that the Rangel bill will not move this year or even next. Having said that, it also seems pretty clear to me that it represents an indication of the direction tax policy is headed under the stewardship of the current leadership in Congress. Accordingly, it seems reasonable to assume that a number of its provisions will in fact see the light of day sooner or later, possibly as part of other tax bills. In this regard, deferral of the effective date, if not termination, of the worldwide interest expense apportionment rule seems highly likely, quite possibly in the shorter term, along with the codification of economic substance and enactment of the Doggett provision. On the other hand, given the complexities and all of the issues to be resolved in connection with the three new--and revolutionary--consolidation-based provisions, it seems possible that a workable proposal will never be arrived at, although given the huge revenue estimate, it also seems likely that the drafters will at least try. It may be that this is simply a strategy to make ending deferral seem more palatable, although one would hope this is not the case. Fasten your seat belts, it's going to be a bumpy ride. 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 Isenbergh, 900 T.M., Foundations of U.S. International Taxation, and in Tax Practice Series, see ¶7110, Foreign Income Taxation--General Principles.

Related Links: Author Listing