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International Tax Reform: Perspectives on Reforming U.S.

Taxation of Foreign Business Income

Stephen E. ShayPartner, Ropes & Gray LLP

Lecturer in Law, Harvard Law School

Prepared for:

The President’s Advisory Panel on Federal Tax Reform

Washington, DC May 12, 2005

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May 12, 2005

Overview of Presentation

Take Away Points Reform Alternatives Appendix A: Planning Under

Current Law Appendix B: Assessment of

Current Law

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May 12, 2005

Take Away Points The taxation of foreign income

directly affects the U.S. tax base If foreign income is taxed at a lower

combined effective rate than U.S. income, taxpayers will shift U.S. income to foreign income

Reduced taxation of foreign income subsidizes U.S. investment in low-tax foreign countries - Why there and not in Des Moines?

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May 12, 2005

Take Away Points

Allowing high foreign taxes to be used as credits • to offset U.S. tax on low-taxed foreign

income, or • to offset U.S. tax on U.S. income treated

as foreign under current rules

subsidizes countries that impose high foreign taxes

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May 12, 2005

Take Away Points Today, US tax planners:

• reduce foreign taxes below U.S. effective rate,• defer U.S. tax on foreign income subject to low

effective foreign income tax, and• use transfer pricing to shift additional income to

low-tax deferral environment, and• when income is repatriated to the U.S., cross-

credit excess foreign tax credits from high-taxed foreign income to offset U.S. tax on low-taxed foreign income in same foreign tax credit limitation category

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May 12, 2005

Take Away Points This tax planning has been

rewarded by favorable court decisions and Congressional passage of homeland dividend relief• Untaxed earnings may be

repatriated for one year at effective U.S. tax rate of 5.25% or less if reduced by foreign tax credits

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May 12, 2005

Take Away Points There is no reason to tax a U.S. person’s

foreign income more favorably than U.S. income

A credit should be allowed for foreign tax to avoid double taxation of income

The unproven efficiency gains of lower taxation of foreign income do not outweigh: • the strong equity arguments against favored

treatment of foreign income• the very substantial complexity required to achieve

and defend favored treatment of foreign income• The inevitable and wasteful tax planning that will

result

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May 12, 2005

Take Away Points

Fundamental reforms, described below, that reduce the effective rate differential between U.S. and foreign income are feasible if tax reform broadens business tax base and lowers U.S. tax rate on business income

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May 12, 2005

International Tax Reform Alternatives

Fundamental international tax reform alternatives include:• Expand current taxation of U.S.-

controlled foreign corporation earnings, subject to a foreign tax credit that constrains cross-crediting, or

• Exempt active foreign business income that bears a sufficient effective rate of foreign tax (or have a functionally equivalent condition) to mitigate tax-motivated shifting of economic activity

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May 12, 2005

International Tax Reform Alternatives Expand Current Taxation of Foreign Income

• Expansion of current taxation of U.S.-controlled foreign corporation earnings, unlike exemption, would not encourage investment in lower-taxed countries

• Expansion of current taxation of U.S.-controlled foreign corporation earnings would encourage non-tax motivated redeployment of earnings (there would be no separate “repatriation tax”)

• Expansion of current taxation of foreign income would reduce many complexities arising from deferral

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May 12, 2005

International Tax Reform Alternatives

• Expanded current taxation of foreign income should be accompanied by improvements to the foreign tax credit to restrict cross-crediting against low-taxed foreign income and U.S. income masquerading as foreign income

• It also will be necessary to balance improved residence taxation of U.S. persons with stronger U.S. source taxation of foreign-owned business to discourage expatriation to foreign ownership

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May 12, 2005

International Tax Reform Alternatives A second best alternative: Exemption of

active foreign business income• An exemption proposal should require a

minimum foreign effective rate of tax or a functional equivalent as a condition for exemption of active foreign business income

• Like current taxation, exemption would eliminate the repatriation tax, but

• Exemption also would encourage U.S. persons who can perform some business activities abroad but who need the cash in their U.S. business to shift business functions abroad

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May 12, 2005

International Tax Reform Alternatives

Exemption of active foreign business income (cont’d)• It is critical not to exempt active

foreign business income that is not foreign and not subject to foreign tax or the problems of current law will remain and worsen

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May 12, 2005

International Tax Reform Alternatives

If the U.S. shifts to a consumption tax and does not continue to tax business income, • foreign countries will have little reason to

keep income tax treaties with the U.S.• foreign countries could increase their

income taxation of U.S. companies’ foreign business operations

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Appendix A

Planning Under Current Outbound International

Tax Rules

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May 12, 2005

Planning Under Current Rules - Deferral

US tax planners try to (and do)• reduce foreign taxes below U.S.

effective rate,• defer U.S. tax on foreign income

subject to low effective foreign income tax, and

• shift income to low-tax deferral environment

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May 12, 2005

Planning Under Current Rules - Deferral

Current transfer pricing rules allow income shifting to controlled foreign corporations in low-taxed countries

No penalty for singles and doubles, only for swinging for the fences and getting caught

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May 12, 2005

Planning Under Current Rules - Deferral

Planning rewarded (examples):• Dover case affirms use of (retroactive)

check-the-box planning to avoid Subpart F

• Hospital Corporation of America, UPS other transfer pricing cases affirm nothing ventured, nothing gained approach to transfer pricing and tax planning; DHL case an exception

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May 12, 2005

Planning Under Current Rules - Deferral

Planning rewarded:• In 2004, Congress passed homeland

dividend tax relief to encourage repatriation of foreign earnings

• Untaxed earnings may be repatriated for one year at effective U.S. tax rate of 5.25% or less if reduced by foreign tax credits

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May 12, 2005

Planning Under Current Rules – Foreign Tax Credits

When income is taxed by U.S., tax planners try to (and do):• Generate low-taxed foreign income

(using weak U.S. source rules), and• Use foreign tax credits from high-

taxed foreign income to offset U.S. tax on low-taxed foreign income in same limitation category

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May 12, 2005

Planning Under Current Rules – Foreign Tax Credits

Low-taxed foreign income may be from either • activities in low-tax foreign countries, or • U.S. activities that generate income that

Code allows to be treated as foreign income

Low- and high-taxed income may be created by separating foreign taxes and income using U.S. tax planning techniques – “check-the-box” planning and more

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May 12, 2005

Planning Under Current Rules – Foreign Tax Credits

Planning rewarded (examples):• Intel case and subsequent regulations

affirm source rule treating U.S. activity for export sales as foreign income

• Guardian Industries case affirms use of check-the-box planning to split foreign taxes from foreign income

• Compaq and IES cases affirm use of structured tax planning to trade foreign tax credits and weakness of anti-abuse doctrines

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Appendix B

Assessment of Current Outbound International

Tax Rules

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May 12, 2005

Assessment of Current Law Problems of current law are not

difficult to diagnose• Effectively unlimited deferral offers too

much of a rate differential for companies to resist – it is a hole in the system

• Like water draining from a bathtub, U.S. multinationals are legally shifting increasing portions of their profits to low- or zero-tax foreign countries See Martin A. Sullivan, “U.S. Multinationals Move More Profits to Tax Havens,” 102 Tax Notes 690 (Feb. 9, 2004)

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May 12, 2005

Assessment of Current Law Transfer pricing rules need

adjustments, but the biggest need is smarter enforcement

Weak source rules and broad cross-crediting high foreign taxes against U.S. tax on other “foreign” income under porous foreign tax credit limitation result in de minimis U.S. tax on repatriated foreign income

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May 12, 2005

Assessment of Current Law Joint Committee on Taxation:

“The present-law system thus creates a sort of paradox of defects: on the one hand, the system allows tax results so favorable to taxpayers in many instances as to call into question whether it adequately serves the purposes of promoting capital export neutrality or raising revenue…”. (JCS-02-05; Jan. 27, 2005)