Report released by top US Senate Finance Committee Republican calls for international tax reform

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1 22 December 2014 International Tax Alert EY Global Tax Alert Library Access both online and pdf versions of all EY Global Tax Alerts. Copy into your web browser: Services/Tax/International- Tax/Tax-alert-library#date Report released by top US Senate Finance Committee Republican calls for international tax reform Executive summary On 11 December 2014, US Senator Orrin Hatch, who is expected to be the Chairman of the Senate Finance Committee when the next Congress convenes in January 2015, released a report outlining various matters for lawmakers to consider in a comprehensive tax reform effort. Covering a wide range of tax policy issues in the individual, business, and international contexts, the report, titled Comprehensive Tax Reform for 2015 and Beyond (the Report), provide[s] background on where we are and where we have been with regard to our tax system as well as some possible direction on where our reform efforts should go in the near future. Importantly, Senator Hatch reinforced his call for a comprehensive approach that fixes the tax code for individuals and families as well as corporations and small businesses. The portion of the Report that discusses international tax reform specifically calls for the United States to move to a territorial type of tax system. The remaining discussion in the international section is much less prescriptive and focuses on identifying issues and potential options as part of international tax reform, such as the treatment of expenses incurred in the United States that are attributable to income of a foreign subsidiary that would be exempt from US tax under a territorial tax system and the need to address the potential for base erosion. The Report also notes that consideration should be given to enacting a patent or innovation box as part of international tax reform, particularly in the context of a move to a territorial tax system.

2 Detailed discussion The Report s first chapter, Introduction to Tax Reform, states, in part, that [t]ax reform should significantly reduce the high US corporate tax rate and also establish a territorial type of tax system, thereby placing US multinational companies on an equal footing with their foreign competitors when conducting business in other countries. The result would be more multinationals establishing or retaining their corporate headquarters in the United States; more exports to global markets; decreased pressure on US multinationals to invert; enhanced competitiveness of US multinationals against foreign-based multinationals in acquiring foreign target corporations; and reinvestment of resources in the United States rather than abroad. The Report further comments that the United States needs a tax system that does not encourage US multinationals to earn income abroad and then discourages those same US multinationals from bringing their cash earnings back home. Chapter 6 of the Report, International Tax Reform, provides more detail with respect to these calls for reform of the US international tax system. The chapter is separated into sections, as follows: (A) summary of hearings involving international tax reform, (B) theories of international taxation, (C) revenues from the US international tax system, (D) the need for a territorial tax system, (E) concerns regarding a territorial tax system, (F) patent or innovation box, (G) worldwide tax system with no deferral, (H) minimum tax, (I) foreign corporations, and (J) nonresident US citizens. Introductory comments in Chapter 6 highlight the significance of international tax in today s tax reform discussion, referencing recent activity involving corporate inversion transactions as evidence that the US international tax system does not operate in a manner that is fair, competitive and efficient. The Report states that [a] new company, if it is being properly advised on tax issues, would almost certainly benefit from incorporating in a foreign jurisdiction rather than the United States. It also states that further evidence that the current US international tax system is not working properly is seen in the fact that US multinationals are penalized when they repatriate earnings back to the United States which means that they have billions of dollars in earnings that are essentially trapped offshore as a result of our international tax system. Sections A-C Committee hearings, economic theories, and revenues The first section in Chapter 6 highlights recent Senate Finance Committee hearings on international tax reform, summarizing testimony from witnesses who advocated that the United States move to a territorial type of tax system. The second section provides a summary of various economic theories of international taxation, including capital export neutrality, capital import neutrality, national neutrality, and capital ownership neutrality. Referencing the fact that the United States has followed the principle of capital export neutrality in taxing the income of US multinationals earned outside the United States through a worldwide tax system coupled with a credit for foreign income taxes, the Report states that [t]he time has come to rethink and reform our international tax system. The third section identifies the revenues generated from the US international tax system, noting that US multinationals reported approximately $400 billion of foreign source net income annually for the years but that the US international tax system raises only about $25-$30 billion of tax revenue per year which represents the residual US tax on that income. Section D The need for a territorial tax system Put simply, the United States needs to adopt a territorial type of tax system, the Report states in the first sentence of this section. The Report notes that such a system would solve the problem of trapped cash overseas and put US multinationals and their foreign competitors on equal footing because foreign companies are currently taxed by the United States on a territorial basis. 2 International Tax Alert

3 The Report describes a dividend exemption system, sometimes called a participation exemption system, as the most common territorial tax system and as providing that a percentage of any dividend received by a US multinational from a foreign subsidiary would be exempt from US taxation. The Report also states that the exempt percentage could be adjusted to take into account expenses allocated to exempt foreign income (as opposed to allowing a full dividend exemption and disallowing certain deductible expenses) and to address revenue concerns. According to the Report, specific anti-base erosion measures would need to be enacted as part of a territorial tax system. The Report notes that variations of a dividend exemption system have been adopted by 28 of the 34 Organisation for Economic Co-operation and Development (OECD) countries. The Report goes on to discuss several issues that would need to be addressed if the United States were to adopt and transition to a dividend exemption system, including the treatment of existing foreign earnings that have not been subject to US tax, expenses that are allocated to exempt foreign earnings, and foreign branches of US multinationals. Regarding the treatment of preenactment foreign earnings, the Report identifies three principles that should guide Congress on this issue: (1) no continuing lock-out for foreign earnings, (2) no windfall to US multinationals, and (3) no windfall to the US Government. To eliminate the lock-out effect, the Report states that pre-enactment earnings should be mandatorily deemed repatriated and taxed. The repatriated amounts could be spread over many years and/or such amounts could be subject to a lower US corporate tax rate. To illustrate one idea of how this might be effectuated, the Report describes the approach taken in the tax reform proposal (H.R th Congress) offered by outgoing House Ways and Means Committee Chairman Dave Camp, which included taxing pre-enactment foreign earnings that are held in the form of cash or cash equivalents at 8.75% and other pre-enactment foreign earnings at 3.5%, with the tax payable over eight years. The Report states that a major issue in adopting a territorial tax system involves expenses of US multinationals that are allocated to exempt foreign income, which in principle should not be deductible. The Report indicates that the United States could utilize an approach similar to other countries with dividend exemption systems: rather than exempting the entire dividend from home country taxation, the home country exempts a portion (e.g., 95%) of the dividend. The portion (e.g., 5%) of the dividend that is taxable serves as a proxy for expenses that otherwise would be allocated to exempt foreign income and could be disallowed as deductions. In considering the amount of the dividend that might be taxable by the United States, the Report notes that for certain industries the appropriate amount may be 25-30% of the dividend. However, it also states that the resulting 70-75% dividend exemption would make the United States an outlier compared to other countries that have adopted a dividend exemption system and would perpetuate the lock-out effect. The Report further states that the simplest approach to addressing expenses might be to impose a proxy tax on the earnings of a foreign subsidiary. However, the Report notes that such a tax, imposed on an annual basis, would effectively eliminate deferral which would be a significant change from current law. Finally, the Report notes two options for addressing foreign branches in a dividend exemption system: fully tax the income of the foreign branch on an annual basis as under current law or exempt such income from taxation. The Report states that the latter option raises a series of issues that would need to be addressed as part of the design of the dividend exemption system. It also indicates that foreign branches could be treated as foreign subsidiaries, the effect of which would be to equalize the treatment of foreign branches and foreign subsidiaries in a dividend exemption system. Section E - Concerns regarding a territorial tax system One of the concerns cited by the Report regarding the adoption of a territorial tax system is the potential International Tax Alert 3

4 erosion of the US tax base through shifting income outside of the United States or shifting expenses into the United States. According to the Report, [a]nti-base erosion measures would need to be enacted to protect the US tax base. The Report cites as an example a low-tax kick-in rule that would treat income earned in a low-tax jurisdiction as subject to immediate US tax unless significant business activity were conducted in the foreign jurisdiction. The Report notes that both Chairman Camp s proposal and Senator Mike Enzi s proposal (S th Congress) included such provisions. In referencing research regarding the potential incentives to move assets and income abroad under a territorial tax system, the Report reaches the conclusion that although a territorial tax system may put more pressure on our transfer pricing rules and our sourcing rules, it is highly unlikely to result in shifting a significant number of jobs abroad. In addition, the Report cites studies by economists that suggest greater foreign capital investment and employee compensation lead to greater domestic investment and employee compensation, noting that foreign investment generally has a positive effect on domestic exports and research and development spending, resulting in greater demand for domestic output. Finally, the Report states that a move to a territorial tax system may encourage US multinationals to locate debt in the United States to generate deductible interest. Some of the debt could be related to financing foreign operations that generate earnings exempt from US tax. Therefore, the Report states that the United States may need to adopt a thin capitalization rule to prevent US multinationals from deducting an excess amount of interest expense. Section F - Patent or Innovation Box The Report describes a patent or innovation box as a tax incentive that takes the form of a reduced corporate income tax rate on certain income arising from the exploitation of intellectual property (IP). The Report states that a patent box can be viewed as a back end tax benefit, in contrast to research and development tax deductions and credits which are provided at the front end of the innovation process. The Report observes that there is more pressure for a patent box when the research and development credit is expired, but that less pressure might be placed on the need for a patent box if the research and development credit were made permanent (as Senator Hatch has proposed in the past). The Report also suggests that a territorial tax system might create greater incentives for US multinationals to migrate IP abroad and that a patent box could serve as a carrot to incentivize US multinationals to retain ownership of IP in the United States. The Report notes as concerns the complexity associated with determining the income attributable to IP and the game-playing that may arise in making such determination. Finally, the Report states that if a patent or innovation box is enacted, consideration should be given to providing US multinationals a tax incentive to migrate existing IP that is held abroad back to the United States. Sections G-H Worldwide tax system with no deferral and minimum tax Another possible tax system discussed in the Report is a worldwide tax system with no deferral as has been advocated by some academics. However, the Report quickly dismisses such a system as substantively, bad tax policy that would place US multinationals in a globally uncompetitive position and result in more corporations formed outside of the United States. The Report notes that two countries (New Zealand and Finland) that had switched from a territorial tax system to a worldwide tax system have since switched back. Furthermore, the Report asserts that the current US tax rule for determining tax residency (i.e., the place of formation or organization) likely would be subject to abuse under a worldwide tax system with no deferral. The Report states that a more complex managed and controlled test would arguably need to be adopted under such a system. Such a test, according to the Report, would be difficult to administer. The Report further notes that some have proposed a minimum tax on the foreign income of US multinationals and indicates that such a tax could be interpreted in one of two ways: 4 International Tax Alert

5 a foreign minimum tax that could operate as a low-tax kick-in category of subpart F or, alternatively, a US minimum tax that could require that the income of a controlled foreign corporation (CFC) be subject to an immediate US tax with a partial or full credit for the foreign income taxes paid by the CFC. Sections I-J Foreign corporations and nonresident US citizens The Report notes that recent corporate inversions have focused attention on the US tax treatment of foreign corporations. It further describes earnings stripping as the juice in such inversions. The Report then describes several options that have been put forward in recent years as proposals to limit earnings stripping by foreign corporations: Tighten Section 163(j) by eliminating the 1.5:1 debt-equity ratio safe harbor, lowering the excess interest expense threshold from 50% of adjusted taxable income to 25% of adjusted taxable income, repealing the excess limitation carryforward, and limiting the carryforward period for interest disallowed as a deduction Limit deductions for all crossborder payments, not just interest payments, to a related party in a zero-tax or low-tax jurisdiction Enact a surtax that would apply to all payments from a US business to a foreign related party which would approximate the income tax on the outbound payment Finally, the Report notes that the United States is the only industrialized country that imposes citizenship-based taxation. The Report expresses the view that the United States needs to rethink its rules for taxing nonresident US citizens. In this regard, the Report states that taxing only the US source income of US citizens living and working abroad with some permanence makes sense, but indicates that more consideration would have to be given to the permanence and purpose of the stay abroad, residential ties to the United States and abroad, the regularity and length of visits to the United States, and the threshold to be considered a US tax resident again. The Report further notes that under such an approach an exit tax could be applied when a US citizen is considered a nonresident and no longer subject to US worldwide taxing jurisdiction. Implications The Report is significant because it provides insights on key tax policy views of Senator Hatch, who is expected to be the Chairman of the Senate Finance Committee when the 114th Congress convenes in January Consistent with the Senator s previous public comments, the Report stresses the importance of comprehensive tax reform, including a movement to a territorial tax system. The tax reform debate is expected to continue in 2015, and Senator Hatch will play a prominent role in shaping the dialogue and moving the debate forward, potentially with legislative action, on tax reform in general and international tax reform in particular. Companies should be aware of the Senator s views and the positions he has staked out on international tax reform and should continue to actively monitor the tax reform debate in International Tax Alert 5

6 For additional information concerning this Alert, please contact: Ernst & Young LLP, International Tax Services, Washington, DC Barbara Angus Eric Oman Yuelin Lee Min Yu International Tax Services Global ITS, Alex Postma, London ITS Director, Americas, Jeffrey Michalak, Detroit National Director of ITS Technical Services, Jose Murillo, Washington Member Firm Contacts, Ernst & Young LLP (US) Northeast Johnny Lindroos, McLean, VA Financial Services Phil Green, New York Central Mark Muktar, Detroit Southeast Scott Shell, Charlotte, NC Southwest Amy Ritchie, Austin West Frederick Round, San Jose, CA Canada - Ernst & Young LLP (Canada) Albert Anelli, Montreal Israel - Kost Forer Gabbay & Kasierer (Israel) Sharon Shulman, Tel Aviv Mexico - Mancera, S.C. (Mexico) Koen Van t Hek, Mexico City Central America - Ernst & Young, S.A. Rafael Sayagues, San José South America - Ernst & Young Serviços Tributários S.S. Gil F. Mendes, São Paulo 6 International Tax Alert

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