Last week U.S. Senate Finance Committee Chairman Max Baucus (D-Montana) released a staff discussion draft (the “Discussion Draft”) of proposals that, if enacted, would dramatically change the U.S. international tax system. These proposals would repeal the current deferral system and substitute a minimum tax on foreign income in a manner that would substantially raise U.S. taxes for income earned in low tax foreign jurisdictions. The Discussion Draft would also tax earnings currently held offshore, although allowing the tax to be paid over time.
Many commentators have downplayed the likelihood of tax reform, and major tax reform is in fact unlikely to pass this Congress. Nevertheless, we are counselling preparation and vigilance in this effort, because early drafts will set the direction of the reform initiative. Once a provision is written and circulated it becomes harder to change or strike, and could become law later on. For example, few thought the Senate Finance conceptual draft of extending expiring provisions of 2012 would become law, but it was enacted in the “fiscal cliff” process. Moreover, the tax writing committees are giving taxpayers ample time (until January 17, 2014) to submit comments on the Discussion Draft, and they may look unkindly on taxpayers that withhold negative views and expect to be rescued with amendments later. Taxpayers that submit comments by the deadline of January 17, 2014, will have much better standing to request changes later on.
It is also possible that portions of tax reform -- including the international proposals, and the cost recovery proposals that were issued later -- could become part of less ambitious reform efforts. Segments of the tax reform products from both the Senate and the House could be packaged with extensions of expiring items in 2014.
This update provides an overview of certain provisions of the Discussion Draft that may be relevant to your business, including information regarding the process by which taxpayers can submit public comments on the Discussion Draft.
1. Limit Deferral by Imposing a Minimum Level of Tax on Income of CFCs
The Discussion Draft outlines two alternative proposals (“Option Y” and “Option Z”) that would replace the current deferral system with a set of rules that would in effect impose a minimum level of tax on the income of a controlled foreign corporation (“CFC”). These proposals include similar concepts to “Option B” of House Ways and Means Chairman Dave Camp’s 2011 discussion draft, which proposed that all CFCs would be subject to a minimum level of current effective tax on their income.
a. Option Y - “Participation Exemption”
Under Option Y, a corporate U.S. shareholder of a CFC would be entitled to a 100% dividends-received deduction for the foreign-source portion of dividends paid by the CFC out of its non-Subpart F income. However, under Option Y, the following broad categories of income would be treated as Subpart F income and thus subject to U.S. tax on a current basis: (i) “United States related income,” which generally would include income derived in connection with certain property that is imported into the United States by the CFC or a related person and the performance of services by the CFC with respect to persons or property located in the United States; and (ii) “low-taxed income,” which would generally include any income if the effective rate of foreign income tax on such income is less than [80%] (which rate is bracketed in the Discussion Draft) of the maximum U.S. corporate tax rate. Option Y would also amend or repeal several other provisions of Subpart F.
A U.S. shareholder of a CFC would be entitled to a foreign tax credit for taxes paid with respect to Subpart F income. The foreign tax credit limitation would be applied separately for six categories of income (based on Option Y’s proposed revisions to Subpart F). However, a U.S. shareholder would not be entitled to a foreign tax credit for taxes paid with respect to non-Subpart F income when such income is distributed to the U.S. shareholder.
In addition, under Option Y, a U.S. shareholder would be disallowed deductions for interest expense that is allocable to a CFC’s income that is neither Subpart F income nor effectively connected income.
b. Option Z - Expansion of Subpart F
Under Option Z, a U.S. shareholder of a CFC would be subject to current U.S. taxation (in the form of a Subpart F inclusion) with respect to (i) [60%] (which percentage is bracketed in the Discussion Draft) of the CFC’s “active foreign market income,” which is defined as a narrow category of income attributable to certain qualified foreign business activities conducted by the officers or employees of the CFC and (ii) 100% of the CFC’s remaining income (other than effectively connected income). Option Z would also amend or repeal several other provisions of Subpart F.
A U.S. shareholder of a CFC would be entitled to a foreign tax credit for taxes paid with respect to Subpart F income. The foreign tax credit limitation would be applied separately for three categories of income (based on Option Z’s revisions to Subpart F). However, a U.S. shareholder would not be entitled to a foreign tax credit for taxes paid with respect the [40%] of active foreign market income that is not subject to current taxation under Subpart F when such income is distributed to the U.S. shareholder.
Similar to Option Y, Option Z provides that a U.S. shareholder would be disallowed deductions for interest expense that is allocable to a CFC’s income that constitutes the [40%] of active foreign market income that is not subject to current taxation under Subpart F.
2. Taxation of Pre-Effective Date Deferred Income of CFCs
The Discussion Draft proposes to require a corporate U.S. shareholder of a CFC to include in income, as a deemed dividend, the foreign earnings of the CFC that were accumulated in taxable years prior to the effective date of the proposal and that have not previously been subject to U.S. tax. The corporate U.S. shareholder would be allowed a partial dividends-received deduction such that the deemed dividend would be subject to an effective current U.S. tax rate of 20%. The U.S. shareholder would generally be permitted to pay its tax liability in instalments over a period of up to eight years. This proposal would apply under either Option Y or Option Z.
3. Limit Use of “Check-the-Box” Elections for Entities Owned by CFCs
The Discussion Draft proposes to eliminate a U.S. or foreign entity’s ability to make a “check-the-box” election to be treated as a “flow-through” entity if such entity is wholly owned either by a single CFC or by two or members of an expanded affiliated group, at least one of which is a CFC. This limitation would affect both new and existing entities, the latter of which would be treated as having made an election to be treated as a corporation, effective as of the beginning of the taxable year following the effective date of the proposal. This proposal would apply under either Option Y or Option Z.
4. Miscellaneous U.S. International Tax Proposals
The Discussion Draft also includes the following miscellaneous proposals, each of which would apply under either Option Y or Option Z:
Expand the application of the Subpart F rules by eliminating the requirement that a foreign corporation be a CFC for at least 30 days during the taxable year and by defining a U.S. shareholder to include U.S. persons who own 10% or more of the total value of all classes of a CFC’s stock
Repeal the indirect foreign tax credit regime under Section 902 and modify the foreign tax credit regime under Section 960
Repeal foreign tax credit splitting rules under Section 909
Amend the passive foreign investment company (“PFIC”) rules
Amend interest expense allocation and apportionment rules
Expand the circumstances in which income from sales of inventory will be treated as U.S. source
Disregard certain asset acquisitions for purposes of determining the source and character of income
Increase taxation of certain intangible property transfers under Sections 367(d) and 482
Disallow deduction for certain reinsurance premiums paid to non-taxed affiliates
Codify Rev. Rul. 91-32 and tax gain from the sale of a partnership interest on a look-through basis
Repeal the portfolio interest exemption for interest paid on corporate debt obligations
Deny deductions for related party payments arising in connection with certain “base erosion arrangements”
Terminate special rules for domestic international sales corporations (“DISCs”)
Repeal dual consolidated loss (“DCL”) rules
Modify FIRPTA rules in certain respects
Deny deductions (as U.S.-source dividends) for dividends from foreign corporations attributable to regulated investment company (“RIC”) and real estate investment trust (“REIT”) dividends
5. Request for Comments
The Committee staff has requested comments on all aspects of the Discussion Draft as well as on eight technical and policy issues of international tax reform. Although the comment period is open-ended, in order to give them full consideration the staff has requested comments by January 17, 2014. Issues of particular interest for comments include the pros and cons of Option Y and Option Z, and on the relative merits of these options in comparison to the House of Representative’s Ways & Means Committee’s Option C (the “carrot and stick” proposal). Views are also requested on additional ways to address base erosion and profit shifting by foreign multinational companies. To avoid punitive treatment and windfalls, comments are also requested regarding appropriate transition rules and effective dates. Other issues have been left open to comment too, such as thin capitalization rules and a rule permitting U.S. multinationals to bring intangible assets back to the United States. Two full lists of areas for comment are available on the Finance Committee’s website, or we can provide them to you.