The Baucus discussion draft proposes to tax all foreign income of US companies immediately or not at all.
This aims to counter the lock-out effect (lock-out is the term used to describe the situation of US-based multinationals keeping earnings of foreign subsidiaries offshore and not repatriating them) and replaces deferral with a system under which all income of foreign subsidiaries of US companies is taxed immediately when earned, or is exempt from US tax, after which no additional US tax is due.
Baucus specifies the following aspects of the proposal:
- Passive and highly-mobile income is taxed annually at full US rates;
- Income from selling products and providing services to US customers is taxed annually at full US rates with limited exceptions;
- For taxing income from products and services sold into foreign markets, Baucus offers two options, which he calls Option Y and Option Z:
• A minimum tax that immediately taxes all such income at 80% of the US corporate tax rate with full foreign tax credits, coupled with a full exemption for foreign earnings upon repatriation; and
• A minimum tax that immediately taxes all such income at 60% of the US corporate tax rate if derived from active business operations but at the full US rate if not, coupled with a full exemption for foreign earnings upon repatriation.
- Earnings of foreign subsidiaries from periods before the effective date of the proposal that have not been subject to US tax are subject to a one-time tax at a reduced rate of, for example, 20%, payable over eight years.
Motivation
Many major features of the US international tax system date back to the 1960s and while there have been frequent revisions since then (most notably the 1986 tax reform achieved by President Reagan in conjunction with House Speaker Tip O’Neill, the rules “nevertheless address a world that no longer exists,” said Baucus, using the rise in prominence and importance of intellectual property income as an example of areas in which they fall short.
US investment overseas has grown from $52 billion to $4.2 trillion, while aggregate investment in tax haven jurisdictions has grown even faster, rising from $3 billion to $1.7 trillion.
“Failure to react to this changing world has stifled US business and contributed to slow job growth,” said Baucus.
The Baucus discussion draft draws extensively from the proposals of others on Capitol Hill including Senators Enzi, Grassley, Portman, Stabenow and Wyden.
Baucus bemoans the existing US system, with its high corporate tax rate and system of deferral, which incentivises US multinational companies to invest and create jobs overseas.
Many non-US multinationals are based in jurisdictions with systems that impose a significantly lower corporate tax rate, and which contain dividend exemption systems rather than the deferral and credit-based system the US employs.
“These impediments to competitiveness hurt job creation and economic growth,” said Baucus.
Reaction
Dave Camp, chairman of the House Ways & Means Committee, applauded Baucus for his commitment to advancing tax reform, while another Republican, Orrin Hatch, ranking member of the Senate Finance Committee, said the bipartisan desire to overhaul the tax code had “become mired in the partisan desire by some to raise taxes under the guise of tax reform in budget conference negotiations”.
Hatch said he disagreed with Baucus’ decision to release the draft at this time, saying significant differences remain between Democrats and Republicans on Congress’ tax-writing committees.
Business groups also praised the SFC chairman for unveiling his plan, though most were critical of its contents.
John Engler, president of the Business Roundtable (BRT), said the organisation’s CEOs put comprehensive tax reform as the “single-most important issue to get the US economy going”.
“Baucus’ goal of increasing the ability of US businesses to compete abroad is critical,” said Engler. “Unfortunately, we do not believe that the staff’s international discussion draft supports that goal because it would make many American companies even less competitive than their non-US counterparts.”
Cathy Schultz, vice president for tax policy at the National Foreign Trade Council (NFTC), also welcomed the opportunity to advance the tax reform debate off the back of Baucus’s proposals, but said the Montana Democrat’s discussion draft is disappointing and “appears to move us in the opposite direction by proposing to penalise multinational companies and making it more difficult for them to compete globally”.
The National Association of Manufacturers said the proposal fails to promote a globally competitive international tax system. Dorothy Coleman, vice president for tax and domestic economic policy, said the Baucus draft is “not what manufacturers had hoped to hear from the committee”.
Coleman stressed the importance of adopting a new international tax system that is structured to enhance US competitiveness, not raise revenue.
“Overseas operations benefit US jobs and the US economy,” said Coleman. “The ability to compete overseas is particularly important for the US manufacturing sector – almost 50% of US global companies are manufacturers. Tax reform must protect and enhance these critical drivers of our economy.”
Manal Corwin, national leader of KPMG’s International Tax practice and former deputy assistant secretary for tax policy, international tax affairs at the US Treasury Department, said that Baucus’s discussion draft shares some similarities with previous proposals, including the Obama Administration’s tax reform framework.
“Senator Baucus’ discussion draft proposes to adopt a minimum tax on offshore earnings to help address BEPS [base erosion and profit shifting], offering two alternative design approaches for implementation,” she said. “The concept of adopting a minimum tax on offshore earnings was also a key feature of the President’s framework for tax reform.”
Both of Baucus’s alternative options Y and Z eliminate the lock-out effect associated with existing deferral rules by removing the tax liability upon repatriation and instead either exempting certain categories of offshore income from US tax, or immediately subjecting offshore income to US tax at either full or reduced rates depending on the character of the income.
“The elimination of lock-out and the associated complexities of deferral is a welcome proposed reform that at some level is explicitly or implicitly embraced by other proposals out there,” said Corwin. “A related simplification includes the repeal of section 909, dealing with foreign tax credit splitting transactions.”
Corwin added that, while to some extent Baucus’s alternative options adopt existing definitions for passive income under subpart F for determining whether income is subject to full US tax, there are a number of modifications including expanding the category of income subject to full US tax rates to include CFC income from sales into the US.
“This is broader than other anti-round-tripping proposals as it is not limited to goods originally produced or otherwise sourced in the US,” said Corwin.
US reform and the OECD’s BEPS project
Some fear that Baucus’ approach to international reform could raise concerns about the potential negative impact of US tax rules on the competitiveness of US multinationals.
“A reduction in the US corporate tax rate, the reduced rate on active earnings abroad, and widespread adoption of anti-base erosion rules by other countries could help ameliorate these concerns depending on the magnitude of rate reduction and the success, scope and buy-in to the anti-base erosion initiative spearheaded by the OECD and endorsed by the G20,” said Corwin.
The Baucus discussion draft also looks at the adoption of a number of anti-base erosion rules in the context of inbound business activity, and Corwin points out that these proposals – which include the possibility of denying deductions for interest paid in the context of certain hybrid transactions – align with some of the approaches being considered by the OECD to address hybrid mismatches (Action Point 2) as part of its BEPS Action Plan.
Baucus has said comments should be submitted to tax_reform@finance.senate.gov by January 17 2014 to ensure they receive full consideration.
He is seeking comments on both the proposals contained in his discussion draft, and any appropriate rules that could govern the transition to the modernised international tax system.
