Q&A: Are sweeping changes afoot in US foreign business profits?

What has happened?

The Obama administration recently released its Budget proposal for the 2016 fiscal year. President Obama has proposed a new levy for US corporations on profits located abroad which are not repatriated to the US. The proposal represents an aggressive attack on the indirect foreign profits of US corporations. Important features include a 14% tax on accumulated foreign earnings not previously taxed by the US and a 19% tax on all future foreign earnings of US corporations. Obama’s Budget proposal is intended to tackle what he calls ‘stateless income.’ Many multinationals, like Apple, Microsoft and General Electric, have used such techniques to defer US taxation and avoid corresponding foreign taxation on trillions of dollars, leading to equally large stockpiles of cash in non-US jurisdictions.

How likely is it that the proposals will be enacted?

As with all presidential budget proposals, this proposal offers insight into the current administration’s legislative wish list more than it represents legislation likely to materialise. That said, the president’s proposal in some ways mirrors Republican efforts to reform the US corporate tax landscape. Although the details of Obama’s proposed framework for tax reform have thus far received a less than enthusiastic response from Republican members of Congress, they could well set the terms of an eventual debate, and therefore deserve additional consideration.

What’s the context?

Generally, US corporations are not subject to US taxation unless they earn income that is connected to a US trade or business or from sources within the US. Non-US corporations with only foreign source income are generally not subject to US taxation.

As an extension of that general principle, US shareholders of a foreign corporation engaged in an active non-US trade or business generally are not subject to US taxation until the foreign corporation actually distributes its earnings to the shareholders or shareholders sell their stock in the foreign corporation. 

Congress enacted the rules currently contained in sub-part F of the Internal Revenue Code (IRC)  to limit that general rule which allows deferral of US taxation. Congress perceived particular abuse by US shareholders incorporating foreign holding companies as mechanisms for earning – and deferring US taxation on – investment income like dividends, interest, royalties and rents. Sub-part F requires US shareholders of controlled foreign corporations (CFCs) to pay tax on their pro rata share of many categories of passive income, whether or not actually distributed.

However, most categories of active business income earned by a CFC are beyond the scope of sub-part F, and owners of foreign corporations have naturally continued to defer US taxation on such income by opting not to repatriate foreign earnings, i.e. electing not to receive dividends.

The ‘check the box’ regulations issued in the late 1990s allow certain foreign corporations to be treated as disregarded entities or partnerships for US tax purposes (as opposed to legal entities separate from their owners). These regulations helped spawn new creative tax deferral strategies, whereby US shareholders of foreign corporations defer US taxation and avoid paying substantial amounts of foreign income taxes otherwise due.

How would the new proposals work?

The Budget proposes to supplement the existing sub-part F framework with a per-country minimum tax that would apply to US corporations that are shareholders of foreign corporations, or that have earnings from foreign branches or from the performance of services abroad. US corporations would be subject to tax at a rate of 19% less 85% of the per-country foreign effective tax rate (with an allowance for corporate equity). The minimum tax rate would apply regardless of whether foreign earnings are repatriated to the US, and all foreign earnings could be repatriated to the US without further tax. Thus, foreign corporations operating in high-tax countries will not be affected, but those achieving effective foreign tax rates of less than 22.35% will incur higher than normal tax bills.

While a 19% rate represents a drastic reduction of the current 35% rate for repatriated income, it is still substantially higher than rates found in many foreign jurisdictions, like Ireland, where the corporate income tax rate is 12.5%. However, most multinational corporations that take advantage of existing permitted deferral strategies likely wouldn’t be satisfied even if the proposed rate matched the effective tax rates of the foreign jurisdictions in which they operate. A 2004 repatriation incentive program provides a useful lesson: the American Jobs Creation Act of 2004 temporarily allowed US corporations to repatriate foreign profits at a reduced rate of just 5.25%, but merely 843 of roughly 9,700 US corporations that had foreign earnings in 2004 chose to repatriate. 

In addition to a 19% minimum tax on foreign earnings, a one-time ‘transitional tax’ of 14% is proposed on accumulated foreign earnings previously deferred. A reduced foreign tax credit, equal to 40% of foreign taxes associated with such earnings, would be allowed. The transitional tax would apply to earnings accumulated for taxable years beginning before 1 January 2016, and the tax would be payable over five years. Interestingly, it’s not clear how far the look-back period would extend, as the budget proposal contains no limiting language. However, whatever the look-back period happens to be, it should be noted that retroactive taxes are rarely unconstitutional.

Final thoughts?

If enacted into law, Obama’s proposal may ultimately bring unintended consequences, including an increased demand for corporate inversions. Generally, a corporate inversion occurs when a US corporation renounces its US citizenship by merging with or acquiring a smaller foreign company, thereby eliminating the US government’s ability to tax most of the inverted corporation’s foreign earnings. These proposals could well accelerate efforts to invert. Recently issued Treasury regulations that aim to limit corporate inversions are viewed as a mostly ineffective stop gap measure. However, Obama’s Budget, perhaps anticipating this result, also proposes to limit the ability of US corporations to expatriate by reducing the ownership threshold allowable by a US corporation in a foreign post-merger acquisition entity.

Interviewed by Neasa MacErlean for LexisNexis UK Legal Analysis and Lexis®PSL Tax