Administration's Proposals Regarding the Taxation of U.S. Groups' Foreign Income
May 4, 2009
This morning, the Obama Administration provided more detail on its previously announced plan to reform the U.S. tax laws relating to the taxation of income earned by foreign subsidiaries of U.S. corporations, especially the rules deferring taxation of active foreign earnings until repatriated. While the additional information provided by the Administration is good news in one key respect – the Administration is not proposing to repeal deferral in its entirety – the proposed changes will almost certainly increase the overall U.S. tax burden on U.S. multinational corporations and alter the way they structure and finance their foreign operations.
Limitation on Current Deduction of Foreign-Source Expenses (Including Interest)
The proposal would require a U.S. corporation, beginning in 2011, to defer the deduction of U.S. expenses (including interest, but excluding R&D) allocated to foreign sources until the corporation repatriates its foreign earnings. The Administration’s description of the proposal indicates that the proposal would be similar to a bill introduced by House Ways and Means Chairman Charles Rangel (D-NY) in 2007. Under the Rangel bill, a taxpayer’s U.S. deductions and expenses for a taxable year allocated or apportioned to foreign sources, based on its worldwide income, would be allowed only to the extent allocable to the taxpayer’s currently taxed foreign income (i.e., income from foreign sources included in the taxpayer’s income for that year). The foreign-source deductions and expenses allocated to currently taxed foreign income would be based on the ratio of currently taxed foreign income to worldwide foreign income for the year. Deferred foreign-source deductions and expenses would be carried forward until previously deferred foreign income is repatriated (i.e., included in income as a result of a distribution).
For many U.S. multinational corporations, interest expense is the largest U.S. expense that is allocated between U.S. and foreign sources. The proposal, if enacted, would likely result in the deferral of the deduction of a substantial portion of U.S. interest expense for these corporations, and indirectly eliminate a substantial portion of the benefit of the deferral of U.S. tax on unrepatriated foreign earnings. By contrast, U.S. multinational companies that do not have substantial interest expense will breathe a sigh of relief at the Administration’s decision to propose limiting U.S. deductions rather than repealing deferral directly.
Per Se Treatment of Certain Foreign Entities as Corporations
The proposal would require U.S. taxpayers, beginning in 2011, to treat certain foreign entities as corporations, rather than as disregarded or pass-through entities, for (at least some) U.S. tax purposes. The proposal is directed at typical foreign tax planning involving the use of “check-the-box” entities and intercompany loan or royalty structures to reduce foreign tax on foreign income without creating subpart F income that would be subject to current U.S. tax. The description of the proposal does not provide any details on the circumstances under which a foreign entity would be treated as a per se corporation, although it seems likely that the proposal will focus on foreign entities that receive significant amounts of intercompany interest, royalties or similar types of “passive” income that gives rise to a current deduction for the related payor.
Changes in Foreign Tax Credit Rules
The proposal would make two changes to the current foreign tax credit rules, again beginning in 2011. First, the foreign tax credit would be determined “based on the amount of total foreign tax [a taxpayer] actually pays on its total foreign earnings.” Second, “a foreign tax credit would no longer be allowed for foreign taxes paid on income not subject to U.S. tax.” There are no details on either proposal, and the summary description of the proposals could describe a variety of changes to the foreign tax credit rules, leaving taxpayers to speculate as to what the Administration is actually proposing.
For example, the Administration might be proposing something similar to a provision in the Rangel bill, under which a taxpayer would not be permitted to claim foreign tax credits based on the repatriation of specific (e.g., highly taxed) earnings, but rather would be treated as in effect having a single, worldwide pool of foreign earnings to which all of its foreign income taxes would relate. The latter proposal might be narrowly targeted at certain foreign tax planning structures that generate foreign taxes without current inclusion of (all of) the corresponding income, or might be aimed at eliminating, for purposes of determining a taxpayer’s foreign income taxes paid, any foreign taxes paid on items that are not taxable under U.S. tax principles.
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