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Reform International Taxation Rules

The president proposes to reform international tax laws to limit the benefits of income shifting to low-tax foreign jurisdictions. The proposals in the budget are similar to those proposed in the previous two budgets. They aim to limit international tax avoidance and reduce incentives for U.S. corporations to invest overseas instead of in the United States. In combination, the proposals would raise $148 billion between 2013 and 2022.

Currently, the United States taxes both the domestic and foreign earnings of U.S. corporations. When a firm pays U.S. taxes on its foreign profits depends on how its parent company organizes its foreign operations. If an operation is organized as a subsidiary (that is, it is separately incorporated in the foreign country), then its profits are generally not taxed until they are paid to the U.S. parent. The exemption of foreign profits until they are repatriated to the parent company is called deferral. If an operation is organized as a branch (that is, it is not separately incorporated in the foreign country), then its profits are taxed when they are earned.

Not all classes of foreign-source income earned by foreign subsidiaries enjoy deferral. Under “Subpart F” of the current tax law, certain “passive” income such as income earned from investments in foreign assets, foreign base company sales and services income, and income from the insurance of U.S. risk is taxed upon accrual. These exceptions to the general rule of deferral intend to protect the U.S. base by limiting firms’ ability to shift income not arising from active business activities to low-tax foreign jurisdictions. In addition, the parent company pays U.S. tax immediately on dividends, interest, or royalties paid by one subsidiary to another. That last rule does not apply, however, to payments within a corporation—for example, from a local branch to the home office.

To prevent income earned abroad from being taxed twice, the United States allows firms to claim tax credits for income taxes paid to foreign governments. Firms can use these tax credits to offset U.S. tax liability on foreign-source income. A limitation on the credit for foreign taxes prevents U.S. firms from using these credits to reduce U.S. tax liabilities on income earned at home. The limit is the amount of tax that would be due if the foreign income were earned in the United States.

To understand how the credit works, consider a U.S. company that earns $100 in a subsidiary located in a country with a tax rate of 25 percent, so the subsidiary pays $25 tax to the host country. If the subsidiary immediately remits the $100 of earnings to the parent company, the parent company owes $35 of U.S. tax on the $100 (since the U.S. corporate tax rate is 35 percent). However, the company may claim a $25 credit for the tax paid to the foreign country, leaving a net U.S. tax of only $10 (the $35 tax minus the $25 credit).

If the foreign tax rate were 45 percent, and as before the profits are sent home to the parent, the firm would owe $45 in foreign tax, $10 more than the $35 U.S. tax liability. A firm in this situation is said to have “excess credits” of $10 (the $45 foreign tax minus the $35 U.S. tax) because its foreign tax payment exceeds the U.S. credit it may claim in the current year. In some situations, the foreign tax credit system allows firms to use excess credits from one source of foreign income to offset U.S. tax payments on income from another source in a procedure called “cross-crediting.”

To understand how cross-crediting works, consider a company with both of the subsidiaries described above. Cross-crediting allows the parent corporation to use the $10 of excess credits of the second subsidiary (in the high-tax country) to offset the $10 net U.S. tax liability on the first subsidiary (in the low-tax country). In this case, simultaneously repatriating income from subsidiaries in both high- and low-tax countries results in no net U.S. tax liability on the $200 of foreign-source income.

Differences in taxation between the United States and other countries give multinational companies an incentive to alter their transfer prices—that is, the prices they charge for goods purchased from and sold to their affiliates—from what a nonaffiliated customer would be charged. For example, by underpricing sales to their affiliates in low-tax countries and overpricing purchases from them, companies can shift reported profits to their affiliates in those countries, thus reducing tax on the entire corporate group. To deal with this practice, most governments require firms to use an “arm’s length” standard for tax reporting purposes, setting transfer prices equal to the prices that would prevail if the transaction were between independent entities. Yet ample room remains for firms to manipulate transfer prices because arm’s-length prices are often difficult to establish for many intermediate goods and services, especially for intangibles, such as patents, that are unique to the firm.

There are other ways for firms to shift income from high- to low-tax countries. For example, by borrowing money in high-tax countries to finance their overall operations, they can claim larger interest deductions in those countries and so report more profits in low-tax countries.

Research using Treasury tax files suggests that two of the most important vehicles for income shifting are placing debt in high-tax locations and transferring very valuable intangible assets to low-tax subsidiaries without adequate compensation in the form of royalties. Treasury economist Harry Grubert reports that location of intangible income and the allocation of debt among high- and low-tax countries seem to account for all of the observed differences in profitability among high- and low-statutory tax countries.

The president proposes a package of revenue-raising reforms of the international tax system that would affect both the deferral and foreign tax credit features of current law as well as income shifting. The bulk of the revenue raised from these provisions would come from changes related to the deduction of interest expenses against deferred foreign income, the calculation of the foreign tax credit, and the treatment of returns associated with the transfer of intangibles abroad to affiliated foreign companies. These changes would all reduce the benefits of overseas investments, especially investments in low-tax countries. All the provisions would take effect in 2013.

Changes related to the deduction of interest expenses against deferred foreign income

Under current law, companies with overseas operations may immediately deduct expenses supporting foreign investment while deferring payment of taxes on profits from those investments until they repatriate the profits. Under the president’s proposal, companies could not claim deductions on their U.S. tax returns for interest expenses that are properly allocable to foreign-source income until they pay U.S. taxes on their foreign earnings. The provision would effectively limit the benefit of deferral by raising the cost of delaying U.S. tax payments on foreign profits. The rules governing the provision are complicated and have uneven effects across different industries and companies. Multinational companies that are heavily leveraged would suffer most from the provision.

Changes related to foreign tax credits

The president proposes to limit cross-crediting by requiring firms to consider the foreign tax they pay on all of their foreign earnings and profits in determining their foreign tax credits. Under current law, the foreign tax credit is based on earnings and profits on which U.S. tax has been paid. Companies receive foreign tax credits for foreign taxes paid on deferred income when they repatriate that income. This enables them to coordinate repatriations from low- and high-taxed income sources to maximize their foreign tax credits. The provision would limit firms’ ability to blend their repatriations to minimize or avoid U.S. taxes on foreign source income. By so doing, this proposal would reduce cross-crediting and further limit the benefits firms receive from deferral.

Changes related to income shifting

The president proposes two measures to prevent the inappropriate shifting of income outside the United States through the transfer of intangible property.

One proposal would scrutinize the income arising from transfers of intangible property. If a U.S. company transfers an intangible asset (such as a patent) to a related foreign company in a country with a low effective tax rate and circumstances indicate that there is excessive income shifting into the low-tax country, then under the proposal, the return that is deemed to be “excessive” would be taxed currently and not allowed deferral. This proposal reflects a belief that the current transfer pricing regulations are not working adequately for intangible property transfers, providing a backstop method of limiting the benefits from income shifting. A second proposal would strengthen the transfer pricing regulations by clarifying the definition of intangible property in an effort to reduce controversy that has arisen in IRS examinations. In addition, the proposal would clarify that when valuing intangible property, the IRS may take into consideration the prices or profits that the controlled taxpayer could have realized by choosing a realistic alternative to the controlled transaction taken. This seems to be a movement away from the “arm’s length” standard for transfer pricing. Finally, this second provision would allow the IRS commissioner to value multiple intangible properties on an aggregate basis if doing so would achieve a more reliable result.

Two other measures to limit income shifting would limit earnings stripping by expatriated entities and disallow the deduction for non-taxed reinsurance premiums paid by affiliates. The former proposal would limit the ability to reduce tax on income from U.S. operations through the deductions of interest from debt to related foreign parties. The latter proposal would prevent insurance companies from avoiding the subpart F rules limiting deferral of income of a foreign affiliate through reinsurance transactions with a related foreign party not subject to U.S. income tax.

Overall Effects

Taken as a group, the international tax reform proposals would limit the benefits of deferral, limit the ability of companies to shift reported income to low-tax foreign affiliates, and limit their ability to avoid the effects of foreign tax credit limitations. Limiting income shifting protects the corporate tax base by helping ensure that income earned in the United States is not erroneously classified as foreign-source income. In addition, by limiting the tax benefits of investing overseas instead of in the United States, the proposals intend to prevent U.S. multinational companies from shifting employment from home production to overseas operations. But some research finds that foreign investment may increase domestic employment in U.S. multinationals if the investments facilitate more exports to foreign affiliates. And employment in the United States is influenced more by overall fiscal and monetary policies that determine the quantity of American-made goods, services, and assets that American and foreign consumers and investors are willing to purchase than by policies that move jobs from one activity to another.

Policies to limit tax benefits that favor investments by U.S. companies in low-tax countries could boost economic efficiency by providing better incentives for companies to invest where the pretax returns are greatest. But these increased taxes on foreign-source income apply only to U.S.-based multinational companies and not to foreign-based companies that, in most countries are exempt from tax on their active foreign-source income. As a result, opponents of these provisions argue that they would place U.S.-based companies at a competitive disadvantage to multinationals based in other countries and would encourage new corporations to establish their tax residence outside the United States.

Additional Resources

Tax Policy Briefing Book: International Taxation: How does the current system of international taxation work?
Eric Toder, “Will Paring Deferral Create Jobs?” TaxVox, May 5, 2009.
Harry Grubert, “Intangible Income, Intercompany Transactions, Income Shifting and the Choice of Location,” National Tax Journal, Volume LVI, No.2, Part 2.
Joint Committee on Taxation, “Description of Revenue Provisions Contained in the President’s Fiscal Year 2010 Budget Proposal; Part Three: Provisions Related to the Taxation of Cross-Border Income and Investment (JCS-4-09),” September 2009.