New "Territorial Taxation" System Proposed For The US - Income Tax

US House Ways and Means Committee Chairman Releases Discussion Draft

Usually, when the Chairman of the Ways and Means Committee of the US House of Representatives releases a legislative proposal, one expects immediate legislative action on that proposal. In this case, however, rather than be brought for a vote any time soon, the proposal unveiled by Ways and Means Committee Chairman Dave Camp on October 26, 2011, is intended to advance the discussion on how best to reform the US international tax rules.

First of all, the proposal is prominently labeled a "Discussion Draft," and several aspects of the proposal, particularly rates and percentages, are intentionally bracketed. Further, although the proposal acknowledges the need for anti-abuse rules to protect the US tax base, the proposal offers three alternative approaches without expressing a preference for any option over the others.

Second, the proposal was released in a manner to encourage feedback: Chairman Camp released both statutory language and a technical explanation, facilitating scrutiny of the proposal. Indeed, the three-page summary released along with the Discussion Draft invites input on all aspects of the Discussion Draft, but specifically requests "constructive feedback" on some of the more difficult and problematic aspects of the Discussion Draft.

Proposal's Relationship with Broader Tax Reform

Although the proposal's focus is on new US international tax rules, those rules would be part of a broader tax reform package that includes:

Individual income tax reform which is generally unspecified, other than that the individual income tax base would be broadened and individual income tax rates lowered
New top corporate tax rate of 25%
Unspecified domestic corporate tax reforms to "pay" for the lower corporate tax rate

The international tax reform (i.e., the new participation exemption system) would be revenue neutral in and of itself.

Highlights of Discussion Draft's International Tax Reforms

1. Adoption of participation exemption system similar to that used by many other advanced foreign economies:

Foreign-source dividends received by a 10% US corporate shareholder from a controlled foreign corporation (CFC) would be eligible for a 95% dividends received deduction.
Gains from the sale of shares of a CFC by a 10% US corporate shareholder would be eligible for a 95% exclusion.
Losses on the sale of shares of a CFC by a 10% US corporate shareholder generally would be disallowed.
Foreign branches of US corporations would be treated as CFCs.
US corporate shareholders that own 10% or more of a foreign corporation that is not a CFC (a "10/50 company") must make an all-or-nothing election whether to treat such 10/50 companies as CFCs.
Previously untaxed foreign earnings would be taxable (i.e., deemed repatriated), subject to a lower rate (5.25% is the amount bracketed in the proposal), with the opportunity to spread the tax over eight years.
Expenses allocable to the exempt dividends or gains would not be deductible.

2. Significant modification to US foreign tax credit rules:

Generally no foreign tax credit would be available for amounts excluded by participation exemption system (including for withholding taxes).
Indirect (section 902) foreign tax credit for 10/50 companies and CFCs would be repealed (deemed credit only available for subpart F income).
Foreign tax credit baskets would be repealed (including for individuals).
Foreign tax credit expense allocation rules would be cut back to apply only to directly allocable expenses (including for individuals).
New foreign tax credit matching rule (section 909) would be repealed (including for individuals).

3. New rules for "passive income" would be adopted, using the current subpart F income rules as a base. Subpart F rules would be in some ways reduced (e.g., repeal of section 956), in other ways expanded (Subpart F would now apply to all 10/50 companies that are treated as CFCs), and no longer necessary rules (e.g., for previously taxed income) removed.

4. The proposal includes provisions to prevent what it terms "base erosion":

For US companies with foreign affiliates (i.e., a "worldwide affiliated group"), "thin capitalization" rules would disallow a portion of net interest expense of the US members of the group if the US members of the worldwide affiliated group fail a debt-to-equity differential test and the US companies' net interest expense exceeds a (currently unspecified) percent of adjusted taxable income.
Three possible anti-abuse options (labeled Options A, B, and C) are floated:
- The proposal by the Obama Administration to tax "excess returns" from transfers of intangible assets to low-taxed affiliates.
- A proposal to treat "low-taxed cross border income" (using a presumptive effective tax rate of 10% as the test for whether the income is low-taxed) as Subpart F income, thereby subjecting such income to immediate US tax (although the income would be eligible for foreign tax credits).
- A proposal to subject foreign intangible income to immediate US tax as Subpart F income but at a special lower rate (presumptively 15%). This option is described in the three-page summary as "combin[ing] the carrot of an 'innovation box' and royalty relief with the 'stick' of a current (subpart F) inclusion for intangibles-related income of CFCs in low-tax jurisdictions."

Conclusion

The participation exemption system proposed by Chairman Camp raises many significant issues. These include:

It applies only to US corporations, not individuals, who own 10% or more of a foreign corporation.
Subpart F would apply to 10% corporate shareholders in foreign corporations which are not controlled by the US shareholders.
Foreign branches of US corporations would be treated as CFCs.
The applicability of the participation exemption to partnerships with corporate partners is unclear.
The interaction of the participation exemption system with existing and future US tax treaties is not addressed.

It is also unclear what impact the proposed participation exemption system--especially its deemed repatriation provision--will have on the various temporary "repatriation" proposals being advocated in Congress.

The proposed base erosion options will give heartburn to affected companies, with each option raising its own issues of feasibility and administration, including whether any or all the anti-abuse measures can be practically designed and implemented.

The three-page summary also notes various issues which are not explicitly addressed in the Discussion Draft:

Overall domestic loss and overall foreign loss accounts
Foreign tax redeterminations resulting from foreign tax refunds or additional foreign taxes paid
Additional Subpart F changes, including with respect to recapture accounts
Dual consolidated losses
Cross-border reorganizations

The Discussion Draft explicitly requests affected taxpayers to review the proposal and make suggestions to improve it. Any US company with international operations or aspirations that fails to accept that invitation does so at its (US tax) peril.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.