Rate Competition Is New International Tax Planning Reality
Lower corporate tax rates around the world are expected to play an important part in multinational companies’ tax planning in 2017, with a rate as low as 15 percent on the table in the U.S. and countries such as the U.K. planning to maintain or lower their current rates.
A radical reduction to the 35 percent U.S. rate is almost certain. The June 2016 House Republican tax blueprint proposes a 20 percent corporate tax rate, and President-elect Donald Trump has proposed a 15 percent rate.
“The bottom line for the international section of the blueprint is to eliminate tax as an incentive to locate outside of the United States,” Barbara Angus, the House Ways and Means Committee’s chief tax counsel, told a recent tax conference. The June tax blueprint reflects “a move towards a cash flow tax, and that allows us to look at broader adjustments such as are used by our trading partners,” she said. The blueprint contemplates elimination of taxes on exports and elimination of the effective current loss subsidy for imports.
The House Republican plan also contemplates a territorial system, Angus said—”a 100 percent exemption for dividends brought home from foreign subsidiaries, as many of our trading partners have.” In addition, she noted changes in the Subpart F area that will move in the direction of making U.S. controlled foreign corporation rules “look more like those of other countries, and a focus particularly on asset income.”
A deemed repatriation provision for earnings would be part of the transition into the new territorial system, she said.
Transfer Pricing, FDAP Income
One obvious tax planning dynamic that would change if the U.S. corporate rate fell significantly would be transfer pricing planning. Currently, multinational enterprises generally plan to keep as much taxable income as possible out of U.S. taxing jurisdictions, given the current 35 percent corporate tax rate, said John Warner, a shareholder at Buchanan Ingersoll & Rooney PC.
That would presumably change if the U.S. corporate rate dropped to the low end of the global spectrum, Warner told Bloomberg BNA. “In particular, tax planning as to the situs for intellectual property development, ownership and exploitation would be ripe for revision.”
Warner also said a 15 percent or 20 percent rate on corporate net income would mean that multinational enterprises would have more incentive to structure their U.S. investments and operations through U.S. trades or businesses (USTBs) or permanent establishments (PEs).
Thus, multinationals would avoid being subject to tax on U.S. source fixed, determinable, annual or periodical income (FDAP), which might still be subject to a 30 percent gross-basis withholding tax in the absence of such USTB or U.S. PE status, he said.
Foreign governments have been engaged in a years-long exercise to reduce their corporate income tax rates—or in some cases, maintain rates below 20 percent.
U.K. Chancellor of the Exchequer Philip Hammond said in November that his government still planned to reduce the 20 percent corporation tax to 17 percent by 2020. The U.K. rate has fallen from 28 percent since 2010.
Other European tax competitors include Ireland, with a current rate of 12.5 percent. Hungary plans to reduce its corporate rate to 9 percent in January. Switzerland has an 8.5 percent rate. The Netherlands rate is 25 percent and Luxembourg’s 21 percent.
Two Asian tax competitors, Hong Kong and Singapore, have corporate tax rates of 17 percent and 16.5 percent, respectively.
The U.K. has made itself attractive by moving to a territorial system and substantially lowering its rate, while at the same time enacting stringent anti-avoidance measures to ensure that U.K. profits are taxed, Paul Schmidt, tax chair at Baker & Hostetler LLP in Washington, told Bloomberg BNA.
Peter Barnes, of counsel in the international tax group at Caplin & Drysdale Chartered in Washington, said countries outside the U.S. tend to focus more on consumption taxes, such as goods and services taxes, and taxes that essentially are based on sales—as with the U.K.’s diverted profits tax—and withholding taxes on digital sales.
A U.S. tax overhaul may give a slight momentum to these foreign law changes, Barnes told Bloomberg BNA, “but the impact of U.S. changes will not be great, because the trend in these foreign law changes is already underway.”
He also warned that even with lower corporate income tax rates, the U.S. will need to ensure that foreign-owned businesses in the U.S. pay appropriate tax. “The U.S. has not always done a good job of protecting the U.S. tax base,” Barnes said.
Given the dramatic reduction in worldwide corporate tax rates in the last 10 to 15 years, “it would be a bit tricky for the major industrialized countries to complain a lot about our corporate tax rate dropping substantially,” Warner said.
“Of course, if our rate drops to the lowest among developed countries, there could be some further reductions in rates in other countries—particularly in countries whose corporate rates are now in the 25 percent range,” he said.
Schmidt said he expects tax competition will continue, particularly for small economies where low effective rates on high amounts of income are a key source of revenue. As a result, he said, foreign base erosion, profit shifting and stateless income that have been the subject of the Organization for Economic Cooperation and Development’s base erosion and profit shifting initiatives will remain an issue.
“At this point there are more questions than answers,” said Carol Doran Klein, vice president and international tax counsel at the U.S. Council for International Business. “A dramatic lowering of the rate in the U.S. might well encourage rate reductions in other countries, but the rate is only one part of the picture.”
Doran Klein told Bloomberg BNA that unanswered questions include how the U.S. will tax foreign earnings, as well as how, if the U.S. moves to a territorial system, its tax base will be protected from erosion.
Ideal U.S. Corporate Tax Rate
Edward Kleinbard, a professor at the University of Southern California’s Gould School of Law, advocates a U.S. corporate statutory tax rate of between 25 percent and 28 percent. The former chief of staff of the congressional Joint Committee on Taxation said the U.S. “is not a small open economy and we make a mistake to model it as such.”
The U.S. has a privileged position as one of the world’s largest internal markets, said Kleinbard at a conference in November held by the American Enterprise Institute and the International Monetary Fund in Washington. “Materially lower rates exacerbate tax competition in ways that are unhealthy for smaller countries.”
Warner said Kleinbard is probably right from a policy perspective. Reducing the U.S. corporate rate to 15 percent or 20 percent—that is, below 25 percent—is unlikely to bring many more jobs or facilities to the U.S. “The U.S. market is big enough” that multinational companies “will invest here so long as the U.S. tax rate is competitive.”
A lower-than-average rate might bring more taxable income to the U.S. in the form of IP-related taxable income and income from tweaks in transfer pricing analysis, Warner said. “But there is probably little reason to think that a lot of additional hard investment would come in just because our rate was lower than, for example, the U.K. rate.”
Schmidt said the concept of a cash flow tax or destination-based tax that was raised in the Ways and Means blueprint “is intriguing and could be quite attractive. It could have the advantage of largely eliminating artificial incentives with respect to where to base operations, while also encouraging exports.”
Other export incentives have been determined to violate U.S. trade obligations, Schmidt said. Those incentives include domestic international sales corporations, foreign sales corporations and the extraterritorial income regime. “A key will be to carefully navigate those rules, or perhaps to revisit those trade obligations,” he said.
Doran Klein questioned whether the proposed cash flow tax would be considered consistent with U.S. World Trade Organization obligations. “Is Congress willing to take a chance that the WTO would invalidate a major corporate tax reform years after adoption?” she asked, adding that how the European Union state aid cases affect the calculation is also in question.
‘Apples and Oranges.’
Warner said Angus’s point about the benefits of eliminating taxes on exports “sounds enticing, but there’s a bit of comparing apples and oranges.”
It is true that the EU countries have territorial systems as well as lower corporate tax rates than the U.S. currently has, and exempt exports from their value-added taxes, he said.
However, the overall corporate tax burden in those countries includes hefty VATs that are built-in tax costs, Warner said. “So, going to a system with even a 25 percent corporate tax rate that exempted export-related income, but did not have a VAT, would not just level the competitive playing field, but would probably result in a significantly lower tax burden environment than the EU has.”
Controlled Foreign Corporation Rules
Warner speculated that if the U.S. achieves “bargain-basement corporate tax rates” that prompt foreign-based multinationals to shift income to the U.S., “other countries will discover a renewed interest in controlled foreign corporation rules to capture some lost revenue.”
In addition, if foreign countries come to believe that low U.S. corporate rates will cause multinational enterprises headquartered in those countries to shift income to the U.S., those countries will start to seek more tax information about U.S. affiliates, he said—“something that at least the Rand Paul wing of the Republican Party will no doubt resist strongly.”
Schmidt said inversion transactions are likely to have no place in a modernized U.S. international tax system.
“I doubt there will be much effort expended on withdrawing the inversion regulations,” he said. “That would not likely be a priority nor a particularly efficient use of government resources.”
Moreover, inversions aren’t politically popular on either side of the aisle, he said. “A goal of tax reform will be to level the playing field with respect to international tax reform, which should substantially reduce the tax incentives for inverting.”
Barnes said a key question will be whether the U.S. offsets the reductions in income taxes with increased consumption taxes.
There may not be a federal VAT, but the U.S. can increase consumption taxes in other ways, such as with increases in federal excise taxes and by pushing away costs currently borne at the federal level, he said. The states, he noted, already raise significant revenue through consumption taxes.