Fair Approaches for Taxing Previously Untaxed Foreign Income (Guest Blogger Jeffery M. Kadet)

Guest Financial Law Prof Blogger Jeffery Kadet) has written a three part series on the fair approaches for taxing previously untaxed foreign income that will be posted this week on Monday, Tuesday and Wednesday.  The full article is available on SSRN: http://ssrn.com/abstract=2587103

Abstract:

In connection with any transition to a new international tax system, we need an approach that effectively deals with the trillions of dollars of previously untaxed foreign income held by CFCs. There is logic and fairness in applying a rate on those earnings that is less than the 35 percent home country rate because the rules of the game are being changed significantly.

Many U.S. multinationals have had legitimate commercial reasons for retaining their earnings overseas. For these, I can happily accept whatever rate Congress chooses, whether it is at the lower 3.5 percent level of TRA 2014, the 14 percent level in the Administration's Green Book, or the 20 percent level in the Baucus discussion draft.

However, for those U.S. multinationals that have aggressively pushed the envelope to maximize their stateless income over the past decade and longer through convoluted tax structuring, we as a country cannot be rewarding such behavior with favorable lower-than-35 percent rates.

In this article, I suggests two approaches to identifying CFC earnings that should be subject to the full 35 percent corporate tax rate when transitioning to a new tax system, with the remainder subject to whatever favorable transition rate Congress might choose.

Part 1 of 3

The 2016 Obama administration green book released on February 2, 2015, proposes a new per-country minimum tax approach to taxing the foreign earnings of C corporations and their controlled foreign corporation subsidiaries. In conjunction with the transition to this new approach, the green book includes a one-time 14 percent tax on earnings accumulated in CFCs not previously subjected to U.S. corporate tax. A partial foreign tax credit would apply. This proposal is similar to provisions in several prior international tax reform proposals from Congress. (See, for example, former House Ways and Means Committee Chair Dave Camp’s international discussion draft, the Tax Reform Act of 2014, and former Senate Finance Committee Chair Max Baucus’s discussion draft on foreign-source income tax reform.)

Thinking about these proposals, I have mixed feelings, which others may share. In connection with any transition to a new international tax system, we need an approach that effectively deals with the trillions of dollars of previously untaxed foreign income held by CFCs. I can see the logic and fairness of applying a rate on those earnings that is less than the 35 percent home country rate because the rules of the game are being changed significantly, and many U.S. multinationals may have legitimate commercial reasons for retaining their earnings overseas. So I can accept whatever rate Congress chooses, whether it is at the lower 3.5 percent level of TRA 2014, the 14 percent level in the green book, or the 20 percent level in the Baucus discussion draft.

I may be oversimplifying a little, but I see two categories of CFC earnings. First, there are plenty of CFCs that have accumulated earnings from conducting legitimate business operations in their countries of incorporation and that were structured without any significant profit-shifting intentions. Those CFC earnings should benefit from whatever lower-than-35-percent rate Congress chooses.

A second category of CFC earnings, which grew significantly following the 2004 repatriation tax holiday, is the zero- or low-taxed earnings that resulted from conscious, and often aggressive, tax structuring meant to achieve the goals of:

• avoidance of any current U.S. taxation through planning around the CFC rules in subpart F; and 

• avoidance of taxation in the foreign countries in which operations are conducted or sales are made. 


Professor Edward D. Kleinbard has given us the appropriate label of ‘‘stateless income.’’[1] Whether through congressional hearings (think Apple[2], Microsoft, and Hewlett-Packard[3]), the tireless work of journalists (think Jesse Drucker of Bloomberg regarding Google[4]), or the efforts of whistleblowers (think the International Consortium of Investigative Journalists’ effort on the ‘‘Lux leaks’’[5]), the success and unbelievable extent of aggressive, and often 
convoluted, tax structuring has been well publicized. Bloomberg’s Richard Rubin recently reported on Gilead Sciences, Inc., which reported in its 2014 Form 10-K more than $8.2 billion of foreign pre-tax earnings on less than $7 billion of foreign sales.[6]

Now back to my mixed feelings. While I’m happy to subject the first category of CFC earnings to a beneficial congressionally determined lower- than-35-percent rate, I find it abhorrent to reward multinationals that have aggressively pushed the envelope to maximize their stateless income. Whether one is a Republican or a Democrat, we simply cannot reward that behavior with any beneficial lower-than-35-percent rate upon transition to a new system of taxing international income.

Convoluted tax avoidance structuring may be technically legal, but to quote Margaret Hodge, chair of the U.K. Parliament’s Public Accounts Committee, it’s ‘‘morally reprehensible.’’[7] It’s not just Hodge who speaks in these terms. Sen. John McCain, R-Ariz., in his opening statement[8] at the 2013 Senate subcommittee hearings on Apple said:

As the shadow of sequestration encroaches on hard-working American families, it is unacceptable that corporations like Apple are able to exploit tax loopholes to avoid paying billions in taxes. . . . It is completely outrageous that Apple has not only dodged full payment of U.S. taxes, but it has managed to evade paying taxes around the world through its convoluted and pernicious strategies. . . . It is past time for American corporations like Apple to reorganize their tax strategies, to pay what they should, and invest again in the American economy.

Considering those words from a Republican and former presidential candidate, what we really need is an administratively easy approach to distinguishing between the two categories of CFC earnings so that earnings resulting from ‘‘convoluted and pernicious strategies’’ are taxed at the 35 percent rate that would have been paid in the absence of those strategies (with an offset for any foreign taxes paid).

For simplicity, this article mentions only the corporate 35 percent rate. For individual U.S. shareholders of any CFC, the normal section 1 individual rates should apply — without the benefit of the qualified dividend income rules. It should also be noted for fairness to Sen. McCain that he appears to have forgotten some of his 2013 rhetoric in light of the recent announcement of an Apple $2 billion global data command center in Arizona.[9]

[To be continued in Part 2 tomorrow]

Jeffery M. Kadet has been a Part-Time Lecturer for about a decade within the University of Washington Law School Graduate Program in Taxation teaching several international taxation courses.  In addition to this and other academic activities over the years, Jeff has spent more than 32 years in public accounting, of which more than 22 years were spent practicing and living outside the U.S. in Singapore, Moscow, Tokyo, Istanbul, Hong Kong and Shanghai.  He has worked in numerous industries and has specialized in international taxation and business planning. 

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[1] Kleinbard, ‘‘Stateless Income’s Challenge to Tax Policy,’’ Tax Notes, Sept. 5, 2011, p. 1021; Kleinbard, ‘‘Stateless Income’s Challenge to Tax Policy, Part 2,’’ Tax Notes, Sept. 17, 2012, p. 1431. 


[2] Senate Homeland Security and Governmental Affairs Permanent Subcommittee on Investigations, ‘‘Offshore Profit Shifting and the U.S. Tax Code’’ (May 21, 2013). 
 

[3] Permanent Subcommittee on Investigations, ‘‘Offshore Profit Shifting and the U.S. Tax Code — Part 1 (Microsoft and Hewlett-Packard)’’ (Sept. 20, 2012). 
 

[4] Drucker, ‘‘Google 2.4 Percent Rate Shows How $60 Billion Is Lost to Tax Loopholes,’’ Bloomberg, Oct. 21, 2010. 


[5] Available at http://www.icij.org/project/luxembourg-leaks. 
 

[6] http://www.bloomberg.com/news/articles/2015-02-26/gilead-avoids-billions-in-u-s-taxes-on-its-1-000-a-pill-drug 

[7] Raymond Doherty, ‘‘Tax Is a Choice for the Rich, Says Hodge,’’ Economia, Oct. 30, 2014. 

[8] See supra note 2 (McCain’s opening statement). 

[9] http://time.com/3693605/apple-data-center/