A regulatory tax hike on US multinationals

By Daniel Bunn, Vice President of Global Projects, Tax Foundation, Washington, D.C.

Throughout the first year of the Biden administration, one tax policy theme was consistent. The President and Treasury Secretary Janet Yellen were focused on increasing the tax burden on U.S. companies—particularly multinational companies.  As Secretary Yellen put it last year, “It is about making sure that governments have stable tax systems that raise sufficient revenue to invest in essential public goods and respond to crises, and that all citizens fairly share the burden of financing government.”

But while much of the policy focus has been on proposals embedded in the Build Back Better agenda, which has not yet made its way through Congress, a meaningful tax hike for multinational companies has already been adopted.

Final foreign tax credit (FTC) regulations released just at the beginning of the year represent a tax hike for many U.S. companies that earn profits from customers abroad. While the initial motivation for revising FTC rules was the adoption of digital services taxes (DSTs) in foreign jurisdictions, the final rules have impacts well beyond the DSTs.

Back in 2018 and 2019, as DSTs were first beginning to come on the scene, it was not clear whether those taxes should be eligible for U.S. FTCs. The U.S. government was opposed to the design of the DST, opened trade investigations, and threatened foreign jurisdictions with tariffs.

It did not appear consistent that the U.S. would oppose the DSTs while providing U.S. taxpayers with FTCs for DST payments.

So, when the IRS began work on refreshing the FTC rules, it seemed likely that DSTs would not be creditable. Unsurprisingly, that is one result of the regulations released in December.

However, that is not where the regulations stopped. The Internal Revenue Service (IRS) took the logic of disallowing credits for DSTs much further.

Whereas previously many foreign taxes on businesses would lead to a U.S. FTC, the scope for eligible taxes is now much narrower.

The final regulations state that:

the fundamental purpose of the foreign tax credit…is served most appropriately if there is substantial conformity in the principles used to calculate the base of the foreign tax and the base of the U.S. income tax. This conformity extends not just to ascertaining whether the foreign tax base approximates U.S. taxable income determined on the basis of realized gross receipts reduced by allocable costs and expenses, but also to whether there is a sufficient nexus between the income that is subject to tax and the foreign jurisdiction imposing the tax.

On one hand, this might sound reasonable. Why should the IRS provide an FTC for a tax that does not look like a tax the U.S. imposed?

However, the rules go on to explain what “substantial conformity” might mean, and the implications are broad. This is because there are many taxes around the world that do not substantially conform to the U.S. tax code but have been historically eligible for FTCs.

Perhaps the most important difference is that the U.S. tax base focuses on the place of production rather than the place of delivery when determining “where” a tax should be owed. A foreign country may require a withholding tax on payments for services rendered by a U.S. company when that company does not have a local permanent establishment. While historically eligible, such a withholding tax would no longer be eligible for an FTC under these rules.

Additionally, even if a U.S. company has local offices in a foreign country and is providing services connected to intellectual property held in the U.S., withholding taxes on royalties paid back to the U.S. headquarters may no longer be creditable.

One certainly can appreciate Treasury’s desire to preclude a credit for DSTs, as those taxes were discriminatory and highly engineered taxes the designers hoped would avoid preclusion under U.S. tax treaties. It is hard to see, however, how steps to disallow FTCs for these novel DSTs (all of which have been enacted in the last couple of years) lead to disallowing FTCs for normal royalty withholding taxes that have been creditable for decades. Nevertheless, by adopting the so-called “attribution” requirement to all royalties, the new rules will impact a much larger set of U.S. companies than just those that are required to pay DSTs.

The new rules will lead to double taxation of U.S. companies and put them at a competitive disadvantage in some foreign markets.

Underlying this outcome is the importance (and inadequacy) of the U.S. tax treaty network. Tax treaties are meant to mitigate the possibility of income being taxed twice in two separate jurisdictions and reduce or eliminate withholding taxes on cross-border payments. Companies doing business in countries where the U.S. has signed a tax treaty will be better off under these new rules than those doing business in non-treaty jurisdictions.

The U.S. tax treaty network is relatively narrow at only 66 countries and mainly includes countries in Europe and Asia. There is very little coverage of countries in either Africa or South America.

The new rules essentially penalize businesses that are doing business in a non-treaty country. The costs of doing business will rise because they will no longer be able to claim FTCs for taxes that do not substantially conform to the U.S. tax code. They will be taxed twice, once under a foreign withholding tax and again under IRS rules.

Let’s say a U.S. construction company is bidding on a contract for a project in Brazil. Other bidders are from Canada and France. Both Canada and France have tax treaties with Brazil, while the U.S. does not. Canada and France also have broader tax treaty networks in general at 96 and 122 treaties, respectively.

Brazil has a 15 percent withholding tax rate that the U.S. company would have to bear and likely not receive an FTC to offset.

This means that the costs for the U.S. company will automatically be higher than its competitors and that cost difference would put any bid from that company at a disadvantage. The Canadian and French companies would clearly be in a better position than the U.S. firm.

Treasury could choose to withdraw the portion of the regulations that goes beyond the creditability of DSTs. This would be the quickest way to minimize the potential for broad and negative impacts.

Two other solutions would take a bit longer.

First, the U.S. government could negotiate and sign more tax treaties. Ratification would require approval of two-thirds of the U.S. Senate. Currently in the Senate’s queue are tax treaties with Chile, Hungary, and Poland. Unfortunately, the Senate has not been too swift to ratify these agreements. It has been almost 10 years since the Chilean tax treaty was submitted to the Senate.

The second longer-term remedy would be a thorough rewrite of the FTC rules once the global tax agreement gets put in place. That agreement (also known as Pillars 1 and 2) would drastically change the rules for where large multinational companies pay taxes. The model rules (as far as they have been developed) do not look at all like current U.S. tax rules. This is particularly true for the Amount A sourcing rules and the allocation of the Under-taxed Profits Rule top-up formula.

When (although it might be more accurate to say “if”) Pillars 1 and 2 are adopted and implemented by the U.S., there would need to be an additional rewrite of the FTC rules.

Whether the regulators will work to fix the double taxation mess that has been created with the recent revisions to the FTC rules remains to be seen.

In the meantime, the Biden administration seems to be following through on a promise to increase taxes on U.S. multinational companies. And it has done so without needing votes in Congress.