by Julie Martin
With the ink still drying on a sweeping reform of the US international tax system, academics, economists, government officials, and tax practitioners gathered in Washington at a February 2 conference to offer suggestions on how to replace or revise the new law.
Discussion at the conference, which was co-sponsored by Georgetown Law’s Institute of International Economic Law (IIEL) and the International Tax Policy Forum (ITPF), also focused on how the US might use the new law’s base erosion and anti-abuse tax (BEAT) provisions, specifically the BEAT’s impact on foreign banks, as leverage in negotiations with the EU on the taxation of US tech companies.
Multi-step tax reform
Paul Oosterhuis, Skadden, Arps, Slate, Meagher & Flom LLP, said the 2017 Tax Cuts and Jobs Act (TCJA) should be viewed as the first step of a multi-step legislative and regulatory process, which could take 3–5 years to complete.
“You don’t always get it exactly right the first time,” Oosterhuis observed, noting that the 1981 Kemp–Roth Tax Cut spurred several rounds of follow-up tax legislation and that a stable international tax system was not achieved until 1988.
Mike Williams Director, Business and International Tax, at the UK’s HM Treasury, noted that when the UK moved from a worldwide to a territorial regime, it did not enact the legislation all at one time. After adding its new dividend exemption system, the UK followed up with controlled foreign company changes, and, later, the foreign branch exemption rules were added, Williams said.
Oosterhuis said that the next round of US international tax reform could come fairly quickly. He noted that President Trump reportedly mentioned at a February 1 Republican retreat in West Virginia that he might like to undertake a further tax reform focusing on savings, retirement, and similar issues.
“We could certainly have the second generation of international reform be part of that,” Oosterhuis said.
Oosterhuis argued the TCJA’s BEAT was a “misfire” that will create international difficulties.
The BEAT targets taxpayers that artificially reduce their US income through deductible payments to related foreign affiliates, adding these payments back into taxable income at a lower tax rate. The BEAT add-backs generally include payments to affiliates for services, interest, rents, and royalties.
Oosterhuis said the BEAT’s division between deductible payments that are added back into income and the cost of goods sold reduction in revenue, which is not added back, is arbitrary and not correlated with base erosion.
He said the US should replace the BEAT with an approach focusing on inbound transfer pricing, addressing concerns such as limited risk distribution.
If the US decides to retain the BEAT, it should consider tying the disallowance to whether the payments are made to affiliates in low-tax jurisdictions, adopting an approach similar to German tax legislation or the UK diverted profits tax, he said.
BEAT, banks & EU tech tax battles
The BEAT legislation does not specify whether cross-border payments are to be taken into account on a net or gross basis. Foreign banks with US operations, which would be hit hard by the BEAT if a gross basis is applied, have asked the Congress for technical corrections clarifying this point.
According to Georgetown University law professor, Itai Grinberg, though, any unilateral reduction of BEAT tax on foreign global systemically important banks (G-SIBs) would be not only inappropriate but harmful to the interests of US MNEs.
Grinberg maintains that the BEAT should be used by the US as a bargaining chip when negotiating with EU countries, particularly to gain concessions in negotiations concerning the international taxation of US tech firms.
He suggested that the BEAT be administered in a robust way with respect to G-SIBs. The impact of the law could then be ameliorated through treaties in exchange for concessions that stabilize the global tax system, he said.
Grinberg said such treatment was justified. G-SIBs strip the US tax base through cross-border payments that are interest for US tax purposes but convertible equity for regulatory purposes. These banks pay little, if any, US tax because of the huge net operating losses they generated from the financial crisis. He said the G-SIBs have likely paid less tax to the US than US tech firms have paid to Europe.
Moreover, Grinberg observed that systemically important European banks often own large percentages of their domestic sovereign’s debts. If a bank’s financial performance is negatively impacted by the BEAT, this can raise the interest rate for sovereign debt. Thus, EU nations are likely to come to the bargaining table, Grinberg said.
Oosterhuis, who represents foreign banks on BEAT issues, responded that it is “inappropriate” and “dangerous” to hold foreign banks hostage in this manner because they are institutions that are relevant to the economy.
Oosterhuis said that taxes have never before been negotiated away in this manner in tax treaties. He also said that if this was the intention behind the BEAT, Congress would likely have mentioned it.
Grinberg countered that the US routinely negotiates withholding taxes with other countries via tax treaty, though he acknowledged his proposal was novel.
“We live in a really, really, hard international tax environment which we did not start,” Grinberg said. He said the US may have to “carry a stick” to ask for a principled conversation on international taxation. Grinberg also said that different options could be employed to reach the same results for US tech firms.
“There’s a lot of tax lawyer shibboleths about how we do tax at the international level that [are] just totally uninformed by the way that we do international agreements in every other space,” Grinberg added.
Calum Dewar of PwC said that many aspects of the BEAT and the TCJA’s global intangible low-taxed income (GILTI) regime need clarification through technical corrections or Treasury guidance.
For the BEAT, is unclear what the base erosion amount should be if services are delivered at markup; namely, is it the amount of the markup or the total cost plus markup. The answer makes a huge difference to the calculation, Dewar said.
Dewar said that to determine the BEAT tax, one must compare modified taxable income to the US tax liability. This calculation gives rise to BEAT in some situations where it would not be expected if a company has a large amount of foreign tax credits, Dewar said.
Dewar said that a GILTI inclusion increases taxable income and thus increases foreign tax credits. As a result, GILTI has a negative influence on the BEAT calculation, he said.
GILTI & FTC allocation
Dewar also said that the TCJA’s framework for calculating the foreign tax credit for GILTI income is very unclear. Practitioners are trying to figure out how to deal with what is effectively a new basket for foreign tax credit purposes and how expense allocations operate in this context, he said.
Dewar said the GILTI amount can be very large and there is also a risk that GILTI could attract a very large expense allocation, making the incremental GILTI tax significant even if the overseas tax rate is in excess of 21 percent.
Oosterhuis said there are ways to deal with the expense allocation issue through technical corrections or regulatory action. For example, other items of income may be added to the GILTI basket, like royalty income received by US multinationals from foreign affiliates, or interest income on a look-thru basis. That would reduce the pressure on expenses in the GILTI basket, he said.
Alternatively, Oosterhuis said, a lot of the expenses could be pulled out of the GILTI basket. “It makes no sense at all to have R&D expenses allocated to the GILTI basket . . . you allocate the R&D to royalties and not the GILTI income,” he said.
Dewar said that another area in dire need of Treasury guidance is the TCJA’s new hybrid mismatch rules. Dewar noted that while the OECD/G20 base erosion profit shifting (BEPS) rules on hybrids are about 400 pages long and the UK rules run about 80 pages, the new US hybrid legislation is only 4 pages long.
International tax conundrum
University of California Berkeley professor Alan J. Auerbach said that he views the TCJA as temporary legislation, given all the expiring provisions in the new law.
Auerbach said the US was unable to solve the basic conundrum of the existing international tax system with respect to multinationals, which is that the more you move to a residence-based principle and reduce profit shifting incentives, the more you also encourage inversions and make US companies less competitive.
He said a solution is to change the structure of the tax system, to move to a destination-based system, such as a destination-based cash flow tax or apportioned sales based taxation.
While that was not adopted, Auerbach said, the ultimate reform arguably moves in that direction.
By adopting a minimum tax at a lower rate than the domestic tax, the US’s new system is somewhere in-between residence taxation and territorial taxation. But by also adopting a lower overall corporate tax rate, there is less reliance on taxation, so hopefully, problems of both are lessened, Auerbach said.
Auerbach said elements of the BEAT and the foreign-derived intangible income (FDII) provisions also move the US in ‘baby steps” toward destination-based taxation. He said the FDII is most likely not WTO compatible, though.
Rate reduction & tax avoidance
Reed College economics professor, Kimberly Clausing, on the other hand, predicted that the TCJA’s corporate rate reduction will probably not do much to curtail tax avoidance by large multinationals. Most companies will hire advisors to game the new rules, she said.
Clausing added that the TCJA territorial provisions will make profit shifting worse as they remove the “speed limit” on tax avoidance. Other provision, such as the GILTI and BEAT, raise revenue but only address about one-tenth of the profit shifting problem, Clausing said.
Clausing also said that is not likely that the FDII provisions will attract much investment because taxpayers know that the rates could always change.
Moreover, she said the exclusion from GILTI of a deemed 10 percent return on tangible assets creates a perverse incentive for companies to locate assets offshore. She said this is particularly worrisome because the incentive is to move real parts of the tax base, not just financial parts.
Tangible and intangible asset location
Asked whether, given the GILTI provisions, taxpayers would be wise to locate tangible property outside the US, Dewar said the answer, unfortunately, depends on the taxpayer’s specific facts.
The TCJA offers accelerated expensing, which would be a factor weighing toward locating tangible property in the US, Dewar said. On the other hand, if borrowing is part of the transaction, the TCJA’s new interest restrictions may come into play. Further, locating tangible property in the US will limit some of the benefits of the FDII calculation, he said.
Dewar said the best location for intangibles is still up for debate.
Looking just at the numbers, if the tax rate offshore is exactly 13.125 percent, it makes no difference where the IP is located, he said. If the rate is lower, locating IP offshore appears to be better, numerically. If the offshore tax rate is higher than 13.125 percent, it may make sense to try to bring the IP onshore.
He cautioned, though, that new US law includes built-in increases to the tax rate and that this rate may go higher if the US administration changes. Further, Dewar said, one must be cautious of bringing assets into the US. As in the Eagles’ song, Hotel California, “you can check in, but you can’t check out,” Dewar warned.