Good news, Congress is trying to make taxes easier. Bad news, it’s still complicated enough that you need to hire a lawyer to help you.
Under the Camp Proposal (the House of Representatives’ proposal for the 2014 Tax Reform Act), the current international tax regime under the Internal Revenue Code (“IRC”) would be subject to a number of reforms aimed at reducing confusion, and increasing US economic competitiveness abroad.
The Camp Proposal is designed to reduce the “lock out” effect (which traps earnings from US foreign subsidiaries abroad), increase the U.S. tax base to maximize revenue, and give US companies the ability to engage in limited credit planning to maximize their foreign tax credits (“FTC”).
Under Section 4103 of the Camp Proposal, Congress would amend IRC Section 863(b) and do away with the 50/50 rule, which is used in determining the allocation of income from the sales of inventory produced in the US and sold overseas.
For example, suppose a U.S. manufacturer solely produces goods in the U.S. at a cost of $40 and sells these goods to a foreign distributor for $100. He has $60 of income, but from what source?
Under IRC Section 863(b) of the current Code, the U.S. manufacturer would be able to claim $30 as U.S. source income and the other $30 as foreign source income; this is referred to as the 50/50 rule. Under the Camp Proposal, however, all of the manufacture’s income would be allocated based on where the inventory was produced. Therefore, the hypothetical U.S. manufacturer would have $60 worth of U.S. source income.
Why is the sourcing of the income so important?
Taxes paid by a foreign subsidiary of a U.S. parent corporation on foreign source income in a foreign jurisdiction, may be credited against a U.S. parent corporation’s US tax liability. The objective of sourcing is not to have a U.S. parent corporation pay taxes twice on the same income. Under IRC Section 960 of the current Code, certain types of “subpart F income ” are eligible for a FTC.
FTCs, however, are limited under IRC Section 904. IRC Section 904 requires the U.S. parent’s foreign source income and its worldwide taxable income to equal the ratio between the U.S. parent’s FTC and their US federal income tax liability. Therefore, if a U.S. parent corporation builds up its foreign source income, it may receive a larger FTC and use it to offset part of its US tax liability.
The risk is that this type of credit planning may be abused using aggressive cross crediting. In that situation, a U.S. corporation, with operations all over the world, would try to maximize foreign source income in high tax rate jurisdictions. By doing so, the corporation would receive an “excess FTC” because the FTC will only go up to the U.S. corporate tax rate of 35%. The corporation would then use the “excess FTC” to offset its “residual US tax,” which is left over because the operations in the corporation’s low taxing foreign jurisdiction did not generate a large enough FTC. This aggressive credit planning can effectively reduce a U.S. corporation’s, operating a foreign production subsidiary, U.S. tax liability to as close to $0 as possible.
From the view of U.S. manufacturers, the 50/50 rule is in essence a subsidy that reduces its marginal costs, and in the spirit of encouraging U.S. domestic growth, should probably not be tinkered with. However, according to proponents of the Camp Proposal, a repeal of the 50/50 rule would lead to an increase of $1.8 billion in U.S. tax revenue over the course of nine years. On the other hand, there is a downside to repealing the 50/50 rule.
Taking away the 50/50 rule could spur U.S. manufacturers to move all of their operations to foreign jurisdictions where they can generate more subpart F income. By installing these operations overseas, under the Camp Proposal’s new allocation rules, their entire income from the production of that inventory would be sourced abroad and escape U.S. taxation.
The 50/50 rule is the least of this Congress’s concerns. The Camp Proposal’s modifications of intangible asset income under Section 4112 are far better suited to reduce foreign base erosion. By creating new types of subpart F income and creating tax neutral incentives, US domestic corporations might think twice about allocating operations and expense overseas. The 50/50 rule is not causing excessive abuse of the FTC system; rather, the rule is acting as a domestic manufacturing incentive.
Congress did not alter the 50/50 rule in the 1986 Tax Reform Act, and it should not do so under this current Tax Reform Act. The Camp Proposal’s alteration of the 50/50 rule may not be the U.S. tax revenue generator it seems to be, and may come with substantial risk of flight from U.S. manufacturing.
Instead, Congress should remedy the practice of income hording overseas by modifying the existing subpart F income rules. This would undoubtedly lead to the creation of a tax neutral environment, which in return would no longer make the move overseas as attractive and beneficial to U.S. corporations as it currently is.
Posted August 9, 2014