Brian J. Arnold
March 17, 2020
View Past Issues
US International Tax Issues: A View from the Congressional Research Service
The 2017 changes to the US international tax system were extensive and controversial. The prior system was a worldwide system with deferral for active business income earned through foreign corporations. The 2017 changes produced a hybrid worldwide/territorial system with foreign source income earned directly by US corporations subject to US tax at 21 percent but foreign source active business income earned through foreign corporations completely exempt from US tax – both when earned and when remitted as dividends. However, a minimum tax is imposed on global low-taxed intangible income (GILTI) of foreign corporations controlled by US corporations at half the ordinary 21 percent corporate rate. This minimum tax on foreign source income is supplemented by a minimum tax of 10 percent (12.5 percent for taxation years beginning after 2025) on deductible base-eroding payments by US corporations to foreign related parties (the base-erosion anti-abuse tax, or BEAT).
The new system also provides a lower rate of tax on “foreign derived intangible income” (FDII) to induce US companies to repatriate capital from abroad. In addition, the United States has adopted earnings-stripping rules to restrict the deduction of interest to 30 percent of EBITDA.
The overall economic effects of these dramatic changes to the US international tax rules are uncertain. Their enactment was rushed, without the usual congressional scrutiny. Moreover, the sustainability of the changes is questionable, since a Democratic President and Congress are likely to roll back at least some of the changes.
In this context, Issues in International Corporate Taxation: The 2017 Revision (P.L. 115-97) (February 20, 2020) available at http://crsreports.congress.gov, a 44-page study prepared by the Congressional Research Service for members of Congress and Congressional Committees, is welcome. The authors of the study are Jane Gravelle, a well-known and respected public finance economist, and Donald Marples. The study compares the new US international system with the prior system. It analyzes the economic implications of the changes, especially for the location of investment and the compatibility of the new system with US tax treaties, the WTO agreements, and the OECD minimum standards. Finally, the study identifies several major concerns about the new system and possible options for dealing with these concerns.
In general, the study focuses on four major issues that the 2017 tax reforms were intended to deal with: the allocation of investment between the United States and other countries, profit-shifting between the US and other countries, the repatriation of profits by foreign subsidiaries of US corporations, and inversions of US corporations (a largely unique US problem involving US corporations becoming foreign corporations because of the US place-of-incorporation test for corporate residence; the parts of the study dealing with the new anti-inversion rules are not discussed in this report).
The study points out some important features of the prior US international tax system:
- The US effective tax rate on foreign source income was 2.3 percent in 2004 because of the deduction of expenses (such as overhead, R&D and interest) incurred by US corporations that were properly attributable to foreign source income; and
- the effective US tax rate on dividends from foreign subsidiaries was only 3.3 percent because of deferral and the worldwide limitation on the foreign tax credit.
The new system for US corporations with a 10 percent or greater interest in a foreign corporation is a hybrid of exemption (profits from tangible foreign assets), current taxation of foreign branch income and Subpart F income (foreign passive investment income) at the full US rate, and current taxation of foreign income from intangible assets (GILTI) at a reduced rate (10.5 percent for years beginning before 2025 and 13.125 percent thereafter). In addition, intangible income from the export of goods and services (FDII) is taxable at a reduced rate of 13.125 percent for years beginning before 2025 and 16.406 percent thereafter.
The new US rules to prevent profit shifting include the BEAT, minor modifications to Subpart F, and changes to transfer pricing rules (especially with respect to intangibles), and tougher earnings-stripping rules. In addition, the shift to an exemption system for dividends from foreign corporations was accompanied by the deemed distribution of the accumulated post-1986 earnings of foreign subsidiaries, with US tax at 15.5 percent for earnings held in cash and 8 percent for other earnings; the tax is payable over 8 years.
The study analyzes how the 2017 changes have affected the allocation of investment and whether those changes make the allocation of investment more efficient on a worldwide basis (capital export neutrality) or better for the United States (national neutrality). The study compares US and foreign tax rates before and after the 2017 reforms and also analyzes the effects of the GILTI, FDII, BEAT, and earnings-stripping rules.
Marginal effective tax rates on equity-financed tangible investments were much higher than those on intangible investments both before and after 2017. For all investments, the marginal effective tax rate declined from 15.6 percent before 2018 to 3.2 percent after 2017 (taking into account bonus depreciation before 2018 and current expensing of machinery and equipment after 2017) and from 19.7 percent to 10.9 percent (without taking those measures into account). The equivalent marginal effective tax rates for debt-financed investments increased from -64 percent before 2018 to -48.4 percent after 2017 (taking into account bonus depreciation before 2018 and current expensing after 2017) and from -53.5 percent to -27.4 percent (without taking these measures into account). The smaller negative rates (or reduced subsidies) under the new rules are attributable to the new restrictions on interest deductions; they will result in increased tax revenues of almost $18 billion in the first full year and cause marginal effective tax rates to increase by 2 percentage points under the new law once fully implemented (assuming that debt financing amounts to 32 percent of all financing and 20 percent of the deduction of net interest expenses is disallowed).
The study concludes that “Overall, it is unlikely that the location of investment will be significantly affected by the tax change.” (At 23). Further, “it is not clear that capital stock in the United States would increase” and might contract because debt financing will be more costly. (At 23-24). Moreover, any impact on US investment is likely to be offset by decreases in foreign tax rates.
The study suggests that the 2017 tax cuts have had little impact on wages but in the short term have benefited shareholders in the form of share buybacks. The current expensing for equipment makes the United States an even more favoured location for investment in equipment as compared to other countries. The changes will result in a greater incentive for US firms to invest in tangible assets abroad, since there will be no US tax on the income from such assets. For inbound investment into the United States, the study concludes that the effect depends on whether the investment is financed by debt or equity. For debt-financed US investment, the changes will increase national neutrality but for equity-financed investments, worldwide efficiency will be enhanced. Surprisingly, the study suggests that although the US tax-rate cut puts US tax rates in the middle range of tax rates in OECD and G20 countries, “rate reduction alone might not affect profit shifting” (at 27) because most profit shifting occurs with low- or no-tax countries. However, the GILTI, FDII, BEAT, and interest-deduction restrictions will significantly reduce the incentives for profit shifting through placing debt in the United States or through transfer pricing.
The study mentions but does not take a position on the potential conflicts between the US tax changes and international agreements. More specifically, the issues are:
- Does the BEAT violate the non-discrimination article in US tax treaties?
- Is the FDII an export subsidy in violation of the WTO?
- Is the FDII a harmful tax practice in violation of the OECD minimum standard in BEPS Action 5?
The final part of the study identifies several concerns with the new international rules. For example, the GILTI regime allows a foreign tax credit for only 80 percent of foreign taxes paid, no carry-forward, and requires a separate GILTI basket with an allocation of expenses that may result in the US taxation of GILTI in excess of the 13.125 percent statutory rate. However, the GILTI foreign tax credit limitation operates on a worldwide basis, allowing cross-crediting of high and low foreign taxes. Some have suggested that taxing GILTI and FDII at the ordinary 21 percent corporate tax rate would eliminate any incentive to earn income in the US or abroad. Others have suggested that the foreign tax credit limitation for GILTI should be based on a per-country approach or that both GILTI and FDII should be limited to low-tax countries.
With respect to the BEAT, the lack of any credit for foreign tax has been criticized on the basis that it “act[s] primarily as a tax on foreign-source income rather than achieving the objective of limiting profit shifting through outbound payments.” (At 38). The BEAT can be avoided by embedding royalties in the cost of goods sold and by using the services cost method, whether a mark-up is added or not. In addition, the threshold for the application of the BEAT ($500 million) has been criticized as too high, and it has been suggested that the BEAT should be targeted at abusive situations. Another option would be to remove interest expenses from the BEAT and restrict the deduction of such expenses to those allocable to US source income or assets, which would require the restoration of the worldwide allocation of interest expenses in order to deny the deduction of interest expenses incurred to earn exempt foreign source income.
This study is a useful reminder of all the problems associated with all aspects of the 2017 changes to the US tax system. These problems should have been thought out at the beginning but that was not done, with the result that ongoing technical fixes will be necessary for many years. Moreover, as noted above, it seems likely that a Democratic President and Congress would make significant changes to the 2017 rules. Joe Biden has proposed to raise the US corporate rate back up to 35 percent, which would likely necessitate many other changes. The problems with the US international tax rules should also be a warning to the international community about making changes to the international tax system based substantially on the US GILTI and BEAT measures.
Although I was critical of the Canadian government’s tepid response to the US changes, in retrospect, that type of cautious wait-and-see approach may have been the best approach. That said, I still think it would be a good idea for Canada to reduce its corporate tax rate and make a number of other significant changes to the corporate tax system. However, as we face the global pandemic of Covid-19, now is not the right time to engage in sweeping changes to the tax system; instead, we should be introducing generous relieving measures for businesses and individuals who are suffering economically so we can all survive this devastating disease. Best wishes to everyone and stay healthy!