Baucus Releases International Tax Reform Draft

This week, Senate Finance Committee Chairman Max Baucus (D-MT) is moving ahead with tax reform, starting with the release of discussion drafts on reforming the international tax system, tax administation, and cost recovery. Today, Baucus released the draft on international taxes.

Baucus’ international tax reform draft moves toward a hybrid territorial/worldwide system—setting up a minimum tax on overseas income that in many cases now goes untaxed or near untaxed until it is repatriated into the United States. Companies would pay tax when the income is earned, and wouldn’t owe any additional tax when it is brought back to the U.S.

By taxing income as it is earned, this draft is intended to help address two of the biggest problems of the international tax system—the current incentive to hold cash overseas in order to avoid taxation and the ability to pursue tax evasion schemes that allow many companies to structure their subsidiaries to entirely avoid tax. 

The draft appears intended to be revenue neutral in the long-term, with a one-time infusion of over $200 billion from a 20% tax on all previous-earned foreign profits, paid over 8 years.

Elements of a hybrid worldwide/territorial system with a minimum tax

In all cases, Baucus would tax overseas income as it is earned, completely ending the deferral system we have now.  If it is passive or mobile income without a clear source (like investment income), it would be taxed at the full U.S. corporate income tax rate. The draft does not specify what the corporate rate is, but Baucus has said that he hopes to lower the top U.S. corporate income tax rate to less than 30 percent. In this post, we use a 28% top rate as an example, but the actual rate could be higher or lower.

If the income is from operations of a business abroad, the draft presents two alternative options:

  1. Tax the income at 80% of the full rate (22.4%, assuming a 28% top rate), which is close to the OECD average effective tax rate of 20.6%; or
  2. Split the income into two categories: active income taxed at 60% of the full rate (16.8%, assuming a 28% top rate) and passive income taxed at the full rate.

The minimum tax would apply to subsidiaries with low effective tax rates. For instance, a subsidiary in Ireland would be taxed at Irish rates of 12.5% and would have to pay an additional 9.9% to the U.S., assuming a top U.S. rate of 28% (under the first option). However, a subsidiary in Germany would already pay German rates of 29.5% and would therefore not owe any U.S. tax, assuming a top U.S. rate of 28%, because the 29.5% paid to Germany is larger than the 22.4% minimum tax.  Neither would owe any additional tax if they bring the money back to the U.S.

Income Earned in Example Countries Under Hypothetical Mininum Tax
(Assumes 28% top rate and the first option "Option Y")
  United Kingdom Germany Ireland Bermuda
Company Earnings $1 billion $1 billion $1 billion $1 billion
Minimum Tax Rate 22.4% 22.4% 22.4% 22.4%
Foreign Country’s Statutory Tax Rate 24.0% 29.5% 12.5% 0%
Taxes paid to foreign country $240 million $295 million $125 million $0
Taxes owed to U.S. due to minimum tax 0% 0% 9.9% 22.4%
U.S. Tax Paid $0 $0 $99 million $224 million
Additional Tax When the Income is Repatriated $0 $0 $0 $0
Total Taxes Paid $240 million $295 million $224 million $224 million

In contrast, Chairman Dave Camp’s draft would move to a 95% territorial system for active income, so companies would only pay the tax of the other country. If the income was repatriated, a company would pay at a 1.25% rate (5% subject to tax x 25% corporate tax rate). Passive income would be subject to a 10% minimum tax. Camp offered various options to deal with intangible income, taxing it at a 15% minimum rate or a 25% normal rate.

One-time charge on profits parked overseas

The draft includes a one-time charge of 20% on all outstanding earnings of foreign subsidiaries that have not yet been subject to U.S. tax, regardless of whether they are repatriated or not, which would likely raise over $200 billion. In contrast, Camp’s draft would charge 5.25% on all foreign earnings, and an additional 1.25% if the income is repatriated, for a total charge of 6.5%

Elements to end tax evasion

A common tax evasion tactic under the current system is that U.S. companies can set up foreign subsidiaries, which sell into the American market, but are taxed under another country's jurisdiction. The Baucus draft would tax income from such activities at the full U.S. corporate rate.

The draft would also eliminate the international portion of “check the box,” which some companies use so that their cash transfers between subsidiaries are disregarded by the IRS. If the two subsidiaries are in countries with very different levels of taxation (Germany and Bermuda, for instance), the check-the-box rules allow the company to shift profits and in some cases avoid tax entirely.

Similar to "thin capitalization" rules in Camp's draft, new rules would limit the interest deduction to borrow in the U.S. if the resulting foreign income is not subject to U.S. tax, or if the U.S. parent company is over-leveraged compared to its subsidiaries.  

Overview of International Tax Reform Plans
  Camp Obama Baucus
Corporate Tax Rate 25% 28% unknown
Dividend Exemption 95% None 100%
Transition 5.25% tax on all foreign earnings N/A 20% tax on all foreign earnings
Intangible Income Options: Tax excess low-taxed intangible income in Subpart F, or all intangible income at minimum of 15%, Include excess low-taxed (<15% ETR) intangible income in Subpart F N/A
Low-Taxed Income Non-active business income w/ ETR*<10% taxed in Subpart F Global minimum tax (details not specified) Global minimum tax of 80% or 60% of corporate rate
Foreign Tax Credit (FTC) No FTC for 95% exempted dividends; only directly allocable deductions for foreign income New limit determined on a “pooling” basis; defer interest deduction for deferred foreign income Generally limits opportunities for cross-crediting. 
Subpart F (excluding base erosion) Repeals exclusion for previously taxed income if eligible for dividend exemption No changes Adds “United States related income” as a category of Subpart F earnings, covering sales in the U.S.
Interest Deductibility Thin Capitalization rules tighten tests for leverage and adjusted taxable income Disallows interest deductions greater than 25% of adjusted taxable income Limits interest deductions for domestic companies if the associated foreign income is exempt from tax
Other Election to treat 10/50s as CFCs Disallow deduction for reinsurance premiums to exempt affiliates Eliminates check-the-box and CFC lookthrough

Update: Blog updated on 11/20 to clarify several descriptions of elements of the discussion draft.