Finance Committee Provides Its Framework for International Tax Reform
The Senate Finance Committee has been working all year in five bipartisan working groups on tax reform, and today they have reports to show for it. Of particular interest is the international tax reform working group's report, since there has been some potential common ground emerging between the two parties, and this reform has been linked to a Highway Trust Fund solution. We will summarize the other four reports in a later post.
For background, the federal government taxes U.S. multinational corporations on their foreign income with a deferral system. This means that "active" foreign income is generally only taxed when it is repatriated to the U.S., while "passive" income – basically financial income that is highly fungible and mobile – is taxed immediately. The companies get foreign tax credits for the taxes they pay to foreign governments to prevent double-taxation.
The working group's framework discusses five issues in international tax reform:
- Ending the Lock-Out Effect: The deferral system currently in effect encourages companies to keep active income outside the country. To address this lock-out, lawmakers could change the deferral for active income, either by eliminating it and taxing it immediately or exempting all or most of the income. Most prominent tax reform plans have done the latter, and the working group recommends doing so as well. Details of the exemption system are left to be filled in.
- A Patent Box System: Some countries with an exemption system also include a "patent box," which reduces the tax rate on income earned from intellectual property to encourage companies to keep IP in its resident country. The group seems to support a patent box, saying lawmakers should "combat the efforts of other countries to attract highly mobile U.S. corporate income through the implementation of our own innovation box regime," although it is light on the details of how to do it.
- Base Erosion: Countries with exemption systems don't generally have a pure territorial system, where no foreign-source income is taxed. Instead, they have various base erosion provisions to prevent companies from artificially shifting income out of the resident country. These provisions could take the form of a minimum tax on foreign income, as the Tax Reform Act of 2014 and President Obama have proposed in different forms, and include more targeted provisions as well. The working group does not say whether it would support a minimum tax or other provisions, simply saying that "the co-chairs are committed to designing base-erosion proposals that protect the US tax base and address the proliferation of tax havens, while not undermining the ability of American companies to compete abroad." This will be a key issue in any international tax reform.
- Interest Expense Limitations: The tax code currently limits interest deductions by prohibiting companies from deducting interest expenses in excess of 50 percent of their income or if their debt-to-equity ratio is greater than 1.5 to 1. This provision helps to discourage over-leveraging and earnings stripping, but both the Tax Reform Act and the President proposed tightening these limits in different ways. Again, the working group does not specify what action it would take, but it indicates that it would continue to look at what rules would best balance companies' financing needs and protecting the corporate tax base.
- Deemed Repatriation: A transition to a new international tax system would likely be accompanied by a "deemed repatriation" tax that would hit the untaxed income that U.S. companies have maintained overseas. Both the Tax Reform Act and the President included this tax and used it to close part of the Highway Trust Fund shortfall. The working group supports the use of a deemed repatriation tax in international tax reform but is undecided about the rate or whether to use a multi-tier structure to provide a lower rate for non-cash holdings.
The framework – as its name suggests – is just a start on international tax reform, but as an area with potential for bipartisan progress, it is important to get the conversation underway. It is an area that could have a significant effect on the economy and transportation policy.