Although light on details, the recent statement on tax reform from the “Big 6” group of Republican Congressional and White House policymakers provided two important hints on the direction that tax reform may be heading. First, the Big 6 remain dedicated to imposing a “system that encourages American companies to bring back jobs and profits trapped overseas.” Whether this means true international tax reform or merely lower tax rates at home is up for debate. However, if international tax reform remains a goal, the joint statement made clear that it will not be accomplished by way of a destination-based cash flow tax (a “DBCFT”). Without a DBCFT, what other options for international tax reform are there? One proposal that we have seen a handful of times in recent years is a foreign minimum tax.
What is the foreign minimum tax concept? The current system allows taxpayers to defer paying tax on active earnings of controlled foreign corporations (“CFCs”) until repatriation to the United States, but ultimately taxes those earnings (as well as passive earnings of CFCs and earnings generated by branches of U.S. corporations operating in non-U.S. jurisdictions, which are not eligible for deferral) at the full 35% corporate tax rate once repatriated (subject to offset by credits for taxed paid in other jurisdictions (i.e., “foreign tax credits”)). The purest form of the foreign minimum tax would eliminate the deferral of tax on active offshore earnings in exchange for a lower “minimum tax” on all offshore income, generally payable first to the jurisdiction in which the income is earned, with the rest, if the applicable jurisdiction’s tax rate is less than the foreign minimum rate, payable to the United States. In some versions, the foreign minimum tax rate would also apply to earnings of a U.S. corporation generated through a branch or from the performance of services overseas.
In exchange for paying the foreign minimum tax on an annual basis, foreign minimum tax proposals typically allow U.S. corporations to repatriate offshore earnings without incurring additional tax, and include exemptions for gain from the sale of a CFC to the extent attributable to previously taxed earnings. Proposals for a foreign minimum tax are generally coupled with a one-time “transition tax” on all previously untaxed offshore earnings.
The theory, pros and cons. The theory behind the foreign minimum tax is that U.S. corporations should pay some base level of tax on all of their (and their subsidiaries’) income, no matter where it is earned. The foreign minimum tax is a way to lessen the overall burden of a world-wide system of taxation without encouraging profit-shifting to low-tax offshore jurisdictions. The foreign minimum tax would therefore help the U.S. tax system become more competitive with territorial systems common in other developed countries. However, the foreign minimum tax has drawbacks. Critics argue that it does little to combat inversions (at its core, the foreign minimum tax is a residency-based system – U.S.-headed corporate groupsare subject to the tax while non-U.S. groups are not). Another issue is that while the foreign minimum tax is simple in concept, it requires a complex set of rules to determine where income is earned and tax is paid, and the amount of tax that must be paid to the U.S. to “top up” foreign taxes below the minimum rate.
Recent Examples. Proposals for a foreign minimum tax differ dramatically. Three examples stand out:
The Trump Campaign Proposal. Although not labeled as such, President Trump’s campaign proposal for international tax reform was, in effect, a shift toward a foreign minimum tax. It called for an end to deferral of offshore earnings coupled with a foreign tax credit regime, an overall corporate rate of 15% and a transition tax of 10% on all previously untaxed offshore earnings. Effectively, the Trump campaign plan would have resulted in taxation of offshore earnings only when such earnings were taxed at less than 15% in other jurisdictions.
The Obama FY 2016 Budget. Perhaps the purest proposal for a foreign minimum tax was released as part of the Obama Administration’s FY 2016 budget. (The administration’s explanation of the proposal is available here, starting on p. 20.) Under the proposal, a U.S. corporation would have been subject to current U.S. taxation on the earnings of each of its CFCs or foreign branches for each tax year at a rate equal to 19% minus (but not below zero) 85% of the applicable “per-country foreign effective tax rate.” The per-country foreign effective tax rate would be calculated by looking at all foreign earnings and associated foreign taxes “assigned” to a particular jurisdiction over a 60-month period ending on the last day of the CFC’s tax year (or the last day of the U.S. corporation’s tax year in the case of branch earnings). Only foreign taxes that would be creditable under the current regime would count, and “foreign earnings” would be calculated using U.S. tax principles but would include disregarded payments deductible elsewhere, such as disregarded intra-CFC interest or royalties, and would exclude dividends from related parties.
Foreign earnings would be “assigned” to a jurisdiction based on tax residence for local law purposes. If a CFC’s earnings were “stateless” and thus not subject to foreign tax anywhere, the earnings would be subject to the full 19% rate. The tax would be imposed on the foreign earnings assigned to a particular jurisdiction for the taxable year (calculated using the same rules used to calculate the per-country foreign effective tax rate), less an “allowance for corporate equity,” which would exclude an unspecified portion of foreign earnings attributable to “active” income from the tax base to “provide a risk-free return on equity invested in active assets.”
The foreign minimum tax was coupled with a one-time 14% transition tax on all previously untaxed offshore earnings. No additional U.S. tax would be imposed on repatriation of offshore earnings (as all offshore earnings would have been previously tax either under the transition tax or the foreign minimum tax). The proposal similarly exempted gain on the sale of a CFC to the extent attributable to previously taxed earnings.
The Camp Discussion Draft Option C. Former Congressman Dave Camp’s (R-MI) 2014 tax reform discussion draft included a more limited example of a foreign minimum tax. Camp proposed a residence-based territorial system with a foreign minimum tax overlay.
In a residence-based territorial system, taxpayers have even greater incentive to shift income overseas. As a means to fight this base erosion, the Camp discussion draft expands the existing subpart F regime and its current taxation of certain types of offshore income, including by way of so-called “Option C,” which effectively creates a minimum level of tax on offshore income. Beyond this high-level principle, the specifics get complicated quickly.
Option C proposes a new category of subpart F income – “foreign base company intangible income” (“FBCII”), which, very generally, would be taxed annually in the United States to the extent not taxed in a foreign jurisdiction at an effective tax rate of at least 15%. Despite its name, FBCII under the Camp discussion draft would not be limited to “intangible” income. Rather, the FBCII calculation appears, at base, to be aimed at identifying a proxy for a deemed “profit” component of a CFC’s income beyond what the Camp drafters appear to believe is a normal return.
Specifically, FBCII is defined as the excess of a CFC’s “adjusted gross income” over 10% of its “qualified business asset investment” (generally the CFC’s aggregate adjusted basis in tangible property other than certain actively traded commodities). “Adjusted gross income” is defined as gross income less income from the production or extraction of actively traded commodities. FBCII is then reduced by amounts separately taken into account in other categories of foreign base company income, and then separates out FBCII that is “foreign derived” – i.e., FBCII that is earned from goods sold for use, consumption or disposition outside of the United States and services provided with respect to persons or property located outside the United States. FBCII that is not “foreign derived” would be subject to tax in the U.S. at the full 25% corporate tax rate otherwise proposed by Camp’s proposal. However, “foreign derived” FBCII would be subject to tax in the U.S. only to the extent necessary to “top up” the tax rate paid offshore to 15%. This is accomplished by way of a flat 15% tax rate on FBCII in the U.S., coupled with a new “high-tax exception” that would exempt FBCII taxed offshore at a rate in excess of 15% and a domestic deduction to offset tax paid offshore at a rate less than 15%.
As noted above, the FBCII regime served as an overlay to the otherwise territorial system that Camp proposed. Specifically, the Camp proposal would allow U.S. corporations to repatriate offshore earnings generated after the effective date largely tax-free by way of a 95% dividends-received deduction for eligible foreign-source dividends. Like the Obama and Trump campaign proposals, the Camp proposal called for a one-time transition tax on previously untaxed offshore earnings (but at a split rate – 8.75% on cash and cash equivalents and 3.5% on other offshore earnings).
Complexity and the Impact of Design Choices. All three examples of recent foreign minimum tax proposals get to roughly the same place – offshore earnings are subject to current taxation in the United States to the extent not subject to tax at a minimum level elsewhere. The concept is simple, but as the descriptions of the Obama Administration’s proposal and the Camp discussion draft show, the specifics are complex. Both the effectiveness of a foreign minimum tax and its impact on particular taxpayers will vary considerably, depending on the scope of income subject to the tax, the means of implementation, tax rates, contours of the transition tax and other design choices.
For example, one key design choice is whether (and how) to tailor a foreign minimum tax to impose no U.S. tax on a “normal” return from capital invested abroad. If the goal of international tax reform is to enhance the competitiveness of U.S. multinationals without encouraging an erosion of the U.S. tax base, one could argue that taxation of U.S. corporation’s offshore earnings should be limited to instances in which a U.S. corporation artificially diverts profits overseas to low-tax jurisdictions without an active investment in such jurisdiction. The question, however, is how to achieve this goal within a foreign minimum tax system. The Obama Administration’s FY 2016 punted on the particulars of this question, stating merely that foreign earnings subject to the minimum tax would be reduced by an unspecified “allowance for corporate equity.” The Camp proposal provides a more thorough, albeit one-size-fits-all-industries, approach by excluding a 10% return on investment from the minimum tax. Like with many design choices, the 10% threshold produces winners and losers, depending on the normal rate of return in the industry in which a taxpayer operates.
Another key design choice is whether to apply the minimum on a country-by-country basis (as does the Obama Administration’s FY 2016 budget) or on a worldwide basis, looking at all foreign taxes and all foreign income collectively. While it would be considerably simpler to impose a foreign minimum tax on a worldwide basis, it would not be as efficient at targeting profit shifting to tax haven jurisdictions (as it could allow taxpayers to divert profits to low-tax jurisdictions to balance out foreign taxes paid in high-tax jurisdictions with no incremental U.S. tax cost).
What about revenue? The DBCFT was expected to raise a significant amount of revenue over the 10-year budget horizon – by some estimates, more than $1 trillion – and tax writers were counting on this revenue to ease the path to rate cuts and other reforms in the budget reconciliation process. Now that the DBCFT is no longer under consideration, tax writers will need to look to other alternatives to help fund lower tax rates. Analyses of the Obama Administration’s FY 2016 proposal predicted an increase in revenue of $205 billion over 10 years from the foreign minimum tax. The Joint Committee on Taxation estimated that the creation of FBCII as a new Subpart F category would raise $115.6 billion over 10 years. While not an insignificant revenue raiser, a foreign minimum tax falls well short of the gap left by the DBCFT.