U.S. Tax Policies Affecting Our Global Companies

Monday, October 4, 2010 - 01:00
Caplin & Drysdale

Editor: Please describe your firm's practice in the tax area.

Rosenbloom: I have been practicing with the firm of Caplin & Drysdale since 1968. The firm specializes in taxation, and my own specialty is international, or cross-border, taxation.

My career has been spent for the most part in private practice, with the exception of three and a half years in the Treasury Department, where I was the International Tax Counsel. When I went to the Treasury, it was primarily to do international tax, both with respect to policy and the negotiation of treaties. When I left in 1981, my practice focused on international tax. Over the years, I have done both inbound and outbound cross-border tax work for corporations, individuals, partnerships, exempt organizations, governments, and various exotic entities. My corporate clients have included foreign and domestic insurance companies, banks, and industrial companies. However, if there has been one area in which I have particularly specialized, it has been financial services.

I have done transfer pricing work for both foreign and U.S. businesses, as well as a great deal of work with tax treaties. I have worked on the computation of effectively connected income for foreign persons, and on subpart F for controlled foreign corporations. Many of my projects have involved the foreign tax credit, sometimes in its more esoteric aspects, and there has been an increasing amount of work for high-net-worth individuals. This last area is not something I have historically concentrated on, but it has been hard to escape in recent years with all the attention paid to offshore accounts, compliance, and related matters.

In addition to my practice, I have taught international taxation or specific aspects of that subject (foreign tax credit, tax treaties, transfer pricing) ever since 1984 at five U.S. law schools and probably ten different educational institutions outside the United States - notably in Australia, Italy, Brazil, South Africa, Mexico, Taiwan, Germany, and the Netherlands. I have also done consulting for international organizations and foreign countries. This work has included assignments for the Treasury, the World Bank, U.S. AID, the Inter-American Development Bank, and the OECD, and international tax matters in Eastern Europe, the former Soviet Union, Senegal, Malawi, South Africa, Central America and, to a lesser extent, South America. So I would say my career has had three components - private practice, teaching, and consulting with foreign governments.

Editor: How are U.S. companies affected by the U.S. tax structure?

Rosenbloom: It is true, as far as I know, that the U.S. statutory rate of corporation taxation today is one of the highest among OECD countries - if not the highest, then one of the two or three highest, at 35 percent. The only real competitor we have for top ranking is Japan. I believe Japan may still be a little higher than we are.

So that much is true, but I am not sure how significant that fact is because companies do not pay tax at statutory rates - they pay at what we call effective rates. The effective rate is simply the amount of tax paid divided by the amount of income earned, so it reflects the beneficial effects of deductions. The appropriate comparison is between the effective rate in the United States and the effective rate in other parts of the world - a very difficult exercise because the effective rate varies tremendously among industries and companies within each jurisdiction.

Whenever someone starts talking about how high our rate of tax is in the United States as compared with other countries, I want to think about that a bit. I agree that our statutory rate should be reduced, but I also believe that many deductions and credits in the Internal Revenue Code should be eliminated. So I would definitely support reducing the statutory rate, but I am not so sure the changes I would favor would lower the effective rate for all companies or even for the "average" company.

As a more general matter, there is no question that improving our system for taxing cross-border income is a good idea. And I definitely agree that promoting exports and research are worthwhile goals and very much in our national interest. But I am not so sure about the appropriate means for achieving those goals, and I do not think companies are in full agreement on that point either, as among themselves.

Editor: Are U.S. corporations competitively disadvantaged when they go into head-to-head competition with foreign companies?

Rosenbloom: I think U.S. companies have been disadvantaged by our tax system but not necessarily in the way they believe they have been disadvantaged. Our exceptionally complex rules, coupled with our unusual political process, have combined to lead companies to try to bolster financial results by gaming the tax system. This is not a moral judgment. It is an observable fact. The downside, in my view, is that this sharp focus on the tax system has led many companies to become distracted by this readily available means of improving earnings, to the detriment sometimes of their core businesses. In other words, a lot of the energy that has gone into changing or manipulating the tax system might have been better spent on improving products and services.

The U.S. tax system can be viewed as imposing tax on top of the tax that applies in a foreign jurisdiction, but there is also something called deferral, which means that when a foreign subsidiary earns income from a foreign business activity, even if the subsidiary is owned 100 percent by a U.S. parent company, there is no U.S. tax until the earnings are repatriated, and that can happen whenever the U.S. parent company chooses to do so. Some U.S. companies have earnings that have been outside the United States for 50 years or more. With such a delay (deferral) in repatriation and actual payment of tax, the distinction between the U.S. system and a pure exemption system is far less than might at first appear.

Editor: What is the effect of the Administration's proposal to reduce the U.S. Foreign Tax Credit for repatriated foreign profits?

Rosenbloom: President Obama deliberately did not propose ending deferral directly but instead proposed deferring certain deductions and making it more expensive to take advantage of deferral. What the President proposed is to deny a full foreign tax credit on a company-by-company basis. Let me give an example, since this is complicated if you are not familiar with the rules. Assume a U.S. parent company has a foreign subsidiary in Germany and another foreign subsidiary in the Bahamas, and that each subsidiary earns 100; the German company pays German tax of 35, the Bahamas company pays zero tax. Under current law, if the U.S. parent brings back the 65 that remains in Germany to the United States, it is entitled to a foreign tax credit for the full 35 of German tax, regardless of whether money is brought back from the Bahamas.

One of President Obama's proposals was that if the U.S. company brings back the 65 from Germany but nothing from the Bahamas, it would have to take into account the Bahamian earnings not brought home, so that instead of claiming a full 35 of credit for the German tax, it would be entitled to a much lesser credit - on the order of 14.

He also proposed that if a U.S. company has deductions in the United States that support income earned in a foreign corporation (for example, salary paid to U.S. employees whose task is to supervise foreign operations), some or all of that deduction would be deferred until the income was brought back to the United States. In other words, the U.S. company could not use currently deductible expense to earn income that is not taxed currently.

Both of these proposals go in the direction of limiting the deferral advantage, because companies would basically suffer a disadvantage for keeping money abroad in foreign corporate solution and not repatriating it. In that sense, the President's proposals here are anti-deferral.

Editor: Why would the disallowance until 2018 of the provision that would have allocated interest on a worldwide basis be harmful to global companies?

Rosenbloom: Allocation of interest in that manner is not unreasonable. However, it is both expensive and complicated. Not all borrowings abroad are made in U.S. dollars, and some complex currency rules, not envisioned in the statute, would be needed. Also, if the worldwide apportionment rule is justified as a matter of tax policy, I see no reason why it should be elective.

When a U.S. company prepares its tax return, it reports its income and deductions exactly like any other taxpayer. In computing the foreign tax credit, companies know how much foreign income they have, but the hard part is determining which deductions go with that income. Companies would prefer that as few deductions as possible be associated with foreign income because for any given amount of net income recognized, they prefer that a high proportion be foreign so they can claim credit for more foreign taxes, and one of the items they have complained about most is the treatment of interest expense.

Let's take a company, call it ABC. ABC has interest expense in the United States, but it also has foreign subsidiaries and foreign activity and some of that U.S. interest expense is assigned to the foreign category. When the deduction for interest is so assigned, it reduces the foreign income of ABC and constrains its ability to utilize foreign tax credits.

ABC and other companies would say that it is not appropriate to attribute interest expense incurred in the United States to foreign income because foreign subsidiaries may be borrowing themselves and incurring their own interest expense, so they have no need for any support from the U.S. borrowing. They are right. It is not fair to take domestic borrowing and say that it invariably supports foreign activities because those foreign activities may well stand on their own. But if worldwide apportionment of interest is the right and proper rule, let's put it in place for everyone, not just those persons who elect it. I think elective provisions are terrible tax policy.

Editor: How does the Administration justify these changes?

Rosenbloom: The Administration says, in essence, that companies have abused deferral to stash earnings from what are basically U.S. assets and activities in tax haven jurisdictions outside the United States. But I am not sure that, at this point, it is the Administration whose views count for much. The President has not really pushed on either of the foreign tax credit proposals discussed above, and my own judgment is that they are, if not dead, then at least moribund.

The main driver of tax policy at the moment is the Paygo rules in Congress. If you had to put your finger on one thing that has had a really large effect in the past year or so, it is the decision of Congress that it must pay for what it wants to spend. I am really surprised by this development. A child could appreciate that it is sensible, but I am still surprised. In any event, that is why the year 2010 has witnessed the most substantial set of international provisions enacted into law that this country has had for many years.

Please email the interviewee at hdr@capdale.com with questions about this interview.