Robert Goulder of Tax Notes and Jeffery M. Kadet of the University of Washington School of Law discuss the House Ways and Means Committee proposal to eliminate key features of the subpart F regime.
This transcript has been edited for length and clarity.
Robert Goulder: Hello everyone. I’m Bob Goulder, contributing editor with Tax Notes. Welcome to the October edition of In The Pages.
Today we examine a proposal that’s come out of the House Ways and Means Committee. If enacted, it would alter subpart F. Our featured content, “Ways and Means Bill Lobbyist Change: Less Subpart F, More Profit Shifting,” lays this out in detail. It was written by Professor Jeffery M. Kadet with the University of Washington School of Law. Professor, welcome to In the Pages.
Jeffery M. Kadet: Thanks. It’s a pleasure to be here.
Robert Goulder: Professor, the House bill would weaken subpart F. Can you explain?
Jeffery M. Kadet: Happy to. Subpart F defines these categories, foreign base company sales income (FBCSI), and foreign base company services income, and also foreign personal holding company income. This focus has been around since the formation of the subpart F rules back in 1962.
There’s a simple way to think of this income. You look at the location and whether a related party is involved. For example, with FBCSI, you look at the point of origination for whatever product is being sold outside the country of incorporation, and then — is a related party involved. If those conditions are met, then you may have FBCSI.
Now, the bill would make the related-party condition applicable only if it’s an operation in the United States. It would forget about, in essence, any related parties within the group that are in other countries.
Robert Goulder: How will that change cross-border tax planning?
Jeffery M. Kadet: Well, the premise is that multinationals have been very active at searching out anything that lowers their taxes. The preponderance of profit shifting structures involve changes which are paper only, as opposed to changing actual operations. The point is that in attempting to set up profit shifting structures, there have traditionally been certain constraints in the subpart F rules. Multinationals structure things to side-step those rules.
How do you move income out of a country? By narrowing the scope of subpart F, you’ve expanded what companies can do in terms of their ability to come up with structures that meet what fewer constraints are left. With the current situation, where we expect a domestic rate of 21 percent and a global intangible low-taxed income rate of 10.5 percent, there’s a strong motivation to continue profit shifting. The incentives are not going away.
Robert Goulder: Can you comment about what you describe by the spillover effects?
Jeffery M. Kadet: I believe it was 2006 when section 954(c)(6) came in, the flow-through rule for subpart F. It essentially said that for foreign personal holding company income, it’s okay to shift royalties or interest from one controlled foreign corporation to another.
What that did was open the door to more profit shifting. Again, if we reduce how much subpart F can be a factor, there will be greater motivation not just to pull income out of other foreign countries, but it will further encourage new profit shifting structures — whether through cost sharing agreements or other things that have the effect of pulling more current taxation out of the U.S. and into CFCs. That’s what I would call the spill-over effect.
Robert Goulder: You criticize not only the substance of these two provisions, but also the procedural aspects. That the bill alters subpart F was not included in the committee summary or the Joint Committee on Taxation chairman’s mark. What explains these omissions?
Jeffery M. Kadet: What was totally not mentioned was that the long-beloved branch rule would be completely eliminated. When one goes through the draft language of a bill or a new law, you look at it — and you see the words that are in the draft. But what you don’t see, unless you go back and search for it, are the words that were there before.
What’s missing here? Section 954(d)(2) is where the branch rule is located. In this innocuous manner, the bill says we’re putting in place a new section 954(d)(2). But there’s silence on what was there before. And what was there before was the branch rule.
The branch rule is significant. Since the advent of the check-the-box rules there’s the ability to have one CFC with disregarded entity subsidiaries in many other countries, with all of them treated for U.S. tax purposes as one CFC, with divisions or branches in various places around the world.
After seeing the Whirlpool case and how egregious the facts were — they were pretending that the branch rule doesn’t exist. Whirlpool is a good example of how the branch rules have been, either ignored or challenged by aggressive taxpayer positions. With the government victory in Whirlpool, perhaps the IRS will spend more time looking at these structures where there’s one CFC and a bunch of disregarded entity subsidiaries underneath it.
The proposed elimination of the branch rule, prospectively, seems like a major development revenue wise. However, looking at the revenue estimate, the section where the two subpart F changes are included, it projects I think a $20 billion revenue gain over 10 years — but no loss. They included gains from other items to mask the loss in revenue from this constraining of subpart F. From the standpoint of making this as obscure as possible, not only is it hard to spot the elimination of the branch rule as you look at the bill, but it’s also not something that’s going to attract your attention if you look at the cost estimates.
Robert Goulder: To play the critic, if somebody says we’re going to have less subpart F . . . does it matter if the same foreign income is picked up by the GILTI regime?
Jeffery M. Kadet: If anything is not in subpart F, it will slop over into one of two categories: qualified business asset investment or GILTI. Some of that income will go tax-free under the participation exemption.
Maybe it’s not so common for some companies, especially if they don’t have a lot of fixed assets. But for some industries that exemption may be material. But when we look at the rest, which gets slopped over into GILTI, then we’re looking at taxation, yes, but at the lower rate with a 10.5 percentage point rate differential.
To the extent there’s a difference, it encourages multinationals to move profits out of the U.S. and into some sort of international structure, which helps the bottom line and earnings-per-share and equity-based compensation. There’s plenty of motivation.
So, when it’s outside of subpart F, then it’s either getting a nice rate preference by virtue of GILTI — or it’s under QBAI and therefore under the participant participation exemption and not being taxed at all in the U.S.
Robert Goulder: One last question, Jeffery. What should Congress do?
Jeffery M. Kadet: There should be a level playing field between pure domestic businesses and multinationals that operate both inside and outside the borders of the U.S. Right now there’s clearly an advantage to a multinational, whether it’s through actual operations or merely through some of these profit shifting structures.
Now if you listen to lobbyists, one of the things they cry about is the fact that they have to remain competitive against our foreign competitors. Of course, I agree. They need to remain competitive, but you know is this merely a red herring?
If you look at the granular level, as opposed to the general statements they make, competitiveness must be judged on a case-by-case basis. In some cases, it’s the foreign party that may be disadvantaged.
It’s not a one-size-fits-all situation where every U.S.-multinational needs a lower GILTI rate in order to compete effectively. If we look at what U.S. industry has done, they’d been rather successful on the world stage. I think it’s more important to have fairness between pure domestic business and multinationals.
From a tax policy perspective, it’s better to have something that is neutral. The obvious thing to be done to achieve this neutrality is to make the domestic rate and the GILTI rate the same and presumably to do away with the participation exemption. If you do that, you take away the motivation to move operations outside the U.S.
Robert Goulder: That’s it for today; thank you for joining us.