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Thursday, November 21, 2013

Avi-Yonah: Preliminary Thoughts on the Baucus International Tax Reform Proposal

Avi-YonahTaxProf Blog op-ed:  Good in Parts: Preliminary Thoughts on the Baucus Proposal, by Reuven Avi-Yonah (Michigan):

Like the proverbial egg, the international tax reform proposal advanced by Senator Baucus has some good and some more dubious elements. Overall, it is a helpful beginning. Whether it will lead to positive outcomes depends crucially on how the proposal fares in the legislative process.

There are three elements in the proposal that represent a useful advance over current law.

First, the proposal segregates US related income of controlled foreign corporations from foreign related income, based on whether the goods or services are destined for ultimate consumption in the US. I have for twenty years supported this type of destination based income tax because it is less subject to tax competition than other types of source or residence based taxation of corporations. The problem raised by this proposal is whether it can be compatible with our tax treaties, since the CFC will typically not have a permanent establishment in the US. If we can adopt this rule as a treaty override, we should consider adopting a similar rule for foreign corporations that are not CFCs.

Second, the proposal greatly simplifies the PFIC rules, which are overdue for simplification. It makes mark to market mandatory for publicly traded entities and applies a simple interest charge on a deemed return in other cases. This is a more administrable rule than the current one, and in conjunction with FATCA will make our system for taxing foreign source income of individuals more enforceable.

Third, the proposal to abolish the portfolio interest exemption for corporate bonds is a very significant step forward toward curtailing the ability of both US residents and foreigners to avoid all taxation on US source income by routing it through tax havens. While this is likely to encounter a lot of opposition, now is the right time to coordinate such action with the OECD. The rest of the world is eager to take action to close its tax gaps and we have a real opportunity to end the tax haven problem if we coordinate with it.

As for the core of the Baucus proposal, ie., the two options for territoriality, in my opinion option Y is far superior. It imposes a minimum tax of 80% of the US rate on all foreign source income of CFCs, including both the effective foreign rate and the residual US tax. This means that if the US rate is reduced to 30% the minimum tax would be 24%, which is about the same as the OECD average. If this rate structure is adopted the incentive to shift profits will be much reduced. But it is critical that the minimum tax rate not be reduced further, and it is concerning that the rate is bracketed and the promised revenue neutrality only applies in the long term.

Option Z, on the other hand, has a much bigger disparity between taxed and untaxed foreign income, and the line that it draws between active and other foreign income is the same flawed line that underlines current law. This division between active and passive income is irrelevant to competitiveness, which is determined by the overall tax rate, and is obsolete in a world where business relies heavily on intangibles.

If we have to adopt territoriality as a price for getting tax reform, then option Y is an acceptable way to go because it does not draw lines that cannot be defended (the line between US and foreign sales is defensible) and because the disparity between US and foreign rates is relatively small. But the key question is whether this disparity will not grow as the multinationals lobby for relief. And the ultimate question is whether territoriality is worth the price. If we can tax US income at 30% and foreign income at 24%, wouldn't it be better to just tax all income at 27%? There is no good evidence that such a tax would put US companies at a competitive disadvantage, and it will eliminate the incentive to shift income, treat domestic and foreign oriented businesses the same, and eliminate most of the complexity in the Baucus proposal.

At a time when our trading partners in OECD are considering tightening their tax rules on multinationals, the Baucus proposal is a good first step toward demonstrating that we are serious about taxing our multinationals. This proposal can be the start of a good negotiation with the OECD. But it can only fulfill this role if it is not watered down beyond recognition.

http://taxprof.typepad.com/taxprof_blog/2013/11/avi-yonah.html

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Comments

Reuven, as always, you say a lot very clearly in a very few words.

You've summarized the best approach by saying: "If we can tax US income at 30% and foreign income at 24%, wouldn't it be better to just tax all income at 27%? There is no good evidence that such a tax would put US companies at a competitive disadvantage, and it will eliminate the incentive to shift income, treat domestic and foreign oriented businesses the same, and eliminate most of the complexity in the Baucus proposal."

Simply excellent.

Jeff

Posted by: Jeff Kadet | Nov 24, 2013 9:58:37 AM