Weekly SSRN Tax Article Review And Roundup: Elkins Reviews Repetti’s International Tax Policy’s Harm to Manufacturing and National Interests

This week, David Elkins (Netanya, visiting NYU 2021-2023; Google Scholar) reviews a new paper by James R. Repetti (Boston College; Google Scholar), International Tax Policy's Harm to Manufacturing and National Interests, 2023 Wis. L. Rev. __ :

The discourse in the field of international tax avoidance has always contained an underlying tension. On the one hand, politicians, the popular press, and member of the academic community often lament that international tax avoidance can involve little more than shuffling papers, that the change in structure is not reflective of any change in actual economic activity. Prototypical examples include corporate inversions, the placing of intellectual property in tax havens, and routing royalties and interest through strings of related entities. Sensitive to such objections, Congress or the Treasury may impose restrictions that deny beneficial tax treatment to maneuvers that lack economic substance. The problem is that corporations may respond by moving their real economic activity abroad, and the same pundits who condemn the form-over-substance of certain types of tax avoidance will now decry the substance, namely loss of American jobs and other harm to the domestic economy.

In this week’s feature article, Professor James Repetti describes one particular aspect of this quandary: how Congressional attempts to combat international tax avoidance have led to significant incentives for multinational enterprises (MNEs) to move manufacturing outside the United States, with the consequent economic, social, and geopolitical harm.

Subpart F, enacted during the Kennedy administration, sought to end the practice of MNEs deferring tax on their foreign source income by accumulating such income in the hands of controlled foreign corporations (CFC). The idea behind subpart F was to subject such income to U.S. tax as it accrued, rather than only when it was distributed to the U.S. parent. On the hand, Congress did not want the new CFC regime to harm the competitiveness of U.S. multinationals. Therefore, it provided that “subpart F income” would not include income that is derived from business operations in foreign countries. However, Congress foresaw that this limitation on the applicability of subpart F could be abused. A CFC located in a tax haven could purchase goods manufactured in another country and then sell those goods at a large markup to its U.S. parent. The income of the CFC would derive from the business of buying and selling inventory and would therefore not be subject to subpart F. In a preemptive attempt to forestall such abuse, Congress provided that subpart F income would include “foreign base company sales income” (FBCSI), defined as income from property that was not manufactured by the CFC, was manufactured and sold outside of the CFC’s country of incorporation, and was bought from or sold to a related person. The logic was that deferral should be available only for CFCs with a “legitimate” reason for being in a low-tax country (such as manufacturing in that country, purchasing goods manufactured in that country, or selling in that country).

As is often the case with anti-avoidance measures, tax advisors soon developed means to circumvent the FBCSI restriction. The restriction does not apply to goods manufactured by the CFC. Therefore, a CFC located in a tax haven could contract with a manufacturer in another country to manufacture goods for it. Because the activities of the contractor are imputed to the CFC, the CFC is considered to be the manufacturer and its income is not FBCSI and consequently not subject to subpart F. The article goes on to describe how the 1997 check-the-box regulations facilitated the avoidance of subpart F by permitting U.S. MNEs to disregard some of the entities in their corporate family.

The 2017 Tax Cuts and Jobs Act was intended to level the playing field, but instead merely incentivizes U.S. MNEs to open their own factories in low tax countries, rather than rely on contract manufacturers. The GILTI (Global Intangible Low-Taxed Income) regime effectively divides a CFC’s non-subpart F income into two parts. The first part, equal to 10% of the CFC’s tangible assets, is not subject to U.S. tax at all. The remainder is taxed at the rate of 10.5%. This regime does not eliminate the incentive to engage in contract manufacturing, because subpart F income is taxed at the full corporate tax rate of 21%, while non-subpart F income is either not tax or is taxed at a reduced rate. Moreover, GILTI creates an additional incentive to hold tangible assets abroad, because of the exemption for income equal to 10% of those tangible assets. The more tangible assets that one holds abroad, the greater the exemption. The FDII (Foreign Derived Intangible Income) regime, also enacted in 2017, reduces from 21% to 13.125% the effective tax on sales from a U.S. corporation to a foreign buyer that constructively derive from the corporation’s deemed U.S. intangible property. The formula for determining how much income derives from deemed U.S. intangible property is similar to the GILTI formula: any income exceeding 10% of the corporation’s U.S. tangible property is considered to have been derived from U.S. intangible property. This scheme also incentivizes the movement of assets abroad (the fewer U.S. tangible assets it owns, the more of its U.S. income will be classified as FDII). In other words, by moving tangible assets overseas, a U.S. MNE will both increase the amount of its foreign income that is exempt from U.S. tax (effectively reducing the tax rate from 10.5% to 0% on that income) and increase the amount of its U.S. income that is subject to a reduced rate of tax (reducing the rate on that income from 21% to 13.125%).

As far as policy recommendations are concerned, the author proposes eliminating the contract manufacturing exception and amending the check-the-box regulations to prohibit the sole owner of an entity from disregarding an entity formed outside the United States.

The author does a commendable job describing some extraordinarily complex concepts in the field of international taxation. His description of subpart F, GILTI, and FDII is one of the most lucid and articulate I have seen, as is his description of how they incentivize the movement of manufacturing activity abroad. His analysis of how those provisions affect how corporations operate or might operate abroad is well reasoned and convincing. It exemplifies two critical features (or “bugs” in current nomenclature) regarding anti-avoidance measures: they can often be circumvented by sophisticated tax advisors, and they often have unintended and deleterious consequences.

I will though mention a couple of points for the author’s consideration. First, the description of how the check-the-box regulations facilitate the exploitation of the contract manufacturing exception could perhaps have been a bit further elucidated. It is not entirely clear from the article how the capacity to operate via disregard foreign entities (as opposed to, say, foreign branches) is conducive to exploiting the contract manufacturing exception. Second, although the author demonstrated that both GILTI and FDII incentivize the exporting of manufacturing, his recommendations refer only to subpart F. I think that a word or two about whether the author has any proposals to amend the other regimes to reduce the incentives they provide – and if not why not – would be helpful.

This is an important and well-written article that will benefit tax scholars and policy makers. I highly recommend it not only to those interested in international taxation but to anyone who is interested in tax policy in general.

Here’s the rest of this week’s SSRN Tax Roundup:

• Mark J. Cowan (Boise State) & Joshua Cutler (Boise State), ESG and the Demand for State Tax Incentives, _ Fla. Tax Rev. _ (2023)
• Yariv Bauner (Florida), Taxation of Information and the Data Revolution (2023)
• Anges Cheng (Hong Kong Polytechnic) & Chia-Hsiang Weng (Nat’l Chengchi), How Does Media Sentiment Influence the Adjustment of the Level of Tax Avoidance? (2023)
• Michael T. Fatale (Mass. Dep’t of Rev.), Post-Pandemic State Taxation of Non-Resident Telecommuter Wages, _ B.C.L. Rev. _ (2023)
• Venessa Fetter (Vermont), A Global Climate Wealth Tax To Fund a Worldwide, Just Transition, in Ecological Transition and Environmental Taxation (2023)
• Brain D. Galle (Georgetown) & Stephen E. Shay (Boston College), Admin Law and the Crisis of Tax Administration, _ N.C.L. Rev. _ (2023)
• John Gallemore (North Carolina), Jesse van der Geest (Tilburg), Martin Jacob (WHU) & Christian Peters (Tilburg), Corporate Tax Planning and Industry Concentration (2023)
• Luís Calderón Gómez (Cardozo), Too Good to be True: Private Placement Life Insurance Policies, 178 Tax Notes Fed. 555 (Jan. 23, 2023)
• Bradley W. Joondeph (Santa Clara), State Taxes and “Pike Balancing” (2023)
• Robert W. McGee (Fayetteville), Why Do People Evade Taxes? Summary of 50 Surveys (2023)
• Annette Morgan (Curtin), Brett Freudenberg (Griffith), Ann Kayis-Kumar (UNSW), Van Le, Rob Whait (South Australia), Michelle Cull (Western Sydney), Donovan Castelyn (Curtin) & Connie Vitale (Western Sydney), Pro bono tax clinics: Aiding Australia’s Tax administration and Developing students’ self-efficacy, 24 J. Australian Tax. 76 (2022)
• Diane M. Ring (Boston College) & Costantino Grasso (Manchester Metro.), Beyond Bribery: Exploring the Intimate Interconnections Between Corruption and Tax Crimes, 85 Law & Contemp. Probs. 1 (2022)
• Darien Shanske (UC Davis) & David Gamage (Indiana), Why States Should Conform to the New Corporate AMT, 107 Tax Notes States 601 (2023)