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President Obama's International Tax Reforms

May 7, 2009

 

On May 4, 2009, President Obama unveiled his administration’s plan to reform the United States international tax rules and to improve their enforcement. These reforms are intended to end incentives for job creation abroad and to curb the use of tax havens.

The majority of the proposals, if enacted, would not be effective until 2011. The proposed plan is as follows:

Eliminating “Check-the-Box” Entity Classification Elections for Certain Offshore Entities

Current law generally allows U.S. businesses to elect (“check-the-box election”) to treat their foreign subsidiaries as pass-through or disregarded entities for U.S. federal income tax purposes. This elective regime has made it easier for taxpayers to reduce their overall tax burden while at the same time deferring U.S. taxation of their foreign earnings. For instance, a U.S. parent’s foreign corporate subsidiary in a tax haven or other low-tax jurisdiction may make a loan to a second-tier subsidiary (which has made a check-the-box election to be disregarded for U.S. tax purposes) in a higher-tax jurisdiction. Interest on the loan will generate valuable deductions for the second-tier subsidiary, but little to no tax to the foreign corporate subsidiary in its jurisdiction. Moreover, because of the second-tier subsidiary’s check-the-box election, the foreign corporate parent will not be viewed as earning interest income for U.S. tax purposes. Thus, the interest income earned by the foreign corporate subsidiary will not generate a tax liability for the U.S. parent. The administration proposes to require U.S. firms to treat certain foreign subsidiaries as corporations for U.S. tax purposes.

Reform of Deferral Rules for Investing Abroad

Current law generally allows U.S. taxpayers to defer the payment of U.S. federal income taxes on certain foreign profits until those profits are repatriated to the United States; however, U.S. taxpayers are able to deduct on a current basis certain expenses that they incur in the United States even though such expenses are allocable to the operations that generate the deferred foreign profits. For example, a U.S. company may deduct all interest on its debt even though it must allocate a portion of its interest against its foreign income. The administration sees this current timing disparity as an incentive for U.S. companies to invest abroad rather than creating jobs in the United States. It proposes to eliminate this perceived incentive by denying a deduction for expenses allocable to the foreign income of U.S. taxpayers until such time when such income is repatriated back to the United States.

Foreign Tax Credit Reform

Subject to various limitations, current law generally allows U.S. taxpayers to credit against their U.S. federal income taxes foreign taxes paid on overseas profits. The administration believes that the current system is too permissive in that in certain circumstances it permits well-advised taxpayers to effectively select which foreign taxes they want to claim a credit for and to claim a credit in some instances with respect to foreign taxes paid on income that is not subject to current U.S. tax. The administration would tighten the foreign tax credit rules by (i) determining a taxpayer’s foreign tax credit based upon taxes actually paid on its total foreign earnings (thereby preventing the taxpayer to select which foreign taxes to credit) and (ii) disallowing foreign tax credits for foreign taxes paid on income not subject to U.S. tax.

Research and Experimentation Tax Credit Permanent Enactment

Current law allows certain companies to claim a tax credit equal to 20 percent of qualified research expenses above a base amount; however, this law is set to expire on December 31, 2009. The administration views this tax credit as a means to spur innovation and job creation in the United States and is seeking to make it permanent.

Enhancing the Ability to Monitor and Tax Overseas Income

The administration plans to enhance information reporting, increase tax withholding, strengthen penalties and improve the ability of the United States to monitor overseas income activity and prevent tax evasion by U.S. taxpayers, particularly those with accounts at foreign financial institutions. The focus of these reforms would be to strengthen the current-law “qualified intermediary system” and discourage U.S. taxpayers from maintaining banking or other financial relationships with foreign financial institutions that are not qualified intermediaries. This would be done through various new disclosure requirements, withholding taxes, presumptions of tax evasion, and penalties. The reforms would also extend the current-law statute of limitations for international tax enforcement from three to six years.

Increase International Tax Enforcement

The administration plan would provide additional funds for the IRS to hire 800 new employees devoted specifically to the enforcement of the U.S. international tax rules, particularly in the area of transfer pricing and sophisticated financial transactions.

The administration proposals are conceptual in form and have not yet been the object of a more detailed legislative proposal. We will continue to monitor and provide updates regarding these proposed reforms.


IRS Circular 230 Disclosure

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any matters addressed herein.