Accounting & Tax

Watch Out for the Expense-deferral Rule

Corporate tax experts say the centerpiece of Obama's foreign tax reform proposal is the expense-deferral rule — and it will affect every multinatio...
Marie LeoneMay 5, 2009

The details are sketchy, but the intent is clear. President Obama is pushing Congress to rework tax rules affecting U.S. multinational corporations so that more revenue will flow back into the United States – about $210 billion over the next 10 years, according to the Treasury Department.

Obama’s plan, parts of which were released yesterday during the President’s press conference, outlines four rule reforms aimed at companies with overseas subsidiaries. The proposed rules would put restrictions on the practice of deferring tax payments related to overseas profits, close the foreign tax credit loophole, make permanent the research and experimentation tax credit, and eliminate the “check the box” rule that allows companies to shift income between subsidiaries on a tax-free basis. More details on the new rules are expected to be released later this week.

Raising the $210 billion looks feasible when the Treasury Department puts the numbers on the table. Treasury says that U.S. multinational corporations paid about $16 billion in U.S. taxes on approximately $700 billion of foreign active earnings in 2004, which is the most recent year for which data is available. That is an effective U.S. tax rate of about 2.3%. By comparison, the Government Accountability Office (GAO) estimates that the average effective U.S. tax rate on the domestic income of large corporations with positive income is 25%.

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In addition, 83 of the 100 of the largest U.S. corporations have subsidiaries in tax havens, according to a 2009 GAO report. What’s more, nearly one-third of all foreign profits reported by U.S. corporations in 2003 came from the low-tax countries of Bermuda, the Netherlands, and Ireland. Taken together, the extra revenue generated by targeting foreign-source income and closing tax-haven loopholes could mean Obama will reach his goal.

“To some extent, all U.S.-based companies with international operations are negatively impacted. It’s just a matter of varying degrees,” says Marc Gerson, a tax attorney with Miller & Chevalier and a former majority tax counsel for the House Committee on Ways and Means.

From a corporate perspective, “CFOs will have to evaluate the proposals on an individual, company-by-company basis,” adds Gerson, because it is difficult to generalize about the potential effect of the proposals. Many factors will need to be taken into consideration, such as the extent of a company’s international operations, the structure of those operations, and the company’s debt profile.

For example, Gerson believes that highly leveraged companies will likely be stung more than other companies by the proposal that affects the timing of deductions allocated to foreign-source income. Currently, companies are allowed to defer paying U.S. taxes on profits from foreign subsidiaries until they repatriate the profits back to the United States. But the Obama rule change would force companies to give up the deferral and repatriate profits before claiming an interest-expense deduction. For highly leveraged companies, the interest deduction may be more valuable than the deferral, contends Gerson.

As a result, passage of the deferral proposal in its current form could force debt-laden companies to repatriate profits and pay taxes on that income sooner rather than later, says Gerson.

The deferral proposal is “the centerpiece of the plan,” says tax expert Robert Willens, and would have “the most far-reaching impact.” Every multinational corporation would be affected by that proposal, he says. Under the proposed rule, multinationals likely will be asked to make “arbitrary allocations of their otherwise deductible expenses – except for research expenses – between their domestic and foreign income,” says Willens.

He explains that the expenses allocated to foreign income would not be currently deductible, but rather held in some sort of limbo or ‘suspense’ account until profits are repatriated. “This is, in many ways, a ‘backdoor’ way of substantially repealing the deferral regime that multinationals have long enjoyed.”

The last president to take a serious crack at changing the expense-deferral rule was John F. Kennedy, says tax attorney James Reidy of McDermott Will & Emery. He notes that the allocation process is a complex and time-consuming exercise, and says that until more details on the Obama proposal are released, it is difficult to conclude what kind of effect the change would ultimately have on corporations. The administration will have to spell out, for example, what kind of expenses will be included in the deferral proposal, which can be anything from interest on loans and real estate taxes to the chairman’s salary and a plane flight to Europe.

Regarding what Obama calls the check-the-box loophole, Willens says he doesn’t believe that the proposal is as comprehensive as the deferral proposal, “although the revenue estimate is large.” The Treasury estimates that $86.5 billion will be raised between 2011 and 2019 if the rule is eliminated.

“That gambit seems to involve an attempt by U.S. companies to avoid U.S. tax on passive investment income earned abroad that would otherwise be taxed in the U.S.,” says Willens. “I think for those companies who used the technique, it will be a serious blow, but I don’t believe the number of companies affected will be anywhere near the number affected by the expense-deferral provision.”

For his part, Reidy says that the administration’s characterization of the check-the-box or passive income rule as a “loophole” is “grossly misleading,” especially since it relates to a regulatory regime set up during the Clinton Administration.

According to the Treasury Department, the passive income rule is legal. The problem, says the Obama Administration, is that it has resulted in the shift of “billions of dollars in investment from the U.S. to other countries.” Essentially, current law allows U.S. businesses to establish foreign subsidiaries in a tax haven, and then categorize income that is shifted between the haven subsidiary and other foreign subsidiaries – for instance through interest on loans – as passive income for the U.S. parent, which subject to U.S. tax.

However, the decade-old check-the-box rule allows U.S. companies to disregard the subsidiaries for tax purposes, so income can be shifted among them without reporting any passive income or paying the attendant U.S. taxes. The Treasury Department provides a hypothetical example to make its point: A U.S. company invests $10 million to build a new factory in Germany. At the same time it sets up three new corporations: one a wholly owned Cayman Islands holding company, the second a German company owned by the holding company that also owns the factory, and the third a Cayman Islands subsidiary, also owned by the holding company.

The Cayman subsidiary makes a loan to the German subsidiary. The interest on the loan is income to the Cayman subsidiary and a deductible expense for the German subsidiary, so income is shifted from the higher-tax region of Germany to the no-tax haven of the Cayman Islands. Under existing U.S. tax law, the income shift would count as passive and taxable income for the U.S. parent. But the passive income rule allows the company to make the two subsidiaries and the passive income “disappear” via a check-the-box option. As a result, the company is able to avoid U.S. and German taxes on its profits, says the Treasury Department.

Obama’s proposals are not slated to take effect until 2011, but will spark “spirited debate” among lawmakers in the meantime, says Willens.