Treasury’s new regulations limit the ability of foreign-based multinationals to reduce taxable profits on U.S.-source income. This is a major expansion for the Obama Administration, which had previously targeted only so-called “inversions” – transactions in which U.S.-based firms have sought through mergers to “re-domicile” themselves as foreign-based companies.
Treasury has done this through new curbs on earnings stripping, where the U.S. affiliate of a foreign company injects equity into a foreign affiliate based in a low tax country and then borrows money from that firm. The U.S. firm can deduct the interest it pays, while the interest income the foreign affiliate receives is tax-free or taxable at a very low rate.
Anti-avoidance rules in place since the 1960s prevent a U.S.-based multinational from benefiting from this type of transaction by treating the passive income of its foreign affiliates as current taxable income of the U.S. firm. But the United States cannot tax the foreign-source income of foreign-based companies, so those firms can receive a benefit on their U.S. investments that is not available to their U.S-based competitors.
Treasury would limit this benefit by using its regulatory authority under a 1969 statute to define some payments to related parties as dividends, which are not deductible, rather than interest, which is. But in a key changes of emphasis, Treasury would not limit this provision to just inverted companies. By so doing, it recognizes that inversions are part of a broader problem of tax laws that favor foreign-based multinationals over U.S. firms.
Treasury’s new regulations also mark a more subtle shift in the U.S. approach to the trade-off between rules that encourage more investment in the United States and rules that help the competitiveness of U.S.-based firms. In the long-standing debate on the treatment of outbound investment by U.S.-based multinationals, the Administration has generally sided with those who would expand the taxation of foreign-source income of US companies. It has advanced proposals that would encourage US multinationals to invest at home instead of overseas, while placing them at an additional disadvantage compared to foreign-based competitors that pay no domestic tax on their active foreign-source income.
The new regs for inbound investment work in the opposite direction. By eliminating a competitive advantage enjoyed by foreign companies, the rules make U.S. companies more competitive and reduce their incentives to invert. They also, however, could reduce foreign investment in the United States by limiting the ability of foreign-based firms to avoid the burden of our very high corporate tax rate.
In the past, the United States has been reluctant to take this step, in part because of lobbying by business groups who raised worries about job loss in communities benefiting from foreign investment
With the new regulations, the United States will be following the example of our major trading partners, who are cracking down on what they view as income shifting at their expense by U.S.-based multinationals. All this fits into a new pattern in which countries care more about the competitiveness of their home-based companies than about attracting investment from either their own or foreign companies.
Until recently, we have seen a race to the bottom, as countries competed with each to lower tax rates on their own multinationals by moving towards territorial systems, and relaxing rules that make it hard for their companies to avoid tax. Now, countries are increasingly trying to protect their own home-based companies by raising taxes on their foreign competitors. These moves may shore up the corporate tax base of these countries, but they raise interesting and as yet unanswered questions about how the entire worldwide taxing system is evolving.
Perhaps it is time to update the late Senator Russell Long’s famous dictum, “Don’t tax you, don’t tax me, tax the fellow behind the tree.” The new mantra can be “Don’t tax you, don’t tax me, tax the company across the sea.”
