Tax & Accounting Blog

U.S. FY2017 Budget Includes BEPS-Related Proposals

BEPS, Blog, Checkpoint, ONESOURCE, Transfer Pricing February 11, 2016

On February 9, 2016, President Obama submitted the Administration’s FY 2017 budget proposals to Congress. The budget included a number of international tax proposals that are similar to the FY 2016 proposals, specifically related to BEPS, including the following:

  • Restrict deductions for excessive interest of members of financial reporting groups
  • Limit shifting of income through intangible property transfers
  • Restrict the use of hybrid arrangements that create stateless income
  • Impose a 19% minimum tax on foreign income
  • Impose a 14% one-time tax on previously untaxed foreign income
  • Proposals related to controlled foreign corporations (CFCs)

On the same day, the U.S. Treasury released the corresponding General Explanations of the Administration’s Fiscal Year 2017 Proposals, which provide greater details regarding these proposals on pages 2 through 26. Senate Finance Committee Chairman Orrin Hatch (R-UT) characterized the President’s policies as mostly “recycled” and also “misguided,” stating that such proposals have “repeatedly failed to be cleared by Congress.” Also, Secretary of Treasury Jack Lew will testify at the Ways and Means Committee on Thursday, February 11th.

We address each international tax proposal relating to the OECD BEPS Project in turn:

Restrict deductions for excessive interest of members of financial reporting groups – see OECD BEPS Action 4 recommendations

Under current law, foreign multinational groups are able to take deductions for related-party debt on their U.S. operations and shift their earnings to low-tax jurisdictions. This gives the multinationals a competitive advantage over domestic companies, which have to pay U.S. tax on all of their earnings from U.S. operations. The proposal would address over-leveraging of a foreign-parented group’s U.S. operations relative to the rest of the group’s operations by limiting U.S. interest expense deductions to the U.S. subgroup’s interest income plus the U.S. subgroup’s proportionate share of the group’s net interest expense.

The proposal generally would apply to an entity that is a member of a group that prepares consolidated financial statements (‘financial reporting group’) in accordance with U.S. Generally Accepted Accounting Principles (GAAP), International Financial Reporting Standards (IFRS), or other methods authorized by the Secretary under regulations. Under the proposal, a member’s deduction for interest expense generally would be limited if the member has net interest expense for tax purposes and the member’s net interest expense for financial reporting purposes (computed on a separate company basis) exceeds the member’s proportionate share of the net interest expense reported on the financial reporting group’s consolidated financial statements (excess financial statement net interest expense). When a member has excess financial statement net interest expense, the member will have excess net interest expense for tax purposes for which a deduction is disallowed in the same proportion that the member’s net interest expense for financial reporting purposes is excess financial statement net interest expense. If a member fails to substantiate its proportionate share of the group’s net interest expense, or a member so elects, the member’s interest deduction would be limited to the member’s interest income plus 10% of the member’s adjusted taxable income (as defined under Section 163(j) of the Internal Revenue Code (IRC)).

Regardless of whether a taxpayer computes the interest limitation under the proportionate share approach or the 10% alternative, disallowed interest would be carried forward indefinitely and any excess limitation for a tax year would be carried forward to the three subsequent tax years. A member of a financial reporting group that is subject to the proposal would be exempt from the application of IRC Section 163(j). U.S. subgroups would be treated as a single member of a financial reporting group for purposes of applying the proposal.

The proposal would be effective for taxable years beginning after December 31, 2016.

Limit shifting of income through intangible property transfers – see OECD BEPS Actions 8-10 recommendations

Under current law, there is a lack of clarity regarding the scope of the definition of intangible property that applies for purposes of taxing outbound transfers of intangible property by a U.S. person to a foreign corporation and the allocation of income and deductions among related taxpayers. These rules are intended to prevent inappropriate shifting of income from the U.S. to low- or no-tax jurisdictions. The proposal would provide that the definition of intangible property for these purposes also includes workforce in place, goodwill, and going concern value, and any other item owned or controlled by a taxpayer that is not a tangible or financial asset and that has substantial value independent of the services of any individual.

The proposal also would clarify that where multiple intangible properties are transferred, or where intangible property is transferred with other property or services, the IRS Commissioner of the IRS may value the properties or services on an aggregate basis where that achieves a more reliable result. In addition, the proposal would clarify that the Commissioner may value intangible property taking into consideration the prices or profits the controlled taxpayer could have realized by choosing a realistic alternative to the controlled transaction.

The proposal would be effective for taxable years beginning after December 31, 2016.

Restrict the use of hybrid arrangements that create stateless income – see OECD BEPS Action 2 recommendations

The proposal would deny deductions for interest and royalty payments made to related parties under certain circumstances involving a hybrid arrangement, including where (i) as a result of the hybrid arrangement, there is no corresponding inclusion to the recipient in the foreign jurisdiction or (ii) the hybrid arrangement would permit the taxpayer to claim an additional deduction for the same payment in another jurisdiction.

The Secretary would be granted authority to issue any regulations necessary to carry out the purposes of this proposal, including regulations that would (1) deny deductions from certain conduit arrangements that involve a hybrid arrangement between at least two parties to the conduit arrangement; (2) deny interest or royalty deductions arising from certain hybrid arrangements involving unrelated parties in appropriate circumstances, such as structured transactions; and (3) deny all or a portion of a deduction claimed with respect to an interest or royalty payment that, as a result of the hybrid arrangement, is subject to inclusion in the recipient’s jurisdiction pursuant to a preferential regime that has the effect of reducing the generally applicable statutory rate by at least 25%.

In addition, the proposal would eliminate exceptions under current law, which led to situations where shareholders are not subject to tax currently in either the United States or in the related firm’s foreign jurisdiction because an entity is considered a separate corporation under U.S. tax law and a pass-through entity in another jurisdiction. The proposal would require current U.S. taxation of such payments.

The proposal would be effective for taxable years beginning after December 31, 2016.

CFC proposals – see OECD BEPS Action 3 recommendation

Impose a 19% minimum tax on foreign income

This proposal generally would impose a minimum tax on foreign income of U.S. multinationals at a rate of 19% reduced (but not below zero) by 85% of the effective foreign tax rate imposed on that income. Under the minimum tax, foreign earnings of U.S. multinationals generally would be subject to tax either immediately when earned or, if sufficiently high foreign taxes are paid on the income, not at all. Imposing an immediate minimum tax on foreign earnings that otherwise would be eligible for indefinite deferral under current law directly addresses the incentives under the current system to locate production overseas and to shift and maintain profits abroad.

The Administration proposes to supplement the existing Subpart F regime with a per-country minimum tax on the foreign earnings of entities taxed as domestic C corporations (U.S. corporations) and their CFCs. The minimum tax would apply to a U.S. corporation that is a U.S. shareholder of a CFC or that has foreign earnings from a branch or from the performance of services abroad. The effective foreign tax rate would be determined on an aggregate basis with respect to all foreign earnings and the associated foreign taxes assigned to a country in a manner described in regulations prescribed by the Secretary. It is expected that such determination generally would be based on the 60-month period that ends on the date on which the domestic corporation’s current taxable year ends, or in the case of CFC earnings, that ends on the date on which the CFC’s current taxable year ends. For this purpose, the foreign taxes taken into account are those taxes that, absent the proposal, would be eligible to be claimed as a foreign tax credit. Furthermore, subject to rules applicable to hybrid arrangements, the foreign earnings taken into account would be determined under U.S. tax principles but would include disregarded payments deductible elsewhere, such as disregarded intra-CFC interest or royalties, and would exclude dividends from related parties. The country to which foreign earnings and associated foreign taxes are assigned is based on tax residence under foreign law.

Impose a 14% one-time tax on previously untaxed foreign income

In connection with the transition to the minimum tax, this proposal would impose a one-time 14% tax on earnings accumulated in CFCs and not previously subject to U.S. tax. A credit would be allowed for the amount of foreign taxes associated with such earnings multiplied by the ratio of the one-time tax rate to the maximum U.S. corporate tax rate for 2016. The accumulated income subject to the one-time tax could then be repatriated without any further U.S. tax.

The proposal would be effective as of the date of enactment and would apply to earnings accumulated for taxable years beginning no later than December 31, 2016. The tax would be payable ratably over five years.

Subpart F proposals

These proposals would expand the categories of Subpart F income in two ways: (1) Create a new category of Subpart F income for transactions involving digital goods or services and (2) expand the category of foreign base company sales income (FBCSI).

New category of Subpart F income

First, the proposal would create a new category of Subpart F income, foreign base company digital income, which generally would include income of a CFC from the lease or sale of a digital copyrighted article or from the provision of a digital service (see OECD BEPS Action 1 recommendation). An exception would apply where the CFC earns income directly from customers located in the CFC’s country of incorporation that use or consume the digital copyrighted article or digital service in such country.

Expand category of FBCSI

The proposal would expand the category of FBCSI to include income of a CFC from the sale of property manufactured on behalf of the CFC by a related person. The existing exceptions to FBCSI would continue to apply.

Additionally, the proposal would modify the thresholds for applying Subpart F by amending the ownership attribution rules under IRC Section 958(b) so that certain stock of a foreign corporation owned by a foreign person is attributed to a related U.S. person for purposes of determining whether the related U.S. person is a U.S. shareholder of the foreign corporation and, therefore, whether the foreign corporation is a CFC. The pro rata share of a CFC’s Subpart F income that a U.S. shareholder is required to include in gross income, however, would continue to be determined based on direct or indirect ownership of the CFC, without application of the ownership attribution rules of IRC Section 958(b).

Finally, the proposal would eliminate the requirement for a foreign corporation to be a CFC for an uninterrupted period of at least 30 days in order for a U.S. shareholder to be required to include in gross income Subpart F income earned by the CFC.

The proposal would be effective for taxable years beginning after December 31, 2016.

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