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Gucci Gulch Redux: The Problems of the Wyden Proposal

Posted on Aug. 30, 2021
Reuven S. Avi-Yonah
Reuven S. Avi-Yonah

Reuven S. Avi-Yonah is the Irwin I. Cohn Professor of Law at the University of Michigan.

In this article, Avi-Yonah critiques a recent U.S. tax reform proposal that would overhaul the global intangible low-taxed income, foreign-derived intangible income, and base erosion and antiabuse tax regimes.

Copyright 2021 Reuven S. Avi-Yonah.
All rights reserved.

On August 25 Senate Finance Committee Chair Ron Wyden, D-Ore., and Finance Committee members Sherrod Brown, D-Ohio, and Mark R. Warner, D-Va., released a “discussion draft”1 of Wyden’s international tax reform proposals, which is an updated version of the proposals he advanced last April. In April I wrote, “Unfortunately, the Wyden Plan relies heavily on ideas the GOP enacted in 2004, and represents a step backward even from some elements of the Trump tax law.”2 Between April and August, the corporate lobbyists have succeeded in modifying the proposal to make it even worse.

Wyden, Brown, and Warner describe their proposal (the Wyden proposal) as follows:

To overhaul GILTI [global intangible low-taxed income], the senators propose repealing the tax exemption for foreign factories that incentivizes shipping jobs overseas, raising the GILTI rate, and moving to a country-by-country system that prevents multinational corporations from shielding income in tax havens from U.S. tax. The senators’ proposed “high-tax exclusion” is a simpler country-by-country approach, excluding income from countries where it is already taxed at a higher rate than GILTI, with the remaining low-tax countries subject to GILTI taxation. Lastly, the treatment of research and development expenses and headquarters’ costs would be adjusted, to prevent companies from paying higher taxes under GILTI when they invest in the United States.

To overhaul FDII [foreign-derived intangible income], the senators similarly propose ending the built-in incentive to offshore factories and other assets, and equalizing the FDII and GILTI rates. The offshoring incentive will be replaced with a new provision to reward current year innovation-spurring activities in the United States, like research and development.

To overhaul BEAT [base erosion and antiabuse tax], the senators propose restoring the full value of tax credits for domestic investment. To pay for this change, the proposal creates a higher, second tax bracket for income associated with base erosion; this raises revenue from the biggest base eroders, and uses that revenue to support companies investing in the United States.

The best way to address timing issues in GILTI and to integrate concepts from the Biden administration’s SHIELD [stopping harmful inversions and ending low-tax developments] proposal are still to be determined. Additional international tax policies are also under consideration, and the discussion draft is a starting point for conversations in the Democratic caucus on how to reform the international tax system to meet shared goals.3

Each of these elements is flawed, and together they represent a proposal that is far inferior to the proposal the Biden administration released in March.4 Some detailed comments follow.

Not Specific Enough

Unlike the administration proposal of a 28 percent domestic rate and a 21 percent GILTI rate, the Wyden proposal does not specify either rate, other than stating that the GILTI rate would be increased (from 10.5 percent) and that the FDII rate (currently 13.125 percent) would be equal to the GILTI rate. As a result, it is also harder to evaluate the proposed high-tax exclusion from GILTI, because that depends on comparing the foreign effective rate with the GILTI rate. The exclusion applies if the foreign effective rate is as high or higher than the GILTI rate, but we do not know what the GILTI rate is or how it compares with the domestic rate. Personally, I would prefer to equalize the domestic and GILTI rates at, for example, 25 percent to minimize profit shifting (25 percent is about the OECD average).

Added Complexity

The proposed high-tax exclusion from GILTI, far from being “a simpler country-by-country approach,” adds tremendous complexity. Much of the Wyden proposal is devoted to dealing with the mechanics of the high-tax exclusion, for example, the treatment of branches and losses, as well as timing issues. This is far more complicated than the Biden administration proposal, which simply applies GILTI at 21 percent on a CbC basis, with U.S. residual tax due if the foreign country tax is lower than 21 percent. Also, a high-tax exclusion requires retaining the dividend participation exemption, which is one of the worst features of the Tax Cuts and Jobs Act.5 The administration proposal eliminates the qualified business asset investment exemption (which the Wyden proposal likewise does) and simply taxes all foreign income at the GILTI rate with foreign tax credits.

Also, as the Wyden proposal acknowledges, adopting a high-tax exclusion gives the multinationals the benefit they obtained by lobbying the Trump Treasury to extend the subpart F high-tax exclusion to GILTI without any statutory basis.6 This was presumably done because otherwise the Biden Treasury could eliminate this giveaway by regulation. It reminds me of how the Republicans enacted section 954(c)(6) in 2006 to prevent a Democratic administration from reversing check-the-box by regulation, except that in this case, it is Democratic senators undermining a Democratic administration.

Moreover, a high-tax exception is prone to abusive tax planning, as illustrated by the following example.

Example: MNE is a U.S. multinational with controlled foreign corporations in countries A and B. Each CFC has $100 in income. It also has $100 in U.S. income.

Country A’s statutory tax rate is 15 percent. Country B’s is 0 percent. The GILTI rate is 21 percent with no QBAI, so all CFC income is subject to tax unless it qualifies for the high-tax exclusion, which is set at an effective foreign rate that is the same as the GILTI rate, or 21 percent. The U.S. domestic rate is 28 percent.

Before tax planning, the result under the proposal is that MNE pays $21 - $15 = $6 on country A income and $21 on country B income. It also pays $28 on U.S. income.

Now MNE borrows in the United States and deducts $60 in interest expense, $30 of which is allocated under the interest expense allocation rule to the CFC in country A because it has assets (while the country B CFC has none).

So now the tax base in country A for U.S. purposes is $70, and the effective tax rate is 15/70, or 21.4 percent, which makes it eligible for the high-tax exclusion. As a result, the U.S. tax on country A income is zero, while the U.S. tax on country B income remains $21.

At this point, MNE shifts $100 of domestic income from the United States to country A. MNE also shifts $100 of country B income to country A.7

So now the U.S. tax is zero because there is no tax on country A income (since it qualifies for the high-tax exclusion) and there is no income in country B or in the United States.

Before planning, MNE paid the United States $28 on domestic-source income, $6 on country A income, and $21 on country B income, as well as $15 to country A. The total tax was $70 ($15 to country A and $55 to the United States.).

After planning, MNE pays $45 to country A and nothing to the United States. Its effective global tax rate declines from 23.3 percent to 15 percent.

Under the Biden administration proposal, that planning does not work because the income from countries A and B is segregated and there is no high-tax exclusion, so the result would be a total tax of $28 in the United States, $6 + $15 in country A, and $21 in country B, or $70. Reducing the country A tax base has no effect on this.8

R&D and Headquarters Expenses

Allocating R&D and headquarters expenses to GILTI is wrong since GILTI is taxed at a lower rate than domestic income, as Stephen E. Shay has pointed out.9 In general, it is far from clear that either deduction benefits the United States because most R&D is just updating already successful products, like the iPhone, and most headquarters expense is bloated salaries for executives. These two deductions are the main reasons Amazon and its ilk do not pay U.S. tax on domestic income.

Repealing FDII

Repealing FDII (as in the Biden administration plan) is much better than the proposed alternative, especially because it keeps the FDII export contingency, and so is likewise open to a WTO challenge.10 The Biden administration proposal is not export contingent. As stated above, basing FDII on R&D has little to do with true innovation.

Additional BEAT Rate

The addition of a second rate to BEAT adds complexity to what is already a very complicated, as well as flawed, statute (revenue from BEAT is far below the 2017 revenue estimate). The SHIELD plan is a much better proposal because, unlike BEAT, it is coordinated with the OECD’s pillar 2, which is quite likely to be adopted by October. The right way to “integrate concepts from the Biden administration’s SHIELD proposal” is to drop the BEAT proposal and adopt the SHIELD proposal. This will also eliminate the need to restore “the full value of tax credits for domestic investment” under BEAT, which in turn requires a second rate as a pay-for.

Conclusion

The Wyden proposal states that it is “a starting point for conversations in the Democratic caucus on how to reform the international tax system to meet shared goals.” I would suggest that there is a much better starting point, namely the Biden administration proposal. On every point that the Wyden proposal is different than the administration proposal, it is inferior. The only good points in the Wyden proposal are those that it aligns with the administration proposal (for example, eliminating QBAI and adopting CbC for GILTI). Whenever it deviates, as in the high-tax exclusion, retaining FDII, retaining BEAT, and retaining the participation exemption, the Wyden proposal is closer to the TCJA (enacted over the opposition of every Democrat in Congress) than to the Biden administration proposal.11 This is truly a return to Gucci Gulch, with the corporate lobbyists running the show.

FOOTNOTES

1 Finance Committee, “Modifications of Rules Relating to the Taxation of Global Income” (Aug. 24, 2021).

2 See Reuven S. Avi-Yonah, “The Devil in the Tax Details,” The American Prospect, Apr. 8, 2021.

4 White House, “The American Jobs Plan ” (Mar. 31, 2021); and Treasury, “The Made in America Tax Plan” (Apr. 2021).

5 See supra note 3 (“Presuming it otherwise meets the requirements of the dividend exemption system under section 245A, it would be exempted through an additional deduction at the time of repatriation, leading the high-tax tested income to be functionally exempt from U.S. tax.”).

6 See supra note 3 (“Sec. 1(b) provides for a country-by-country system applied to GILTI. It does so through a high-tax exclusion modeled on regulations issued by the Treasury Department in 2019 and 2020.”).

7 These shifts would increase the country A tax to $45, so that more U.S. expenses would need to be allocated to the country A CFC to keep the effective tax rate above the GILTI rate.

8 Therefore, it is not true, as the discussion draft argues, that “different country-by-country systems achieve the same purpose — keeping any excess credit created in one country from reducing the top-up tax on income from another country. Under the high-tax exclusion, that is achieved by excluding any income (and the related taxes) which may create an excess credit. Under systems that would use separate foreign tax credit baskets for each country, that is achieved by excluding excess credits from the system while keeping all the income in the system. The end results are essentially the same.”

9 Shay, “Addressing an Opaque Foreign Income Subsidy With Expense Disallowance,” Tax Notes Federal, Aug. 2, 2021, p. 699.

10 See supra note 3 (“The foreign-derived ratio calculation remains unchanged.”).

11 See supra note 3 (“Additionally, the discussion draft’s tailored approach shows significant existing architecture in GILTI, FDII, and BEAT would be retained, making taxpayer compliance and administration simpler.”).

END FOOTNOTES

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