Paper on Territoriality Proposals Is Presented to Treasury

From: gregory.may@freshfields.com

The JCT report just issued reminds me that I neglected to send you the attached version of my territoriality paper as promised a few weeks ago.

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Gregory May

Recent proposals from both the President's Advisory Panel on Federal Tax Reform and the Joint Committee on Taxation for the United States to adopt a territorial international tax system¹ are significant mileposts in what still remains a long road toward new US international tax policy. While extension of recent tax reductions almost certainly will eclipse major international tax reform during the current Administration, the recent territoriality proposals may become a meaningful departure point for future developments.² This paper reviews the proposals for corporations and business taxpayers. It does not deal with the basic policy questions about whether the United States should adopt territoriality.³ It instead considers selected questions about how the United States might implement a territorial tax system along the lines of the current proposals if it chose to adopt territoriality in principle. The paper begins with a selective overview of the current proposals. It then considers key issues that would need to be resolved in developing the proposals into law. It addresses those issues by considering in turn the points relevant to controlled foreign corporations, branches, non-controlled foreign corporations, financial institutions and tax treaties.

1. Current Proposals

The territoriality proposal offered by President's Advisory Panel in November 2005 so strongly resembles the proposal made by the Joint Committee staff in January 2005 that they can be discussed together for present purposes.⁴ A separate, corporate residence proposal from both groups also should be considered a component of the proposed approach to territoriality.

1.1 Corporate residence

The core of the territoriality proposals is a source-based exemption. But the proposals also suggest a fundamental change to the criterion for corporate residence. Place of incorporation draws a residence-based line too easily avoided under the current worldwide taxation system (notwithstanding the anti-inversion reform),⁵ and a legalistic line would present similar risks under a territorial system. Under the proposals, the United States would define the residence of foreign corporations not by place of incorporation, but by place of effective management and control. Effective management and control takes place where a company's officers undertake day-to-day management and supervision, not where (as under the traditional management and control test) the board of directors chooses to meet.

1.2 Foreign dividend exemption

The centerpiece of the territoriality proposals is the foreign dividend exemption. A US corporation could exclude from income dividends received from a controlled foreign corporation in which it holds at least 10% of the shares. A corporate 10% shareholder of any other foreign corporation could elect, at least under the Joint Committee's proposal, to treat the corporation as a controlled foreign corporation. Interest and other expenses properly allocable to exempt foreign dividends would be nondeductible.⁶ The indirect foreign tax credit would be repealed for income other than subpart F inclusions.⁷ The Advisory Panel, which suggests giving shareholders an exemption for dividends paid by US corporations, would deny the exemption to the extent a corporation pays dividends from exempt foreign earnings.⁸

Four basic features of the dividend exemption formulation are worth noting at the outset. Two are relatively conventional, but two are not. First, the proposal applies only to corporate direct investors as defined by the 10% shareholding threshold elsewhere used to denote direct investment.⁹ Conventional foreign dividend exemptions in other countries have the same or a substantially similar basic limitation.¹⁰ The preference for corporations over other business entities presumably would extend to all large businesses if the United States were to adopt the Advisory Panel's proposal to tax all large business entities at the entity level.¹¹

Second, the proposal does not apply to foreign source income other than dividends. Interest, royalties, fees and sales income received from controlled foreign corporations or any other foreign source remain fully includible in income.¹² The payer generally would have been able to claim a deduction (or tax basis) for such payments in the source country. Excluding the receipts from income therefore would eliminate tax on the amounts entirely.

Third, the proposal applies only to dividends from controlled foreign corporations subject to subpart F. This generally limits the exemption to dividends out of active business income or income highly taxed abroad. Basing the exemption on familiar distinctions in the current anti-deferral regime has appeal, but extending the benefit to dividends out of low-taxed active business income is a relatively heavy dose of import neutrality. Exemption systems in other countries typically apply only to dividends from companies subject to tax in jurisdictions with normal corporate tax regimes.¹³

A fourth feature of the Advisory Panel's proposal -- recapture of the foreign dividend exemption when a domestic corporation pays dividends -- apparently was intended to put some limitation on the generous treatment of low-taxed active business income, but it seems anomalous in the context of tax reform proposals that generally favor corporate/shareholder integration and import neutrality. The panel proposes that dividends paid by domestic corporations would qualify for the otherwise generally applicable exemption only to the extent paid out of earnings subject to US tax.¹⁴ Foreign earnings subject to US tax satisfied with foreign tax credits apparently would count as taxed earnings for this purpose.¹⁵ But given repeal of the indirect foreign tax credit for income other than subpart F inclusions, the proposal effectively would withdraw international double taxation relief when a domestic corporation distributes foreign active business earnings.

Perhaps the Advisory Panel, which generally advocates a single level of taxation on corporate income, conceived its territoriality regime as strictly a corporate tax benefit rather than an international tax system.¹⁶ Indeed, the panel suggests that taxing dividends paid from exempt foreign earnings and requiring a domestic corporation to disclose to shareholders the relative amount of its exempt foreign earnings may reduce what it acknowledges to be the temptation to use aggressive transfer pricing and other strategies to overstate exempt foreign earnings.¹⁷ Although the panel believes shareholder reaction will discipline corporate abuses of the system, it apparently believes those reactions will not deter corporate repatriation of active business earnings.¹⁸ It elsewhere cites the domestic tax cost of repatriation (what some -- presumably rhetorically -- have called the repatriation tax) as one of the main problems with the current system,¹⁹ so it must have concluded that shifting the cost to shareholders (through what might be called -- without exaggeration -- a distribution tax) can solve the problem. Territorial systems in other countries typically aim to provide permanent protection from international double taxation.

1.3 Controlled foreign corporations

As far as corporate direct investors are concerned, the territoriality proposals effectively convert subpart F from an anti-deferral regime into an exemption regime. Subpart F scopes territoriality relief in two ways. First, foreign dividends are exempt only if received by a corporate direct investor from a controlled foreign corporation. Second, current inclusions under subpart F do not qualify for the proposed foreign dividends-received exemption. Subpart F sorts what the proposals call passive or other mobile foreign income which enjoys no deferral and would enjoy no exemption from active or less mobile foreign income which enjoys deferral and would enjoy exemption.²⁰ In other words, only foreign earnings subjected to subpart F and found to be deferrable will enjoy exemption.

1.4 Foreign tax credit

The proposals contemplate repeal of the indirect foreign tax credit except with respect to taxes on subpart F inclusions. The weight of repeal falls on corporate direct investors in foreign corporations not controlled by US direct investors (so-called 10-50 companies). Corporate direct investors would not need the indirect credit for amounts actually received from controlled foreign corporations because all distributions would be exempt or previously taxed and other payments would not be out of earnings anyway. Corporate direct investors in foreign corporations managed and controlled within the United States presumably would not suffer from the repeal because the corporation's subsidiaries would be treated as controlled foreign corporations and any foreign taxes for which corporate direct investors could have claimed indirect credit would be directly creditable by the corporation. But corporate direct investors in 10-50 companies would be denied the double tax relief currently provided by indirect credits. The Joint Committee proposal would allow investors to claim double tax relief in that situation by electing to treat the 10-50 company as a controlled foreign corporation, thus qualifying dividends for exemption in exchange for current inclusion of subpart F income.²¹ The Advisory Panel recognizes the need for relief, but it does not endorse a particular proposal.²²

The direct foreign tax credit rules would remain in place. The Joint Committee proposes no changes. The Advisory Panel proposes a single overall foreign tax credit limitation.²³

1.5 Share gains

As a logical corollary to the dividend exemption, a corporate direct investor could exclude gain on shares in a controlled foreign corporation to the extent it does not exceed the controlled foreign corporation's undistributed earnings.²⁴ And as a logically corollary to the limitation on the dividend exemption, a US shareholder's gain on shares in other foreign corporations would not qualify for the 75% exclusion the Advisory Panel proposes for gain on shares in domestic corporations.²⁵ The exclusion for gain on controlled foreign corporation shares is the territorial system's cognate to the relief currently provided by Code section 1248, and like the proposed territorial system itself, the relief would be more or less generous than current law depending upon the controlled foreign corporation's effective foreign tax rate.

1.6 Branches

A foreign branch would be treated as a controlled foreign corporation for all purposes, and all trades or businesses conducted within the same country would be treated as a single corporation. Branch income therefore would be includible or excludable on the same basis as the earnings of a controlled foreign corporation. Transactions with branches and between branches would be recognized intercorporate transactions.²⁶ These would be substantial changes to the US international tax system. They are related to the Advisory Panel's proposal to tax all large businesses (receipts over $10 million) at the entity level regardless of the form in which they operate²⁷ and the Joint Committee's proposal to treat all wholly-owned foreign business entities as corporations.²⁸ The proposals reflect an underlying perception that elective entity characterization has too substantially undermined the current tax system and, in particular, the international tax system.

2. Controlled Foreign Corporations

Since the controlled foreign corporation dividend exemption is their centerpiece, a discussion of implementing the territoriality proposals must begin with controlled foreign corporations. There are at least important three issues that lawmakers would have to resolve.

2.1 US source earnings

Many commentators had believed that a territorial system would require substantial elaboration of the United States' source rules. The territoriality proposals for business taxpayers effectively sidestep the sourcing issues by relying on the distinctions between active business income and passive or mobile income drawn in subpart F. Dividends paid by a controlled foreign corporation apparently would qualify for the proposed territorial exemption even if they are paid out of income from US sources or income effectively connected with the conduct of a US trade or business. On its face, this seems more generous than current law. Current law generally treats a controlled foreign corporation's dividends as US source income in the same proportion as the corporation's US source earnings.²⁹ In principle at least, foreign tax on the income cannot be relieved to the extent dividends have been resourced under this rule.

Only US source income earned by trades or businesses conducted abroad or income protected by treaty would appear to benefit from the proposed change in the scope of international double tax' relief. A foreign controlled corporation's other US source earnings will bear US tax. Its passive US source income generally will bear tax because 10% US shareholders, including the corporate direct investors otherwise entitled to the dividend exemption, must pay tax on their shares of the income currently under subpart F. Its income from US trades or businesses generally will be taxed to the corporation itself unless it can claim a treaty exemption. The focus therefore is on whether the exemption system should apply to dividends from a foreign company that operates abroad but derives most of its business income from the United States. In particular, lawmakers might ask whether corporate direct investors should benefit from an exemption for dividends paid out of untaxed US earnings when its shareholders cannot benefit from the otherwise applicable domestic dividend exemption to the extend dividends are paid from exempt foreign earnings.

These questions arise in various relatively common situations where general arguments about export or import neutrality are unlikely to provide practical political answers. The classic, or at least the most inflammatory, example is low-taxed active business income earned at a so-called runaway plant. A US corporation shifts manufacturing of products for the US market to a subsidiary in a low-tax foreign location with or without all of the related intangibles. The subsidiary derives substantially all of its income, net of whatever it has to pay or amortize for the intangibles,³⁰ from sales made to US customers that, depending on the vagaries of the manipulable title passage rule, may or may as well be treated as partly US source income.³¹ Other examples include offshore financing, insurance and leasing or licensing operations sufficiently active to avoid subpart F and sufficiently well operated to avoid engaging in business within the United States. In each case, current law should and often does effectively impose US tax on a portion of the foreign company's economic earnings either in the form of the deductible payments it makes (or non-deductible payments it is deemed to make) to taxable US persons (royalties, for example) or in the form of payments subject to withholding that it receives from US customers (rents, royalties or insurance premiums, for example). US source interest income, however, generally can avoid US tax because exemptions from US interest withholding tax are so widely available.

The United States cannot adopt a foreign dividend exemption until political concern about runaway plants has been resolved on a basis sufficiently neutral to provide stability for the new system. The views taken on at least four implementation-related policy issues may determine whether that is possible. The first issue is whether US transfer pricing rules and enforcement practices need modification or improvement in light of the challenges a territorial exemption system would present. The second is whether the subpart F exemptions for otherwise passive income earned by active financing, insurance and leasing or licensing businesses³² need amendment to prevent what under a foreign dividend exemption system could become a legal, corporate equivalent to the once dreaded flow-back of bearer bonds.³³ The third is whether any nation, particular a nation of debtors, can afford to consider tightening its withholding tax exemptions for interest and other financial income. The fourth -- and most fundamental -- policy issue is whether the foreign dividend exemption should cover only dividends out of earnings that bore foreign tax at a sufficiently meaningful effective rate.

The Advisory Panel clearly understood the first concern about transfer pricing, and it suggested that imposing tax on domestic dividends to the extent paid out of foreign earnings (and perhaps equally, the associated publicity) would encourage corporations not to shift operations abroad.³⁴ The panel also understood the second issue about active businesses earning passive-type income, and given the long and complicated history of the exemptions, perhaps it can be excused for suggesting nothing other than the need for anti-abuse rules.³⁵ The panel might be forgiven for not raising the third issue about tightening withholding tax rules. It arises only if measures to deal with the second issue are inadequate, and withholding on financial flows would be inconsistent with the international norm in developed countries. The panel's failure to mention the problem with low-tax foreign earnings, however, is more unaccountable. Subpart F long has contained a high-tax kickout provision on which a foreign tax qualification for dividend exemption could be based.³⁶ A foreign tax qualification arguably would provide a relatively simple and effective resolution for concerns about offshore finance, insurance and leasing/licensing. Many countries with foreign dividend exemption systems deny exemptions to dividends from low-taxed jurisdictions as various defined.³⁷ Perhaps the Advisory Panel simply took the virtues of international tax competition as a self-evident article of faith.

2.2 Expense allocation

Implementing the denial of deductions for interest and other expenses allocable to excluded foreign dividend income would require corporate direct investors to allocate expenses between US and foreign source income and then between taxable and exempt foreign source income. Just as taxpayers under the current credit system benefit from allocating expenses and losses away from all foreign source income, taxpayers under an exemption system would benefit from allocating expenses and losses away from excluded foreign source income. But while the allocation under a credit system simply increases the taxpayer's foreign tax credit limitation and might not actually produce a credit, the allocation under a territorial system invariably determines whether the expense or the loss can be deducted. It has been observed that the expense allocation required under an exemption system increases complexity at the same time introduction of the system raises the stakes.³⁸ Apparently much of the revenue increase project from the proposals arises from the expectation that expenses related to foreign income would be identified more thoroughly than they are currently in practice.³⁹

Concerns about the weight being placed on expense allocation require more empirical analysis, but the two basic concerns just mentioned may be overstated. It is not clear that the allocations required are more complicated than those required by current law, which calls for allocations of expenses among classes of income and then between statutory groupings within each class.⁴⁰ Indeed, allocations would be simpler if lawmakers simultaneously adopted the proposed single foreign tax credit limitation. Perhaps that provides some basis for revenue projections that assume corporate direct investors could be forced to allocate expenses more thoroughly. It also is not clear that the foreign dividend exemption raises the stakes current law has placed on the table. The current foreign tax credit system, perhaps even with the limitation simplifications adopted in 2004,⁴¹ seems to leave many corporate direct investors with excess foreign tax credit. The resulting international double taxation is as burdensome, at least a priori, as the denial of a deduction. Indeed, an exemption system may lower the stakes if the types of foreign source income left subject to US taxation -- subpart F inclusions and passive income -- generally will have borne foreign tax at lower effective rates.

With that said, it nevertheless seems certain that current rules for expense and loss allocation would be revisited in the implementation of a foreign dividend exemption. At a minimum, the regime would need a well-developed interest netting rule⁴² to prevent taxpayers from borrowing more heavily through active business entities operating abroad. At the maximum, the regime might make worldwide interest and expense allocation mandatory rather than elective.⁴³ Much also will turn on how the regime treats foreign losses. If losses related to exempt income are denied or are carried forward as offsets against gain on controlled foreign corporation shares, the stakes obviously would be higher than if they are allowed to offset taxable foreign source income (subject, presumably, to recapture).⁴⁴

It is interesting to note in passing that the Advisory Panel and the Joint Committee reports simply ignore an approach to expense allocation adopted in many exemption systems. Those systems exclude less than 100% of foreign dividends as a proxy for disallowing related expenses, the typical exemption being 95% of a dividend received. The approach has at least three things to recommend it. It obviously is simpler. It clearly is more easily enforced. And it should enable the government to project revenues more effectively. The approach also has great disadvantages. Unless coupled with additional rules disallowing interest deductions when borrowings are disproportionately related to excluded foreign dividends, the approach would subsidize borrowing. It would be unfair to corporate direct investors who incur fewer expenses than the chosen inclusion percentage assumes. And if direct investors are allowed to offset the includible portion of the dividend with foreign source losses, it might make dividend remittances more irregular and less easily projected. In any event, the United States is unlikely to adopt the approximate approach given its long-standing preference for specific allocations.

2.3 Branches of controlled foreign corporations

The proposals to treat foreign branches as controlled foreign corporations presumably would apply to branches of controlled foreign corporations. And the Joint Committee's proposal to treat all foreign business entities as controlled foreign corporations overtly targets hybrid branches of controlled foreign corporations. Those proposals would play a significant role in determining how much of a controlled foreign corporation's earnings is subpart F income ineligible for exemption. All transactions between a foreign corporation's branches or wholly-owned business entities would be recognized, and many of the transactions could yield subpart F income. Since the proposals contemplate treating all branches within the same country as a single entity, the foreign personal holding company income exemption for dividends, interest, rents and royalties received from a related company actively conducting business in the same country⁴⁵ presumably would remain. But the relief it provides almost certainly is too narrow in the context of a territorial regime.

Planning structures widely adopted under the elective entity characterization rules have allowed US multinationals to reinvest foreign earnings abroad and to shift earnings from high-tax to low-tax countries without recognizing subpart F income. The structures have wide support, and they are consistent with the preference for import neutrality underlying territorial tax systems. The proposals therefore are unlikely to be implemented in a way that would end the standoff reached after the 1998 attempt to extrapolate subpart F's branch rules to cover hybrid branch structures.⁴⁶ If a foreign corporation's branches and hybrid branches are to be treated as controlled' foreign corporations, some expansion of the foreign personal holding company income exemption for amounts received from related parties seems quite likely. Indeed, it might be sensible to supplement it with the broader exemption that the passive foreign investment company rules provide for interest, dividends, rents or royalties paid out of a related person's active income.⁴⁷

3. Foreign branches

The current US approach to foreign branches departs from international norms in two fundament ways. First, US law insists on disregarding actual branch transactions except for limited purposes. Second, the US elective entity characterization rules can require the United States to disregard entities and transactions that other countries recognize and tax. There seems to be some reversal of both approaches in the proposals to tax all large businesses at the entity level and to treat a US corporation's foreign branches as separate controlled foreign corporations.

3.1 Branch characterization

If the US characterization of a branch differs from the residence country's characterization, even international consistency in the treatment of branch transactions will not prevent inconsistent taxation. The proposals do not expressly address -- and they may compound -- that problem. Under the proposal to treat foreign branches as corporations for US tax purposes, all foreign branches automatically would become reverse hybrids. Reverse hybrid treatment might not expose US corporations to double taxation if the international norms for branch taxation effectively treat branches like subsidiaries operating at arm's length. On the surface and in principle, the separate entity treatment for branches often advanced as the international norm -- at least under OECD-based treaties (perhaps even US treaties⁴⁸) -- seems to promise such an outcome. But realization of the outcome remains uncertain, especially in so far as equity, or free, capital is concerned.⁴⁹

The proposals do not expressly address hybrid entity branches doing business abroad. But treating a first-tier foreign legal entity as a branch obviously would be inconsistent with the proposal to treat branches as corporations. Indeed, allowing US direct investors to make hybrid branch elections would let them avoid the consequences of the proposal to repeal the indirect foreign tax credit except with respect to subpart F income. If cross-crediting were permitted, investors in high-tax countries would elect out of the exemption regime in order to benefit from the shelter that excess direct tax credits could provide to other low-taxed foreign source income.

3.2 Branch transactions

Having rather consistently refused to recognize branch transactions, US tax law has few precedents from which to craft rules for treating a branch as a separate corporation. An even greater difficulty at the moment is that the international norms themselves -- taking reports of the OECD working groups as some indication -- are migrating (or at least some governments think they should migrate). The prospects for major international tax reform being what they are, of course, the international dust may be settled by the time the United States seriously considers a territorial regime. It may be sensible to assume, therefore, that the income of foreign branches treated as separate corporations could be determined using some version of the transfer pricing approach mooted in the OECD drafts on the attribution of profits to permanent establishments.⁵⁰

Implementation of the proposal to treat foreign branches as controlled foreign corporations would present various questions even if most countries had relatively consistent transfer pricing models. Some questions relate to inevitable differences in the implementation of relatively similar models. Imputed royalties for the use of intangibles may be a good illustration. Section 367(d) of the Internal Revenue Code deems a first-tier foreign subsidiary to have paid its US parent royalties commensurate with income for the use of intangibles contributed to it. The statutory requirement to impute a royalty could create a distortion if the country that treats the branch as a permanent establishment rather than a separate company does not impute a royalty because it saw no asset contribution. And some countries may not agree to impute a royalty commensurate with income, especially in circumstances where the branch has contributed substantially to the development of the intangibles or the market commercializing them. The stakes here may be higher under an exemption system because foreign taxes driven to a high effective rate by the disallowance of deductions are final taxes.

More fundamental problems will arise if the section 367(a) toll-charge on outbound transfers to foreign corporations applies when a corporation transfers property to reverse hybrid branches. Given the long history of ignoring transactions between a branch and its head office, identifying transactions that should be treated as property transfers might not be easy. Even matters as common as the allocation of corporate opportunities would have considerable significance when an exemption is at stake.⁵¹ The virtual fungibility of assets and risks in a world of synthetic reality will compound the difficulties in many businesses. While levying the toll-charge on transfers to foreign branches would be a heavy burden on multinationals, it is not clear how to relieve it without opening a hole in the revenue net that surely would unravel.

Other issues will relate to the adequacy of US relief for foreign taxes on branch remittances. In principle, it should be equivalent to relief for foreign taxes on foreign dividends. A foreign branch profits tax like the one imposed by the United States, however, shifts remittance taxes from the home office to the branch. If a branch is deemed to be a controlled foreign corporation and it has no subpart F income, such a branch tax might be an indirect tax for which no foreign tax credit was available absent adjustments to the technical taxpayer rule.

4. Non-controlled foreign corporations

US corporate direct investors in 10-50 companies are obvious losers under the territoriality proposals because the dividends received from 10-50 companies would be includible and indirect foreign tax credits would be unavailable. The Joint Committee's proposal to let corporate direct investors treat a 10-50 company as a controlled foreign corporation is not likely to be a workable alternative in many cases. The absence of adequate information long has been a problem for direct investors claiming indirect credits for foreign taxes paid by 10-50 companies, so obtaining the information needed to satisfy subpart F reporting and compliance requirements would be difficult at best. Indeed, a foreign commercial company not controlled by US persons typically does not keep records adequate for this purpose. It would not, for example, generally track related party transactions in the way subpart F requires, and it almost certainly would have used arguably nonconforming transfer pricing practices.

Allowing corporate direct investors in 10-50 companies to claim indirect foreign tax credits may prove to be the only feasible solution, but it sits uneasily with the basic territorial regime for several reasons. Exemption is the normative means for eliminating international double taxation under a territorial regime. The conditions for exemption must preserve whatever measure of export neutrality has been found necessary to protect the national revenue base. The proposals find those conditions in subpart F. They deviate from the territorial norm to allow indirect foreign tax credits for subpart F inclusions simply to enforce those conditions without creating international double taxation. If direct investors can claim indirect credits under other circumstances, they have opportunities to structure their affairs to obtain international double tax relief without satisfying the conditions for relief established by the system. Electivity presents particular risks if, as the Advisory Panel proposes, investors can cross-credit freely. If indirect credits were to be retained for 10-50 company dividends, therefore, they almost certainly would have to be subject to separate limitation.

Investments in non-resident partnerships would present similar issues, but the proposals offer no hints about how partnerships not engaged in a US trade or business would be treated. It might be consistent with the proposed treatment of large businesses generally and foreign branches in particular to treat non-resident partnerships as foreign corporations, determine whether they are controlled foreign corporations or 10-50 companies and then tax a 10% US corporate partner's partnership income based on the conclusion. The choice of partnership form otherwise would allow corporate direct investors in foreign joint ventures effectively to elect out of the exemption regime when doing business in high-tax jurisdictions. The investor could claim direct foreign tax credits for its share of the joint venture's foreign income tax. Opting for credits could benefit the investor unless income from each 10-50 company is subject to separate limitation.

5. Financial institutions

The territoriality proposals do not directly address the treatment of banks, insurance companies and other financial institutions, but those businesses would have a particular interest in how the proposals are implemented. As a practical matter, banks and some other financial institutions are the taxpayers with the greatest stake in the consequences of treating foreign branches as controlled foreign corporations. The subpart F exceptions for active financing income and active insurance income⁵² also would take on much greater significance for them. The subpart F exceptions as applied to both branch and non-branch operations would become the predicate not for deferral, but for exemption. Given its checkered history and impermanent status, the active financing exemption would need to be settled before it could bear this weight.

The enhanced or better enforced interest allocation rules likely to accompany implementation of a territorial regime probably would affect financial institutions more than other taxpayers. Since money is their stock in trade, there seems to be a growing consensus -- at least among OECD governments -- that financial institutions should allocate capital charges as well as interest to their branch operations for purposes of computing the income attributable to a permanent establishment.⁵³ In the domestic context, it could be argued that they should allocate interest expense on a worldwide basis to achieve substantially the same objective. Thus, even if worldwide allocation generally remained elective under a territorial system,⁵⁴ it could be required for financial institutions. Alternative means of allocating the cost of money based on the emerging OECD consensus would be more complicated. They would require the elaboration of branch capital concepts,⁵⁵ guidelines for allocating capital to particular types of business⁵⁶ and guidelines on the relative equity capitalization of foreign and domestic operations. Developing domestic rules of this type inevitably would lead to inconsistencies between domestic requirements and practices in other countries. Whatever the approach taken to charges for the use of money, it may determine whether financial institutions, are winners or losers under an exemption system.

6. Treaties

The Joint Committee's report notes that implementation of the territoriality proposal would require the United States to renegotiate all of its US income tax treaties. The treaties follow the OECD approach to specifying the method that each treaty country must use to relieve double taxation. Agreed against the background of the long-standing US adherence to a credit system, they oblige the United States to give resident taxpayers credit for income tax paid to the treaty country. Language in the double tax article in the 1996 US model treaty is typical. It says that the United States will allow direct and, as to dividends from corporate direct investment, indirect credit for income tax imposed by the other country "[i]n accordance with the provisions and subject to the limitations of the law of the United States (as it may be amended from time to time without changing the general principle hereof)."⁵⁷ US treaties from earlier eras contain substantially similar language.

Changes to all treaties almost certainly could not be negotiated and brought into force without substantial delay, and the United States would be at a marked disadvantage in negotiations undertaken against the backdrop of legislation effectively compelling them. Implementation of a territorial system therefore would require another approach to the treaty obligations to allow foreign tax credits. There are at least two alternatives. First, a foreign tax credit system with separate limitations for each company or at least for each country could continue to apply to dividends received from controlled foreign corporations resident in countries with unmodified treaties. The use of separate limitations to prevent cross-crediting should remove the benefit high-tax countries otherwise might see in preserving their existing treaties. The separate limitations also should not be a change to the "general principle" of the double tax article in existing treaties, the treaty standard against which changes to the credit system could be tested.⁵⁸ Low-tax countries would have an incentive in any event to negotiate the treaty changes needed to qualify dividends from their companies for exemption.

A second alternative might be more effective because it would bridge over the treaty problem. Corporate direct investors could be given an election to claim foreign tax credits under treaties subject to per country limitations, but the election would apply to their dividends from all controlled foreign corporations or at least to from those resident in countries with unmodified treaties.⁵⁹ Direct investors receiving most of their dividends from low-taxed subsidiaries would not make the election if it meant opting out of the exemption regime altogether, and they would not make the election even if it only applied to earnings from treaty countries as long as per country limitations applied to prevent cross-crediting. Because a separate limitation for dividends from a high-tax country would be economically equivalent to an exemption, direct investors receiving most of their dividend income from high-tax countries would have no incentive to make the election.⁶⁰ For the same reason, corporate taxpayers should not be able to argue successfully that the forced election effectively denies them the protection from double taxation contemplated by any particular treaty.

17 February 2006

² Predictions about the efficacy of tax policy ideas are notoriously unreliable, and the corporate/shareholder integration proposal advanced during the last Republican administration correlates rather imperfectly with the half-measure adopted during the current one. See I.R.C. § 1(h)(11) (enacted 2003). For recent commentary on prospects for the Advisory Panel's proposal for an alternative tax system, see Philip D. Morrison, "Why Tax Reform Panel's 'GIT' Proposal Will Soon Be Gone," Daily Tax Rpt., Feb. 16, 2006.

³ The recent literature contains some excellent examinations of territoriality as a policy choice and of the recent proposals from a policy perspective. See, e.g., J. Clifton Fleming, Jr. & Robert J. Peroni, "Exploring the Contours of a Proposed U.S. Exemption (Territorial) Tax System," Tax Notes, Dec. 19, 2005; Lawrence Lokken, "Does the U.S. Tax System Disadvantage U.S. Multinationals in the World Marketplace?", 4 J. Taxation Global Trans. 43 (Summer 2004); Hugh J. Ault, "U.S. Exemption/Territorial System vs. Credit-Based System," Tax Notes Int'I, Nov. 24, 2003; Brian J. Arnold, "Comments on the Proposed Adoption of a Territorial Tax System in the United States," Tax Notes Int'I, Mar. 11, 2002; Michael J. Graetz & Paul W. Oosterhuis, "Structuring an Exemption System for Foreign Income of U.S. Corporations," 54 Nat 7 Tax J. 771 (2001). See also Roseanne Altshuler & Harry Grubert, "Repatriation Taxes, Repatriation Strategies and Multinational Financial Policy," 87 J Pub. Econ. 73 (2003).

⁴ Both proposals resemble the exemption system that Michael Graetz and Paul Oosterhuis outlined in a paper delivered at the Brookings Institution/International Tax Policy Forum Conference on Territorial Income Taxation in 2001. See Graetz & Oosterhuis, supra note 3.

⁵ Adv. Panel Rpt. 135; Jt. Comm. Rpt. 178-181; see I.R.C. § 7874.

⁶ Adv. Panel Rpt. 241; Jt. Comm. Rpt. 190.

⁷ Adv. Panel Rpt. 240; Jt. Comm. Rpt. 192.

⁸ The Advisory Panel would not allow a dividends-received exemption for distributions from foreign corporations because it believes they could not readily demonstrate whether dividends came from earnings taxed in the United States. Adv. Panel Rpt. 125. The currently enacted half-measure of corporate/shareholder integration, of course, lets dividends from eligible foreign corporations enjoy the same reduced tax rates available for domestic qualified dividend income. I.R.C. § 1(h)(11)(C) (dividends on shares of foreign corporations publicly traded in the United States or resident in most treaty countries).

⁹See I.R.C. § 951(b) (subpart F inclusions for 10% shareholders); U.S. Treas. Dep't, Model Income Tax Treaty, Sept. 20, 1996, art. 10(2)(a) (5% dividend withholding rate for 10% voting shareholders)

¹⁰See Fleming & Peroni, supra note 3, at 1562-63.

¹¹See Adv. Panel Rpt. 129.

¹² Jt. Comm. Rpt. 191.

¹³ Section 2.1 below considers this feature of the proposals more fully.

¹⁴ The Advisory Panel suggests that a dividend would be paid out of taxed earnings in the same proportion as the corporation's taxed earnings bear to its total worldwide earnings, which might be approximated for this purpose by using pretax income as reported on the company's consolidated financial statements. Adv. Panel Rpt. 244.

¹⁵See Adv. Panel Rpt. 244.

¹⁶ Compare the policy choice to extend the reduced rate on qualified dividend income to dividends from qualified foreign corporations; I.R.C. § 1(h)(11)(C). For a statute designed to reserve a tax benefit to corporate taxpayers, see the now repealed normalization rules that prevented utility regulators from passing accelerated depreciation benefits to ratepayers; I.R.C. § 167(1) (repealed 1990).

¹⁷ Adv. Panel Rpt. 242, 244.

¹⁸ Compare the recently enacted statutory provisions encouraging corporations to repatriate foreign earnings, I.R.C. § 965, and to distribute their earnings to shareholders, I.R.C. § 1(h)(11).

¹⁹ Adv. Panel Rpt. 133.

²⁰ Adv. Panel Rpt. 134-135, 239-241; Jt. Comm. Rpt. 189.

²¹ Jt. Comm. Rpt. 192.

²² Adv. Panel Rpt. 240.

²³ Adv. Panel Rpt. 241.

²⁴ Adv. Panel Rpt. 240; Jt. Comm. Rpt. 191 (speaking of "a U.S. corporation's gain," but only to the extent of "undistributed exempt earnings").

²⁵ Adv. Panel Rpt. at 102, 125-126. The effective tax on domestic share gains at the top rates recommended by the Advisory Panel would be 8.25% for individuals (.25 x .33) and -- although the panel's report does not directly say the same regime would apply -- 7.875% for large businesses (.25 x .315).

²⁶ Jt. Comm. Rpt. 191; see Adv. Panel Rpt. 240 (vague reference to treating branches as affiliates).

²⁷ Adv. Panel Rpt. 129.

²⁸ Jt. Comm. Rpt. 182-183.

²⁹ I.R.C. § 904(h).

³⁰ The subsidiary could obtain use of the intangibles through contribution or license (which may be substantially equivalent; see I.R.C. § 367(d)), purchase or cost sharing arrangements.

³¹ The subsidiary could make sales from the low tax jurisdiction and pass title to the US customer either within or without the United States. See I.R.C. §§ 862(a)(6), 863(b)(2), 954(d)(1)(A).

³²See I.R.C. § 954(c)(2)(A), (h) & (i).

³³ In both cases, US persons make deductible interest/passive payments into foreign markets and other US persons receive the income tax free.

³⁴ Adv. Panel Rpt. 244.

³⁵ Adv. Panel Rpt. 240-41.

³⁶ I.R.C. § 954(b)(4).

³⁷ A simpler methods for identifying low-tax jurisdictions would use a black list (usually based on headline rates) or white list (often including treaty partners without regard to headline rates) and possibly also a gray list (generally for exception regimes in countries with acceptable tax systems).

³⁸See, e.g., Fleming & Peroni, supra note 3, at 1565.

³⁹See, e.g., Kenneth J. Keis, "JCT Recommendations Would Have Little Effect on Noncompliance," Tax Notes, Feb. 7, 2005, at 724.

⁴⁰See I.R.C. § 864(e)-(g); Treas. Reg. § 1.861-8.

⁴¹See I.R.C. § 904(d)(2) (as effective for tax years beginning after 2006).

⁴²See Treas. Reg. § 1.861-10.

⁴³See I.R.C. § 864(f) (elective worldwide allocation for tax years after 2008); Adv. Panel Rpt. 241; Jt. Comm. Rpt. 190.

⁴⁴ Graetz & Oosterhuis, supra note 3, at 778-781.

⁴⁵ I.R.C. § 954(c)(3).

⁴⁶See Notice 98-35, 1998-2 C.B. 34 (revoking Notice 98-11, 1998-1 C.B. 433, and withdrawing Temp. Treas. Reg. § 1.954-9T).

⁴⁷ I.R.C. § 1297(b)(2)(C).

⁴⁸See Nat'l Westminster Bank v. United States, 97 A.F.T.R.2d 2006-369 (Ct. Cl. 2005).

⁴⁹ See Nat'I Westminster Bank, 97 A.F.T.R.2d 2006-369; OECD Comm. on Fiscal Affairs, Discussion Draft on the Attribution of Profits to Permanent Establishment -- Part I (General Considerations) (Aug. 2, 2004), -- Part II (Banks) (February 2001), -- Part III (Enterprises Carrying on Global Trading of Financial Instruments) (February 2001), -- Part IV (Insurance) (2005).

⁵⁰See id.

⁵¹See, e.g., Hospital Corp. of Amer. v. Comm'r, 81 T.C. 520, 587-91 (1983), nonacq., 1987-2 C.B. 1 (transfer of corporate opportunity not within I.R.C. section 367(a)).

⁵² I.R.C. § 954(h) (for tax years of foreign corporations beginning before 2007) & (i).

⁵³See OECD Comm. on Fiscal Affairs, Discussion Draft on Attribution of Profits -- Parts II (Banks), III (Global Trading) & IV (Insurance), supra note 49.

⁵⁴See I.R.C. § 864(f) (elective worldwide expense allocation for tax years after 2008).

⁵⁵Cf. Treas. Reg. § 1.884-1(c) ((US net equity); Prop. Treas. Reg. § 1.987-2(c) (branch equity).

⁵⁶See, e.g., Prop. Treas. Reg. §§ 1.482-2(a)(3), 1.863-3(h), 1.864-4(c)(2), (3) & (5) (global dealing).

⁵⁷ U.S. Model Income Tax Treaty, supra note 9, art. 23(1); see OECD Comm. on Fiscal Affairs, Model Income Tax Treaty, 1992, art. 23B.

⁵⁸ Per country limitations are not a deviation from international norms. Indeed, the United States used per country limitations before the Tax Reform Act of 1976.

⁵⁹Cf. I.R.C. § 904(h)(10) (applying a per item separate limitation when taxpayers elect to rely on a treaty to resource amounts received from a US-owned foreign corporation).

⁶⁰ Assuming excess foreign tax credits could be carried forward, taxpayers receiving most of their dividends from direct investment in high-tax countries might have an incentive to opt out of the exemption system if they expected the relative effective tax rates in those countries to decrease significantly and soon enough to permit timely absorption for credit carryforwards.