US: The dust from BEPS still swirls, fuelled in the US even more by the winds of inversion
Last year at about this time, we boldly offered our predictions as to the outcomes multinationals could reasonably expect as a result of the efforts of the OECD and the unprecedented energy expended on its base erosion and profit shifting (BEPS) project. We were limited in our vision by the absence of the actual BEPS Action Plan, which was released two days after our publishing deadline. One of our predictions described how, perhaps from the perspective of unintended OECD consequences, countries like Ireland, Switzerland and Singapore could see their economies grow and unemployment dwindle. And they would quietly thank the OECD for its missionary-like zeal in chasing the no-economic-activity brass-plate companies out of places such as the Cayman Islands. If our vision had been just a little sharper last year, we would have added the UK to our shortlist of BEPS beneficiaries.
What these BEPS beneficiaries have been able to do that the US has not is to combine a competitive corporate income tax rate of 20% or less with varying levels of infrastructure to support the location of substantial functions and fixed assets within their borders. This combination has allowed the multinationals operating within their borders to enjoy a relatively low corporate tax burden while maintaining the substance that will be necessary to pass muster with the tax authorities in the post-BEPS world.
In contrast to the BEPS beneficiaries, the US maintains a corporate income tax rate of more than 39% (including state income taxes) – the highest among all OECD countries. Moreover, the US is just one of a handful of OECD countries with a worldwide rather than a territorial income tax system. It is no wonder that the US is experiencing a spate of so-called inversions – transactions in which a US parent multinational group relocates its corporate domicile outside the US, generally by means of acquiring an existing foreign parent group (often in one of the BEPS beneficiary jurisdictions).
At a July 22 2014 US Senate Finance Committee hearing on international tax issues, witnesses testified about both BEPS and inversions, but the inversion topic dominated. While there is bipartisan support for Congress to take some action to address inversions, the opening statements of Ron Wyden, Finance Committee chairman, and Orrin Hatch, the highest ranking Republican on the committee, highlighted the split between Senate Democrats and Republicans over the appropriate approach.
Senate Democrats and the Obama Administration support an immediate measure that would broaden the scope of Internal Revenue Code Section 7874 (the existing anti-inversion provision that has been in effect since 2004) by decreasing the limit on post-inversion shareholder continuity (above which the new foreign parent would be treated as a domestic corporation for US tax purposes) from 80% to 50%, retroactive to May 8 2014. Other changes under consideration include a special limit on the interest expense deductions granted to US corporations that invert.
Republicans, on the other hand, have, for the most part, opposed anti-inversion measures, aside from broader tax reform intended to address what they perceive to be the root cause of inversions: a high corporate tax rate and an uncompetitive worldwide tax system. Moreover, Republicans have strongly opposed retroactivity in any anti-inversion legislation.
What is yet to be seen is whether bipartisan support for an immediate measure could still emerge as the number of inversions – and thus mainstream media coverage and populist support for action – continues to increase. According to chairman (and inversion critic) Wyden, more than a dozen of these transactions have already been announced in 2014, and another 25 could happen by the end of the year. Supporters of an immediate measure may invoke the logic of Fortune magazine editor Allan Sloan, who testified before the Committee that: "sometimes you have to address the immediate symptom before going on to the cure. If you're bleeding out, you need to put on a tourniquet, then deal with the wound".
As evidenced by the scope of the July 22 hearing encompassing both BEPS and inversions, the current inversion debate is often thought of as the other side of the BEPS coin. Very broadly, the BEPS Action Plan and the anti-inversion proposals under consideration in the US are both efforts to protect the corporate income tax base. But most of the similarities end there. Beneath the surface, there is little or nothing about inversions that is contrary to either the letter or the spirit of the BEPS Action Plan, which is primarily intended to address the perceived problem of double non-taxation.
The popular perception – perhaps fuelled by mainstream media and political rhetoric – may be that inversions are a primary culprit in contributing to such double non-taxation. The story may go that XYZ Corporation deserted its corporate citizenship by re-domiciling in a tax haven, thereby dodging its obligation to pay US taxes. Reflecting this perception, in a July 24 speech President Obama characterised inverting multinationals as "a small but growing group of big corporations fleeing the country to get out of paying taxes", while Jacob Lew, Treasury Secretary, has similarly called for "greater economic patriotism".
However, contrary to popular perception, the US operations of an inverted multinational group remain fully subject to US taxation on their income earned in the US. As such, these multinationals continue to pay billions of dollars in US corporate income taxes.
The primary tax benefit of an inversion is that the new group parent is no longer subject to the worldwide tax system of the US, but rather, is subject to the territorial system of its own jurisdiction. This allows for the distribution of lower-tier earnings without the imposition of the 35% US corporate income tax that would be imposed (albeit with an indirect foreign tax credit) on repatriations to a US parent. Obtaining the benefits of a territorial tax system is hardly abusive: the vast majority of OECD countries have adopted territorial systems, and the recent tax reform proposals of both political parties have supported moving the US to, or in the direction of, a territorial system. It is no wonder, then, that the BEPS Action Plan does not promote a return to worldwide tax systems or even remotely suggest that territorial systems are part of the BEPS problem.
A possible second, indirect tax benefit of an inversion might be the support that such a transaction could provide for allocating more income outside the US under transfer pricing principles if the set-up of the new non-US parent were accompanied by the movement of functions, assets and risks to that jurisdiction. Here, the tax benefit would be the direct result of applying the very same arm's-length principle that the BEPS Action Plan seeks to strengthen. Indeed, the reallocation of income commensurate with the relocation of functions, risks and assets is a transfer pricing outcome "in line with value creation," the very goal of the OECD's three Action Plan items regarding transfer pricing.
There may be other incidental tax benefits of inversions depending on the facts and circumstances of the particular transaction. For example, the new non-US parent may choose to capitalise the former US parent group in part with intercompany debt, resulting in the US group obtaining interest expense deductions. However, intercompany financing with bona fide debt is unquestionably appropriate under US tax law, and in any event the intercompany loans are separate transactions from the inversion itself. The policy issues related to intercompany debt are by no means unique to inverted multinationals.
The great irony of the current uproar over inversions is that the transactions do not seem abusive by the standards of the OECD's BEPS Action Plan, which has become (for better or worse) the international 'gold standard' for evaluating cross-border transactions from a tax policy perspective. While US policymakers are sidetracked on the inversion debate, the OECD is moving full speed ahead with the BEPS Action Plan, including its anticipated September 2014 deliverables on the digital economy, hybrid entities and instruments, preventing treaty abuse, transfer pricing for intangibles and transfer pricing documentation. In the earlier debate over these items, the US government emerged as an unlikely ally of multinationals, fending off suggestions for lowering the PE threshold for the digital economy, 'special measures' that would make it easier to recharacterise related party transactions, a subjective anti-avoidance rule on top of a limitation on benefits provision in tax treaties, and an overly burdensome version of the country-by-country reporting template.
This state of play in which US policymakers are trying to moderate the proposals of certain countries coming out of the BEPS Action Plan, while at the same time focusing most of their efforts on US-centric issues like inversions, is indicative of how different the US corporate tax system and its challenges are from those of the rest of the world. At this point, it seems that the general design plan for US corporate taxation, particularly its system of worldwide taxation and its high corporate tax rate, is out of step with the thinking of the rest of the world. The need for reform is universally acknowledged, but the content, scope and timing of any change remains uncertain. The fact that the United States Congress is terrified of even whispering about an alternative revenue stream from a source like a VAT is a topic for another day. As we observed last year in the context of BEPS, 'watchful waiting', flexibility and openness to change will serve multinationals well in the continued environment of uncertainty.
Stay tuned for an update on these topics next year. If history is any guide, they won't go away any time soon.
Joel Williamson, Charles Triplett and Jason Osborn