Sheppard on Earnings Stripping

Our favorite tax fashionista, Lee Sheppard, has an interesting article out today. See "News Analysis: The Fashion in Interest Deduction Restrictions," Tax Notes, Nov. 28, 2011, p. 1061.

Earnings Stripping

What is earnings stripping? First, some background. Many jurisdictions, including the United States, permit taxpayers to deduct interest expense in computing net taxable income. Deductible interest reduces pre-tax income and taxes owed to the revenue authority. The deductibility of interest expense creates a difficult challenge for policy makers. The issue will be lurking below the surface as Congress begins wading into the waters of tax reform.

Deductible interest creates a "bias" for debt-heavy capital structures ("overleverage"). The deduction for interest expense artificially decreases the "real" cost of debt relative to the "real" cost of equity. Overleveraged capital structures are more likely to capsize during the "trough" of business cycles, creating turmoil and trauma for stakeholders of the overleveraged business (employees, customers, local communities, etc.).

Deductible interest also permits business owners to "strip" taxable income out of the the tax base. This "earnings stripping" or "base erosion" involves variations on a theme. Sheppard's article focuses on cross-border earnings stripping.

A corporate parent with a foreign subsidiary may be able to fund the subsidiary with "shareholder loan" capital that pays interest. With proper treaty planning, (i) the shareholder loan pays interest, (ii) the interest expense is deductible, reducing taxable income and tax liabilities in the subsidiary's jurisdiction, and (iii) low or no withholding taxes apply to the interest payment. This type of structure permits the parent to "strip" earnings out of a higher-tax jurisdiction into a lower-tax jurisdiction.

Designing an "interest strip" is not rocket science. Tax advisors can use the basic structure in domestic transactions. Assume a group of pension funds pools capital and purchases a U.S. business organized as a corporation. The pension funds capitalize an acquisition vehicle with a mix of equity capital and "shareholder loan" capital. The decision to capitalize with equity and debt is effectively "deemed" to have economic substance. The target business generates taxable income after the acquisition. But the acquisition vehicle pays deductible interest expense on its shareholder loans. The pension funds are tax-exempt entities, so pay no tax when they accrue or receive interest. Voila, an "interest strip" -- shifting tax revenue from the U.S. Treasury to the pension funds.

(In the long run, query whether foreign and domestic pension funds will be able to use their tax-advantaged status to purchase every commercial enterprise on Earth. Marx would be vindicated. The working class -- through pension funds and their investment managers -- would control the means of production.)

U.S. Rules

Congress understands that earnings stripping can be a big problem. It enacted Code section 163(j) to address the issue. Sheppard snorts at the U.S. rules: "[I]t remains ridiculously easy to strip [income out of the United States] using interest deductions, despite a statute squarely aimed at foreign-parented groups."

I won't go into section 163(j) in detail. It limits a corporation's related-party interest deductions if the corporation has too much leverage and too much interest expense. It works in some cases, but has a couple obvious shortcomings. First, it doesn't apply to my domestic example above (where a group of pension funds acquire a U.S. business and use shareholder loans to interest strip). The statute only bites if the shareholder loan capital is provided by a "related" person.

Second, the U.S. limitation does not expressly contain any transfer pricing limitation. Take a technology business. Many technology businesses are capitalized with low ratios of third-party debt to equity ("leverage ratios"). But let's assume that a foreign parent corporation purchases a U.S. target corporation and injects leverage (a shareholder loan) into the target's capital structure. Assume that external leverage ratios in the industry are very low (10% or lower). But the foreign parent capitalizes its new subsidiary with $20x of equity capital and $80x of shareholder loan capital (an 80% leverage ratio).

The U.S. earnings stripping rules do not prohibit the legal structure. And while the U.S. transfer pricing rules impose "arm's length" pricing requirements on intercompany transactions, IRS agents do no commonly focus on shareholder loans (in my experience). Unlike Sheppard, I don't fault section 163(j), so much as lax or unsophisticated U.S. tax administration.

German Rules (and Copyists)

Historically, the U.S. has exported principles of tax law and administration. But the rest of the world has caught up. Sheppard summarizes discussion at a recent International Bar Association annual meeting in Dubai. Tax professionals explored various European earnings stripping limitations. At some point, U.S. policymakers will start paying attention.

According to Sheppard, Germany was the first country to revise its earnings stripping rules. The German rules have serious teeth. The rules apply to all debt of a German affiliated group (an organschaft). The deduction for net interest expense is limited to 30 percent of EBITDA, regardless of whether the payer is related to the lender. EBITDA for this purpose is capped by the group's taxable income. (This effectively limits the benefit of timing or temporary differences to an organschaft with external or internal leverage.)

Practitioners apparently regard the limitation as "stingy." In my view, this is another example of German sensibility and efficiency. The rule is simple to describe and understand. It keys off EBITDA of a business; the financial metric that lenders and equity investors care about when financing an enterprise. The limitation may get low marks on "elegance," but it gets high marks from an administrative perspective. From a tax compliance perspective, policymakers should balance ease of administration against "technical perfection."

Italy has adopted a close variation of the German rule. The French legislature is considering a similar regime to address perceived abuse of French thin cap rules. The Dutch, Irish and Swedish are openly struggling with excessive leverage in domestic capital structures due to cross-border private equity transactions.

If you work in the international tax space or the domestic M&A space, Sheppard's article is definitely worth a quick read.

Reilly and Solomon on 28% Cap

I want to highlight a terrific article published by Mary Anne Reilly and Martin B. Solomon in yesterday's Tax Notes. See "Sophistry Supporting Complexity: The 28 Percent Deduction Limit," Tax Notes, Nov. 21, 2011, p. 1019.

I'm a big fan of examples in tax articles and reports. Reilly and Solomon provide good examples that illustrate something I've been saying for months. Team Obama is unable or unwilling to articulate a coherent tax policy agenda. The Obama administration sometimes articulates principles that resonate with the political left and the political right. But the principles always degrade into populist mish-mash when translated into specific legislative proposals.

Background

In September, President Obama launched his 2012 re-election campaign by proposing a $447 billion new stimulus measure (ahem, "jobs plan"). With a 9% national unemployment rate, Obama will be facing headwinds in the next election. He decided that he might be able to save one job (his own) by deflecting criticism to "obstructionist" Republicans.

We are running deficits as far as the eye can see. As partial funding for the new stimulus measure, the Obama administration proposed a 28% cap on certain deductions and exclusions. The specific proposal begins on page 137 of this PDF (page 134 of the report). The new cap is projected to raise approximately $400 billion. It's unclear how the new cap would apply if the 2001-2003 temporary individual tax discounts (the "Bush tax cuts") expire in 2012.

Howard Gleckman at Tax Vox reacted to the proposed cap as follows:

An across-the-board cap on the benefit of deductions and the like is often seen as rough justice — a way to tackle the Revenue Code’s trillion dollars in tax expenditures without fighting over each one. The theory: It is an easier political lift to curb such popular breaks as the mortgage interest deduction through a broad reduction of all subsidies than to fight the powerful housing industry head-on.

But Obama does pick and choose the preferences he wants to target. He nails all itemized deductions, all right, but he also goes after some – but not all – above the line deductions. Of the roughly two dozen write-offs available to those who take the standard deduction, Obama targets just eight, including health insurance for the self-employed, medical savings accounts, health savings accounts, and some higher education expenses.

He also reduces the benefit of two other hot-button breaks — the tax exclusions for municipal bond interest and the value of employer-sponsored health insurance. In other words, for those making more than $200,000, some muni bond interest and some of the value of their medical coverage would be taxed.

However, Obama would protect other exclusions, including those for retirement savings. Picking winners and losers this way is likely to defeat any claims of rough justice and make passing the plan that much tougher.

Sophistry, Complexity and Inequity

Reilly and Solomon criticize the 28% Cap Proposal on three grounds.

First, they argue that it represents politically-motivated sleight of hand. I'm not going to dwell on this argument. I believe that we should eliminate tax expenditures directly, not limit tax expenditures through complicated and unfair caps and floors. All variations of the 28% cap represent political expedience, not good tax policy.

Second, they argue that the "complexity created by separating the tax cost of income from the tax benefit of deductions is quite significant." Ironically, the "principles for tax reform" outlined by Obama in his recent message to Congress include "a call for simplification." The 28% Cap Proposal goes in the opposite direction. Do we want simplification? Or do we want to induce migraine headaches for tax preparers? You decide. The 28% Cap Proposal would require:

[A] computation of the tax on a new item called adjusted taxable income (ATI); a determination of another new item, the minimum marginal rate amount (MMRA); computation of tax on the greater of taxable income or the MMRA; and a computation of the "additional amount," which is the excess of the tax on ATI over the greater of the tax on taxable income or the MMRA, plus 28 percent of the excess of ATI over the greater of taxable income or the MMRA. This last number represents the additional tax generated by the new 28 percent deduction limitation.

Third, they argue that the "proposal is loaded with potential inequities and questionable tax policy." Most important, the new rules would have a cliff effect. They would be "triggered on an all-or-nothing basis when a taxpayer's adjusted gross income is above $250,000 for a joint return and $200,000 for a single taxpayer," potentially resulting "in an enormous addition to tax as a result of as little as $1 of additional income."

Reilly and Solomon provide an example of a family (the Cliff Family) with two parents and two children. The example compares the tax liabilities of the Cliff Family assuming AGI of $250,000 and $250,001, respectively. The authors hold other numbers constant to demonstrate the impact of the 28% Cap Proposal. Based on "middle of the fairway" assumptions, the authors demonstrate that $1 in additional salary income to the Cliff Family would trigger a $5,708 incremental tax liability.

The political left has vehemently argued that the "wealthiest" taxpayers are not paying their "fair share." The Obama administration has consistently defined "wealthy" taxpayers to include a family with $250,001 of taxable income. Does a $5,700 tax liability on $1 of incremental income satisfy the administration's definition of "fairness"? Is there someone on the political left creative enough to defend the "fairness" of the cliff effect? I'll stay tuned for that development.

Sacrifice Without Balance

In today's post, I'd like to highlight an excerpt from Joseph Thorndike's article, "What the Civil War Can Teach Us About Tax Reform." See Tax Notes, Nov. 21, 2011, p. 944. Thorndike hits a couple points that are consistent themes on this blog. The emphasis is mine.

What can the Civil War tell us about today's debate over deficit and debt reduction? It's the notion of sacrifice that links the two eras. Then, as now, the nation faced a serious fiscal crisis. And then, as now, lawmakers struggled over how to allocate the pain incurred while solving it.

Differences abound, of course. An entitlement-driven fiscal crunch is not the same thing as a war, no matter how severe it might become. Mortal sacrifice on the battlefield is not the same as economic sacrifice from a paycheck.

Still, the notion of shared sacrifice unites those episodes. Clearly, solving today's fiscal problems will be painful, requiring higher taxes and lower spending. The necessary changes won't be pleasant for anyone -- and they will be deeply painful for some, especially those who depend on key social programs.

But today's lawmakers have failed to acknowledge that broad-based sacrifice will be necessary to solve the nation's fiscal problems. No one in either party is willing to talk about meaningful entitlement reform.

Lawmakers are also not being honest about taxes. If higher revenues are going to be part of the solution, then the extra burden will almost certainly fall on everyone. But so far, the champions of higher revenues have been unwilling to acknowledge that everyone will end up paying more. Instead, they have focused narrowly on raising taxes on those with high incomes.

I've said it before and I'll say it again. Democrats and Republicans have been complicit in deficit-spending for decades. They created entitlement programs that are structurally imbalanced and unsustainable. They designed tax expenditures that distort markets, stoking health care inflation and contributing to the real estate bubble. They manufacture drama to score points with political supporters who cannot or choose not to keep track of the bigger picture.

We cannot address these structural and tax policy challenges by increasing taxes on "millionaires and billionaires." There is no "class war" between the 1% and the 99%. If we want a bigger government and if we want to maintain federal spending on entitlements, we'll need to raise taxes on the top, middle, and bottom of the income spectrum. We may need to eliminate "sacred" tax expenditures. We may need a VAT or carbon tax. The status quo is a path towards extreme hardship for millions of Americans when the bottom falls out from under the political class.

Bill Bradley on Tax Reform

This year marks the 25th anniversary of the Tax Reform Act of 1986. Whether you liked it, hated it, or come down in the middle, TRA 1986 was a monumental event in the history of U.S. tax policy.

To commemorate the anniversary, the editors of Tax Notes profiled several veterans of the 1986 tax reform effort this week. Nearly all of the interviews and personal recollections are worth a quick read. However, I wanted to spend a few minutes summarizing Meg Shreve's interview with Bill Bradley.

Bill Bradley is a former Senator (D-NJ) and Democratic presidential candidate. His popularity traces back to his career as a hall of fame basketball player with the New York Knicks. He was no intellectual slouch, attending Oxford as a Rhodes Scholar after a basketball career at Princeton.

Highlights from the interview:

[1] We need to define "tax reform."

Bradley emphasized that we can't do tax reform without defining tax reform. Do we close loopholes and use all the revenue from to lower rates? Or do we close loopholes and use only some of the revenue to lower rates (with some of the revenue dedicated to deficit reduction or new programs)? Alternatively, do we shift the paradigm by lowering income tax rates and offsetting the revenue shortfall with a consumption tax or some other source of revenue (e.g., a carbon tax)?

In 1986, political leaders defined tax reform as revenue-neutral loophole closers. Republicans wanted lower rates, and Democrats wanted fewer loopholes. In a sense, the stars were aligned to permit a political consensus. The Code was riddled with loopholes that were exploited by the highest earners, and top marginal tax rates were high. By eliminating loopholes, TRA 1986 increased taxes on the individuals and businesses that exploited the loopholes. The increased tax revenue was used to "pay for" lower tax rates across the board. The result was that "the top 5 percent paid a higher percent of the income tax revenue after tax reform than before tax reform even though the rate dropped from 50 to 28 percent."

Unfortunately, defining tax reform is more difficult today. Today's "loopholes" are tax expenditures that benefit tens of millions of middle-class taxpayers. Top marginal tax rates are lower today than in 1985. Even without the rancorous climate in Washington, it would be heavy lift for political leaders to adopt the 1986 definition of tax reform.

[2] We need a president that is "full square" behind tax reform and a Treasury Secretary with the gravitas to cut a deal.

Bradley recounted President Reagan's commitment to tax reform. Reagan "gave a couple of speeches," but delegated broad authority to former Treasury Secretary James Baker to cut a deal. Reagan "made it acceptable and led the charge." Baker ultimately brokered a tax reform deal with Bradley himself.

If Bradley is correct, we aren't going to see tax reform before 2013 or 2017. Meaningful tax reform is not a priority for President Obama. His priorities range from socialized health care and "spreading the wealth around" to green jobs and hybrid vehicles that will run 120 miles on a gallon of fuel. His Treasury Secretary, Timothy Geithner, is a bookish technocrat who has struggled to tread water due to economic conditions outside his control.

Bradley did not put a grade on Obama's efforts to drive tax reform. He suggests that Obama has been evasive for political reasons ("If the answer is 'we need to close loopholes to raise revenue and we don't touch rates' -- if that's what you mean, then say it.").

[3] Tax reform is too complicated for most people and will never be a "mainstream" issue. But political leaders need to articulate the principles guiding reform.

Bradley explains that the 1986 reforms were motivated by three simple principles. First, equal incomes should pay equal taxes. Second, the income tax should be progressive (those with higher incomes should pay more). Third, the market is more efficient at capital allocation than the Ways and Means Committee.

Team Obama has struggled to articulate clear, simple principles in respect to tax policy. Obama wants to increase taxes on "millionaires and billionaires," but defines millionaires as married working professionals with taxable income of $250,000. The income tax is steeply progressive, with the top 1% of taxpayers contributing 37% of income tax revenues. But he wants to "spread the wealth around" further, without defining what constitutes a "fair share." He has caught the "Buffett Bug," and become obsessed with the effective tax rates paid by the 400 top earning individual taxpayers. He sniffs at Bradley's quaint notion that the market is better at capital allocation than legislators and bureaucrats in Washington.

No wonder that individual Americans are confused and frustrated by the rhetoric around tax reform.

Tax Reform: Bill Parks

I'd like to use Friday to discuss an interesting article that was published in Tax Notes during the week.

On August 15, Bill Parks offered a set of principles to guide corporate tax reform (For Corporate Taxes: Lower Rates, Raise Revenues, 132 Tax Notes 745).

Our tax system is broken, and the best way forward would be a Big Reform which substantially changes existing tax rules and regulations. In the United States, the taxation of business income has become increasingly skewed between multinational "princes" and domestic "paupers." What do I mean by "princes" and "paupers"? Let's examine two hypothetical businesses.

Assume that ToolCo manufactures specialized parts and equipment for U.S. industrial clients. The business is medium-sized (less than 500 employees), located in the Midwest, and generates solid but unspectacular profits for its owners. ToolCo uses state-of-art engineering software, including some applications (intellectual property) designed by its resourceful technology group, in the manufacturing process. Because ToolCo is a domestic business with domestic IP development, manufacturing and sales, ToolCo's effective tax rate for a multi-year period is consistently in the range of 40%.

Compare ToolCo to BigTool Inc. Like its smaller competitor, BigTool manufactures specialized parts and equipment. However, BigTool is a U.S. based multinational, with thousands of employees located in the U.S. and foreign countries. Through transfer pricing and cost sharing arrangements, BigTool shifts much of the intellectual property for its operations to low-tax foreign jurisdictions. Consequently, BigTool pays the U.S. tax rate (40%) on a relatively small proportion of its worldwide profit. Its global effective tax rate for a multi-year period is consistently in the range of 20%.

In my simple examples, BigTool is the multinational "prince," and ToolCo is the domestic "pauper." The U.S. tax system imposes higher costs on purely domestic businesses, compared to multinational business that can develop intangibles offshore and use transfer pricing to shift income to low-tax jurisdictions.

I am not alleging that U.S.-based multinationals are "avoiding" tax or engaging in otherwise unscrupulous behavior. In fact, large public multinationals are subject to extremely rigorous accounting and financial reporting requirements. They are simply capitalizing on a structural advantage permitted by the existing tax system. The bottom line result, however, is perverse. Capital will flow away from domestic businesses (where after-tax returns are lower) towards multinational businesses (where after-tax returns are higher).

As noted, Bill Parks's recent article offers a set of principles to guide corporate tax reform. I've been noodling on Big Reform ideas lately, and Bill nails one of them on the head:

I propose that we assess corporate taxes on the same percentage of worldwide profits as domestic sales contribute to worldwide sales... Any anomalies will be a small price to pay for fairness and consistency. It eliminates the tendency to manipulate many factors to show most or all profits outside the United States. Calculating this percentage would require firms to report revenues and expenses to the IRS using [International Financial Reporting Standards or "IFRS"].

In other words, scrap existing book-tax differences and key taxable income off book income (in Bill's article, book income reported under IFRS principles). Then, allocate book income between the U.S. and foreign jurisdictions based on a percentage of sales in the respective jurisdictions (again, as reported under IFRS principles). Bill's theory is that the allocation proposal would generate more tax revenue than the existing international tax rules. He would use the additional revenue to lower corporate income tax rates.

The proposal has an intuitive appeal based on its simplicity. It would eliminate our reliance on transfer pricing rules to define and protect the U.S. tax base. Less is more when it comes to transfer pricing: the existing rules are porous, ineffective and impose daunting costs on taxpayers and the IRS.

Let's revisit my example in light of Bill's proposal. ToolCo (the mid-size, purely U.S. business) would be a winner. By broadening the base and lowering rates, domestic manufacturers and service providers (like ToolCo) will have increasingly competitive cost structures. BigTool (the large, multinational business) could be a winner or a loser, depending on its mix of U.S. and foreign sales. If, say, 80% of its sales were made in the United States, it would pay more U.S. tax. On balance, it seems likely that Bill's idea would result in a fairer tax distribution between domestic and foreign businesses. In other words, multinationals would pay more tax under Bill's proposal, because income would no longer flush down the cracks of a leaky transfer pricing system.

Bill's article provides a reminder about tax reform. Reform should be guided by fairness and simplicity. Policymakers should weigh both virtues when designing an improved tax system. Incremental reforms that add complexity are probably worse than no reform at all.