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.

Prioritize and Compromise

On Monday, Michael Durst elaborated on a previous tax reform proposal (see Durst, "An Employment, Equity, and Competitiveness Tax Act," Tax Notes, Sept. 26, 2011; discussing Durst, "Radical Centrism and the Corporate Income Tax," Tax Notes, Sept. 5, 2011).

Durst describes his proposal as "a two-pronged, radically centrist tax package" with two key elements:

1. A reduction in the corporate tax rate to 15 percent, along with elimination of opportunities to shift income to tax havens and other significant corporate base broadeners. The goal would be to increase U.S. job creation, both through the effects of the lower rate and by eliminating current tax haven techniques that encourage job creation outside instead of within the United States.

2. A reform of the individual income tax that would make the tax more progressive, primarily by increases in rates applying to the highest-income taxpayers. Maximum rates nevertheless would remain low by historical standards....

I don't agree with Durst's entire reform proposal, but I agree with Durst that legislators need to prioritize and compromise. Our tax system is a ramshackle structure decomposing from within, and I'd love to strip it down to the studs and begin renovation. However, if we have to renovate incrementally, I'd start with corporate tax reform.

Our corporate tax rate is uncompetitive by international standards. Capital is mobile and ruthlessly unpatriotic. As such, it migrates to the highest after-tax return opportunities. The uncompetitive U.S. tax rate discourages capital allocation to U.S. businesses by decreasing after-tax returns to investors. This has a pernicious ripple effect that hits the capital-intensive manufacturing industry particularly hard. Less capital means a higher cost of capital. A higher cost of capital means higher input costs. Higher input costs mean higher-cost products and services. Higher-cost products and services are less competitive in domestic and international markets (and more expensive for domestic consumers).

Compounding matters, the U.S. transfer pricing regime is porous, favoring multinational enterprises that can migrate intangibles offshore over U.S. businesses with tangible assets, operations and employees in the United States. The deck is effectively stacked against U.S. businesses relative to their multinational and international competitors.

A growing consensus of tax professionals, academics and economists has acknowledged the need to reform the corporate tax system by lowering rates. Hopefully, that message will begin to resonate with legislators, who are struggling to cope with our lapsed economic hegemony. Although I don't expect a "grass roots" movement for corporate tax reform, I hope that the most zealous advocates of high corporate tax rates achieve irrelevance.

Meanwhile, there is no free lunch. Although corporate tax reform is a priority, we can't escape the fact that government obligations will continue to swell as the Baby Boom generation enters retirement. Realistically, we'll need to offset a decrease in corporate tax revenues with another source of revenues. Legislators should consider a VAT, and they should consider progressive increases in average tax rates as a trade-off for corporate income tax reform.

In particular, a reduction in the corporate tax rate could be partially offset by eliminating the tax preference for certain investment income. Corporate earnings are taxed at a 35% top marginal rate, and the 15% rate applicable to qualified dividends and long-term capital gains reduces the overall tax burden on the underlying business income. By lowering the corporate tax rate, legislators would undermine the conceptual justification for the 15% rate.

The existing political climate is depressing to those of us who don't extract power or lobbying money from gridlock. Tax reform seems virtually impossible before 2012. However, we don't need a "Buffett Rule" to jump start the process. Corporate tax reform is possible if legislators would simply prioritize and compromise. A reduction in corporate tax rates, offset by taxing investment income at the same rates as ordinary income, could be an important step towards fundamental tax reform.

Stay tuned for more details on my own corporate tax reform proposal.

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.