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The topsy-turvy world of US taxation

Category Technical Articles
AuthorTechnical Department
Proposals to deal with the problem of ‘corporate inversions’ for US tax purposes could have much wider implications for UK companies with operations in the US: Heather Self, Deputy President of the Chartered Institute of Taxation, explains the issues for UK companies. This article appeared in the October 2002 issue of Tax Adviser.
Key points

  • A number of US companies sought to emigrate and take their overseas interests outside the scope of US controlled foreign company legislation
  • These moves were felt to be ‘unpatriotic’ and measures were suggested to combat them
  • Additional tensions such as the continuing saga with WTO over US tax incentives led to perception that US companies were being subjected to an ‘unfair’ tax regime compared to foreign multi-nationals
  • In July 2002 the American Competitiveness Act of 2002 was introduced to Congress
  • Although it is unlikely that it will be enacted in its current form, it does contain proposals which would significantly restrict the deductibility of interest by US subsidiaries of UK companies
  • There is a real risk that US tax costs will start to rise for UK multinationals within the next twelve to twenty-four months

Quite often the work of the CIOT’s Technical Committee can seem a thankless task. We put forward lists of anomalies and suggestions for the next Budget, only to see most of them ignored. Then we comment on the Finance Bill, and if we are lucky (or very persistent) we persuade ministers that there really is a technical problem which ought to be amended. However, whenever I get frustrated with the United Kingdom (UK) legislative process, I remind myself just how much worse it is in the United States (US).

Any Bill has to be approved by both Senate and Congress. A bill can start life in either chamber, and it is common for different versions to be put forward by each house, or even several versions by different committees. Eventually, an agreed version is produced and a vote is taken – but even that can be overturned by Presidential veto in some circumstances. And, just as in the UK, the needs of marginal constituencies (and even boundary changes) can have a material effect on the willingness of individual senators or congressmen to pursue an issue.

The current saga began with the high-profile decision by a small number of prominent US companies to ‘invert’ their operations to a new location outside the US. The purpose was not to avoid tax on their US operations, but to take their overseas interests outside the scope of US controlled foreign company (CFC) legislation (sub-part F). In its simplest form, the transaction would be as follows:


  • Suppose that US Inc is a publicly-quoted US company, with extensive operations overseas.
  • A new holding company, Bermuda Inc, would be formed.
  • Bermuda Inc would acquire the shares of US Inc in a share for share exchange.
  • US Inc would sell its foreign operations to Bermuda Inc.

The transaction would give rise to a chargeable gain, either for the shareholders or for the corporation (or possibly both). However, in the current stock market climate, the tax burden on the transaction is likely to be relatively low.

In practice, of course, the transaction would be more complex – for example, there might need to be a Luxembourg company below Bermuda Inc, to reduce withholding taxes on dividends. But, broadly, as a result of a transaction which would generate little or no tax, future profits on non-US operations could be sheltered from US tax. These savings could be significant: one group calculated that its effective tax rate would reduce from 30 per cent to 22.5 per cent as a result of the inversion. The reduction was due not only to the CFC benefits, but also to the potential opportunity to introduce gearing into the structure: it is this latter issue which could ultimately affect UK groups.

United States politicians did not approve of these transactions, and a number of proposed measures were put forward. The general theme was that it was ‘unpatriotic’, particularly during the War Against Terrorism, for US companies to seek to reduce their overall tax burden. There was even one bill called something like the Uncle Sam Needs You To Pay Your Taxes Bill!

There were other tensions too, such as the continuing saga with the World Trade Organisation (WTO) over US tax incentives. The WTO had already declared the old system of Foreign Sales Corporations illegal, and was now heading in the same direction over its replacement (the Extra-Territorial Income rules), with the threat of sanctions by the European Union (EU). And then there was Enron, which made the idea of companies ‘moving’ to a tax haven such as Bermuda even more suspicious.

All of these factors contributed to the natural xenophobia of the US. The perception was that US companies were being subjected to an ‘unfair’ tax regime compared to foreign multinationals, and that the WTO’s actions were preventing the playing field being levelled. The fact that some companies were ‘escaping’ and not paying their fair share of tax added fuel to the fire.

It rapidly became clear that foreign companies were going to get caught in the backlash – and not for the first time politicians appeared to take the view that raising money from foreigners would be a good idea. The perceived problem was that a US subsidiary with a foreign parent could get a deduction for interest paid to its parent, whereas a wholly-US group could not benefit from this deduction. This seems somewhat illogical, given that ultimately the parent has to get its funds from somewhere (shareholders or an unrelated lender) and so the mere fact that interest crosses an international border does not point to evidence of a distortion.

A moment’s pause

Pausing for a moment, let us reflect on what the apparent mischief was and other routes available to prevent it. The mischief relates to companies seeking to move out of the US tax net. Would this not be much more difficult if the US, in common with most of the rest of the world, had a residence test based on management and control rather than merely on incorporation? Secondly, consider why the companies are seeking to move: it is clearly connected to the complexity of the US’s CFC regime, coupled with their incredibly complex rules for allocating interest expense across a worldwide group. As a result of this, many US multinationals are unable to get full relief for their interest costs. Would it not be better for the US to consider levelling its playing field by addressing the complexity of its tax system, rather than seeking to penalise others?

Interestingly, during the debates on the new Substantial Shareholding regime, the UK Government also expressed concerns that companies might seek to migrate out of the UK tax net. The counter to this was that if the government could succeed in implementing its goal of having a competitive tax system, companies would not want to leave!

Anyway, what happened next?

In July 2002, a Bill called The American Competitiveness Act of 2002 was introduced by Congressman Bill Thomas, Chairman of the House Ways & Means Committee. The Bill is wide-ranging, and although it is unlikely to be enacted in its present form, it indicates some major areas of potential concern.

The Bill is in three parts. The first part deals with Competitiveness Provisions: these comprise a series of measures designed to simplify the US foreign tax system and to reduce the tax burden on US companies. The second part deals specifically with inversion transactions, and proposes that for a five-year period (beginning 11 July 2002), any such transaction would be disregarded and hence the inverting company would remain fully subject to US tax.

If the Bill stopped there, UK companies would have very little to complain about. However, included in the second part of the Bill are proposals which would significantly restrict the deductibility of interest by US subsidiaries. The key features are:


  • The current safe harbour rule, where the earnings stripping rules do not apply if a company has a minimum debt:equity ration of 1.5:1, would be abolished.
  • Companies would have to ensure that their US debt:equity ratio did not exceed their worldwide ratio, calculated on US tax principles.
  • Companies affected by the earnings stripping rules would only be allowed to deduct interest up to 35 per cent of their adjusted taxable income, reduced from the current ratio of 50 per cent.
  • Any disallowed interest expense could only be carried forward for five years, instead of indefinitely.

These rules would significantly increase the compliance burden on UK multinationals, and would make it likely that any UK group with significant US operations would have great difficulty in getting a full tax deduction for its commercial interest expense. The proposals potentially breach not only the existing UK/US Treaty, but also the new treaty which is not yet in force. They have therefore caused great concern among major UK companies.

The final part of the Bill deals with anti-avoidance legislation in respect of ‘Tax Shelters’. While the proposals would significantly increase potential penalties, as well as the requirements which apply to ‘Promoters’ of tax schemes, they are not of significant international concern.

So, where will it all end? The Thomas Bill has not yet been adopted by either the Senate or the House, and is a long way from gaining full support. Mid-term elections in November mean there is likely to be a hiatus for a few months, but the issues are unlikely to go away. In particular, now that the earnings stripping rules are firmly on the agenda, UK companies will need to monitor developments carefully as there is a real risk that within the next year or two US tax costs will start to rise for UK multinationals.

Technical Department
020 7235 9381

October 2002 by

 

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