US government is hell bent on taxing firms’ offshore earnings

The Obama administration last year took specific aim at US multinationals and outsourcing, proposing a series of tax measures designed to reduce the benefit of tax deferral for US companies on offshore earnings.

A continuing economic crisis and other legislative priorities in Washington helped ensure that nothing of significance came into being in terms of international tax reform.

A year later, it is back to the drawing board—to the “same” drawing board, in fact. In President Obama’s first State of the Union Speech to Congress on January 27, the tax rhetoric sounded all too familiar.

The President stressed that he wanted to encourage businesses to stay within the US, specifically noting that “it is time to finally slash the tax breaks for companies that ship our jobs overseas and give those tax breaks to companies that create jobs right here in the US.”

A few days later, on February 1, the administration released its fiscal year 2011 budget along with new US tax proposals, highlighting the intention to reform US tax rules that allow companies to “indefinitely defer the payment of US taxes on foreign income while immediately benefiting from the tax deductions associated with these activities,” as well as rules that allow companies to “take advantage of transfer pricing to shift income earning in the United States to lower-tax countries.”

US rules, like in India, impose tax on a resident company based on its entire worldwide income. Offshore profits earned by a foreign subsidiary of a US group may, however, potentially escape current US taxation — at least until such time as such earnings are repatriated to the US in the form of a dividend — hence, the “deferral” opportunity.

The challenge for US multinationals comes in navigating a complicated set of anti-deferral rules (so-called controlled foreign corporation or CFC rules), where “deemed” dividends from foreign subsidiaries can be triggered and result in current taxation to the US parent.

Examples that can result in deemed dividends include situations where a foreign subsidiary earns passive-type income (e.g., dividends and interest) or generates offshore income from certain related-party transactions.

The new US tax proposals would not eliminate tax deferral on offshore earnings entirely. Instead, the proposals continue to take a surgical approach, similar to last year’s proposals, to try to chip away at the benefits of tax deferral for US multinationals.

For example, beginning in 2011, US companies would be required to defer US tax deductions for any interest expense allocable to untaxed foreign earnings. Further, foreign tax credit benefits would be tightened.

US companies would be required to determine its foreign tax credit on receipt of a dividend from a single foreign subsidiary on a consolidated basis, taking into account all foreign subsidiaries. Under present law, U.S. multinationals may repatriate earnings of high-taxed subsidiaries (and use foreign tax credits to offset the resulting US tax), while leaving the low-taxed earnings offshore.

A new provision included as part of this year’s proposals would also attempt to tax “excess returns” associated with transfers of intangibles offshore. If a U.S. multinational transfers an intangible to a foreign subsidiary in circumstances that demonstrate “excessive” income shifting from the US, income equal to such “excessive” amount would trigger a deemed dividend to the US company under the CFC rules, subject to immediate taxation.

One notable missing item from this year’s proposals is any change to the “check-the-box” rules.” Last year, the Obama administration had proposed to eliminate check-the-box planning with regard to certain foreign subsidiaries, intended to ensnare more offshore inter-company transactions in the US tax net under the CFC rules and ostensibly generate more US tax. This proposal had generated a lot of discussion last year.

US multinationals will continue to face a difficult tax landscape in the US going forward, as evident by the administration’s new tax proposals.

Tax certainly cannot be ignored, typically being the biggest expense item on a profit and loss statement. With the high 35% US corporate tax rate (second highest among all OECD countries —- behind only Japan —- and far above the 25% OECD average), it is not surprising that US corporates increasingly look to locate profit-generating activities outside of the United States and keep earnings offshore, if at all possible.

The writer is associate director, PwC. Views are personal.