How are the UK and US responding to global tax competition? Both jurisdictions are aware of the need to have competitive effective tax rates but, at present, they achieve that result in slightly differing ways. In the UK, we have largely moved to a system under which profits are only taxed where they arise. A dividend exemption for overseas corporate profits (a concept proposed now to be extended to branches) means that there is no incremental tax on remittance. In the US, the debate on a possible dividend exemption system is unresolved and lags far behind what is happening in the UK.
Having vied with one another at one time in the past to be, at least on paper, the least attractive holding company jurisdiction, the UK and the US have both been reflecting recently on how best to respond to global tax competition.
The new government in the UK has completed work commenced by the previous administration and largely moved to a system under which profits are only taxed where they arise.
A dividend exemption for overseas corporate profits (a concept proposed now to be extended to branches) means that there is no incremental tax on remittance.
Corporations are left free to invest according to their commercial wishes and free of tax impediments that seek to level everything back to the home jurisdiction rate.
Both jurisdictions are acutely aware of the need for competitive effective tax rates |
Such a system is, of course, vulnerable to base erosion (through domestic interest deductions etc) and artificial profit diversion (protected by a mixture of transfer pricing and CFC rules) – but both jurisdictions are clearly well aware of the problems that can thereby arise.
In the US there is particular sensitivity about the fact that giving free rein to tax competition by exempting overseas dividends may favour foreign over domestic investment and encourage the export of jobs.
In the UK, the sensitivity is more in the area of preserving multinational competitiveness so that UK multinationals do not leave the UK or become controlled by foreign multinationals with a possibility of a loss of jobs in the domestic economy as a result of post-merger business restructuring.
Both jurisdictions are acutely aware of the need for their own multinationals to have competitive effective tax rates so that they can grow (whether through acquisition or otherwise) and do not themselves become vulnerable to takeover.
At present, however, they achieve that result in slightly differing ways.
A multinational’s effective tax rate derives from the combination of its global earnings and its global cash and deferred tax liabilities.
Effective tax rates will first of all vary according to where earnings arise around the world on underlying operating income.
Where developed countries have high tax rates for their own domestic reasons, the multinational will try to drive the local tax charge down, by gearing levels or royalty structures, to the minimum that is acceptable to the local authority.
Withholding tax will also need to be minimised or eliminated.
If the passive income arising overseas from the location of mobile assets such as capital and IP can then escape immediate and deferred taxation in the home jurisdiction, the global effective tax rate will come down proportionately.
If the home jurisdiction has harsh CFC rules which capture the income on mobile capital as it arises, there may still be a tax saving if the home jurisdiction rate is lower than the local rate.
If the home jurisdiction’s CFC rules do not capture the income on mobile capital as it arises and, moreover, exempt it on remittance, so much the better.
In the US, deferral has been key. Overseas profits are not generally taxed until they are returned to the US |
If, however, there is (as in the US) holding company tax on remittance with relief for local taxes through a foreign tax credit system or deferral of foreign taxes under the CFC rules only so long as it can be shown that income is being permanently reinvested offshore, the effective tax rate can be damaged by current taxes or taxes provided for in the books on a deferred basis.
All this is simple and straightforward – but it highlights some fundamental tax policy issues as to what price holding jurisdictions should demand for their territory to be the home jurisdiction of the multinational concerned.
Should they tax only domestic income in the holding jurisdiction and income remitted from overseas in the form of regular taxable income such as interest and royalties?
Should they then have interest limitation, transfer pricing and CFC rules which prevent domestic base erosion and the artificial diversion of profits?
Should they have deferral and tax dividend remittances with credit for foreign taxes so that everything eventually levels up to the home country rate?
Or should there be an intermediate regime taxing foreign income – at a rate and on a basis to be determined – as it arises and thereby leaving future investment decisions to be taken without a tax cloud hanging over them?
The business environment is never static. Multinationals need to grow.
They can do that by making profits and reinvesting their income in a growing business – in which case the amount they have to reinvest will be reduced if taxes are higher (see what has happened in the insurance sector where capital is a precious commodity and many companies are now based offshore both from the US and the UK).
Multinationals can otherwise grow by acquisition. When growing by acquisition, they will be competing with their peer group in other jurisdictions.
They will then be at a disadvantage if the stream of future earnings that the target represents is valued at a higher price by a global competitor because of a lower effective tax rate.
In that case, a competitor may grow more quickly. It could then eventually become a predator.
At present, multinationals in both jurisdictions are undoubtedly able to operate competitively.
In the UK, however, corporates would say that, until the territorial system came in, that was at the price of having to run very hard with CFC planning.
US corporations would likely agree that remaining competitive under the present system requires too much tax planning.
In the US, deferral has been key.
Overseas profits are not generally taxed until they are returned to the US (which enables some groups to achieve very competitive rates, assuming that the profits, wherever originated, can be located for tax purposes in a low-rate or no-tax jurisdiction) – and if they are demonstrably, permanently reinvested outside the US then no accounting provision needs to be made either so the book tax rate is low too.
Encouraging your multinationals to continue to invest abroad by having a tax penalty on repatriation is clearly a questionable policy , and there may be evidence of US companies paying higher prices than they really ought to in the scramble for offshore acquisitions (even though a US investment may be commercially more appealing.) However, such a policy is arguably no more so than allowing a tax benefit engineered by careful tax planning to become permanent.
There are further key differences between the two jurisdictions in that the US can have effective anti-inversion rules free of EU fundamental freedom constraints.
There is no doubt that the looming shadow of EU litigation influenced the outcome of the debate in the UK.
Tax clearly does not operate in a vacuum – many other factors will come into the decision as to where to locate, not least the strengths of the capital markets in each jurisdiction and the attributes that are otherwise on offer.
If tax was the only answer to the question – or issue – everyone would be located in a tax haven.
There are clearly many other issues that come ahead of tax, not least the ability to be able to run a business efficiently and profitably.
In some cases, however, tax can be a swing factor when the decision is otherwise a close one.
In tax terms jurisdictions will also have to check as many as possible of the other boxes that are important namely: no dividend withholding tax, low domestic corporate tax rate, no burdensome interest allocation rules or restrictions, good treaty network, exemption on overseas dividends, exemption on capital gains from selling share participants and a benign CFC regime.
The UK has, for some time, ticked most of the above boxes – but it has more recently run into severe problems on the CFC side.
The UK has had CFC – and transfer pricing – rules to protect its base for many years.
By and large, the transfer pricing rules work.
The UK is taking some risks with its CFC regime which may turn out to be too generous or, in the eyes of the EU, too strict |
The CFC rules, however, had been considerably extended since they were first introduced in 1984 beyond their original tax avoidance remit.
The CFC rules have also been subject to significant challenges in recent years under the EU fundamental freedom laws (profits made from an investment elsewhere in Europe should be taxed when they are received by the parent and not as they accrue in the subsidiary) on the same basis as profits made from an investment elsewhere in the UK.
Matters came to a head in the UK in 2007 when the government sought to extend the CFC rules so that they picked up most offshore passive income (income from royalties and treasury activities).
Many UK-based groups responded to that by saying that this would make it impossible for them to maintain an effective tax rate which was competitive in global terms.
A significant number of UK quoted companies have subsequently inverted – but many stayed and put the effort into lobbying for change.
That looks, at present, to have been a good call.
Territoriality has been the result with the lowering of the domestic tax rate (eventually to 23%).
The government has made it quite clear that it wishes to take tax out of the decision as to where business should be done.
If an overseas jurisdiction can offer equivalent attributes to the UK and a better tax rate, then the UK will accept that rather than seeking to level everything back to the UK tax regime.
This is clearly a brave decision – but it is, perhaps, one that recognises stark economic realities in increasingly mobile and fast moving global markets.
The first step in achieving territoriality has been to exempt most overseas dividends (there are some anti-avoidance exceptions) from tax on remittance.
This applies whether the dividends come from the EU or outside the EU, from a tax haven or from a developed jurisdiction.
The second step (which is a protracted process) has been to bring the UK CFC rules into line with what multinationals have said they would like to achieve.
It was always the case under the old rules that most active businesses were exempt from the rigours of the CFC regime.
Income from mobile capital was always the target – though there were certain activities (such as captive insurance businesses and companies which mainly did business with affiliates) which had come under particular scrutiny.
Now, a series of exemptions are being put forward which will exempt most trading operations, look favourably on IP and also give a special tax regime for treasury companies.
There will also be a more generous motive-based exemption than has been the case hitherto.
While, at one time, it looked likely that some form of interest restriction or allocation would come in with this, the government decided that there were sufficient interest restrictions in place already and that additional ones would just complicate the investment picture.
The existing regime was seen as an attractive part of the UK package – though the wisdom of this decision will obviously be kept under review.
The US House of Representatives had hearings this summer on the US rules for both outward and inward investment, and the possibility of a dividend exemption system was central to the discussion.
The Senate began hearings on the same issues in September.
But overall the debate in the US on a possible dividend exemption system is unresolved and lags far behind what is happening in the UK.
Under the present rules, the US taxes certain passive (or so-called subpart F) income of foreign subsidiaries of US corporations as it is earned by the subsidiary and other income when distributed as a dividend or otherwise repatriated, in each case with a credit for foreign tax imposed on the income.
There are transfer pricing and other rules intended to constrain the ability of US corporations to deflect income into low-tax jurisdictions.
There is broad consensus among all those interested in the subject, however, that the present rules are ‘broken’.
On the one hand, the transfer pricing and subpart F rules have not prevented a huge build-up in untaxed cash in foreign subsidiaries; and there is no reason to believe that the build-up will not continue and grow if the rules are not changed.
On the other hand, with a 35% rate on corporate taxable income, the US leads the OECD in nominal corporate tax rates, which together with the enormous complexity of the subpart F and foreign tax credit rules arguably make it an ‘unfriendly’ place to be, both from the perspective of a US corporation and a foreign investor in the US.
While rules intended to stop expatriations were enacted in 2004, they have not completely stopped US incorporated businesses from moving abroad.
How will this be resolved? There are, broadly, two issues – the treatment of the untaxed cash that has been built-up in foreign subsidiaries of US corporations and the system that should apply to foreign investment going forward.
The two issues, of course, cannot be separated from foreign investment into the US or, entirely, from the tax treatment of US shareholders of US corporations.
On the first issue, the US corporations which have accumulated untaxed cash abroad have pushed, understandably, for a rule similar to (but likely without the same limitations as) the rule that applied to repatriations in 2005, which reduced the repatriation tax to 5.25% of the dividend.
Critics of that view point out that the 2005 rule did not result in the promised increased investment in the US by those who benefitted from the repatriation holiday; and there is, of course, a visceral reaction to any tax amnesty that benefits some but not all US corporations – it is seen to be a reward for questionable behaviour.
On the other hand, if nothing is done, the cash may stay there – what corporation with, say, $15 billion of untaxed foreign cash in a foreign subsidiary (and that is the scope of the numbers) would bring that home, as opposed to investing abroad, if only $9.75 billion was left after the repatriation?
On the second issue, there is no consensus on what to do – some US multinationals have argued for a dividend exemption system, ie, a system similar to that of the UK and an increasing number of other OECD countries in which, in lieu of a foreign tax credit, foreign earnings, including dividends from foreign subsidiaries, would simply be exempt from US corporate tax.
The basis for the argument is the same as in the UK – that in a world in which other developed countries have increasingly moved to exemption systems, US business will not be competitive in bidding for foreign businesses unless the US goes in the same direction.
However, there are obviously other considerations than ‘competitiveness’ – revenue (ie, who will pay the taxes that are needed?); equity between foreign and domestic investment; and, given that the US at the moment has a form of partial integration (allowing a reduced rate of tax on corporate dividends and gains from sales of shares and other capital assets), how an exemption system fits into shareholder taxation.
And there are alternatives, such as reducing the rate of corporate tax and strengthening the subpart F foreign tax credit and transfer pricing rules.
That is the approach taken so far by the Administration, although its proposals are vague on a reduction in the rate of corporate tax.
But the biggest open point at the moment may be the obscurity of the exemption system that is being proposed by its business proponents.
Academic formulations of an exemption system have viewed it as a substitute for a foreign tax credit system on active business income.
As a consequence, it would not apply to passive foreign income (which would presumably continue to be taxed under subpart F), to income that was deductible in the country of source (such as royalties or interest) or, arguably, to any other income that (whether through the failure of the transfer pricing rules or otherwise) had not been subject to foreign income tax.
No deduction would be allowed for domestically incurred expenses allocable to the foreign income.
It is far from clear that US businesses would support that sort of exemption system – indeed, when an exemption system was previously considered, the possible tax on foreign source royalties and interest persuaded business not to support the change.
Through the amended CFC regime and by continuing to monitor transfer pricing irregularities, the UK obviously feels that it can protect its base.
A pragmatic decision has, as already mentioned, been taken on interest allocation restrictions.
Quite how the debate pans out in the US remains to be seen.
The US does not face EU pressures – but its multinationals have to swim in the same global pool as others and some pressure is clearly being felt.
There is little confidence in the US about how effective its transfer pricing and subpart F rules are, which may be understandable in view of the build-up of untaxed cash in low-rate or no-tax foreign jurisdictions.
In the UK, the more open and transparent relationship with businesses that has been engendered over the last few years has certainly helped HMRC feel more confident that they are policing transfer pricing properly.
It could be that a similar approach might pay dividends in the US, but it would demand resources from the tax authorities.
The jury is clearly out – and it is equally clear that one size may not fit all.
There are some major issues of economics, politics and tax policy here:
The UK is taking some risks with its CFC regime (which may turn out to be too generous or, in the eyes of the EU, too strict) and with its generosity of interest restrictions/allocation.
But the UK is being brave in allowing a business to locate itself in the jurisdiction which offers the best overall package – if somewhere else is doing better than the UK, then the UK wants to compete on equal terms rather than imposing what many multinationals have clearly regarded as too high a charge for the privilege of being UK-located.
In logical terms, that is a good place to be.
The US plainly needs to address the build-up abroad of untaxed cash, the high nominal rate of corporate tax and the deficiencies in its foreign tax credit, transfer pricing and subpart F rules.
How these different issues will play out, however, is unclear.
Some of the solutions, such as a significantly lower corporate tax rate or significantly tighter transfer pricing rules, could have consequences for foreign investment in the US – for example, leading to a tightening of the ‘earnings stripping’ rules that limit the deductibility of interest on debt to, or guaranteed by, a related foreign person and to stricter enforcement of the transfer pricing rules.
A space that is definitely worth watching.
Steve Edge, Corporate Tax Partner, Slaughter and May
Willard Taylor, Of Counsel, Sullivan & Cromwell
