Tax, budget debates may feature adverse proposals

March 8, 2010
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Despite the winter storms in Washington, D.C., the political process continues.

The Obama administration released its 2011 tax proposals in the “Green Book’ in early February. Many were proposed last May in the 2010 Green Book. The proposals include both tax increases and cuts. As with any government proposal, there are estimates of the increased revenues and costs of the proposals, though many in Washington have a fair share of skepticism regarding the actual accuracy for the estimates and the methodology used to arrive at them.

A good share of the revenue-raising proposals is centered on U.S. businesses that conduct business operations outside the U.S. The recent mantra in Washington has been to look to reforming how certain offshore income earned by U.S. businesses is taxed in the U.S. There is a view among some inside and outside of government that many U.S. businesses are not paying the appropriate amount of U.S. tax on international earnings.

The U.S. is one of the few major industrialized companies that taxes its corporations on worldwide income without exemptions for active business earnings earned outside the home country. The U.S. system generally taxes such income when it is brought back into the U.S. through dividend, interest, royalties or through the sale of products/services. Dividends from foreign subsidiaries are taxed and a foreign tax credit is allowed for any foreign corporate tax levied on the income when it is paid to its U.S. C corporation parent company.

In cases of subsidiaries conducting business in lower tax jurisdictions (most of our trading partners), this results in additional U.S. tax (after any foreign tax credits) being paid by the U.S. businesses on the foreign earnings. This treatment is different from the treatment in most of our trading partners such as Canada, Germany, France, and most recently the U.K. All of these countries generally exempt all or most of dividends from subsidiaries that have generated active business income outside of their home country. The exemption method used by the other countries generally allows for no residual tax on the foreign income that is earned (via a payment of a dividend) if the income is from active business operations in a foreign country and if the earnings were subject to tax in that country and there is a double taxation treaty with that country.

The 2011 Green Book proposals still seek to tax certain types of income earned outside the U.S. or limit certain U.S. deductions. The biggest surprise was what was no longer included in the proposals. This was the elimination of the proposal to reform or to restrict the ability to use the entity classification rules otherwise known as the “check-the-box” rules. These rules were utilized by many businesses, in structuring foreign operations. The 2010 proposals included provisions to limit the ability of U.S. taxpayers to use these rules in some of their international structures. The estimate of the expected revenue gains of that proposal were revised downward last summer as it became apparent the actual reform may generate significant revenues to our trading partners and not result in lucrative estimated  revenue gains forecast for the U.S.

The new proposals include raising revenue (taxes) on certain transfers of intangible assets outside the U.S. This includes patents, trademarks, knowhow, etc. The concern is that intangibles are moved to offshore jurisdictions that may be considered by some as tax havens or low-cost tax jurisdictions and income is allowed to accumulate free of any U.S. corporate income  tax.

The Green Book proposals also include a plan that will defer interest deductions of U.S. companies conducting business outside the U.S. if foreign earnings are not currently taxed in the U.S. The deferred interest deduction becomes available when the foreign earnings are actually taxed in the U.S. In addition, the use of foreign tax credits and their calculation is proposed to be changed with the intent to apparently restrict taxpayers from choosing certain types of foreign income that have low or high effective rates of underlying tax. This is accomplished by “pooling” the earnings or all foreign subsidiaries and all foreign taxes into one pool. Some commentators have made the observation that this may present issues with double taxation agreements with our trading partners, and as a result, put strain on the relationships we have with them.

The proposals also included some rules that may impact businesses in Michigan that deal more domestically than internationally. Many companies, including manufacturers, distributors and retailers, use various forms of the last-in, first out (LIFO) method of determining their inventories. This method of accounting accounts for an inflation factor in the year-to-year changes in a business’s inventory.

The proposals made in early February include one to eliminate LIFO. There is a phase-in of the repeal. This proposal may have direct impact on West Michigan, as many businesses have adopted this method. The repeal will result in additional taxable income for the businesses that use the LIFO method and could impact their ability to be in compliance with loan covenants, as the business will require additional cash to pay the additional income tax that results from the repeal. With many Michigan-based companies trying to work through the recession, tough credit markets and high unemployment, such a proposal, if enacted, may have unintended consequences.

There is a proposal in the Green Book to restore the research tax credit. Technically speaking, the research credit expired Dec. 31, 2009. The research credit is proposed to be extended. Despite its existence in the Tax Code for many years, the research credit typically is extended in one- or two-year increments. At a time when we hear from the White House and from Congress that investment in new technologies is of high importance, the research tax credit becomes an orphan looking for a permanent home and just gets a short-term residence in the Tax Code. This is ironic in some respects as the types of jobs the research credit rewards businesses for creating are those involved with science, engineering and technology. Most of these jobs typically are higher-paying jobs that require an educated work force.

We will need to watch as the tax and budget debates take place. Changes in the performance of the economy and other political events may impact what legislation is considered and possibly enacted. Unfortunately, some of the uncertainty revolving around the proposals may impact decisions by owners and management at affected companies. Stay tuned. It may be an interesting spring and summer.

William F. Roth III is a tax partner with BDO Seidman LLP. The views expressed are not necessarily those of BDO Seidman LLP.

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