The gaming industry is no longer overwhelmingly populated by independent operators and small suppliers working solely in the United States. The industry, rather, has transformed over the past two decades into a global behemoth. Major casino operators have properties located not only in multiple U.S. jurisdictions, but now also own, or participate in joint venture ownings, properties in foreign countries. The gaming supplier industry is likewise international in scope. Gaming equipment manufacturers develop new gaming devices from business locations throughout the globe and sell products in jurisdictions spread across every continent except Antarctica. The collective gaming industry should, therefore, pay close attention to international tax reform proposals emanating from Washington, D.C.
One recent reform proposal, publicly announced by President Obama and Treasury Secretary Timothy Geithner on May 4, 2009, is the subject of this article. The president’s international tax reform proposal comes on the heels of increased efforts by the Internal Revenue Service to encourage greater disclosure of U.S. taxpayers’ offshore financial activities.
Why the Emphasis on Tax Reform?
Tax reform is an area that even an armchair American political strategist can identify as a subject that will resonate with the American public. It was Justice Sutherland in the quintessential 1935 Supreme Court decision Gregory v. Helvering who acknowledged that structuring one’s business affairs in a manner that results in paying the least possible tax is a part of the American way of life. With recent budget shortfalls in the United States, attributable to the “Great Recession” we are living through, coupled with massive new governmental spending programs, there is even greater need to replenish federal and state revenue streams.1 The system of international taxation has long been the target of criticism due to its complex rules that may encourage “tax planning” strategies by multinational corporations intended to eliminate or evade U.S. taxation. Thus, the timing of the Obama administration’s current push to reform international tax may simply be a fortuitous opportunity to change a system that politicians have rebuked as one that denies the U.S. government its entitled tax revenue.
What is International Taxation?
The U.S. generally has a policy of taxing the global income of its residents, including corporations, and only taxing the income once.2 The system of global tax is faced with a dilemma when a U.S. resident corporation owns a foreign domiciled subsidiary. If the foreign subsidiary is viewed as a foreign resident and its earnings are taxed by the foreign jurisdiction, U.S. taxation would result in double taxation. In 1962, subpart F entered the Internal Revenue Code (IRC) to reduce the prospect of double taxation of multinational corporations. At a basic level, subpart F allows U.S. taxpayers to defer U.S. taxation on income earned overseas by foreign subsidiaries. To preserve a single layer of taxation, subpart F also grants the Foreign Tax Credit (FTC), which allows for a credit against U.S. income for foreign taxes paid. CEOs, CFOs and other business executives recognize the complexity of tax laws and their constant evolution, particularly subpart F of the IRC.3 U.S. corporations appropriately began to develop sophisticated—and legal—corporate and transactional structures to minimize U.S. taxation and gain advantage of the favorable provisions of subpart F.
President Obama’s Proposal
President Obama’s international tax reform proposal is embodied by two general themes. First, the president’s proposal calls for the elimination of certain benefits currently available under subpart F that are perceived as avenues for gaming the tax system. Second, the proposal incorporates initiatives intended to eliminate the use of offshore “tax havens,” the popular nomenclature used to identify low-tax jurisdictions often used when structuring the overseas activities of U.S. taxpayers. The reforms are also intended to serve as a device to generate more tax revenue. The administration’s own estimates place the revenue-raising figure at approximately $210 billion over a 10-year period.
Eliminate Existing Subpart F Benefits
The auspices of President Obama’s proposal to eliminate subpart F benefits attributable to U.S. taxpayers’ overseas activities is to promote investment in the U.S. The president’s proposal operates under an assumption that current tax law encourages U.S. taxpayers to make investments overseas by allowing for (1) current deductions against U.S. income tax for expenses that generate profits from overseas activities in low-tax jurisdictions, and (2) deferral of payment of U.S. income taxes on profits generated overseas. The president’s proposal offers three methods to reduce these perceived incentives and encourage U.S. based investments:
• Eliminate U.S. income tax deferral rules under subpart F to require U.S. tax deductions for expenses associated with overseas investments to be deferred until such time as the profits attributable to the overseas investment are repatriated to the U.S.;
• Close FTC loopholes by (1) basing the FTC on total foreign taxes actually paid on total foreign earnings; and (2) disallowing the FTC for foreign taxes paid on income not subject to U.S. taxation; and
• To offset the increased U.S. tax burden, and ostensibly to encourage investment in the U.S., the research and experimentation tax credit would be made permanent.
The rationale supporting the elimination of the subpart F deferral regime is that it creates a mismatch between the time expenses are deducted and the time income is subject to U.S. taxation. The anti-deferral proposal primarily attacks the ability to currently deduct interest expenses. For example, under current tax law, a U.S. corporation could borrow funds to make an overseas investment in a low-tax jurisdiction. The U.S. corporation may be able to currently deduct its interest expenses associated with the loan that finances the overseas investment. The earnings generated by the overseas investment would, however, be subject to current taxation, if at all, in the foreign jurisdiction. U.S. taxation would only occur if the profits were ultimately repatriated to the U.S. Thus, under current law, a timing mismatch can be created between the current deduction of interest expenses attributable to the overseas investment compared to the time the associated earnings may be subject to U.S. taxation. The Obama administration’s proposal would eliminate the timing mismatch.
The theory supporting the proposal to reduce the availability of the FTC is aimed at stopping the use of planning techniques that serve as FTC generators or generate FTC for income that is not currently subject to current U.S. taxation. The precise details of the proposal to eliminate FTC loopholes have not been fleshed out and, thus, are the subject of speculation. There is some suspicion that the language in the first part of President Obama’s proposal to shift the determination of the FTC to be based on the amount of foreign tax the “taxpayer actually pays” is coded language intending to eliminate planning techniques that generate FTC when a third party bears the economic outlay of the foreign tax.4
Attacking the Use of Offshore “Tax Havens”
The use of low-tax offshore jurisdictions in tax planning structures has gained significant attention from the IRS and U.S. tax policymakers. President Obama offers two proposals intended to strengthen enforcement against perceived abuses with the use of offshore tax havens.
First, President Obama’s proposal calls for the elimination of the use of check-the-box regulations to develop entity structures that eliminate passive income for U.S. tax purposes, while at the same time allow for the ability to transfer income tax-free between foreign subsidiaries. The proposal would require U.S. corporations to treat foreign subsidiaries as corporations for U.S. tax purposes.
Under current law, a U.S. corporation can form foreign hybrid entities that are treated as disregarded entities for U.S. tax purposes and corporations for foreign tax purposes. Figure 1 illustrates the use of a disregarded entity structure and the transactions designed to avoid U.S. passive income. Ordinarily, when foreign subsidiaries make interest payments or transfer other forms of payments to another foreign subsidiary, the payment is considered passive income for subpart F purposes. Using check-the-box rules, the passive income disappears because the foreign subsidiaries are disregarded for U.S. tax purposes. Thus, the use of disregarded entities allows for profits and income to be transferred among foreign subsidiaries without triggering U.S. tax.
Second, the Obama administration’s proposal would attack the use of offshore tax havens by individual taxpayers to evade U.S. taxes. The president’s proposal is aimed at strengthening existing U.S. tax laws to enhance information reporting requirements, increase income tax withholding, increase tax penalties, shift the burden of proof to make it more difficult for holders of foreign bank accounts to evade U.S. taxes, and provide additional enforcement tools to the IRS. This proposal comes on the heels of a recent initiative announced by the IRS to encourage U.S. resident taxpayers to file Foreign Bank and Financial Account Reports (FBAR). U.S. residents must annually file a FBAR when the individual owns a financial account with deposits in excess of $10,000. The failure to file a FBAR is subject to significant civil monetary fines and criminal penalties. The recent IRS initiative allows individuals to avoid criminal prosecution by voluntarily disclosing the unreported foreign account(s), pay any additional income tax due and pay any applicable tax penalties.
The IRS and policymakers generally agree that some reforms are necessary to the U.S. system of foreign taxation under subpart F. There is little debate that subpart F is a complex taxation system that may have imperfections. The propriety of implementing international tax planning structures to minimize tax is subject to debate and can be politically polarizing. Notions of tax equality (that is, what is the appropriate “fair share” of tax corporations should pay) raises political questions and is often a source of political rhetoric, which can lead to enactment of inefficient tax laws based on bad policies.
The early emphasis that President Obama and congressional Democrats have placed on tax reform, particularly with respect to international taxation of U.S. taxpayers, makes it is apparent that some level of reform is likely to occur. Senior staffers to Democratic congressional leaders have publicly stated that congressional leaders may not have the stomach to proceed with international tax reform without the blessing of U.S.-based multinational corporations. President Obama’s international tax reform proposal is significant because it changes the rules of the international taxation of U.S. taxpayers’ foreign activities, even though the revenue-raising estimates may be paltry compared to the 2009 deficit level. Thus, gaming businesses with foreign activities may soon be forced to revisit long-used—and, in many instances, perfectly legal—structures for foreign activities. What ultimately is enacted may differ from the administration’s early outline. However, it is never too early for the gaming industry to begin to pay attention to what is happening in Washington, D.C., and the affect policy changes may have on existing structures used to carry on international business activities.
1. Senior congressional staffers at a meeting of the American Bar Association Tax Section recently acknowledged the need for new sources of revenue. The congressional staffers stressed that the current deficient stands at approximately $1 trillion and that by the end of 2009, it is projected to reach $2 trillion.
2. A notable exception is the “C corporation” tax regime, which imposes two layers of tax: once when income is earned by a corporation and twice when earnings are distributed to shareholders.
3. The complexity of federal tax laws, along with continuous layers of complexity added each time Congress amends the IRC, brings back memories of my days as a student in the NYU graduate tax law program. Illustrating this complexity was Professor Leo Schmolka, who brought forth a copy of the IRC from the early 1960s for me to inspect. The 1960s version of the IRC consisted of approximately 200 pages, in one volume, printed in a normal-size font. To gain the intended perspective, the copy of the IRC on my desk consists of two volumes spanning more than 5,600 pages and is printed in a small font on thin paper. This two-volume set is in addition to the six volumes of final, temporary and proposed Treasury Regulations, also printed in nearly microscopic font.
4. See Reuven S. Avi-Yonah, The Obama International Tax Plan: A Major Step Forward, available online at www.law.umich.edu/centersandprograms/olin/papers.htm (May 2009).