Intro
In considering the treatment of investments made by domestic companies in foreign operations (branches and foreign subsidiaries), a number of issues are likely to determine the taxation of foreign profits:
- How best to maintain an internationally competitive tax system?
- Whether the home country should tax some or all foreign profits?
- Of particular importance to banks, should foreign branches be taxed in the same fashion as foreign subsidiaries?
Here, we review how the debate is being pursued in three key jurisdictions, the US, UK and Japan. In each a territorial system of some sort has been adopted or is being considered for adoption.
US
In the US, the challenge of reducing the budget deficit has raised the question of how much revenue should be raised and what form taxation should take. A good part of the discussion on corporate taxation has focused on how to tax the offshore profits of US multinationals. In general, some commentators in the US tend to favor a territorial system whereby the offshore profits of US companies can be brought back to the US tax-free. Under the so-called 'capital import neutrality' theory (which supports a territorial system of taxation), the competitiveness of US multinationals is thought to be enhanced, thereby benefitting the US economy as a whole. Equally important, a territorial system would enable multinationals to move offshore profits back to the US without a tax penalty, where they could then be invested, creating additional US jobs.
Conversely, other commentators argue that the current system of taxation under which multinationals are not taxed on their active operating earnings until they are repatriated to the US encourages US companies to invest offshore where their earnings are taxed (often artificially) at a low effective rate. They argue this moves jobs out of the US. Under the so-called 'capital export neutrality' theory, investment decisions are to be made without regard to tax considerations. Under a pure version of this theory, this can only be accomplished by taxing foreign earnings currently (even before they are repatriated to the US) so that the earnings of a US group are taxed at the same rate of tax irrespective of where in the world they are earned.
A number of specific issues arise in the debate over the two approaches:
- Transfer pricing – Most of the world operates under the 'arm's length' standard for judging the appropriate level of charges between related taxpayers. This is the bedrock on which the OECD transfer pricing guidelines are based. Increasingly, some tax authorities are questioning whether this standard works effectively in the real world, pointing to the fact that a disproportionate amount of a group's profits often ends up in a foreign jurisdiction with a low effective rate of tax. Hence, some countries are beginning to look at allocation formulas for determining the proper distribution of profits. Purportedly, this would take subjective considerations out of the transfer pricing debate.
- Allocation of capital – This is of particular importance in a territorial system because capital comes free of an interest charge. Hence, a subsidiary that is funded largely with capital will be more profitable than one funded with debt. All countries address this issue in some fashion. The US government has typically thought that capital should be allocated 'fungibly' (i.e., in proportion to the assets held by different companies).
- Taxation of offshore passive income – No jurisdiction is willing to permit a foreign subsidiary to accumulate earnings by lending into the home country or other countries with operating subsidiaries in order to reduce the effective rate of tax on these earnings and then repatriate these earnings tax-free to the home country. The US will have some form of controlled foreign subsidiary (CFC) rules to deal with this problem.
- Stewardship expenses – These expenses involve supervising the operations of CFCs, but typically the benefit is purely for the shareholders of the parent company. Hence, they normally cannot be charged to foreign subsidiaries. Some countries permit these expenses to be deducted in the home country, some do not permit their deduction since they relate to tax-exempt foreign earnings, and some level an arbitrary tax of 5 percent against foreign distributed earnings to off-set this benefit. No decision has been made in the US on how to treat these expenses.
UK
In the UK, some of the same themes arise, in particular a concern about the budget deficit and a desire for new sources of revenue. Set against this is a desire to make the UK a competitive business location. We have already seen a significant incremental change in the tax burden on banks in the form of the UK's bank levy, but corporate tax rates continue to fall, even for banks. Despite the UK budget deficit, we are seeing sizeable reductions in the UK corporation tax rate, which will fall to 23 percent by 2014. The general approach to tax policy tends to be rather more pragmatic than driven by the intellectual debate on capital export neutrality versus capital import neutrality in the US.
There are three particular areas where the taxation of the world-wide income of UK groups is undergoing fundamental change:
- The UK has just introduced a branch exemption. A UK company will in future be able to make an irrevocable election to exempt the profits of all of its overseas permanent establishments from UK corporation tax, subject to various anti-avoidance rules: it will be necessary for the permanent establishments to have substance; in addition, where the branches have incurred losses in years leading up to the election it will be necessary to recoup some of the losses before electing into the regime.
- The UK is attempting to make its CFC regime more attractive to multi-national groups, following some high profile emigrations (or 'inversions') of large UK groups to overseas locations. In the future, it should be possible for a greater proportion of the income of overseas subsidiaries to be exempt from UK tax.
- Specifically for banking groups the bank levy (introduced with effect from 1 January 2011) will apply on a world-wide basis to the balance sheets of all branches and subsidiaries: this is potentially creating a significant fresh disadvantage to locating a global banking group in the UK.
Japan
Japan also has a high budget deficit that needs to be plugged through increased tax revenues. The March 11 earthquake, the tsunami and the Fukushima nuclear accident have added to the pressure to look for new sources of tax revenue. The immediate impact has been a postponement of the proposal to reduce the headline corporate tax rate from 41 percent to 35 percent1 and an open discussion of increasing the consumption tax from the current 5 percent to 10 percent or more. Some legislators are in favor of reducing the headline corporate tax rate to promote Japanese competitiveness with places like Hong Kong and Singapore, and introducing a 'reconstruction tax' for a temporary period; other groups favor postponing the reduction in the headline rates by a few years.
There has been no significant debate on capital export neutrality versus capital import neutrality, but Japan did introduce a foreign dividend exclusion regime in 2009 to encourage Japanese companies to repatriate their foreign earnings. These rules provide for 95 percent of dividends to be excluded from taxable income (the remaining 5 percent is taxable) for a shareholder owning more than 25 percent of a foreign corporation for six months or longer. These rules are applied in conjunction with the CFC rules. Broadly, the exemption is available to foreign corporations that have an effective tax rate of more than 20 percent or meet some of the other conditions to avoid having their earnings taxed under the CFC regime. The rules have encouraged many Japanese manufacturing groups to repatriate earnings from overseas but there have been no instances of corporate inversions yet in Japan; in practical terms, these are unlikely owing to cultural and language issues.
Currently, these foreign dividend exemption rules do not apply to foreign branches of Japanese corporations, which are taxed on worldwide income. (Japan determines the residency of corporations based on the location where the corporation has been legally established and not based on the place of their effective management, which is the standard used in many jurisdictions.) The taxation of branch profits is likely to be an area of future legislative activity, particularly in view of the UK decision to introduce an exemption for branch profits.
There is no special tax on banks like the UK's bank levy. As a practical matter most Japanese banks (and many Japanese corporations) do not actually pay any corporate tax due to tax loss carry forwards which can be used over seven years. There was a proposal to limit the use of tax losses to offset only 80 percent of taxable income but this has not yet been passed into law. As in the UK, in the medium term the burden of taxation is going to shift from corporate taxes to indirect taxes (i.e. consumption tax) and increased taxation on individuals in higher income brackets.
Conclusion
The fiscal pressures on national treasuries in these countries are severe. Many commentators would argue that reducing public expenditure would lead to more sustainable recovery than increasing taxes. Nevertheless, tax has a key role to play. Tax authorities in all three countries are exploring variations of measures to extract more tax revenues from their own companies' overseas operations. The challenge will be to achieve this without provoking a damaging round of beggar-thy-neighbor.
1,2011 Tax Reform Proposals, Japan