A global look at the changing world of tax 

Interviewer’s opening remarks

In the wake of the financial crisis, governments across the developed world are still struggling to eliminate budget deficits, restore national finances, and stimulate growth and investment.

In particular, governments are looking at how they can use their tax systems toward these ends—including how they can boost their tax revenues through the taxation of foreign profits of domestic companies earned through offshore subsidiaries or branches.

In assessing their tax policies in this area, governments need to think about: how any changes will impact the competitiveness of their tax systems compared to other countries in attracting and retaining investment.

Different countries are taking different approaches to these issues.

Joining me today to explore how this debate is playing out in three key jurisdictions is Managing Director John Bush, with KPMG in the United States and Tax Partners Tom Aston with KPMG in the United Kingdom, and Brajeshwar Banerjee, with KPMG in Japan.

John, let’s start with the US. That country’s deficit problems and the debates going on over taxation have been a heated topic of debate over the last several months. Can you help us clarify what issues and solutions are on the table?

John

My focus is going to be on taxation of corporations and really there are two questions here. Do we want to tinker with the current system or undertake true reform? I'm going to discuss true reform and the overall goal of true reform is really, essentially, to broaden the base and reduce effective tax rates. There seem to be three alternatives under active consideration. The first would be a territorial system, the second would be one of full inclusion, or so-called full inclusion, and the third would be some form of the current system. Let me talk about each. The territorial system is one where US corporations are taxed locally in their overseas operations but the profits that they earn overseas, when brought back to the United States, are not subject to any additional US tax. The full inclusion system, by contrast, is a system where US corporations operating overseas are taxed, currently, on their foreign earnings and once they’re taxed they can then be bought back to the United States tax-free, but keep in mind that the earnings themselves are subject to US tax. And finally, the current system is a bit of a hybrid between the two. Earnings of US corporations from overseas locations are not taxed currently but they are taxed when they come back to the United States. So those are the three alternatives and let me talk a little bit about the issues that relate to each of the three and highlight some of the problems that are being discussed. So, transfer pricing. In a territorial system because the earnings are not subject to tax in the United States it is increasingly important to get the earnings that are subject to tax overseas correct in amount. Some tax authorities or some tax experts in the United States, believe that's almost an impossible task but many countries around the world have territorial systems today and it seems to work for them. There is some discussion about substituting something called allocation formulas versus arms linked pricing to deal with territorial issues. An allocation formula is kind of a wooden approach to things but it looks at such factors as the amount of revenue earned in a jurisdiction compared to revenue earned elsewhere and simply using that ratio to allocate taxable income to a particular country. The second issue worthy of note is the allocation of capital and allocation of debt with the result that, where does is interest expense fall? Obviously, if you have no interest expense in your jurisdiction the amount of taxable income there will be much higher and some companies try to take advantage of that situation by locating debt raising in countries with high tax rates so they get an interest expense there and putting capital into low tax jurisdictions to enhance their income there. The United States can be expected to address that issue in some form probably with some kind of allocation formula. And the final issue that is worth noting, initially, has to do with the taxation of passive income. And let me start with an example of what the problem is that tax authorities focus on. You have a home country, in this case the United States, one of the multinationals here raises money here in the form of debt, takes that debt funding and contributes it to a low tax foreign jurisdiction in the form of capital, so there's no interest expense there, and then the company located in that low tax jurisdiction lends the funds back to the United States. And so if you follow that trial, debt raising in the US, capital contributions to low tax jurisdictions loaned back to the US, interest income in the low tax jurisdiction, interest expense in the US and then, to top things off, the foreign low tax company dividends back to the United States tax-free. Obviously, that is sort of a vicious circle that the tax authorities will not accept and to deal with that kind of problem, highlighted by that example, there will be some kind of jurisdictional taxation of passive income in low tax jurisdictions. So that gives you a quick overview of the debate in the United States. Will there be major reform? If there is, for US multinationals will the reform take the form of a territorial system or so-called full inclusion system or some kind of tinkering with the current system.

Interviewer

Tom, I imagine the tax policy makers in the United Kingdom are grappling with similar issues.

Tom

In the UK we have a lot of the same themes that John has just been talking about in the US. There’s obviously very big budgetary constraints, as we have in most countries in the world, and at the same time a desire to make the tax system more competitive and obviously some tension between those two objectives. We've already seen a significant incremental change in the tax burden on banks, so we've got the new UK bank levy but at the same time corporate tax rates are falling even for banks. There are three particular areas where the taxation of the worldwide income of UK groups is undergoing fundamental change and these are very big issues for banks. First of all we got a brand new branch exemption in the UK; 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; you're going to need to have substance in the branches in particular. Also, the CFC rules which have been under review for five or six years now may finally be reaching some kind of fresh landing and could potentially be a lot less onerous than they have been in the past. Hopefully that's going to reduce the incentive for UK groups to migrate out of the UK which has been a big issue for the UK over the last few years. The other big issue, though, going in the opposite direction is that whilst, for corporate income taxes, we are seeing a move to a territorial base our brand-new tax on banks, the bank levy, applies on a global basis in a way that is particularly unhelpful to UK headquartered groups. So for banking groups who are headquartered in the UK with the bulk of their operations overseas, the whole global balance sheet is going to be subject to bank levy and has a very strong disincentive to set up a new banking group in the UK.

Ban

I think the earthquake certainly was very disruptive and the proposal for lowering the corporate tax rates should have been effective at the end of March but the earthquake hit on March 11th which meant at the last minute things got derailed. One of the ways that Japan’s is looking at filling the budget gap is by raising indirect taxes, more specifically, the consumption tax. If you compare consumption tax in some of the European jurisdictions, for example, which are in the late tens or perhaps sometimes even in the 20% range, compared to that of Japan that has, at the moment, 5%, so a lot of people believe that there is room to increase consumption tax to a moderate amount, by a moderate amount, for example, up to 10% or even 15% and thereby they don't have to tinker with the corporate tax rates to build a budget deficit. Having said that, I think what Tom and John said before was interesting because Japan in 2008 did introduce a foreign dividend exclusion regime in the same year as it was introduced in the UK. And one of the features of that is that it simply allows Japanese corporations to repatriate 95% of their income tax-free and only 5% is subject to tax. So, maybe going back to what John was saying, in Japan we do not look at interest expense, or if your interest expense for the corporation is more than 5% of the amount that you repatriate back then so be it, it doesn't really matter. The avenues for these, the fact that they get tax 5% means that that's enough and so that's a good thing, at least, for Japanese corporates and we’ve seen there have been cases where a lot of Japanese multinationals are choosing to repatriate their foreign earnings back to Japan. I think, what's going to happen and part of it has already happened which was reinforcing the CFC regime so now you have specific CFC rules which apply if the foreign corporation is in a less than 20% tax jurisdiction or if the effective tax rate through tax holidays or otherwise is below 20% but there are rules to say that if you have or meet certain active business, kind of, tests then you are excluded from the CFC regime and therefore you still get your dividend exclusion. So we haven't seen these rules leading to the fear, I guess, which exists in the US multinationals choosing to move out of the US and set up shop elsewhere. One would hope that Japanese multinationals continue to operate out of Japan and not go out to a low tax jurisdiction to set up operations. And so far, I think, that's been the case but I think in the future we need to see if cases of open inversions do take place or not. Unlike the UK, branches are not allowed to avail of this dividend exclusion but this maybe changed in the future particularly in view of the changes that have come in the UK recently.

Interviewer

Thanks to each of you for your insights on how tax reforms for offshore profits are taking shape in your home countries. Before we conclude, do you have any closing comments?

John

Well, let me say that the United States is a bit of an outlier in two respects in the tax debate. First of all we have no national consumption tax, we do have state and local sales taxes but no national consumption tax so that's very different than both Japan and the UK and most other countries in the world. And secondly, unlike Japan and the UK, which have moved in recent years to a territorial system, that is still very much under debate in the United States and the outcome of that is quite uncertain. Indeed, the outcome of the whole form of tax, tax reform in the United States, is uncertain given the political climate that we face today here.

Tom

I think we’re being pulled into different directions as we discussed earlier. Corporate tax rates are coming down and that's benefiting everybody but probably for banks that's been more than offset by the impact of the bank levy which is applying on a global basis and it would be great to see that being redesigned to operate territorially but there doesn't seem to be any inclination that that's going to happen in the short term.

Ban

I think, for Japan, we are in a period of change and I think after the earthquake, with regards to the lowering of the corporate tax rates that we were talking about earlier, seems there are two schools of thought. One school of thought is of the view that, maybe, lowering of the rate should be postponed by a couple of years until Japan is able to reconstruct and come out after the reconstruction phase following the earthquake and tsunami. And there's another school of thought which says well, maybe we should go ahead with the lowering of the headline tax rate as we had planned to do this year but didn't get done because of the earthquake. And then to fund the reconstruction we should have a temporary special kind of a reconstruction tax. This is still being discussed and we would hopefully have some clarity on this as months go by and hopefully by early 2012 at the latest. I think we are in a period of change and we just have to make sure, as tax professionals, we are on top of things and are able to advise our clients accordingly.

Interviewers Closing Remarks

Thank-you John Bush, Brajeshwar Banerjee and Tom Aston