Transfer Pricing: A World of Pain

Transfer Pricing: A World of Pain

China, India, and other once tax-friendly domains look to squeeze U.S.-based multinationals on sales between subsidiaries.

Yet another unwelcome side effect of the global recession: hungrier international tax authorities. Experts say that officials in previously tax-friendly countries, including China and India, are looking to fill their coffers by extracting more from U.S.-based multinationals. Among their favorite areas to probe: transfer pricing, or the pricing of sales between subsidiaries and subsequent allocation of taxable income among various countries. Long a focus of the U.S. Internal Revenue Service, transfer pricing is “the lowest-hanging fruit, because it’s very subjective and most companies don’t have adequate documentation to back up their assertions,” says Larry Harding, CEO of High Street Partners, an international business-expansion consultancy.

Changes are perhaps most dramatic in China, where foreign businesses enjoyed favorable treatment (even surpassing that of local companies) until last year. In January, China’s tax authorities issued new rules requiring foreign multinationals to submit extensive transfer-pricing documentation by year-end. More recently, they circulated a notice to local tax authorities urging rigorous enforcement on a variety of business-tax issues, including transfer pricing. “A lot of U.S. companies will be exposed,” predicts Harding.

China is hardly alone. “There’s an explosion of transfer-pricing controversies out there,” says Garry Stone, global transfer-pricing leader for PricewaterhouseCoopers. The number of such disputes among his clients doubled over the past year, he says, with India, Canada, Turkey, and Greece among those bringing more scrutiny to bear. The areas that often lead to controversy include intellectual-property values, costs of back-office functions, and losses of any type, he says.

Meanwhile, the IRS is maintaining its aggressive approach to transfer pricing. The agency recently fought through the courts to force semiconductor company Xilinx to allocate stock-option expenses to its Irish subsidiary, boosting the company’s U.S. tax bill by about $40 million and leading many other tech firms, including Apple, Cisco, and Cadence Design Systems, to take additional income-tax expenses. Stone says he understands that the IRS is adding 1,200 people to its international staff this year; the 2010 budget calls for another 800.

How to cope? Stone says more companies are seeking advance pricing agreements in which a company gets preapproval for its transfer-pricing methodology from tax authorities. Failing that, updated documentation and clear explanations of methodologies are critical. Despite such efforts, in some cases it may be impossible to avoid a penalty. “Even if you have the documentation and it is perfect, it could be challenged,” says Harding. “A lot of governments go in there planning to get something.”

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23 Singapore Business Times Investment round table – Equities: what’s on the horizon

OVERVIEW

STOCK prices around the world recently hit their highest levels for this year, buoyed by a wave of optimism about prospects for a global economic recovery – only to fall back to a three-month low this week on fresh doubts about the sustainability of that recovery. So, is it ‘for real’ or is it destined to run out of steam? The Business Times empanelled a team of key experts to answer this critical question, and to tell us whether the world faces a threat of inflation, deflation or stagflation in the coming months. There were mixed views on the prospects for equity markets, but interestingly, everyone on the panel was bullish about gold.

Panellists

Mark Mobius, executive chairman, Templeton Asset Management

Eisuke Sakakibara, former vice finance minister for international affairs, Japan, and now Professor at Waseda University, Tokyo

Jesper Koll, president and CEO, Tantallon Research, Japan

The Hon Robert Lloyd-George, chairman of Lloyd George Management, Hong Kong

Ernest Kepper, former senior official of the International Finance Corporation (IFC) and Wall Street investment banker who now heads an Asian financial consultancy

William Thomson, chairman, Private Capital Ltd, Hong Kong and senior adviser to Axiom Funds, London and formerly a Vice President of the Asian Development Bank

Christopher Wood, managing director and equity strategist, CLSA Asia-Pacific Markets, Hong Kong

Moderator: Anthony Rowley, Tokyo correspondent, The Business Times

Anthony Rowley: Let me start by asking: is the apparent recovery in the global economy for real, or a ‘phony’ one? And, are stock markets justified in behaving the way they have been doing lately?

Eisuke Sakakibara: I don’t understand why equity prices are so high – in Japan the US and elsewhere. In China’s case, there is obviously a very major bubble in the equity market. Also, I don’t see any reason why the US Dow Average should be more than 9,000 (as it is now)or why the Japanese Nikkei average is more than 10,000. I just cannot understand it.

Ernest Kepper: This is a phony recovery. A turn-up in the economy is not the same as the economy recovering all lost ground. To keep rising in the future, markets need a sign of real economic recovery, and that requires a surge in consumer spending, business investment and home buying, combined with a reduction in government spending.

I fully expect to see the markets rise for a while longer, even as high as Dow 10,000 or S&P 1,100. After that, I think that we are going to see another leg down when the current rally ends, just as the powerful rally following the initial crash in 1929, ended up dealing out severe losses to those who held onto their shares.

William Thomson: In the wake of Lehman’s failure the global financial system was staring into the abyss of a systemic meltdown. Governments then junked their economic philosophies and threw fiscal and monetary assistance at the problems on an unimaginable scale, just to keep things afloat. It has worked to the extent the system limps on and there has been a rally in the markets. But there has been no recovery in the real economy yet in the West. The pace of decline has slowed and the second half of 2009 could be modestly positive. But modest is the operative word since unemployment is likely to continue to grow well into 2010, reaching double digits even on the official count.

With housing foreclosures likely to keep climbing in the wake of extended unemployment, the consumer is likely to keep his wallet shut and try and repair his balance sheet. Modest economic recovery should continue as long as neither fiscal or monetary conditions become restrictive too quickly. But markets need a period of consolidation whilst they assess future prospects, so a broad trading range may be possible for the rest of the year. Dips can bought and rallies sold.

Anthony: Are any of you gentlemen more optimistic about the global outlook?

Robert Lloyd-George: This is not a ‘phony’ recovery. It may be slower and weaker than usual because of the debt super-cycle. But it is a real recovery – in trade, auto sales, consumer spending, corporate capital spending and so on.

We are ‘climbing a wall of worry’ because many economists (and hedge fund managers) do not believe in the recovery and still have 50 per cent cash, awaiting a correction, which may never come. Earnings, and GDP, figures will slowly improve and equity markets will strengthen well into spring of 2010.

Mark Mobius: The financial crisis was real in the banking system but not in the industrial economy. It impacted the economy because the banking system froze. However, markets are leading indicators and they are telling us the recovery is on the way now.

Jesper: I agree. There is nothing ‘phony’ about the recovery; globally, the policy response was swift and massive and very correct. Since the start of 2009, slowly but surely, global money and credit have started to flow again.

Markets have, of course, been pulled by the massive liquidity creation; the tell-tale sign was the US banks raising massive amounts of private capital this spring without much problem; and beyond financial companies, corporations in general have been very fast in cutting costs and slashing inventories. Many CEOs used the crisis as an opportunity to do all the harsh and hard things they had been wanting to do for years, but could not ; corporations are now mean and lean. Corporate profits for many companies are poised to explode in the coming two years; global stock markets are – right now – transitioning from a ‘liquidity market’ to an ‘earnings market’ ; in this phase, stock selection will become increasingly important.

Anthony: What is driving recovery in the markets – emerging markets especially?

Mark: In a word, money is what is driving the recovery. The money supply in most countries is rising at a very rapid pace. This money is finding its way into the economic system and is driving prices and economic activity. Added to this are the US$600 trillion in financial derivatives which amplifies money supply.

Jesper: In a word – growth. There is no question that the structural growth potential of ‘Chindonesia’ – China, India and Indonesia – is easily about two times, if not three times higher than that of the US, Europe or Japan. Even so, it will be interesting to see how long emerging markets sustain their growth premium. Valuations are now very stretched and if the US and Japanese recovery continues to gain visibility, these two markets could well start to outperform the emerging world for a couple of quarters.

Robert: Emerging Markets – Brazil, India and China anyhow – have clearly risen faster and stronger from the crisis, for good fundamental reasons – young consumers in hundreds of millions, and governments following ambitious infrastructure plans (in turn), driving demand for commodities.

Christopher Wood: Recovery is partly driven by the hope of a US restocking cycle and partly by the fact that Asia and emerging markets in general are becoming more domestic-demand driven.

William: We are in the midst of a historic shifting of economic power globally from a worn-out, complacent, over-leveraged, demographically challenged and decrepit West to a youthful, striving, high savings and increasingly well educated and confident Asia eager to take its place at the top table internationally.

Emerging markets cannot decouple completely in a globally integrated world but they do have greater flexibility to develop their own internal markets – as we have seen with the Chinese stimulus programme. This growth of emerging markets at the expense of the West is the story of the next 50 years.

Anthony: Let’s focus on China especially for a moment since that is where most of the action continues to be. How do you see prospects in the China market?

Mark: Excellent. Chinese stocks have already gone up a lot and they will correct downwards but that will be temporary.

Robert: I remain bullish on China. Their macro-economic planning and management during the crisis continues to defy the Western pundits. They have plenty of cash (US$2 trillion reserves) and plenty of confidence. The younger generation will consume and borrow more. Economic relations with Taiwan improve. Overseas trade will recover. The renminbi is internationalising.

Jesper: China is one of the countries most exposed to rising cost pressures. Profit margins are already very thin, competition keeps intensifying across most sectors, and skilled labour is scarce. The key to success in the Chinese equity market will be an intense focus on stock selection – the gap between winners and losers is poised to widen sharply.

We will see the rise of true multinationals from China, true global players who do not just manufacture, but actually control the distribution channels and branding across the globe. These will be the real winners emerging from China over the next couple of years.

Ernest: China took aggressive measures to increase bank lending which in turn supported a strengthening of the stock market and is producing what looks like the start of a bubble, which the authorities are now trying to contain.

The Chinese government’s stepping up bank lending was necessary but it’s time for the excessive lending to be scaled back now. China’s stimulus adds its own risk, including those of asset bubbles, overcapacity and non-performing loans.

Christopher: It is possible that the Chinese economy will grow by around 9 per cent in the second half of this year, after 7.1 per cent (year on year) growth in the first half of the year, due to surging public-sector and private-sector fixed-asset investment and resilient consumption. This assumes no real recovery in the West and a negative contribution to growth in terms of net exports. I am still overweight on China equities.

Eisuke: China will continue to grow at a fairly high rate of 7 or 8 per cent for some years to come and next year I think that China will be number two in terms of GDP.

That is only natural (because) China is a big country with a big population. China will need to emerge as a major economic power in the world.

William: The Chinese stimulus programme has been successful but the question is whether it is sustainable. It has involved a rapid expansion of bank balance sheets that could result in substantial losses a few years from now. As long as China’s export markets stabilise then China’s growth rate can be maintained at levels well above the West’s rates. China recognises the old reliance on exports must change and it will. The real question is how fast that transformation can occur. Chinese equities have had a great run and are overdue for a breather but they have a core position in any long-term growth portfolio.

Anthony: Let’s turn to wider issues. Is the world facing a risk of inflation as a consequence of all the liquidity that has been injected into economies, or deflation because of the global recession?

Eisuke: The global inflation threat is almost zero but there are some asset bubbles. If you think in terms of prices of goods, inflation fear is groundless but in terms of the prices of assets, there is a danger of bubbles in China, and even in Japan and the US. I don’t think there will be hyper-inflation.

Robert: I expect inflation to rise within 12 months. Deflation is politically unacceptable in Western democracies and monetising debt is the only way out. This is very bearish for government bonds but mildly bullish for equities, property, and commodities, provided that inflation remains below 10 per cent.

William: We have been printing money like never before: the Fed’s monetary base more than doubled in three months in late 2008. However, this has been going to fill up the black holes in balance sheets created by the credit implosion and velocity has dropped sharply. As a consequence it has yet to create inflation.

As things stand, we still need more quantitative easing and ultimately we need some inflation to reduce the real burden of our excessive debts. Renewed inflation would most likely come from currency depreciation especially the dollar which looks very weak at present and headed further south, possibly disastrously. I believe US government bonds are unattractive under such circumstances, selected equities are relatively more attractive, especially emerging markets on pull backs, as well as some commodities, including gold, silver and oil. Income producing property should also be attractive after the falls of the last two years.

Christopher: The risk in America and the West remains deflation. There remains almost zero evidence of re-leveraging in America.

Mark: Inflation is good for equities but not for bonds because bond rates must go up. Depending on how fast the money supply brakes are applied then the impact on equities could be positive or negative.

Anthony: While we’re talking about inflation, the gold price continues its upward climb. Where is it headed and why?

Mark: Gold has probably already discounted a lot of inflation expectations but when hyperinflation hits then gold could move much higher.

Robert: Gold is going to a minimum of US$2,000 an ounce by 2011, in my view, for all the reasons above. World money supply has doubled in the last two years. No new gold supply, plus dwindling faith in ‘fiat’ currencies all around the world. Neither the dollar, nor the yen, nor the Euro will fill the bill.

Christopher: I maintain a long-term bullish view on gold bullion, with my long-term target price set at US$3,360 an ounce.

William: Gold has been tracing out a huge consolidation pattern since it first crossed the US$1,000 mark in March 2008. The demand for physical gold has been huge during this period of financial crisis as gold performs its familiar role of asset of last resort as governments around the world have engaged in unprecedented levels of quantitative easing. I am looking for a significant breakout to higher prices in the coming months: US$1,200 by the end of the year is not impossible with higher prices next year.

Jesper: Gold is the best hedge we have to the principal risk, which is inflation; so I like gold and also inflation linked bonds as a hedge.

Ernest: Psychology is the driving force behind the price of gold. Unless you have a clear idea who is going to come and rescue your portfolio of paper investments, owning gold and silver is important. Gold is still the only asset class which has risen in price every year since 2001. In fact, it is a bargain for gold to be selling for less than US$1,000 per ounce!

Anthony: In conclusion, what could go wrong to derail the present recovery?

Mark: Money supply has had fed the markets. Excess money supply begets inflation and that is what could go wrong but that is something we don’t have to worry about for probably another year.

Robert: The only real problem I see is the high level of European government debt, which should not affect Asian markets.

Christopher: What can go wrong, and will go wrong, is that Western growth will remain anaemic in 2010 as a result of continuing de-leveraging.

Jesper: The biggest threat is inflation; if we get a new round of cost-push inflation we would be forced to call for a negative earnings cycle coming as soon as 2011. Another big threat is protectionism. Personally, I am hopeful this threat is low; I am very encouraged by the well coordinated response we have had to the global financial crisis, which suggests that global policy makers actually act rationally.

William: Many problems have been swept under the carpet and so a sustainable recovery to former growth rates does not seem to be on the cards for the US, the EU and Japan. The de-leveraging process still has a way to go and consumers, especially, have to continue to rebuild their balance sheets. Governments will have to restrain their expenditures and increase taxes, which will be neither easy nor popular.

Central banks also have to walk a fine line between taking away the punchbowl of quantitative easing and creating the fuel for future large scale inflation.

Ernest: There are two major things that could go wrong – the commercial property mortgage market and stimulus spending which could cause a bubble. Years of loose monetary policy has fuelled a dangerous credit bubble, leaving the global economy more vulnerable to another 1930s-style slump than generally understood.

Throwing billions of stimulus dollars at the banks is unlikely to produce a healthy economy because households are broke. At best, it may only lead to a temporary pickup in growth. Stimulus packages around the world are ultimately going to cause more damage than they prevent. These packages have simply delayed the coming downturn, and by adding significant numbers to the massive debt bubbles of the world’s nations, will ultimately make the downturn worse than had governments not injected massive amounts of money into the economy.

When the (current) debt bubble bursts, the world will enter a serious downturn. The bailout is much bigger than the dot-com and real estate bubbles which hit speculators, investors and financiers the hardest. When the ‘Bailout Bubble’ explodes, the system goes with it because neither the US President nor the Federal Reserve will have the fiscal fixes or monetary policies available to inflate another bubble.

Multinationals – Obama’s Tax Plans for You

IRS Commissioner Douglas Shulman laid out the Obama administration’s plans for cracking down on offshore tax evasion, including extending the statute of limitations.

Full article here:

http://www.webcpa.com/news/IRS-Commish-Details-Global-Tax-Enforcement-Plans-50679-1.html?ET=webcpa:e303:130272a:&st=email

IRS Wins Transfer Pricing Tax Dispute Against Chip Maker

Follow this link:

http://www.webcpa.com/news/IRS-Wins-Transfer-Pricing-Tax-Dispute-Against-Chip-Maker-50655-1.html?ET=webcpa:e301:130272a:&st=email

Exporters – Missing Out on a Tax Opportunity?

The IC-DISC.  I’ve used it to great effect. Are you missing out?

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Last Tax Break Standing

With other breaks coming under pressure, companies are showing renewed interest in a lucrative but little-used tax structure that involves setting up a shell company to which it can funnel export revenues.

Alix Stuart
May 20, 2009

President Obama’s proposed limit on the tax benefits associated with income generated overseas is likely bad news for most multinational businesses. But there may be some consolation for  companies selling U.S-made goods overseas.  

Experts say they’re seeing renewed interest in a lucrative but little-used export tax break known as the IC-DISC (interest charge – domestic international sales corporation). Although the provision fluctuates in popularity depending on the presence of other tax incentives, it’s been part of the tax code for 37 years.  

The structure, which experts say can pay for itself in months, is a way for closely-held companies to cut taxes and for many others to defer taxes on a cash stash. “It’s the only export tax incentive we still have,” says Jonathan Lysenko, international tax director for Amper, Politziner & Mattia, an accounting firm. “What’s really disappointing is that so few exporters take advantage of it.”

To be sure, there are reasons for caution. Staying within the legal requirements of an IC-DISC requires good controls, and the ephemeral nature of tax legislation may affect the benefits. Finance executives considering establishing IC-DISCs “should carefully monitor the potential for future legislative changes,” says Marc J. Gerson, a tax policy specialist with Miller & Chevalier, a Washington, D.C. law firm, noting that in the past Congress has considered legislation that would change the vehicles’ tax treatment.

Assuming they don’t get the ax this session, though, they may provide some welcome tax relief. For companies that are eligible, an IC-DISC “is a no-brainer in terms of the benefits outweighing costs,” says Larry Harding, CEO of High Street Partners, a consulting firm that helps companies expand internationally.

Here’s how an IC-DISC works: an export manufacturer or distributor sets up a shell company, to which it can funnel a percentage of export revenues annually, creating either a tax deduction or tax deferral for the underlying corporation. Those funds are considered “commissions” and are also largely tax-free to the IC-DISC.

The benefits that follow depend upon how a company chooses to use the provision. In closely held companies, for example, owners may use it to transform ordinary income into dividends-and thus be taxed at a lower rate. In that case, the corporation can receive a 35% tax deduction on the commissions it pays to the shell company. The owners of the company would then decide to have the shell company issue dividends to the shareholders (in many cases, themselves), who would then be taxed at the current rate of 15%. Thus the owners would net a 20 percent tax break, say Lysenko.

Since the amount of revenues that can be deferred is limited, IC-DISCs generally offer savings equal to 10% of a company’s qualified export profits, estimates Ralf Eschenburg, director of international tax services at accounting firm CBIZ MHM.

This benefit may diminish somewhat after 2010, when the 15% rate is slated to increase. But the payback period is short enough that companies may still gain from establishing an IC-DISC now.  Setting up the structure takes about a month, and the costs are relatively cheap, meaning “you could see 10 to 40 times the fees in savings within the first year,” Lysenko says.

For companies in need of cash, the IC-DISC can also function as a rainy-day fund for 50% of profits attached to $10 million in export revenues a year. Companies that securitize their export receivables may be able to defer quite a bit more, says Englert.

With interest rates as low as 2%, “it’s a very attractive tool from a treasury management standpoint,” says Joseph Englert, chief executive officer of Export Assist, an export-finance management firm that specializes in setting up IC-DISCs. “We’re seeing much more activity now because of the tightness in the credit market.”

Englert says his business grew between 50 percent and 60 percent last year, mainly because of the adoption of the structure by large and often public companies seeking an extra liquidity cushion. The funds are somewhat restricted, but can be used either as working capital for exports or towards general research and development, which would generate further tax benefits, Englert notes. While few companies announce such a strategy publicly, Thomas Betts and Danaher both list IC-DISCs among their subsidiaries in filings with the Securities and Exchange Commission.

There are, of course, some requirements to qualify. A company must either manufacture products within the United States or distribute U.S.-made products, and at least 50% of the materials used in the process must be made in the United States as well, since the focus is on creating American jobs. (U.S. architects and engineers can also treat service income on foreign construction projects as “export receipts” that qualify for an IC-DISC benefit, Lysenko notes.) The amount of money that can be deferred tax-free is limited to either 4% of export sales, 50% of taxable income from exports, or to a set of formulas emerging from a transfer-pricing method known as marginal costing. Companies can vary their methods from transaction to transaction to get the best deduction, says Lysenko.

 

Practically speaking, annual export sales need only be about $100,000 to make a dividend-issuing IC-DISC worthwhile, and around $2 million to make using an IC-DISC as a piggy bank worthwhile, says Englert. The benefits associated with deferral diminish rapidly after about $250 million in such sales, he adds.

Sound too good to be true? Lysenko says that most companies miss the incentive because they’re not aware of it, and that it has so far generated little controversy among tax authorities. “This has survived all of the changes in tax regime for the past several decades, and as far as we can tell, it doesn’t look like there are going to be any challenges from foreign trading bodies or the U.S. government,” he says. Adds Englert: “Congress has always endeavored to help exporters; it’s not like we just discovered a tax loophole or something.”

Multinationals – Obama’s After You

Multinationals:  You know Obama’s gunning for you.  Here’s his strategy.

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Watch Out for the Expense-deferral Rule

Corporate tax experts say the centerpiece of Obama’s foreign tax reform proposal is the expense-deferral rule — and it will affect every multinational company.

Marie Leone – CFO.com | US

May 5, 2009

The details are sketchy, but the intent is clear. President Obama is pushing Congress to rework tax rules affecting U.S. multinational corporations so that more revenue will flow back into the United States – about $210 billion over the next 10 years, according to the Treasury Department.

Obama’s plan, parts of which were released yesterday during the President’s press conference, outlines four rule reforms aimed at companies with overseas subsidiaries. The proposed rules would put restrictions on the practice of deferring tax payments related to overseas profits, close the foreign tax credit loophole, make permanent the research and experimentation tax credit, and eliminate the “check the box” rule that allows companies to shift income between subsidiaries on a tax-free basis. More details on the new rules are expected to be released later this week.

Raising the $210 billion looks feasible when the Treasury Department puts the numbers on the table. Treasury says that U.S. multinational corporations paid about $16 billion in U.S. taxes on approximately $700 billion of foreign active earnings in 2004, which is the most recent year for which data is available. That is an effective U.S. tax rate of about 2.3%. By comparison, the Government Accountability Office (GAO) estimates that the average effective U.S. tax rate on the domestic income of large corporations with positive income is 25%.

In addition, 83 of the 100 of the largest U.S. corporations have subsidiaries in tax havens, according to a 2009 GAO report. What’s more, nearly one-third of all foreign profits reported by U.S. corporations in 2003 came from the low-tax countries of Bermuda, the Netherlands, and Ireland. Taken together, the extra revenue generated by targeting foreign-source income and closing tax-haven loopholes could mean Obama will reach his goal.

“To some extent, all U.S.-based companies with international operations are negatively impacted. It’s just a matter of varying degrees,” says Marc Gerson, a tax attorney with Miller & Chevalier and a former majority tax counsel for the House Committee on Ways and Means.

From a corporate perspective, “CFOs will have to evaluate the proposals on an individual, company-by-company basis,” adds Gerson, because it is difficult to generalize about the potential effect of the proposals. Many factors will need to be taken into consideration, such as the extent of a company’s international operations, the structure of those operations, and the company’s debt profile.

For example, Gerson believes that highly leveraged companies will likely be stung more than other companies by the proposal that affects the timing of deductions allocated to foreign-source income. Currently, companies are allowed to defer paying U.S. taxes on profits from foreign subsidiaries until they repatriate the profits back to the United States. But the Obama rule change would force companies to give up the deferral and repatriate profits before claiming an interest-expense deduction. For highly leveraged companies, the interest deduction may be more valuable than the deferral, contends Gerson.

As a result, passage of the deferral proposal in its current form could force debt-laden companies to repatriate profits and pay taxes on that income sooner rather than later, says Gerson.

The deferral proposal is “the centerpiece of the plan,” says tax expert Robert Willens, and would have “the most far-reaching impact.” Every multinational corporation would be affected by that proposal, he says. Under the proposed rule, multinationals likely will be asked to make “arbitrary allocations of their otherwise deductible expenses – except for research expenses – between their domestic and foreign income,” says Willens.

He explains that the expenses allocated to foreign income would not be currently deductible, but rather held in some sort of limbo or ‘suspense’ account until profits are repatriated. “This is, in many ways, a ‘backdoor’ way of substantially repealing the deferral regime that multinationals have long enjoyed.”

The last president to take a serious crack at changing the expense-deferral rule was John F. Kennedy, says tax attorney James Reidy of McDermott Will & Emery. He notes that the allocation process is a complex and time-consuming exercise, and says that until more details on the Obama proposal are released, it is difficult to conclude what kind of effect the change would ultimately have on corporations. The administration will have to spell out, for example, what kind of expenses will be included in the deferral proposal, which can be anything from interest on loans and real estate taxes to the chairman’s salary and a plane flight to Europe.

Regarding what Obama calls the check-the-box loophole, Willens says he doesn’t believe that the proposal is as comprehensive as the deferral proposal, “although the revenue estimate is large.” The Treasury estimates that $86.5 billion will be raised between 2011 and 2019 if the rule is eliminated.

“That gambit seems to involve an attempt by U.S. companies to avoid U.S. tax on passive investment income earned abroad that would otherwise be taxed in the U.S.,” says Willens. “I think for those companies who used the technique, it will be a serious blow, but I don’t believe the number of companies affected will be anywhere near the number affected by the expense-deferral provision.”
For his part, Reidy says that the administration’s characterization of the check-the-box or passive income rule as a “loophole” is “grossly misleading,” especially since it relates to a regulatory regime set up during the Clinton Administration.

According to the Treasury Department, the passive income rule is legal. The problem, says the Obama Administration, is that it has resulted in the shift of “billions of dollars in investment from the U.S. to other countries.” Essentially, current law allows U.S. businesses to establish foreign subsidiaries in a tax haven, and then categorize income that is shifted between the haven subsidiary and other foreign subsidiaries – for instance through interest on loans – as passive income for the U.S. parent, which subject to U.S. tax.

However, the decade-old check-the-box rule allows U.S. companies to disregard the subsidiaries for tax purposes, so income can be shifted among them without reporting any passive income or paying the attendant U.S. taxes. The Treasury Department provides a hypothetical example to make its point: A U.S. company invests $10 million to build a new factory in Germany. At the same time it sets up three new corporations: one a wholly owned Cayman Islands holding company, the second a German company owned by the holding company that also owns the factory, and the third a Cayman Islands subsidiary, also owned by the holding company.

The Cayman subsidiary makes a loan to the German subsidiary. The interest on the loan is income to the Cayman subsidiary and a deductible expense for the German subsidiary, so income is shifted from the higher-tax region of Germany to the no-tax haven of the Cayman Islands. Under existing U.S. tax law, the income shift would count as passive and taxable income for the U.S. parent. But the passive income rule allows the company to make the two subsidiaries and the passive income “disappear” via a check-the-box option. As a result, the company is able to avoid U.S. and German taxes on its profits, says the Treasury Department.

Obama’s proposals are not slated to take effect until 2011, but will spark “spirited debate” among lawmakers in the meantime, says Willens.