The Drawing Board: the Structural and Accounting Consequences of a Switch to a Territorial Tax System

National Tax Journal, September 2013, 66 (3), 713–744

BACK TO THE DRAWING BOARD: THE STRUCTURAL AND ACCOUNTING CONSEQUENCES OF A SWITCH TO A TERRITORIAL TAX SYSTEM

Michael P. Donohoe, Gary A. McGill, and Edmund Outslay

We review the basics of international tax planning by U.S. multinational corporations (MNCs) and the organizational structures that facilitate such planning. We then discuss the potential impacts that adopting a participation exemption regime (i.e., a territorial tax system) along the lines proposed by Representative Camp could have on a U.S. MNC’s worldwide supply chain structure and ﬁ nancing arrangements. We compare the change in a corporation’s global accounting effective tax rate under the current U.S. worldwide tax system and four participation exemption options proposed by Representative Camp. Using a hypothetical set of facts representative of a U.S. multinational with highly mobile intellectual property income, we show that the options produce very different accounting effective tax rates and tax revenues received by the U.S. Treasury. We also point out potential tax planning strategies that could be employed pre- and post-effective date of the implementation of a participation exemption system that would change the expected revenue to be received during the transition to such a system.

Keywords: international taxation, tax reform, territorial tax system JEL Codes: H25, H26, M41, M48

I. INTRODUCTION he call for international corporate tax reform has gained traction in the past two Tyears, with the chairs of both tax writing committees pledging to craft comprehensive tax reform to make U.S. businesses more competitive abroad and encourage the creation of jobs in the United States. The urgency to reform the U.S. international tax system has accelerated because of the increased globalization of U.S. businesses and

Michael P. Donohoe: Department of Accountancy, University of Illinois at Urbana-Champaign, Champaign, IL, USA ([email protected]) Gary A. McGill: Fisher School of Accounting, University of Florida, Gainesville, FL, USA (mcgill@uf .edu) Edmund Outslay: Department of Accounting and Information Systems, Michigan State University, East Lansing, MI, USA ([email protected]) 714 National Tax Journal the decline in corporate tax rates abroad. When Japan recently lowered its corporate tax rate below the U.S. rate, the United States was left with the highest statutory corporate tax rate among Organisation for Economic Co-operation and Development (OECD) nations (OECD, 2013b). U.S. House Ways and Means Committee Chairman Dave Camp (R-MI) endorses a plan that would lower the corporate tax rate to 25 percent and move the United States from a worldwide system of taxation to a territorial-type tax system under which qualifying dividends repatriated to the United States would receive a 95 percent dividends received deduction (a 95 percent participation exemption system).1 His stated motivation for moving to such a system is to make U.S. companies more competitive with foreign multinationals and remove the current tax disincentive discouraging repatriation of foreign proﬁ ts back to the United States, the net result of which will be the creation of more U.S. jobs (U.S. House Ways and Means Committee, 2011a). Representative Camp’s counterpart on the Senate Finance Committee, Sen. Max Baucus (D-MT), also supports comprehensive tax reform, but has not taken any posi- tion on international taxation other than endorsing lowering the corporate tax rate and crafting a tax system that will make U.S. companies more competitive globally (Baucus and Camp, 2013). Sen. Orrin Hatch (R-UT), Ranking Member of the Sen- ate Finance Committee, is on record as endorsing a lower corporate tax rate and a transition to a territorial tax system. Sen. Michael Enzi (R-WY) introduced legislation in 2012 that would move the U.S. international tax system to a 95 percent exemption system similar to the Camp proposal, but would not reduce the corporate tax rate. Corporate America has endorsed comprehensive tax reform individually and collec- tively. The U.S. Chamber of Commerce endorses a reduction in the corporate tax rate (no rate is speciﬁ ed) and a transition to a territorial system for the taxation of foreign source income (uschamber.com). The Alliance for Competitive Taxation (ACT), a coalition of 42 U.S. multinational corporations, supports comprehensive revenue-neutral corporate tax reform that includes lowering the corporate tax rate to 25 percent and the adop- tion of an international tax system that will put U.S. corporations on an equal footing with their global competitors (actontaxreform.com). The RATE coalition (Reforming America’s Taxes Equitably), a group of 31 companies, supports a revenue neutral reduction in the corporate tax rate but is not on record as supporting a territorial tax system (RATEcoalition.com). The LIFT America Coalition (Let’s Invest for Tomorrow), an

1 In a pure worldwide system of taxation, resident individuals and entities are taxed on their worldwide income, regardless of where earned. The country of residence mitigates the double taxation of such income through a foreign tax credit mechanism. In a pure territorial tax system, a country only taxes income earned within its boundaries, regardless of residence. A participation exemption system is a form of territorial tax system whereby dividends received from qualifying foreign corporations are wholly or partially (e.g., 95 percent) exempt from residence-country taxation. The Joint Committee on Taxation (JCT) (2006) provides a more detailed comparison of pure and mixed systems of taxation of international income. Consequences of a Switch to a Territorial Tax System 715 alliance of U.S.-headquartered companies and trade associations endorses a revenue- neutral territorial tax system with tax base erosion protection (liftamericacoalition.org). Although LIFT endorses a reduction in the corporate tax rate, it does not recommend a specifi c rate. Most recently, the Tax Innovation Equality (TIE) Coalition (tiecoalition. com), a group of technology-focused companies, promoted a reduction in the corporate tax rate, the implementation of a territorial tax system, and non-discriminatory tax treatment of the income from intangibles. Several U.S. multinational corporations are members of multiple coalitions. Individual corporations have endorsed various proposals, ranging from supporting a territorial tax system (Naatjes, 2011; Ugai, 2013) to a reduction in the corporate tax rate while retaining existing manufacturing and research incentives (Dossin, 2012). Diamond and Zodrow (2013) endorse a transition to a territorial tax system coupled with base erosion provisions primarily because it would simplify the taxation of foreign source income, eliminate tax disincentives to the repatriation of foreign earnings, and provide for more uniform treatment of U.S. multinational corporations without a signifi cant loss in corporate tax revenue. In this paper, we discuss the potential impacts of adopting a territorial tax system along the lines proposed by Representative Camp in his discussion draft issued October 26, 2011. In particular, we focus on how a U.S. multinational corporation might alter its worldwide organizational structure and fi nancing structures in reaction to a transition to a territorial tax system. We compare the global accounting effective tax rates of a hypothetical U.S. multinational company under the current U.S. worldwide tax system and four participation exemption regimes along the lines proposed by Representative Camp. We then analyze potential tax planning responses by a U.S. multinational corporation to Representative Camp’s three base erosion options. This analysis identifi es potential issues that should be addressed in the forthcoming debate on international tax reform. In a nutshell, the discussion draft put forward by Representative Camp would reduce the maximum U.S. corporate tax rate to 25 percent and transition to a participation exemption system that would exempt 95 percent of certain foreign income from U.S. taxation. The exemption would apply to dividends paid by a foreign company to U.S. corporate shareholders owning at least 10 percent of the company’s shares and to capital gains from sales of shares in foreign companies by 10 percent U.S. corporate shareholders. The combination of the exemption and the lower corporate tax rate would reduce the effective tax rate on dividends paid to the United States to 1.25 percent (0.05x0.25). Anti-abuse rules likely would be enacted to prevent erosion of the U.S. tax base with the goal of making the proposal revenue neutral. Pre-effective date tax-deferred foreign earnings of foreign companies owned by 10 percent U.S. shareholders would be taxed once upon implementation of the reform at a 5.25 percent tax rate (similar to the 2005 repatriation holiday), which U.S. companies could pay ratably over eight years. Subse- quent repatriation of these earnings would be taxed under the 95-percent participation exemption system. 716 National Tax Journal

II. BASICS OF INTERNATIONAL TAX PLANNING The goals that underlie international tax planning for most U.S. multinational corporations (MNCs) can be summarized as follows: (1) minimize (“optimize”) the company’s worldwide effective tax rate; (2) reduce overall funding costs (i.e., facilitate the free fl ow of cash from investments that are cash generating to investments that are cash absorbing); (3) manage tax risks (e.g., those associated with transfer pricing); and (4) minimize compliance burdens. Strategies and structures that follow from these goals must align (“rationalize”) with the company’s business strategies, planning, and operations. At the same time, tax planning needs to be fl exible enough to accommodate the company’s projections of future results within and outside the United States and be consistent with the company’s risk tolerance. Risk tolerance often is a function of whether the corporation’s tax department operates as a profi t center (i.e., to enhance shareholder value) or a cost center (i.e., to comply with the tax laws within budget) (Robinson, Sikes, and Weaver, 2010). Most U.S. multinational corporations incorporate both objectives into their mission statement. We discuss the fi rst two goals (“pillars”) of international tax planning (optimiz- ing the worldwide tax rate and facilitating the free fl ow of cash) in more detail below and offer some conjectures regarding how a switch to a participation exemption tax system could affect how a U.S. multinational corporation achieves these goals.

A. Minimize (“Optimize”) the Company’s Worldwide Ef ective Tax Rate (ETR) Corporations manage two effective tax rate metrics: the accounting effective tax rate and the cash tax rate (Donohoe, McGill, and Outslay (2012) provide a more in-depth discussion of these metrics). A goal of international tax planning is to create an organizational structure that produces a global effective tax rate (ETR) that is sustainable over the long run rather than relying on “one-time” short-term strategies that cannot be maintained. This sustainable ETR often is referred to as the company’s “optimal” ETR.2 U.S. corporations routinely benchmark their global ETR against those of competitors in the same industry (Drucker, 2010a). Both accounting and tax considerations go into the achievement and maintenance of an optimal global effective tax rate.

1. Accounting Considerations in Achieving and Maintaining an Optimal Global Ef ective Tax Rate Under the Financial Accounting Standards Board Accounting Standards Codiﬁ cation (ASC) 740, Accounting for Income Taxes, a corporation’s assertion that its low-taxed foreign earnings are indeﬁ nitely (permanently) reinvested in the operations of its for-

2 The optimal ETR excludes discrete (non-recurring) tax rate adjustments such as audit settlements, valuation allowances, and prior period adjustments such as changes in tax rates. Consequences of a Switch to a Territorial Tax System 717 eign subsidiaries allows the corporation to reduce its accounting effective tax rate by the rate differential between the U.S. statutory rate and the rate at which the earnings are taxed by the foreign jurisdiction. (Donohoe, McGill, and Outslay (2012) provide an in-depth discussion of the accounting rules that apply to unrepatriated foreign earnings.)3 In addition, a corporation’s accounting effective tax rate benefi ts from the future tax benefi ts associated with recognized excess foreign tax credits and foreign losses provided the company does not have to offset the benefi ts with a valuation allowance (i.e., management can assert that it is more likely than not that the company will “real- ize” the benefi t in the foreseeable future).

2. Tax Considerations in Achieving and Maintaining an Optimal Global Ef ective Tax Rate Tax strategies that contribute to an optimal global effective tax rate focus on: (1) maximizing the deferral of U.S. tax on (low-taxed) non-U.S. earnings; (2) maximizing the use of foreign tax credits on the U.S. tax return; and (3) eliminating or mitigating the “double taxation” of non-U.S. earnings available under income tax treaties. Achieving such strategies requires the identifi cation of “profi t drivers” and risks and the “migration” of functions (e.g., manufacturing, marketing, distribution, and research and development), risks, and intellectual property to lower-tax jurisdictions (often referred to as “tax-aligning the company’s supply chain”). A key component of global ETR strategies is an organizational structure that ensures deferral of low-taxed foreign source income from U.S. taxation and the avoidance of the U.S. anti-deferral rules (subpart F) on intercompany transactions between the non-U.S. entities in the group. A tax-effective organizational chart includes tax-favored holding companies and the use of “check-the-box” (hybrid) entities. The key objective of these ETR strategies involves the shifting of income from high-tax (e.g., the United States) to low-tax jurisdictions using foreign intangibles migration, contract manufacturing, intercompany sales, and deductible cross-border payments (e.g., interest, royalties, and management fees). To capture this “profi t alignment” with a company’s functional alignment, these cross-border transactions must satisfy the transfer pricing rules imposed by the United States and the foreign taxing jurisdictions.

3. Tax-Aligned Supply Chain Structures The basic goal of a tax-aligned supply chain structure (TASC) is to separate a company’s global profi ts into components by business process. In particular, the overall profi t of an enterprise consists of: (1) the normal profi t associated with each of the functions and risks associated with the creation and sale of the product; and (2) the residual profi t refl ecting entrepreneurial remuneration. A basic principle is that profi t follows risk. As Grubert

3 For example, Microsoft Corporation reduced its 2012 accounting effective tax rate by 21.1 percentage points by shifting income to low tax jurisdictions (primarily Puerto Rico, Ireland, and Singapore) and asserting the earnings were permanently reinvested outside the United States. 718 National Tax Journal

(2012) discovered, profi t margins (as opposed to sales) explain a U.S. corporation’s ability to shift income to low-tax jurisdictions. The higher a company’s profi t margin, the more residual profi t there is to shift to a low-tax jurisdiction. This phenomenon explains why U.S. high-tech and pharmaceutical companies with high profi t margins are able to drive their global effective tax rates much lower than a U.S.-centric manufacturer or retailer with low profi t margins. Strategies designed to shift entrepreneurial profi ts to low-tax jurisdictions have been referred to as “profi t portability potential” and “mobile income reengineering.”4 Figure 1 provides an organizational chart of a typical TASC for a manufacturer with an allocation of profi ts between each function. This organizational chart refl ects the basic characteristics of a TASC and is a composite of examples (case studies) provided in the Joint Committee on Taxation (JCT) report on income shifting and transfer pricing

Figure 1 TASC Model

US Parent

$150 cost-sharing payment $100 dividend + $9 DPC (expense to Principal)

Principal $12 commission payment* $1,000 FG $840 FG sale sale $600 FG sale

Contract $1,020 $300 RM sale LRDs Manufacturers FG sale Commissionaires

$500 conversion cost Worldwide Suppliers customers

Sale of goods RM = raw materials Service and royalty flow FG = finished goods *For direct sales by the principal DPC = deemed paid credit Physical flow

4 Kleinbard (2013) illustrates how Starbucks, a retailer, uses a complex set of Dutch, Swiss, and UK hybrid entities to generate “stateless income” (royalties) that is taxed at a very low tax rate. Consequences of a Switch to a Territorial Tax System 719 by U.S. multinational corporations (JCT, 2010).5 In the report, the JCT summarizes the characteristics of a TASC as concentrating a signifi cant portion of profi table functions in low tax rate jurisdictions and a signifi cant portion of less profi table functions in high tax rate jurisdictions. This profi t shifting is achieved by centralizing intellectual property rights and locating the risk-taking entity (principal or entrepreneur) in a low tax rate jurisdiction, while organizing less profi table operations such as contract manufacturing or limited-risk distributorship in higher tax jurisdictions (JCT, 2010). Central to a TASC is a Principal (“Hub”) Company (PC) located in a low-tax jurisdiction (e.g., the Netherlands, Ireland, Switzerland, Luxembourg, Singapore, or Bermuda). The PC exercises direction, supervision, and control over the supply chain and bears all signifi cant risks of the activities within the supply chain. Such risks could include contractor evaluation, selection, and supervision, entering into contract manufacturing arrangements, product quality control, product development and sourcing, project management, buying and negotiations, and logistics and delivery (JCT, 2010). The PC can either own the intellectual property (IP) or license it from an IP Holding Company within the TASC. It is important that the PC have substance, such as some level of senior management and decision-making functions. As a result, the PC earns the residual (entrepreneurial) profi t associated with the group’s profi t-making activities. Key tax factors that infl uence where the PC is located include a low effective tax rate, a favorable tax regime for foreign source income, a favorable tax treaty network, low withholding taxes on outbound payments, and a generous advance ruling regime (tax rate or tax base negotiation). Key non-tax factors include political and economic stabil- ity, a favorable environment for expatriate personnel, infrastructure, and a dependable regulatory and legal environment. The manufacturing component of the TASC can be an in-house full-fl edged manufacturer, assuming signifi cant manufacturing functions risks, or more likely, either a contract manufacturer (CM) or a toll (consignment) manufacturer (TM). Under a contract manufacturing arrangement, the CM manufactures goods for the PC under a guaranteed sale arrangement (e.g., cost plus a markup). The markup can range from 5 percent on sales to related parties (e.g., the U.S. parent) to 30 percent on sales to unrelated parties (JCT, 2010). A TM converts raw materials supplied by the PC into fi nished goods. The TM does not take title to either the raw materials or the fi nished

5 The Figure 1 organizational chart also refl ects the fi ndings of Lewellen and Robinson (2013) and numer- ous presentations by international tax accountants and lawyers (e.g., Oosterhuis and Spinowitz, 2013). The OECD (2013a) report on base erosion and Graetz and Doud (2013) provide additional discussions on TASC. The U.S. Senate Permanent Subcommittee on Investigations hearings involving Microsoft, Hewlett- Packard, and Apple (2012, 2013) also provide discussions of how these companies shifted income to low-tax jurisdictions through a TASC. Finally, the Figure 1 organizational chart is similar to the “principal model of business structure” presented to the House Ways and Means Committee by the JCT at its July 22, 2010 hearings on transfer pricing, http://waysandmeans.house.gov/media/pdf/111/2010jul22_jct_powerpoint. pdf. 720 National Tax Journal goods, bears insignifi cant risks, and performs minimal functions. If the CM or TM is located in a high-tax country (e.g., Germany), this arrangement minimizes the profi t subject to a relatively high rate of tax. The sales (distribution) component of the TASC could be a full-fl edged in-house distributor that takes on signifi cant sales and marketing functions, risks, and the marketing of intangibles. More likely, the distributor will be a “limited risk distributor” (LRD) or a Commissionaire. A LRD performs much the same functions as a full-fl edged distributor but assumes signifi cantly lower risks. A Commissionaire performs sales and marketing services for the PC. The Commissionaire enters into sales contracts on behalf of the PC, but it does not assume title to the goods and does not bear any signifi cant risks. As a result, little of the overall profi t from the profi t-making activity is assigned to the LRD or Commissionaire. A typical breakdown of profi t allocation to each function would be 65–80 percent to the entrepreneur (intangibles), 5–10 percent each to manufacturing and management, and 10–15 percent to sales and marketing.6 It should be noted that while the PC is treated as a corporation for U.S. tax purposes (to ensure deferral of income earned by the foreign operations), all of the entities below the PC are usually “check-the-box” (disregarded) entities, making them fi scally transparent to the United States.7 Such an arrangement allows intercompany payments to avoid being treated as subpart F income to the PC. A fi nal component of a TASC is the concentration of services and management activities in a shared services center (SCC). Administrative and support operations typically transferred to shared service centers include a range of fi nance and personnel functions such as payroll, accounts receivable, accounts payable, tax compliance and other accounting related services (Sample, 2012). The strategic component of a TASC is the development and sourcing of IP. The research and development (R&D) that creates the IP may be conducted substantially by U.S. employees located within the United States, but the funding is provided by the entity’s U.S. and foreign operations (JCT, 2010; Cook, 2013). The development of new IP often involves a cost sharing arrangement (CSA), under which the U.S. parent jointly develops the intangible and shares the costs of the project with a foreign subsidiary (located in a low-tax jurisdiction). If the U.S. parent makes pre-existing intangible property available to its foreign subsidiary for exploitation under a qualifi ed CSA, the subsidiary must make buy-in payments to the parent. Buy-in payments are the arm’s length charge for use of the intangible multiplied by the subsidiary’s share of reason-

6 These allocation percentages are based on conversations with and presentations made by practitioners, and also refl ect the fi ndings of the JCT (2010). 7 U.S. Department of the Treasury Regulation Section 301.7701-2, effective January 1, 1997, allows taxpayers an election to classify an eligible foreign entity as either a corporation, partnership, or disregarded as an entity separate from its owner (“DRE”). The election, which is made by “checking-the-box” on Form 8832, applies only for U.S. tax purposes. Thus, an eligible (“hybrid”) entity will be viewed as transparent by the U.S. tax authority and as a corporation by the host country. The JCT (2010) provides a more detailed discussion of this topic. Consequences of a Switch to a Territorial Tax System 721 ably anticipated benefi ts.8 The buy-in payment provides a return to the developer for having invested its funds and engaged in other risky activities. Buy-in payments usually decline over time as the value of the intangible decreases (e.g., the IP is superseded by advances in technology). Under U.S. tax law (Internal Revenue Code (IRC) section 367(d) and U.S. Department of the Treasury (Treasury) Regulation Section 1.482-7), royalty payments to the U.S. parent under a licensing (CSA) agreement may be required to be adjusted annually to refl ect the change in the composition of U.S. and international sales related to the products covered under the CSA (JCT, 2010; Cook, 2013).9 The migration of existing intangibles can be a complex and costly undertaking, the details of which are beyond the scope of this paper.10 Needless to say, CSA and buy-in arrangements are the target of much IRS scrutiny and litigation.11 The extent to which profi ts can be migrated to low-tax jurisdictions is illustrated in the much publicized description of Google’s “Double Irish Dutch sandwich” structure through which signifi cant profi ts were shifted to zero-tax jurisdictions (Drucker 2010b).12 Under this arrangement, the details of which are provided in Kleinbard (2011), Sokatch (2011), and Loomis (2012), a U.S. corporation transfers intellectual property to an Irish subsidiary (Irish 1) under a buy-in arrangement. Irish 1 is treated as a resident of Bermuda under Irish law, but as an Irish corporation under U.S. law.13 Irish 1 licenses the technology to a Dutch company (BV), which in turn sublicenses the technology to a second Irish subsidiary (Irish 2). Both BV and Irish 2 are treated as check-the-box hybrid entities in the United States. Irish 2 collects fees from international customers and subsequently pays royalties to BV, which in turn pays royalties to Irish 1. Ireland collects a 12.5 percent tax on the residual profi t left in Irish 2, but does not collect any tax from Irish 1 because it is a non-resident of Ireland. The Netherlands collects a small tax (negotiated in advance) on the residual profi t it earns from Irish 2. Neither Ireland

8 In 2011, the Irish subsidiaries of Apple Inc. paid 60 percent ($1.4 billion) of the R&D costs incurred under the company’s cost sharing arrangement (U.S. Senate Permanent Subcommittee on Investigations, 2012). These subsidiaries earned $22 billion from the intellectual property exploited outside the United States and paid $10 million in global taxes. Ireland imposes a statutory tax rate of 12.5 percent on “trading income” (income from an active trade or business, including royalties). 9 The JCT (2010, p. 65 and p. 79) reported in the “Bravo Company” case study that average annual CSA payments back to the U.S. parent exceeded $9 billion and in the “Delta Company” case study exceeded $6 billion. The royalty income earned by the U.S. group was largely offset by the R&D expenses incurred to produce the IP, resulting in minimal net profi t reported on the U.S. tax return from the CSA agreement. 10 See Sample (2012) for a description of how Microsoft co-develops its IP with its regional operating centers in Singapore, Ireland, and Puerto Rico. 11 See Veritas Software Corp., et al. v. Commissioner, 133 T.C. No. 14 (December 10, 2009) and Xilinx, Inc. v. Commissioner 125 T.C. 37 (2005), aff’d No. 06-74246 (9th Cir. March 22, 2010). As a result of the appellate court decision, Cisco Systems reduced its income tax provision (unrecognized tax benefi t) by $158 million in 2010. 12 Drucker (2010b) estimated that Google incurred an effective tax rate of 2.4 percent on its foreign earnings and reduced its worldwide tax liability by $3.1 billion over 2007–2009 using this strategy. 13 Ireland uses a “mind and management” approach to determining residence rather than the U.S. country of incorporation approach. 722 National Tax Journal nor the Netherlands impose withholding tax on the payment of royalties from Irish 2 to BV and from BV to Irish 1 under EU Council Directive 2003/49/EC.14 The Double Irish Dutch sandwich can be quite powerful in reducing a corporation’s global effective tax rate. As mentioned previously, Google reduced its fi nancial accounting tax provision in 2012 by $2.2 billion using this structure. This reduced the company’s accounting effective tax rate by more than 16 percentage points. VMware, Inc. reduced its accounting effective tax rate by 22.4 percentage points in 2012 and 25.1 percentage points in 2011 through the use of this structure. VMware is one of the few companies to disclose the existence of each of the components of its Double Irish Dutch sandwich in Exhibit 21 to its Form 10-K.

4. The Potential Impact of a Camp-Style Territorial Tax System on the Organizational Structure of U.S. Multinational Corporations A transition to a Camp-style participation exemption system is unlikely to dramati- cally impact a U.S. multinational corporation’s TASC. An effi cient TASC is aligned with the business model of the company and is rationalized on factors other than tax motivation. Under each of the base erosion options (discussed later), corporations using a Double Irish Dutch sandwich to transfer signifi cant amounts of IP profi ts to a low (no) tax jurisdiction (e.g., Bermuda, Cayman Islands) likely will abandon the no-tax leg of the income transfer and locate profi ts in jurisdictions that impose a tax rate that meets the minimum effective tax rate threshold on such income to avoid the new categories of subpart F income (either 15 percent or 10 percent). This could cause some increases in a high tech company’s global foreign effective tax rate. For example, if Google paid an average effective tax rate of 10 percent on its foreign earnings, its foreign provision on its $8,075 million of foreign profi t before tax in 2012 would have increased by almost $400 million, increasing its accounting effective tax rate from 19.4 percent to 22 percent. The governments of Ireland and the Netherlands undoubtedly would welcome the additional tax revenue.

B. Reduce Overall Funding Costs A TASC focuses on a multinational corporation’s worldwide income generated by profi t drivers (IP, risks, and functions) that are strategically located in tax-favorable jurisdictions. A key component of a TASC is to ensure that the transaction fl ows support U.S. tax deferral and other tax planning objectives. Tax planning for a U.S. multinational corporation also takes into consideration the entity’s fi nancial supply chain. Typically, a fi nancial supply chain (FSC) has three objectives: (1) enhancing the deployment of excess cash within the organization on

14 Available at http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2003:157:0049:0054:en:PDF. Consequences of a Switch to a Territorial Tax System 723 a tax-effi cient basis; (2) rationalizing intercompany payments; and (3) effectively managing the ability to remit earnings on an after-tax basis by maximizing the use of foreign tax credits (Deloitte, 2008). One common way to facilitate such objectives is through a treasury center, which monitors and facilitates the deployment of cash within a group of companies. Treasury centers ideally are situated in low-tax jurisdictions that have a well-developed treaty network that allow distributions to avoid withholding tax on cross-border transfers. Attractive locations are jurisdictions that have treaties with the United States that do not include a “limitation on benefi ts” (anti-treaty shopping) provision. Currently, only the treaties with Hungary and Poland lack such a provision, but new protocols awaiting ratifi cation will add a limitation on benefi ts provision that will diminish their attractiveness as treasury centers. The basic components of a tax effi cient FSC are summarized below.15

1. Tax-Aligned Financial Supply Chain Structures One component of a tax-effi cient FSC is the alignment of tax attributes where they produce the optimal tax benefi t. In its simplest form, deductible cross-border payments such as interest, royalties, rents, and management fees should be located in higher-tax jurisdictions. This can be accomplished through tax-advantaged leasing, debt-fi nancing of intercompany sales, and intercompany debt. Not surprisingly, most OECD countries have enacted “thin capitalization” rules that limit that amount of interest that can be deducted on cross-border borrowings (e.g., section 163(j) limits interest paid or accrued by a U.S. corporation on indebtedness to related persons where the debt-equity ratio exceeds 150 percent). Two key objectives in accomplishing the “rate shift” from a high-tax to a low-tax jurisdiction are minimizing withholding taxes on cross-border payments and avoiding the U.S. anti-deferral (subpart F) rules. Ordinarily, payments of interest, rents, dividends, and royalties into a low-tax jurisdiction are characterized as foreign personal holding company income and treated as a deemed dividend on the U.S. parent company’s U.S. tax return. However, the advent of the check-the-box regulations in 1997 and the CFC “look-through” rules (section 956(c)(6)) in 2004 allow such payments to be disregarded for U.S. tax purposes while being respected for foreign tax purposes. Tax planning through fi nancing structures has been under stress recently because of the decrease in worldwide interest rates, the temporary nature of the CFC look-through rules, the static nature of interest deductions (i.e., the effect diminishes as income increases), and the tightening of thin capitalization rules worldwide (e.g., Canada recently reduced its safe harbor ratio from 2:1 to 1.5:1).

15 Due to space limitations, only the basic goals of a tax-efﬁ cient FSC are discussed in this paper. A detailed discussion of repatriation strategies involving the corporate reorganizations provisions (IRC sections 367 and 368) is beyond the scope and objectives of this paper. 724 National Tax Journal

2. Mitigating (Eliminating) the Residual U.S. Tax on Repatriations Under the current U.S. worldwide system of taxation, foreign income that is deferred from U.S. taxation when earned through a foreign subsidiary is subject to residual U.S. taxation when repatriated to the United States. In the case of dividends, the United States taxes the income on a residual basis, giving the U.S. taxpayer a foreign tax credit for taxes paid on the income when earned and any withholding tax imposed by the host country. For example, assume USCo operates in Lo-Tax (with statutory corporate rate of 20 percent) through a wholly-owned subsidiary. The subsidiary reports taxable income of $100 and pays a tax of $20. The subsidiary repatriates the remaining $80 as a dividend, and Lo-Tax withholds an additional $4 (5 percent) of tax on the distribution. USCo computes its residual U.S. tax as follows:

Dividend received (gross) $ 80.00 §78 gross-up for foreign taxes paid + 20.00 Gross income $100.00 × U.S. tax rate × .35 U.S. tax on dividend received $ 35.00 – FTC ($20 + $4) (24.00) Residual U.S. tax paid $ 11.00

Effective tax rate on $100 of foreign income 35%

The imposition of this residual tax is at the heart of the arguments made by U.S. multinational corporations that their foreign earnings become “trapped cash” because of the “punitive” imposition of the residual U.S. tax on repatriations, a tax their competitors located in territorial systems do not face.16 In a report issued in May 2012, J.P. Morgan (2012) listed 66 U.S. corporations that had $5 billion or more of unrepatriated foreign earnings and estimated the total amount of unrepatriated earnings at $1.7 trillion. Mitigation (elimination) of the residual U.S. tax on repatriations can be accomplished through cross-crediting of high and low-taxed income. As a result of the look-through rules and the active trade or business exception, high-tax dividends or branch income can be blended with low-tax royalty income because both types of income are put in the same foreign tax credit category (“basket”). Kleinbard (2011) likens this blending to a tax distillery, where the company’s tax director functions as a master distiller, dip- ping into the ﬁ rm’s casks of high-tax and low-tax foreign income. Efﬁ cient repatriation

16 As an example, Apple Inc. CEO Peter Oppenheimer, when asked if the company intended to use any of its international cash to pay its newly announced $10 billion per year dividend program, stated that a repatriation of such cash would result in “signifi cant tax consequences under current U.S. law” and expressed his view that the current U.S. tax laws provide a “considerable economic disincentive” to U.S. companies that might otherwise repatriate their foreign cash to the United States (Apple Inc. conference call on March 19, 2012, http://seekingalpha.com/article/442491-apple-s-ceo-announces-plans-to-initiate-dividend-and- share-repurchase-program-transcript). Consequences of a Switch to a Territorial Tax System 725 structures separate the high and low-tax entities such that distributions from the entities do not get blended at the foreign entity level, but rather at the U.S. parent-level. Under a territorial-type system, royalties would be fully taxed and could not be cross-credited with dividends or operating income. When a dividend does not produce a favorable tax (or fi nancial accounting) result, U.S. multinational corporations have devised other strategies to bring cash back to the United States without creating income on the U.S. tax return and avoiding a foreign withholding tax. One such strategy is the payment of alternating short-term loans to the parent company. The loans must be structured to avoid the deemed dividend rules of IRC section 956 (investments in U.S. property).17 For fi scal years 2011 and 2012, Hewlett-Packard had an average of $1.6 billion of alternating short-term (45-day) loans from their foreign affi liates, which enabled the company to avoid U.S. residual tax or foreign withholding tax on the cash transfers. U.S. multinational corporations have used corporate restructurings to repatriate cash to the United States without incurring a residual income tax or withholding tax. Such strategies, the complexities of which are beyond the scope of this paper, have acquired such names as the “killer B” transaction (now shut down by IRS Notice 2006-85 and Treas. Reg. Sec. 1.367(b)-4(b)), the “deadly D,” “Shanghai Lady” (section 304 intergroup stock sales), and the “outbound F” (Toce, 2011). Restructuring transactions that attempt to shift stock basis to a newly created foreign subsidiary without shifting earnings and profi ts allow repatriations from the newly created entity to be treated as tax-free returns of capital (“harvesting the stock basis” tax-free) to the U.S. parent that also avoid foreign withholding tax. Needless to say, the current U.S. worldwide tax system engenders complex, creative, and costly uses of the tax code to avoid repatriation taxes (U.S. and foreign) on cash payments back to the United States.

3. The Potential Impact of a Camp-style Territorial Tax System on the Repatriation Strategies of U.S. Multinational Corporations The transition to a territorial tax system likely would have its most dramatic effect on the repatriation strategies of U.S. multinational corporations. Under the Camp proposal, all unrepatriated earnings, pre-effective date and post-effective date, will be subject to the 95 percent exemption system when repatriated back to the United States. As a result, all “unborn” foreign tax credits (primarily withholding taxes) associated with pre-effective date earnings will not be creditable on repatriation. U.S. multinational corporations will have a signiﬁ cant tax incentive to engage in transactions that will “export” these unborn foreign tax credits to the U.S. tax return prior to the effective date without repatriating the earnings on which the foreign taxes were paid or create high-taxed earnings and proﬁ ts that, when repatriated, will not result in a residual U.S. tax.

17 The mechanics of this “alternating loans” strategy are detailed in Ezrati (2012). 726 National Tax Journal

How much of the estimated $1.7 trillion of unrepatriated earnings currently on the books of U.S. multinational corporations would be repatriated remains an open ques- tion (Marples and Gravelle, 2012). Under the tax repatriation holiday in 2005, which provided an 85 percent dividends received deduction on certain dividends repatriated to the United States, U.S. multinational corporations repatriated $312 billion in “excess” dividends, or approximately 40 percent of the total that could have been repatriated (Redmiles, 2008). Not surprisingly, most of the qualifying dividends were repatriated from low-tax jurisdictions (the Netherlands, Switzerland, Bermuda, Ireland, Luxem- bourg, and the Cayman Islands). Regardless of whether actual cash would be repatriated as a result of a switch to a participation exemption system, under the Camp transition provision that would cause a deemed repatriation of all tax-deferred foreign earnings subject to an effective 5.25 percent tax, the Treasury would collect approximately $90 billion over eight years. The assumption that all repatriations to the United States will take the form of dividends may be misplaced, however. The fact that all foreign taxes imposed on dividend repatriations will no longer be creditable under the Camp proposal will make withholding taxes a deadweight cost. As a result, there will be increased lobbying efforts to negotiate a zero percent withholding tax rate on dividends from foreign subsidiaries in U.S. treaties and incentives to structure cash transfers to avoid their designation as dividends (in which case the foreign withholding tax and the U.S. 1.25 percent tax [0.05 × 0.25] are avoided). On the other hand, there may be an incentive to recharacterize royalty payments to the United States as dividends to avoid full taxation on such payments, depending on which Camp anti-base erosion option, if any, would be enacted.

III. IMPACT OF THE CAMP TERRITORIAL TAX PROPOSALS ON THE TAXATION OF A U.S. MNC’S FOREIGN SOURCE INCOME In this section we model alternative tax outcomes related to Representative Camp’s participation exemption tax proposals outlined in his Discussion Draft of October 26, 2011. Under the Camp proposals, the top U.S. corporate tax rate would be reduced to 25 percent and a 95 percent dividends received deduction would be applied to dividends received from foreign subsidiaries (controlled foreign corporations) and joint ventures (“10/50 companies”). No foreign tax credits would be allowed for withholding taxes and deemed paid taxes associated with dividend distributions. In addition, Representative Camp offered three “base erosion” options that focus on intangibles (U.S. House Ways and Means Committee, 2011b). The three base erosion options can be summarized as follows:

Option A: Intangible income attributable to the use or exploitation of intangibles (either through sale, lease, or license) transferred from a U.S. corporation to a related CFC that has not been subject to a speciﬁ ed minimum foreign effective tax rate (more than 10 percent) is included in U.S. income to the extent that such income exceeds 150 percent of costs attributable to such income. To Consequences of a Switch to a Territorial Tax System 727

completely escape subpart F designation, the foreign effective tax rate imposed on the income must exceed 15 percent. This new category of subpart F income is referred to as “foreign base company excess intangible income.” There is a “home country” exception for excess intangible income earned from exploitation of the intangible in the home country of the CFC.

Option B: Foreign source income earned by a CFC that is neither derived from the conduct of an active trade or business in the home country of the CFC (“the home-country exception”) nor subject to an effective rate of foreign tax in excess of 10 percent is included in subpart F income as “low-taxed cross-border income.” The effective tax rate is computed on a country-by-country basis.

Option C: A new category of subpart F income would be created for worldwide income derived by CFCs from intangibles developed in the United States and provides a deduction for the U.S. corporation of 40 percent of its income from foreign exploitation of intangibles. Income taxed at greater than 60 percent of 90 percent of the top U.S. rate (13.5 percent if the U.S. rate is 25 percent) escapes designation as subpart F income.

The facts for the analysis come from the TASC model depicted in Figure 1. For each option, we treat the income earned by the Principal as excess intangible income under Option A and subpart F intangible income under Options B and C. We assume the intangible income earned by Principal (P) results from the transfer of intellectual property (IP) from the U.S. Parent (USP) under a cost sharing arrangement. We also assume the gross profi t from the contract manufacturer (CM) is subpart F foreign base company sales income and is included in USP’s income currently. The assumptions we make in this modeling exercise do not apply to all U.S. multinational corporations; however, we believe they are representative of the organizational structures of the U.S. multinational corporations most likely to benefi t from a participation exemption system (i.e., companies that earn mobile income from intellectual property and enjoy high profi t margins).18 The comparative tax results under the current U.S. tax system and four options under the Camp territorial tax proposals are summarized in Table 1. These computations assume no change in a corporation’s behavior as a result of a transition to a participation exemption. Comparisons of the difference in tax outcomes provides a baseline for our subsequent analyses of how a U.S. multinational corporation might react to the enactment of one of the base options.

18 The global effective tax rate of our hypothetical U.S. MNC is 25 percent, equal to the rate proposed by Representative Camp in his discussion draft and supported by most of the coalitions advocating for comprehensive corporate tax reform. The rate also corresponds to the average effective tax rate of the companies comprising the S&P 500 Info Technology sector, as reported by Ciesielski (2012). 728 National Tax Journal 5 0 0 0 0 0 ) ...... R 8 5 5 0 5 4 T % 2 3 3 3 2 ( E )

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s e e r - D t y C n t r b r r n s v S S e i o i . e . o M n R e o a u o r o T r R D S F U P F N P E U F P C L L W F 730 National Tax Journal

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s e e r - D t y C n t % r b r r n s v S S e i o i . e . 5 o M n R e o a u o r o T r 9 R D S F U P F N P E U F P C L L W F 1 Consequences of a Switch to a Territorial Tax System 731 5 6 0 0 0 0 ...... ) R 8 1 5 0 5 4 T 2 2 3 2 2 % (

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0 P P E U F P C L L W F R P F N 1 D S F 4 T U P F N 734 National Tax Journal

A. Accounting Ef ective Tax Rates under the Current System and Camp Proposals Our TASC model includes a Principal headquarters company that facilitates the manufacture and sale of products through contract manufacturers and limited risk distributorships, respectively. As the entrepreneur in the organizational structure, the Principal captures most of the profi t from the manufacture and sale of the products sold to customers outside the United States. The Principal repatriates some of its profi ts to the U.S. Parent in the form of dividends and makes a royalty payment to the U.S. Parent under a cost sharing arrangement. The Contract Manufacturers (CM) are compensated on a cost plus 5 percent profi t arrangement, while the Limited Risk Distributors and Commissionaires are compensated at 2 percent of sales.19 We initially model the MNC’s global accounting effective tax rate under the current system and compare the result with fi ve alternatives, the current system with a 25 percent tax rate, the Camp participation exemption proposal without any base erosion options, and the Camp participation exemption proposal with each of the three base erosion options. The results are presented in Table 1 and summarized in Table 3. We then consider one of many options available to a U.S MNC to mitigate the base erosion options, as we assume the MNC can negotiate an effective tax rate increase in the Principal’s home country to exceed the minimum tax thresholds needed to avoid each base erosion option.20 These results are presented in Table 2. As summarized in Figure 1 and Table 1, we assume that the CM earns a profi t of 5 percent of cost ($40) on its sale of fi nished goods to the Principal. For illustrative purposes, we further assume the CM profi t is treated as foreign base company sales income and treated as a subpart F inclusion to the USP. The Principal sells the fi nished goods through a LRD and directly to worldwide customers, earning a profi t of $700 that is deferred from U.S. taxation. The LRD earns a profi t of 2 percent of sales ($20) on its sale of the fi nished goods purchased from Principal. The USP receives foreign source income from three sources: a royalty payment of $150 from the Principal, a dividend of $100 from the Principal that brings with it a deemed paid foreign tax credit (FTC) of $9 (no withholding tax is imposed on dividends paid from a Luxembourg resident corporation to a U.S. Parent), and subpart F income of $28 from the CM that brings with it a deemed paid FTC of $12. We also assume the US Parent has U.S. source income approximating 30 percent of its worldwide income.21 In computing the U.S. Parent’s global accounting effective tax rate under the current system, we eliminate the

19 These percentages are consistent with the fi ndings of the JCT (2010) in its analysis of transfer pricing. See, in particular, the JCT examples related to Alpha, Bravo, and Foxtrot. 20 The U.S. Senate Permanent Subcommittee on Investigations (2013, Exhibit 6) reported that Apple was able to “negotiate” an effective Irish tax rate of two percent or below by means of how its Irish taxable income was calculated. Based on conversations with international tax planners, this ability to negotiate host country effective tax rates below the statutory tax rate is not unique to Apple. 21 This ratio is consistent with the fi ndings of the JCT (2010) study on transfer pricing as it related to Alpha. Consequences of a Switch to a Territorial Tax System 735 intercompany income from transactions within the group. The cash tax rate without the intercompany elimination will be slightly higher. As presented in Table 1, our U.S. Parent has a global accounting effective tax rate of 25 percent under the current U.S. tax system (Panel A). With a lowering of the corporate tax rate to 25 percent only, the company’s global ETR decreases to 19.3 percent (Panel B). This ETR provides a baseline against which to compare the results under the Camp participation exemption proposals. Under the Camp participation exemption proposals, dividends from the Principal to the U.S. Parent receive a 95 percent dividends received deduction, regardless of whether the income distributed is from an active trade or business or was previously taxed under subpart F. Such dividends are not entitled to any foreign tax credits (withholding or deemed paid) and therefore are not grossed-up under IRC section 78. It should also be noted that the subpart F income from the CM under the current system would now qualify for the “high tax” exception because the tax rate imposed by the host country (Germany) exceeds 90 percent of the statutory U.S. rate of 25 percent (22.5 percent). We assume the U.S. Parent does not make the election to treat the income as non-subpart F income because the high tax paid in Germany is absorbed by the low-tax income on the US Parent’s tax return, resulting in a lower effective tax rate. Under the Camp proposal with no base erosion provision (Table 1, Panel C), the U.S. Parent’s global ETR is reduced from 25 percent to 17.7 percent and results in a 46 percent decrease in U.S. taxes collected, almost all (90 percent) of which is due to the reduction in the corporate tax rate to 25 percent. Of the three base erosion options (Table 1, Panels D, E, and F), Option B results in the highest global ETR and the highest amount of U.S. tax revenue collected. This results because of the high amount of low-tax intellectual property income earned by the Principal. Option C produces the lowest global ETR and the least amount of U.S. tax revenue collected (almost 40 percent less than under Option B). U.S. multinational corporations with a high proportion of intangible income benefi t more from Option C than Option B. U.S. corporations with a high proportion of U.S. income seeking to retain their U.S. tax benefi ts (research credit, IRC section 199 deduction) likely would be more supportive of Option B because it raises more U.S. tax revenue than Option C, which could be used to subsidize domestic-income based tax incentives (Dossin, 2012). The comparative effective tax rate consequences of the current system under 35 percent and 25 percent statutory tax rates and the four Camp proposal alternatives are summarized in Table 3, Panel A. The tax consequences of each option depend on the types of income earned by each of the functions of the TASC, the U.S. Parent’s repatriation intentions, and the tax rate imposed on the income earned by each function of the TASC. These results are sensitive to the assumptions made about the composition of the MNC’s income (U.S. or foreign) and the tax rate imposed on that income. This analysis provides a template for modeling an MNC’s outcomes under each of the assumptions and provides policymakers a quantitative comparison of the proposals relative to the current system. 736 National Tax Journal

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Table 3 Accounting Ef ective Tax Rate Comparison

U.S. Tax Foreign Tax Global ETR (%) Panel A: Summary of ETRs under the Current U.S. Tax and Camp Proposals Current U.S. tax system $189 $77 25.0 Current U.S. tax system - 25% rate 129 77 19.3 Camp Base Case 112 77 17.7 Option A 153 77 21.6 Option B 227 77 28.6 Option C 142 77 20.6 Panel B: Summary of ETRs with Tax Planning Under Camp Proposals Option A $112 $122 22.0 Option B 112 88 18.9 Option C 97 112 19.7 Option C – Convert royalty to dividend 76 112 17.7

B. Accounting Ef ective Tax Rates under Potential Planning for the Camp Proposals Table 2, Panels A–C, provide an analysis of the outcomes under each of the base erosion options under the assumption that the U.S. Parent can negotiate an increase in its effective tax rate in the Principal’s host country to exceed the threshold amount below which intellectual property income would be taxed as subpart F income. That rate var- ies depending on the option. For Option A, the threshold rate is 15 percent, for Option B it is 10 percent, and for Option C it is 13.5 percent (0.9x0.6x0.25). In each case, the United States collects less tax revenue than under the base erosion options without tax planning and in two cases (Options B and C), lowers its worldwide accounting ETR. The beneﬁ ciary of such tax planning is the Principal’s host country, which now collects additional tax revenue at the expense of the Treasury. It should be noted that the threshold tax rate of 15 percent in Option A removes the incentive to negotiate the Principal tax rate upward. The fact that the threshold tax rate under Option B is 10 percent allows the U.S. Parent to signiﬁ cantly lower its global tax rate compared to Option B without tax planning. Setting the threshold tax rate at 15 percent for all three options would mitigate the incentive to increase the revenues of other countries at the expense of the Treasury in Option B (the ETR would increase to 22 percent) and eliminate the incentive in Option C. Consequences of a Switch to a Territorial Tax System 741

Another concern expressed by policymakers and analysts is that the full taxation of royalties under Option C would give the U.S. Parent the incentive to convert royalty payments into dividend payments, creating another source of transfer pricing scrutiny by the Internal Revenue Service. In Panel D of Table 2 we convert the royalty payment from the Principal into a dividend payment eligible for the 95 percent dividends received deduction. This strategy reduces the global ETR by 10 percent and decreases the tax revenue collected by the Treasury by more than 20 percent. From a policy perspective, concern has been expressed that the 40 percent deduction for foreign intangible income allowed under Option C will be viewed as an illegal trade subsidy by the World Trade Organization, similar to the extraterritorial income exclusion and foreign sales corporation incentives (Sullivan, 2013). This could be problematic, especially if Congress repeals the section 199 deduction to pay for the corporate rate reduction.

V. TAKEAWAYS In this paper, we discuss and illustrate the potential impacts of adopting a Camp-style participation exemption system on the U.S. and foreign taxes paid by a hypothetical U.S. MNC with signifi cant low-taxed intellectual property income and a tax-aligned supply chain designed to optimize the company’s global tax rate under the current system. Consistent with current lobbying efforts by different coalitions, Option C provides U.S. MNCs with signifi cant mobile income with the best outcome. This group of corporations will likely be “winners” if the U.S. transitions to a territorial tax type system. For U.S. corporations with predominantly U.S. source profi ts look- ing to maintain their U.S. tax incentives, enactment of Option B will shift more of the tax burden to U.S. multinational “tax rate makers” and mitigate base broadening proposals to recoup the loss in U.S. tax revenues from a reduction in the corporate tax rate. In addition, while the transition to a territorial tax type system is unlikely to alter the organizational structures of U.S. MNCs, pre-effective date repatriation strategies and post-effective date strategies to mitigate the base erosion options must be considered by policymakers to prevent further leakage of U.S. tax revenues.

ACKNOWLEDGMENTS AND DISCLAIMERS We appreciate helpful conversations with Tim Gibbs as well as constructive feedback from Rosanne Altshuler, John Diamond, Jennifer Blouin, Paul Demere, Mihir Desai, and Peter Merrill. Special thanks to Rosanne Altshuler for organizing the conference on “Reforming the U.S. System for Taxing International Income” held in Washington, D.C. on April 26, 2013, at which this paper was presented. 742 National Tax Journal

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