J. Clifton Fleming, Jr., Robert J. Peroni, & Stephen E. Shay, Worse Than Exemption

• Publication year: 2009

WORSE THAN EXEMPTION†

J. Clifton Fleming, Jr.^*Robert J. Peroni^**Stephen E. Shay^***

INTRODUCTION ................................................................................................ 80

I. THE DEFERRAL PRIVILEGE-THE BASIC BUILDING BLOCK ................ 85

A. The Existing Scope of the Deferral Privilege ............................... 87

B. The Incongruity of Elective Deferral ............................................ 93

C. The Effect of the Deferral Privilege ............................................. 96

D. Transfer Pricing Rules and the Anti-Deferral Regimes ............. 105

E. Competitiveness I ....................................................................... 106

II. ENHANCING THE DEFERRAL PRIVILEGE: PART ONE-EXPLOITING

DEFECTIVE COST ALLOCATION RULES .............................................. 110

A. The Allocation of Expenses to Foreign-Source Income for

Purposes of the Foreign Tax Credit Limitation .......................... 110

B. The Incongruous Benefit of Deducting Expenses Allocable to

Deferred Foreign-Source Income ............................................... 116

C. Competitiveness II ...................................................................... 118

III. ENHANCING THE DEFERRAL PRIVILEGE: PART TWO-AGGRESSIVE

TRANSFER PRICING ............................................................................. 119

A. The Magnified Challenge of the Arm's-Length Standard with

Respect to Intangible Property ................................................... 122

B. Information Asymmetry and the Limits on Enforcement of Any

Transfer Pricing Regime ............................................................ 125

C. Formulary Apportionment Is Not a Panacea ............................. 128

D. The Deferral Privilege Is Enhanced by Aggressive Transfer

Pricing ........................................................................................ 131

IV. OVERLY GENEROUS CROSS-CREDITING: ELIMINATING THE

SHRUNKEN RESIDUAL TAX AND ACHIEVING A NEGATIVE TAX

RATE ................................................................................................... 132

A. The Basic Effects of Cross-Crediting ......................................... 132

B. Export Sales Income That Is Effectively Tax-Exempt under the

Current U.S. International Tax System ...................................... 137

C. Possible Zero U.S. Taxation of Foreign-Source Royalties under the Current U.S. International Tax System ...................... 142

D. Other Types of Effectively Tax-Exempt, Foreign-Source

Income under Current Law ........................................................ 145

V. DEDUCTING FOREIGN LOSSES AGAINST U.S.-SOURCE INCOME: CLEARLY A WORSE-THAN-EXEMPTION RESULT ................................ 145

CONCLUSION .................................................................................................. 149

INTRODUCTION

Customary international law recognizes that every country has the right to impose both source-based taxation on income earned within its borders by foreign persons¹and residence-based taxation on the worldwide income of its own residents.²Thus, so far as international law is concerned, the legitimacy of these taxing rights is fully accepted, and neither of these forms of taxation represents overreaching by governments. Nevertheless, unless ameliorative steps are taken, their full exercise may produce double taxation of international income. This is because, in the absence of mitigation, international income could be subject to source-based taxation in the country where it arises and to residence-based taxation in the country where the earner is a resident.³The resulting tax burden would be a material impediment to international commerce.

Customary international law solves this conundrum by requiring the residence country to provide relief.⁴The foreign tax credit system is one of the two commonly used unilateral approaches for discharging this obligation.⁵

Under the foreign tax credit system, the residence country subtracts the source- country tax on a resident's foreign income from the residence-country tax on the resident's foreign income and collects a so-called residual tax to the extent that the residence-country tax exceeds the source-country tax. Where a resident's source-country tax exceeds the residence-country tax, however, the residence country does not refund the excess to the resident.⁶

Source Rules and U.S. International Taxation, 56 TAX L. REV. 81, 88-106 (2002) [hereinafter Shay, Fleming

The exemption system is the other internationally accepted unilateral method for mitigating international double taxation.⁷Although the term "exemption" seems to imply that residence countries employing this approach will effectively impose a zero rate of tax on all foreign-source income earned by their residents, in practice, countries that use the exemption system approach usually confine the zero rate to foreign-source active business income of resident corporations; other resident taxpayers and other types of foreign-source income are covered by a worldwide taxation foreign tax credit system.⁸

Where the source-country tax is equal to or greater than the residence- country tax, the foreign tax credit system and the exemption system produce identical results, because the foreign tax credit completely eliminates the residence-country tax and treats the resident as if the foreign-source income were subject to a residence-country tax of zero.⁹A difference between the two

Systems: Which Is Better for the U.S.?, 8 FLA. TAX REV. 283, 298 (2007) [hereinafter McDaniel, Territorial vs Worldwide] ("Neither the U.S. nor any other FTC [foreign tax credit] country will accept or has accepted" putting its revenues completely at the mercy of foreign countries' tax rates by allowing an unlimited foreign tax credit.); JANE G. GRAVELLE & DONALD J. MARPLES, CONG. RESEARCH SERV., THE FOREIGN TAX CREDIT'S INTEREST ALLOCATION RULES 5 (2009) ("[T]he purpose of the foreign tax credit limit is not to ensure the efficient allocation of resources; rather, it is concerned with protecting the U.S. tax base."), available at http://opencrs.com/document/RL34494/2009-01-28. Stated differently, allowing an unlimited foreign tax credit would amount to a residence-country tax subsidy of high-tax foreign source countries. See Robert J. Peroni, Back to the Future: A Path to Progressive Reform of the U.S. International Income Tax Rules, 51 U. MIAMI L. REV. 975, 978 (1997) [hereinafter Peroni, Back to the Future]; see also SHAVIRO, DECODING, supra, at 117; Daniel J. Frisch, The Economics of International Tax Policy: Some Old and New Approaches, 47 TAX NOTES systems becomes apparent only when the source-country tax is less than the residence-country tax. In that situation, the foreign tax credit system will allow the residence country to collect a residual tax equal to the difference,¹⁰but this residual tax will be forgone with respect to a resident corporation's active foreign business income if the residence country uses an exemption system.¹¹

Thus, the significant difference between a foreign tax credit system and an exemption, or territorial, system is the residence country's opportunity under the former, but not the latter, to collect a residual tax on active business income earned by resident corporations in low-tax foreign countries.¹²This difference would seem to make the exemption approach friendlier to resident corporations than the foreign tax credit system. Indeed, it is often alleged that the U.S. foreign tax credit system places U.S. multinational corporations at a comparative disadvantage when competing for business in low-tax foreign countries against corporate residents of exemption system countries.¹³

Consequently, it seems counterintuitive that U.S. multinational corporations have resisted replacing the U.S. foreign tax credit system with an exemption regime, which has a zero rate of tax on active foreign business income, and have preferred to retain the U.S. system with modifications that weaken some of its rigors.¹⁴The basis for this odd-seeming preference was clarified somewhat in the following statement by the Staff of the Joint Committee on Taxation in connection with its proposal for a U.S. exemption system: "In many cases, the present-law 'worldwide' system actually may yield results that are more favorable to the taxpayer than the results available in similar circumstances under the 'territorial' exemption systems used by many

U.S. trading partners."¹⁵Similarly, the American Bar Association Section of

Taxation's Task Force on International Tax Reform recently said that "the current U.S. international rules allow U.S. multinationals to achieve outcomes that are superior to exemption."¹⁶

As we have explained in previous articles,¹⁷exemption systems are inefficient because they distort taxpayer decisions in bizarre ways, and they also are inequitable because they allow residents who earn foreign- source income to avoid the tax burden borne by their fellow residents who are primarily domestic-source income earners. Thus, we regard an exemption system as a poor public policy choice. To the extent that the current U.S. international income tax regime creates more favorable results for foreign income-earning U.S. residents than does a conventional exemption system, the U.S. regime is worse from a public policy standpoint. Thus, this Article, which details how the current U.S international income tax system produces untoward results, is entitled "Worse Than Exemption," and we often refer to the overly generous outcomes for foreign income-earning U.S. residents under the U.S. system as "worse-than-exemption" results.

In this Article, we explain how (1) the deferral privilege, (2) defective income-sourcing and cost-allocation rules, (3) generous and practically ineffective transfer-pricing rules, (4) largely unrestricted cross-crediting, and (5) the deduction of foreign losses against...