From our friends at Commerce Clearing House, a review (here) of the Education Jobs and Medicaid Assistance Act of 2010.
The story is that Congress wanted to grant money to the states to relieve budget pressure. To raise $26 billion over 10 years to send money to the states to keep up critical state spending, a number of the more egregious–and legal!–loopholes in corporate taxation were tightened up by the act.
More in a bit, when I have a chance to shorthand down the main points. The takeaway is that, for years, international corporations have been receiving subsidies from the U.S. taxpayers (you and me) to pay their taxes in foreign jurisdictions—where they aren’t hiring many Americans! So we pay for the military protection, AND we cut a nice little gift check on behalf of well-connected expats operating in these countries. Nice.
[Update: A little explanation. American corporations, like American individuals, are taxed on their worldwide income. Although a number of Americans overseas wail about this, it’s really not so bad. That is because of Section 901, the Foreign Tax Credit.
There is also Section 911, the Foreign Earned Income Exclusion, that I’ve written about. But it doesn’t play a role here.
Sorry if this is a little dry. It’s the best I can do to make it clear.
If a company has income earned abroad (including Canada and Mexico!), they are only taxed on it when they repatriate the money to America. That is, when they transfer the money back to an American affiliate or pay it out to an American. For whatever income taxes the company paid abroad, they can take a credit for taxes due Uncle Sam. Up to the 35% or so, which is the highest corporate rate.
So the trick has been figuring out ways to use the Foreign Tax Credit to cover things other than the actual income that the company earned, and/or the actual money that is being transferred back to America. Alternatively, using the Foreign Tax Credit on income that wouldn’t be taxed by America because of differing tax rules.
Most of these games had to do with asset purchases and debt. For example, American companies would buy foreign companies using debt. They borrow in America, deduct the interest in America. This lowers their taxes in the U.S. The money goes to invest in foreign capital, and anything earned in the foreign jurisdiction stays untaxed by America until the company brings the profit home.
Arguably, if the fruits of the investment aren’t being taxed by Uncle Sam, there shouldn’t be an interest deduction for the investment. The act cuts this out prospectively (in the future).
Another way to get around U.S. taxes was to use a “Section 338 election”. This was a strange rule that allowed the American company to treat a foreign corporation as if it were something else. For example, consider a Canadian company holding assets that can, somewhere, generate a paper loss. The acquirer elects to treat the Canadian corporation as a partnership. By doing so, it could combine the operations of the Canadian sub and the American parent for U.S. tax purposes. Uncle Sam would allow the paper losses against U.S. tax.
A variation of this allowed the American acquirer to step-up the basis in assets bought. This means to mark the value of the assets to whatever value the buying company is paying, and the reason to do this is to be able to claim a write-off of the value, known as depreciation. If you pay $500 for a printer with a “depreciable life” of 5 years, you might take $100 a year off on your taxes (we say, “straight-line”) for the next 5 years. You save on taxes this way.
Canada might say that a factory or investment in software had a remaining depreciable value of CAD one million. But the U.S. company pays market value of CAD 20 million. The U.S. company could claim CAD 20 million depreciation on the U.S. tax return. Canada, however, would still tax the profits of the company, because for Canada purposes, the depreciation already occurred. You can’t take it again in Canada.
This means that the U.S. would give the company a 20 million Canadian dollar write-off, over time. No U.S. income tax was due on that 20 million. But in Canada, which already allowed the writeoff, would be collecting tax. The old law was allowing the U.S. company to take a credit for the Canada taxes—even though, like I said, no tax was due on the part attributable to depreciation.
So bottom line: The U.S. was letting the American parent write off the sub AND was letting it use the Foreign Tax Credit on what it paid to Canada—even though, remember, the U.S. was allowing all that fresh depreciation. Nothing was owed to Uncle Sam anyway, but the company still could use what it paid to Canada to cover other income taxes due to Uncle Sam.
I’m happy to see that Congress took some of these murky tax rules and tightened them up. The (other) tax lawyers and accountants will say “yes, but we’ll just figure other ways around the new rules”. But I guess that’s always been part of things too, right?
The point of the Foreign Tax Credit has always been to shelter a dollar of income that has already been taxed by another country. When these rules are twisted to create a number of tax games, it’s appropriate for Congress to clamp down.]