International Tax Reform: Proposals from the House, the Senate, and the Biden Administration
Congress has been actively working in 2021 on legislation designed to enact the agenda laid out by President Biden in his State of the Union address and the budget for Fiscal Year 2022 that he forwarded to Congress in the spring. After enacting additional pandemic-relief legislation, Congress then moved on to infrastructure legislation, which was approved in the Senate and is awaiting final action in the House.
The major legislation in 2021 with respect to tax issues, however, is the budget reconciliation bill, which has been drafted to include many of the key Biden agenda items, including provisions targeting large corporations and high-income individuals, middle-class tax relief, tax incentives and new spending on traditional infrastructure projects and “human” infrastructure initiatives, as well as proposals to address climate change. The budget reconciliation legislation is being considered pursuant to the Fiscal Year 2022 budget resolution that provides reconciliation instructions to the House committees for a package of $3.5 trillion in spending and tax relief provisions, which would be partially offset by corporate and individual tax increases.
House committees have concluded the work necessary to produce legislation in the areas within their jurisdictions, including the House Ways & Means Committee, which is responsible for spending in key areas such as retirement and health care as well as all tax issues, including tax cuts, tax incentives, and tax increases. Legislation from the various House committees has been sent to the House Rules Committee, which is tasked with compiling the various bills into one bill and is expected to make revisions prior to House Floor action.
The Ways & Means Committee bill (“House bill”) includes the following key revenue raising proposals:
- Increase the top corporate tax rate to 26.5% (from 21%)
- Increase the top individual income tax rate to 39.6% and impose a new surtax on the highest-income taxpayers
- Increase the top tax rate on capital gains to 25% and modify the carried interest rules to increase the holding period for assets to qualify for capital gains treatment to 5 years
- Limit the section 199A deduction for certain owners of certain pass-through entities
- Provide additional funding for the IRS in order to increase its compliance and enforcement activities
The House bill also includes changes to key international tax rules that were first enacted in the 2017 Tax Cuts and Jobs Act (TCJA) as discussed below. This True Insight will focus on the proposed international tax rule changes included in the House bill and that are likely to be considered for inclusion in the Senate bill with reference to the proposals that the Biden Administration included in the tax title of its Fiscal Year 2022 budget (“Treasury Proposals”).
The Senate Finance Committee has not yet held a committee markup of draft budget reconciliation legislation or announced that such a markup will occur. Instead, it appears that the SFC may negotiate the Senate tax title more informally to be inserted into the Senate version of the overall package that would go directly to the Senate Floor. The SFC tax title is expected to include changes to the international tax rules as discussed below.
Under normal Congressional procedures, a House and Senate version of the bill would be approved in each chamber and then the House and Senate would “conference” the bill to reach a final agreement. There has been discussion, however, of negotiating the bill between the two bodies prior to bringing it to a vote in either the House or Senate, i.e., effectively “pre-conferencing” the bill.
Status and Timeline for the Budget Reconciliation Legislation
The House bill is not yet scheduled for consideration on the House Floor. Reports are that it is more likely that a final version of the legislation will be negotiated by the House, Senate, and White House before House consideration in order to ensure that there are enough votes to pass the bill on both the House and Senate Floor.
Two key decisions will be necessary before the final details of the bill can be negotiated – the overall size of the bill and how much of the bill will be offset with revenue increases versus deficit spending. The final bill will probably cost less than the current $3.5 trillion House version of the bill in light of opposition from Senate Democrats including Senator Joe Manchin (D-WV) and Senator Kyrsten Sinema (D-AZ), who have stated that the House bill is too expensive.
To cut down the overall size of the bill, they may make changes that reduce the tax revenue raising proposals as well as offsetting amounts of tax cuts and spending proposals. One potential change could result in a proposal to increase the corporate tax rate to 25% instead of 26.5%.
What is the timeline and deadline for approval of this legislation? Although Democratic leadership in Congress has optimistically discussed early approval of this legislation this fall, it is more likely that the bill will be negotiated over the fall and approved by the end of the year. Failure to complete the bill in 2021 will make its approval more challenging, since 2022 is an election year. The current continuing resolution, which was approved to fund the government past the October 1st deadline for a Fiscal Year 2022 budget, expires on December 3, 2021, which could also serve as a convenient deadline for the budget reconciliation bill.
House Ways & Means Markup – The House Bill
The House Committee on Ways & Means approved the tax title of the Build Back Better Act, which includes a significant package of business and individual provisions including corporate, individual, and capital gain rate increases, changes to outbound and inbound international tax provisions, and several provisions affecting high-income individuals, pass-through businesses, and estates and trusts. The corporate and international provisions proposed in the Ways & Means Committee bill are estimated by the Joint Committee on Taxation to raise $963.6 billion over 10 years.
Key international proposals include limitations on interest expense of international financial reporting groups, modification to inbound and outbound international provisions, including global intangible low-taxed income (GILTI), foreign derived intangible income (FDII), foreign tax credit (FTC) rules, base erosion and anti-abuse tax (BEAT), and subpart F income. This summary covers those key proposed changes.
The House bill includes these revenue-raising proposals:
- Limiting the interest deduction of domestic corporations that are part of an international financial reporting group
- Reduce the deductions for GILTI to 37.5% and FDII to 21.875%
- Apply the GILTI regime on a country-by-country basis
- Reduce the allowable net deemed tangible income return from 10% to 5%
- Determine foreign tax credit limitations on a country-by-country basis
- Increase from 80% to 95% the deemed paid credit for taxes attributable to GILTI
- Modify the BEAT rate and calculation of the BEAT
As we discussed in a recent True Insight on the OECD discussions on global tax reform, Treasury is playing a key role in the OECD talks, and it is interesting to note that some of the proposals that were approved by the Ways & Means Committee coordinate with the work being done at the OECD, including the changes to GILTI and BEAT, although there is no specific mention of this in the House bill. In light of the fact that Chair Neal and other members of the Committee sent a letter to Treasury in early August urging a “legislative approach that reflects the substance and timeline of negotiations at the OECD,” it is clear that the Committee opted to take a less stringent approach on these issues as compared to the Treasury Proposals.
Congress may decide to delay the effective dates of some provisions, thereby allowing Treasury and the IRS more time to issue guidance on changes. As we discussed in our recent True Insight, Congress may allow for some delay in the effective dates of certain changes to the international tax rules in order to wait for an agreement at the OECD on changes to the international tax rules, which will require implementation of some rule changes at the country level, i.e., through changes to US tax laws.
Interest Expense of International Financial Reporting Groups
The House bill provides for enacting a new Section 163(n) to limit the interest deduction of certain domestic and foreign corporations that are members of an international financial reporting group who are included in consolidated financial statements and have average gross receipts of more than $100,000,000 over a 3-year period. The limitation also would only apply to C corporations with an average of more than $12 million of net interest expense over a 3-year period.
The Section 163(n) limitation would equal the “allowable percentage” multiplied by 110% of the domestic group’s net interest expense, where:
This proposal is very similar to one that was considered during negotiations on the TCJA. The current Treasury Proposals include an excess interest proposal that is targeted at US subsidiaries of foreign parented groups, while the House bill’s proposal would also apply to US multinationals. There are some other key differences in the two proposals.
The House bill also amends Section 163(j) for flow-through entities to apply at the partner (or shareholder of an S corporation) level, proposes corresponding changes to Section 163(j)(4) in order to take a consistent aggregate approach, and provides transition rules for partners in a partnership.
The House bill also adds Section 163(o), which provides for a 5-year carryover of disallowed interest expense under Section 163(j)(1) or Section 163(n)(1), whichever is lower. For this purpose, interest is treated as allowed as a deduction on a first-in, first-out basis.
Sections 163(n) and 163(o) would apply to tax years beginning after December 31, 2021. The proposal is estimated to raise $34 billion over a 10-year period.
Changes to the Deduction for GILTI
The House bill would reduce the Section 250 deduction for GILTI from 50% to 37.5%, which would result in headline GILTI rate of about 16.5% assuming the proposed corporate tax rate of 26.5%. That would be an increase from the current headline rate of 10.5%. Under current law, the GILTI deduction is already scheduled to fall to 37.5%, but not until 2026.
Treasury is playing a major role in negotiating a global minimum tax rate of at least 15% that is part of the OECD discussions to reform global taxes, which will likely factor into the final result on this issue. The Biden Administration has proposed raising the tax rate to 21%. If Congress does not adopt a GILTI rate of at least 15%, in line with the expected final global rate, US taxpayers who own foreign companies could be denied tax deductions under the global regime.
The House bill provides for country-by-country application of the GILTI regime, which generally would prevent taxpayers from offsetting GILTI amounts between high-tax and low-tax jurisdictions. It also modifies the formula for calculating GILTI by reducing the amount of allowable net deemed tangible income return to 5% on qualified business asset investment (QBAI) (from 10%). Note that the Treasury Proposals support the idea of eliminating the net deemed tangible income return concept.
The House bill would also reduce the “haircut” on FTCs attributable to GILTI so that taxpayers would receive 95% of the value of their credits rather than 80% (current law).
These proposals differ from those in the Treasury Proposals and the SFC Draft in key ways. The SFC Draft would repeal the QBAI exemption rather than decreasing it. The Treasury Proposals call for a 21% headline rate on GILTI and for maintaining current law rules that allow for only 80% of related FTCs to be used to offset GILTI tax.
These changes are effective for tax years beginning after December 31, 2021.
Changes to the Deduction for FDII
Under current law as enacted by the TCJA, a Section 250 deduction that is used to calculate the effective rate on FDII is scheduled to decrease from 37.5% to 21.875% for tax years beginning after 2025. The House bill would accelerate this change by making it applicable to tax years beginning after 2021. With a proposed corporate tax rate of 26.5%, FDII would be taxed at 20.7%
It would also retain the FDII’s concept of a tax-free return on QBAI at a 10% level rather than 5% as proposed for the GILTI regime. Note that the SFC Draft would fully repeal the QBAI concept for FDII.
Overall, the changes made to Section 250 by the House bill are less restrictive than those proposed by either the SFC Draft or the Treasury Proposals with the latter repealing Section 250 altogether. As discussed below, the SFC Draft replaces “deemed intangible income” with a new concept. However, the FDII concept has received criticism as an impermissible export subsidy, so whether it survives is questionable. The Biden Administration has made it clear they would like to repeal the deduction.
Changes to Foreign Tax Credit Limitation and Related Provisions
The House bill would add new Section 904(e), which requires making foreign tax credit determinations within each of the separate limitation categories on a country-by-country basis for purposes of Sections 904, 907, and 960. The provision generally assigns each item of income and loss to a taxable unit of the taxpayer that is a tax resident of a country or has a taxable presence in a country in the case of a branch. The House bill also would repeal the foreign branch income basket.
Foreign tax credit carryforwards would be limited to 5 years (instead of 10 years), and the one-year carryback would be eliminated. The 5-year carryforward would also apply to FTCs in the GILTI basket.
Under the House bill, no US group expenses would be allocable against GILTI inclusions, other than the Section 250 deduction with respect to the inclusions. It includes a special ordering rule that would create a separate limitation loss account with respect to GILTI category income only after all other foreign source income has been considered. The changes would be effective for tax years of foreign corporations beginning after December 31, 2021, and for tax years of US shareholders in which or with which such tax years of foreign corporations end.
Note that the Treasury Proposals would limit the country-by-country approach to the GILTI and foreign branch categories, whereas this proposal extends the country-by-country limitation categories to all Section 904(d) categories. The SFC Draft would prevent cross-crediting through a mandatory high-tax exception regime for subpart F and the GILTI and foreign branch limitation categories.
Changes to the Deemed Paid Credit for Taxes Properly Attributable to Tested Income
The House bill amends Section 904(d)(1) to effectively reduce the “haircut” on the deemed paid credit for taxes attributable to GILTI under Section 960(d) from 20% to 5%, while it also amends Section 904(d)(3) to potentially allow foreign taxes incurred by net tested loss CFCs to be credited. These changes are effective for tax years of foreign corporations beginning after December 31, 2021.
Note that with this change, GILTI would be assessed on foreign income taxed at rates up to 17.4% based on the House bill proposed corporate tax rate of 26.5% with a GILTI hurdle rate of 16.5%.
Limit of Section 245A Dividends Received Deduction to CFC Dividends
The House bill would amend Section 245A to limit the availability of the Section 245A dividends received deduction to dividends from CFCs, and dividends from specified 10%-owned foreign corporations would no longer be eligible. The change would apply to distributions made after enactment of the legislation.
The House bill also amends the language in Section 245A(g) authorizing regulations or other guidance to carry out the provisions of Section 245A, including where a US shareholder owns stock of a specified 10%-owned foreign corporation through a partnership. This change would be effective for distributions made after December 31, 2017.
Limitation on Foreign Base Company Sales and Services Income
The House bill would limit foreign base company sales and services income to US residents and pass-through entities and branches in the US. The proposal would be effective for taxable years of foreign corporations beginning after December 31, 2021, and to tax years of US shareholders in which or with which such tax years of foreign corporations end.
Changes to the BEAT
The House bill would change the BEAT rate to 10% for tax years beginning after December 31, 2021, and before January 1, 2024; 12.5% for tax years beginning after December 31, 2023, and before January 1, 2026; and 15% for tax years beginning after December 31, 2025. The base erosion minimum tax amount is determined without regard to any credits so that regular tax liability would be higher, and Section 38 general business credits can be taken against the BEAT. The House bill eliminates the 3% base erosion percentage threshold except for tax years beginning before January 1, 2024.
The House bill amends Section 59A to compute modified taxable income by
- Disregarding base erosion tax benefits
- Disregarding any base erosion payments in determining the basis of inventory property
- Determining net operating losses without regard to any deduction which is a base erosion tax benefit
- Making adjustments under rules similar to the rules applicable to the alternative minimum tax
It would expand the definition of a base erosion payment by including certain inventory-related amounts paid or accrued to a foreign related party, such as indirect costs that are capitalized under Section 263A and those paid for inventory that exceed certain direct and indirect cost of property in the hands of the foreign-related party. It also expands the existing withholding tax exception for base erosion payments by generally exempting amounts subject to US federal income tax.
Finally, the House bill exempts payments subject to an effective foreign tax rate greater than or equal to the applicable BEAT rate, which is similar to the SHIELD (Stopping Harmful Inversions and Ending Low-Tax Developments) proposal included in the Treasury Proposals. All of these changes would apply to tax years beginning after December 31, 2021.
The proposed changes are a mix of taxpayer-friendly and taxpayer-averse proposals, but overall these changes could result in fewer cases in which US-headquartered companies would be subject to the BEAT. The exemption from base erosion payments for amounts that are subject to US tax including effectively connected income and amounts subject to tax under subpart F or GILTI likely could result In US multinationals not having any significant base erosion payments.
The result of these changes also affects the revenue estimate as compared to the SHIELD concept in the Treasury Proposals, which was estimated to raise $390 billion over nine years. This proposal appears to be intended to raise revenue by eliminating the base erosion percentage test from the applicable taxpayer determination and increasing the BEAT rate, while using revenue to restore the full value of credits and exempt certain payments subject to US tax or sufficient rates of foreign tax.
Senator Wyden’s Discussion Draft – The Senate Bill
Over the past several months, Senator Wyden (D-OR), who is the Chair of the Senate Finance Committee, has released a series of proposals on key tax issues including international tax rules, carried interest, derivatives, a mark-to-market proposal, a stock buyback excise tax proposal, and partnership rules.
On August 25, 2021, three senior members of the SFC released an “International Tax Reform Framework Discussion Draft” (“SFC Draft”) that included legislative language and a section-by-section summary. They requested comments from the public on the draft by September 3, 2021. SFC Chair Wyden along with Senator Sherrod Brown (D-OH) and Senator Mark Warner (D-VA) designed the draft to build on an outline of proposals that they released earlier this year on April 5, 2021.
The SFC Draft includes changes to several current law international tax provisions related to GILTI, FDII, the BEAT, and subpart F in general. The SFC Draft aligns with some of the proposals that were released earlier in 2021 by the Biden Administration and those included in the House bill, but it does differ in approach on some specific issues.
In releasing the SFC Draft, Chair Wyden described it as a starting point for discussions within the Senate Democratic Caucus. He commented that decisions on rates and the overall revenue to be raised from changes in the international area would be made by the full Democratic Caucus.
Changes to GILTI
The SFC Draft proposes to refer to GILTI as “Global Inclusion of Low-Tax Income” and would also make three primary changes to the GILTI regime:
- Increase the effective tax rate on GILTI to an unspecified level to be determined later
- Modify the formula for calculating GILTI to eliminate the exclusion for a 10% return on foreign tangible investment (the qualified business asset investment or QBAI)
- Require GILTI to be calculated on a country-by-country basis, which generally would prevent taxpayers from offsetting GILTI amounts between high-tax and low-tax jurisdictions. The SFC Draft proposes doing this by dividing global income into high-tax (i.e., income subject to an effective rate greater than the GILTI rate) and low-tax groups, with only the latter being subject to residual GILTI tax.
The SFC Draft also includes changes that would (1) address the interaction between the GILTI regime and subpart F income, including the foreign tax credit rules and (2) extend the high-tax exclusion rule to foreign branches. The SFC Draft did not provide details on how the effective tax rate would be calculated or what the rate would be.
Changes to FDII
The SFC Draft retains the acronym “FDII” but redefines it as “foreign-derived innovation income.” The SFC Draft proposes repealing the QBAI element of the FDII regime. It would replace the “deemed intangible income” concept within FDII with a metric referred to as “deemed innovation income” (“DII”) that would be designed to encourage spending on US-based research and development and worker training. It also provides for equalizing the yet to be determined FDII and GILTI rates.
Changes to the BEAT
The SFC Draft would retain the BEAT but make some key changes.
It would modify the current BEAT system into a two-rate system with the addition of a second higher rate applied to “base erosion income” (with the exact percentage to be determined). The base erosion income plus regular income (taxed at 10%) would be equal to the current-law modified taxable income. It would also increase the higher BEAT rate on base erosion income by 2.5 percentage points after 2025 similar to the scheduled increase to the 10% BEAT rate on regular income under current law.
The SFC Draft would make changes to ensure that the value of certain general business tax credits under Section 38 are taken into account.
The approach on the BEAT in the SFC Draft differs from the approach put forward in the Treasury Proposals, which suggest that the BEAT be repealed and an alternative regime called SHIELD, Stopping Harmful Inversions and Ending Low-Tax Developments, be enacted. The SHIELD regime would deny US deductions on related-party payments if they are subject to a low effective rate of tax (with a yet to be determined threshold) in the destination jurisdiction. The SFC Draft summary states that there is continuing interest in the provision but the draft legislative text does not cover SHIELD.
Changes to the Foreign Tax Credit Rules
The SFC Draft would make changes to the FTC system. It would apply a similar FTC haircut for subpart F as for GILTI, although the haircut amount is unspecified and described as between 0 and 20%. It would extend the FTC haircut to taxes imposed on previously taxed earnings and profits to ensure that withholding taxes and net income taxes are treated similarly.
The SFC Draft would extend the high-tax exclusion to foreign branches in new Section 139J and exclude “high-tax foreign branch income” from a taxpayer’s gross income. High-tax foreign branch income is defined as gross income subject to a tax rate greater than the corporate rate or highest individual rate, as applicable. The exclusion would be determined on a country-by-country basis with branches in the same country being aggregated. FTCs attributable to branches with losses would be disallowed.
Allocation of Research & Experimental and Stewardship Expenses
The SFC Draft would amend the FTC limitation rules for certain expenses if activity is conducted in the US. For purposes of determining the FTC limitation, expenses for research and experimentation and for “stewardship” would be treated as 100% allocated to US source income if those activities are conducted in the US. R&E and stewardship expenses that are performed outside the US would be treated as they are under current law.
Significant changes to the international tax rules appear to be likely with the enactment of budget reconciliation legislation, but the details and the extent to which some of the TCJA-enacted reforms will be modified are still unknown. With the possibility that this legislation will be enacted by the end of 2021, businesses are well advised to monitor reports on the negotiations between Congress and Treasury related to these proposals.
If you have questions about any of the information in this True Alert, please contact a member of your TPC engagement team.