Everybody seems most interested in talking about US taxation of multinational enterprise, so, bring it on!
As a law professor, I must start with a hypothetical: Sue is a leading heart surgeon. She went to college and med school on federally-guaranteed loans at schools that received considerable state and federal support. Her clinical work, internship, and residencies were at hospitals that received much government aid. After establishing herself at THE private clinic in New York, she decided to operate only in countries with “reasonable” malpractice laws.
In 2004, Sue received $1 million for surgeries performed in countries with no income tax. $2 million was earned for surgeries in Europe, which was taxed by the countries where the surgeries were performed at 50%. Her only other income was on investments held in an account in London. She is a US citizen and resides in Manhattan. If the US were to tax her, she would happily move to Geneva (where she has numerous personal and professional connections) permanently and renounce her US citizenship. (Remember, this is a hypothetical. Currently, the US would tax her, but little tax would be owed, because of the way that the US foreign tax credit works, which will be discussed in later posts)
How should the US tax her on her $3 million of 2004 surgery income? The pro-business, anti-tax right would say not at all, as taxation would drive her to Europe. More tomorrow.
The first thing to note is that since Sue is an American citizen, she is taxed on her worldwide income, under I believe section 11 (Not sure, don’t have code with me–definitely know this is true for corporations; am still waiting for all my code/regs books to come in the mail from NYC). Therefore, she is taxed on the whole three million dollars. However, she is entitled to the foreign tax credit on the 2 million dollars she was taxed on in Europe. Since the tax rate on the 2 million dollars is higher than the tax rate imposed by the U.S., this whole 2 million dollars will not be taxed by the U.S. In addition, she can carry forward her unused tax credit on this 2 million dollars earned to offset the tax on her 1 million dollars earned in the other country where she earned 1 million dollars because the 50% (not sure if this her marginal tax rate in Europe, or her effective rate of tax in Europe) tax is higher than the tax imposed by the U.S. Thus, her other 1 million dollars of income will be partially exempted here, and she will be able to carry forward any unused tax credit to the next year (though on the facts I don’t think there would be any unused tax credit).
The passive/investment income from her London income would be placed in the passive income basket, and she would be unable to use any of the foreign tax credit derived from her active business, i.e., surgery, as credit against this income. Therefore, she would owe no income on the $2 million from the U.S.; she would pay partial tax on the $1 million she earned in countries with no income tax, and she would pay tax on whatever passive income she has from the investments in London–though there would be some partial credit if there were any tax imposed by England on this passive income (this would depend on the the rate of tax and type of income). I haven’t visited Foreign Tax materials in awhile (I’m more interested in pass-thru entity taxation than anything else), so my analysis is probably pretty rusty.
As much as people like to deride the foreign tax credit system, it is based on a solid premise, I think. You don’t want people or corporations to make decisions based upon the tax aspects of a transaction too much; to do so would produce mass inefficiencies. It also would prevent corporations from expanding their businesses to other countries. Imagine if firms had to pay U.S. tax at an effective rate of say 25%, and then foreign tax at an effective rate of say 40%. 65% of their income would be going to pay taxes, and hence they would not attempt to expand their own businesses outside of their domestic borders. This would produce inefficiencies because firms with a comparative advantage or lower marginal cost would be prevented from entering arenas where they could profit, thereby, increasing the consumer surplus. As a tertiary point, inefficient producers in foreign countries would be protected to an extent, thereby, reducing the consumer surplus. Furthermore, at least the U.S. is attempting to tax. Alot of European countries just wholly exempt foreign source income to begin with. In addition, the system has gotten better with the introduction of different basket regimes under subpart F, to prevent a corporation or person to be able to credit different types of income against other types income.
The greatest abuse in the foreign tax credit system, I think, occurs when corporations and countries bargain for a purchase price that includes a phony tax as part of the price, and consequently, corporations then use this phony tax to reduce their own income owed to the US under section 11. The quintessential example of this is suppose a U.S. firm constructs to build an office in Nigeria. Nigeria is to pay the U.S. firm 6 million dollars, with no taxes. The firm then asks pay to Nigeria 9 million, but have Nigeria tax 3 million on the purchase. Thus, there is no difference in the purchase price, BUT the U.S. company can now exempt 3 million dollars of the 6 million from taxation in the U.S that they have net of the Nigerian contract. However, there never really was any tax on this income to begin with, so the company is much better off than before….The code has attempted to correct this by inquiring into the domestic country’s tax system, its incidence of tax, whether its a normal tax…etc…, but the result has not been great to say the least….I think one of the principal problems, is that the foreign country doesn’t understand that they’re conferring a benefit on the firm that is worth something to the firm, and hence should bargain with the firm to exact a more level purchasing price, i.e., reduce the purchase to an equilibrium level…
This example has two transfer pricing aspects. Assuming the section 1.482 regulations really mean arm’s length in terms economics (OK, many transfer pricing ‘experts’ recite regulations as they stopped being economists preferring to be overpriced whores years ago), one could argue that Sue’s FORCO owes Sue’s USCO a buy-in for the intangibles created in the U.S. And yes, I know the actual drafting of section 936 and section 1.482 gives a nice loophole here (see the court case of Martin Ice Cream for a really fun variation).
The other had to do with the below market loan she received for her eduction. Section 1.482-2(a) comes to mind. But what’s really fun here is loan guarantees with the best two things I’ve read on this from political polar opposites who are not tax/transfer pricing types. Ralph Nader’s June 30, 1999 testimony on corporate welfare correctly argued that issuing guarantees has an economic cost. And the rightwing version of the House JEC in late 2002 had a neat paper on this (about the only ‘economics’ report this crowd has written that was worth reading).
Now if the IRS can staff and train the right crew of good economists …
well, i blame lawyers for why Sue is operating in other countries to begin with.
i have seen docs sued for thousands of dollars for some of the dumbest finicky things on earth.
insurance companies + lawyers –> cause docs to perform defensive medicine –> destroyed health care system.
—–