Way back before passage of the Tax Cuts and Jobs Act, it was widely recognized that any international tax reform that exempted foreign income should disallow deductions for expenses allocable to foreign income. That would be a rock-solid application of long-standing economic, accounting, and legal principles. Back then, this brake on tax benefits of territorial taxation was grudgingly acceptable to pro-business proponents of territorial taxation because revenue losses had to be trimmed if the overall goal of reform was to be achieved.
But in late 2017 the idea that tax reform wouldn’t reduce taxes vanished into thin air. The House Budget Committee on July 27 of that year had approved a budget resolution that kept tax reform revenue neutral. But a mere three months later on October 26, after years of conditioning tax reform on revenue neutrality, Congress adopted the Senate budget resolution allowing a $1.5 trillion tax cut. And so a plethora of painful revenue offsets were no longer needed. Among them was a disallowance, or a proxy for a disallowance, of deductions against U.S. income for expenses allocable to exempt foreign income.
After passage of the TCJA, while most of the international tax priesthood was distracted by the massive complexity of new rules, one former Joint Committee on Taxation economist kept his eye on the big picture (without neglecting the details of the new law). In these pages, Patrick Driessen repeatedly pointed out that the burden of the new tax on global intangible low-taxed income was significantly offset by the benefit of deducting expenses allocable to foreign profits at the full 21 percent rate and that the issue deserved more attention.
“We went from talking a lot about suspending the U.S. tax deduction for allocable expenses in 2009 to seeing little about expense allocation in the TCJA statute and explanations,” Driessen wrote in 2020. A new paper by Stephen E. Shay of Boston College complements Driessen’s work. Not only does Shay estimate the benefit of misallocated expense deductions under current law, but he argues that the necessary changes to eliminate this flaw can — and should — be made by regulation.
In a pure territorial system, the misallocation of expenses can reduce the effective tax rate on foreign profit from zero to significantly below zero. In a quasi-territorial system — that is, a system with a minimum tax mechanism like that of the United States — the misallocation of expenses can reduce the effective tax rate on foreign profit significantly below the minimum tax rate. These variances from the minimum tax rate will not be uniform across taxpayers.
Matchmaking
It is tautological to say that if expenses are not properly matched with gross income, net income will be mismeasured. Lack of matching matters when it is necessary to categorize income. One class of income is an annual accounting period. Expenses not matched with gross income from year to year will give a distorted picture of profits over time. For example, if expenses properly allocable to 2018 corporate profits are deducted in 2017, corporate net profits in 2018 will be overstated and corporate net profits in 2017 will be understated. And if there is a change in tax rates, as there was from 2017 to 2018, the tax benefit is the difference in tax rate (here 14 percent) times the misallocated expenses.
Another class of income we are concerned with is income subject to different tax rates in the same year. For example, if income is generated from a tax-exempt bond, expense properly allocable to that bond should not be allocated to taxable income and deducted.
Example 1: Lee, with $10,000 of wage income and a 20 percent tax rate, pays $2,000 of income tax. Then Lee borrows $1,000 at 4 percent and uses the proceeds to purchase $1,000 of municipal bonds paying 3 percent. If Lee is allowed to deduct that interest expense, the tax saving of $16 more than offsets the decline in before-tax income of $10. Lee’s after-tax income increases by $6. Moreover, Lee could keep borrowing and buying municipal bonds until his total portfolio reaches $12,500 and taxable income is reduced to zero.
This would-be glaring loophole is plugged by section 265. Section 265(a)(2) states that no deduction shall be allowed for “interest on indebtedness incurred or continued to purchase or carry obligations the interest on which is wholly exempt from the taxes imposed by this subtitle.” Section 265 enforces the matching principle when one class of income is taxable and another class of income is exempt. But note that application of the matching principle is important whenever there is any differential in rates between classes of income — not just when the one class of income is taxable and another is exempt. If Lee’s bonds were taxable at a 1 percent rate, they wouldn’t be tax exempt, but the economic effects wouldn’t be substantially different.
A territorial system exempts foreign-source income from U.S. tax. Under the matching principle and applying the same logic as that which motivates section 265, expense allocable to foreign-source income would be disallowed.
Example 2: Lee Corp., with $100 of domestic income and a 20 percent tax rate, pays $20 of income tax. Then Lee Corp. finances foreign expansion with debt giving rise to $50 interest expense and $100 of foreign income (before any interest expense). The $50 of interest expense is deducted in the United States, and U.S. tax is reduced by $10. The United States has a territorial system so there is no U.S. tax on foreign profit. The marginal U.S. tax rate on foreign investment is -10 percent. If the interest expense related to foreign income was disallowed, the marginal U.S. tax rate would be zero.
A territorial system can be overlaid with a minimum tax — in effect, making it a worldwide system with different rates of tax on domestic and foreign income. In this case — application of the matching principle — expense allocable to foreign-source income should be partially disallowed.
Example 3: Assume the same facts as in Example 2, except that now the United States imposes a 10 percent tax on foreign profits. The $50 increase in expense again reduces U.S. tax by $10, but now the $100 increase in foreign profit increases U.S. tax by $10. The net effect is zero. The marginal tax rate on foreign investment is zero, not the minimum tax rate. If the interest expense related to foreign income was disallowed, the marginal U.S. tax rate would be equal to the minimum tax rate of 10 percent.
Allocation Clarification
Before proceeding, let’s clarify for folks who are understandably confused by different expense allocation issues in international tax. In this article, we are talking about the allocation of cost between domestic and foreign for purposes of computing taxable income in a territorial system or any system where foreign and domestic profits are taxed at different rates. Under today’s law, costs incurred in the United States allocable to foreign profits are deductible in the United States for the purposes of calculating taxable income. These costs almost certainly aren’t deductible for foreign tax purposes.
When calculating the foreign tax credit limitation, however, U.S.-incurred expenses allocable to foreign sources reduce foreign-source taxable income and therefore may reduce allowable FTCs. (The FTC limit equals a fraction times U.S. tax before FTCs. The fraction is foreign-source income — reduced by deductions for allocated U.S.-incurred expense — divided by worldwide taxable income.) U.S.-incurred expenses allocated to foreign-source income increase U.S. taxes on excess-credit taxpayers (that is, taxpayers with relatively high-tax foreign income) because they lower the limit on allowable FTCs.
This has been a subject of controversy since 2017 because expense allocations tightening the FTC limitation have the effect of imposing U.S. tax on GILTI even when that income is subject to foreign rates of tax that exceed 13.125 percent, the rate suggested in the legislative history as being the maximum rate of foreign tax that would trigger GILTI liability.
This unwelcome outcome doesn’t result from any shortcomings in how expenses are allocated. It results from using the U.S. FTC rules in the determination of the level of foreign tax that triggers minimum tax. If foreign tax rates that trigger minimum tax were calculated under foreign tax rules without using the FTC (as the Obama administration proposed in its 2015 minimum tax proposal), this problem of minimum tax on high-income taxpayers wouldn’t arise.
Yet another issue in cost allocation is the method of interest allocation for purposes of determining the FTC limitation mandated by the Tax Reform Act of 1986. Instead of allocating worldwide interest expense between domestic and foreign income for purposes of determining the limit, only domestic interest expense is allocated between domestic and foreign income — ensuring the resulting allocation will reduce the FTC limitation. This is called the water’s-edge method. The water’s-edge election was scheduled to be replaced by the worldwide method beginning in 2021, but the American Rescue Plan Act of 2021 (P.L. 117-2), enacted March 11, postponed that change until 2031. This water’s-edge approach was adopted in 1986 simply to raise revenue. Delay of its repeal continues to serve as a revenue raiser, but disregarding foreign debt levels altogether is nonsensical policy.
Another way to help keep expense allocation issues straight is to remember that there are potentially three calculations of income when the expense allocation issue arises. First, there is the calculation of foreign income for foreign tax purposes. As noted, foreign governments generally don’t allow deductions for expenses incurred in the United States. Second, there is the calculation of foreign income for purposes of calculating the numerator of the FTC fraction. That is where expenses incurred in the United States are allocated using the water’s-edge method. Finally, there is the calculation of domestic and foreign income necessary to determine tax in a territorial system or a foreign minimum tax system like the U.S. tax on GILTI. Today, there is no allocation of expenses incurred in the United States to foreign-source income. This article examines whether deductions for those expenses should be disallowed.
A Bit of History
Disallowing deductions for U.S.-incurred expenses allocable to tax-advantaged foreign income isn’t a wild-eyed, new idea. On the contrary, since the seminal papers by Harry Grubert and John Mutti and by Paul W. Oosterhuis and Michael J. Graetz published in 2001 first laid out details of how a territorial system should operate, it seems that every discussion of territorial taxation has endorsed or at least acknowledged the principle that expenses allocable to exempt (or lightly taxed) foreign income should be disallowed (or curtailed).
In 2005 the Joint Committee on Taxation described a territorial proposal under which controlled foreign corporation earnings would provide a tax-exempt stream of income for the U.S. parent corporation. The JCT explained: “Accordingly, deductions for interest and certain other expenses incurred by the U.S. corporation would be disallowed to the extent allocable to exempt (non-subpart-F) CFC earnings.” Similarly, in 2005 the President’s Advisory Panel on Federal Tax Reform proposed that the active business earnings of foreign affiliates wouldn’t be subject to U.S. tax. The report stated: “Accordingly, business expenses that are attributable to those foreign earnings should not be allowed as a deduction against U.S. taxable income.”
In 2007 House Ways and Means Committee Chair Charles Rangel proposed a reform that didn’t include territorial taxation but did adopt a matching approach to foreign income and foreign expenses. The Tax Reduction and Reform Act of 2007 would have retained deferral of active foreign profits but also required deferral of deductions for expenses allocable to foreign income until that income was taxable in the United States. The Obama administration included a similar proposal in its early budgets.
In 2011 Ways and Means Committee Chair Dave Camp released a discussion draft of several territorial proposals. The committee staff explained: “As under the exemption systems of some other countries, [5] percent of a dividend from a CFC remains taxable. This taxation is intended to be a substitute for the disallowance of deductions for expenses incurred to generate exempt foreign income.” In 2012 Sen. Mike Enzi introduced the United States Job Creation and International Tax Reform Act, which also had a 95 percent deduction for foreign dividends, presumably as a proxy for a deduction disallowance.
In 2013 Senate Finance Committee Chair Max Baucus released a discussion draft tax reform under which foreign income was partially exempt from U.S. tax and accordingly disallowed a deduction for a portion of the interest expense of a corporate U.S. shareholder of a CFC. The JCT explained: “In broad terms the portion of the interest expense for which a deduction is disallowed represents the interest that is apportioned to income of a CFC that is exempt from taxation by the United States (because it is not subpart F income or effectively connected income).”
When the Obama administration proposed its minimum tax on foreign profits in 2015, Treasury asserted that “no deduction would be permitted for interest expense allocated and apportioned to foreign earnings for which no U.S. income tax is paid.”
In late 2017 the administration, the House and Senate versions, and the final version of the TCJA included no apportionment of U.S.-incurred expenses in the calculation of foreign-source income. Nor did they reduce the section 245 dividends received deduction as a proxy for the absence of such an allocation.
A More Realistic Example
The table shows a modified version of an example provided by Shay in his recent paper. (U.S. effective tax rates are calculated differently but the qualitative results are the same.) In the example, loosely based on aggregate data available from the IRS, a CFC has $100 of profit of which $10 is subpart F income, leaving $90 of net tested income. The tax-exempt component of this $90 is attributable to a combination of deductions for the 50 percent section 250 deduction (assuming none of the limitations on that deduction apply) and net deemed tangible income return (NDTIR). Shay refers to these two deductions as exemptive deductions. Tax-exempt income is $57.50 equal to $25 (attributable to NDTIR) plus $32.50 (attributable to a section 250 deduction equal to 50 percent of $90 - $25). The fraction of tested income that is tax exempt is 63.9 percent (equal to $57.50/$90), and the fraction that is taxable is 36.1 percent.
A. Determination of the tax-exempt fraction of net tested income: | ||||||
Net tested income | $90 |
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NDTIR | $25 |
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GILTI inclusion | $65 |
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Section 250 deduction | $32.50 |
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Taxable income | $32.50 |
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Taxable/tested income | 36.1% |
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Exempt/tested income | 63.9% |
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Corporate tax rate | 21% |
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Effective tax rate on tested income | 7.58% |
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B. Tax under current law without section 265 adjustment: | ||||||
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| Gross Income | Expenses | Net Income | Tax | ETR |
|---|---|---|---|---|---|---|
Total CFC |
| $100 | $20 | $80 |
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Subpart F |
| $10 | $2 | $8 |
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Tested income | 100% | $90 | $18 | $72 |
| 4.23% |
Taxable | 36.11% | $32.50 | $18 | $14.50 | $3.05 |
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Tax exempt | 63.89% | $57.50 | $0 | $57.50 | $0 |
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C. Tax with section 265: | ||||||
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| Gross Income | Expenses | Net Income | Tax | ETR |
Total CFC |
| $100 | $20 | $80 |
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Subpart F |
| $10 | $2 | $8 |
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Tested income | 100% | $90 | $18 | $72 |
| 7.58% |
Taxable | 36.11% | $32.50 | $6.50 | $26 | $5.46 |
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Tax exempt | 63.89% | $57.50 | $11.50 | $46 | $0 |
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D. Tax rate reduction from misallocated expenses: | 3.35% | |||||
Source: Author’s calculations borrowing heavily from Shay (2021). | ||||||
Without applying section 265 principles, all $20 of expenses allocable to foreign income are deductible. That results in an effective tax rate of 4.23 percent (equal to $3.05/$72). Disallowing deductions allocable to exempt foreign income reduces deductions to $6.50 (36.1 percent of $20). The effective tax rate is 7.58 percent (equal to $5.46/$72). The misallocation of expenses reduces the rate of tax on GILTI by 3.35 percent.
Note that 7.58 percent is equal to 21 percent multiplied by the taxable fraction of 36.1 percent. We can think of 7.58 percent as the “GILTI tax rate” for a given amount of section 250 and NDTIR deductions. It is the rate at which GILTI “should be” taxed. Importantly, it doesn’t vary by the amount of allocable expenses a taxpayer may have.
The overallocation of expenses to taxable U.S. income reduces the effective tax rate on foreign income and therefore provides an added incentive, above that provided by section 250 and NDTIR for foreign investment. In this example, applying section 265 principles, the taxpayer may invest at 21 percent in the United States or at 7.58 percent outside the United States. The overallocation of expenses reduces the U.S. tax rate on foreign income to 4.23 percent. Also, the effect of misallocation isn’t neutral across taxpayers.
Objections
None of these calculations take into account foreign taxes. A combined domestic and foreign tax rate on foreign income would indicate a smaller after-tax benefit from foreign investment and a smaller benefit from not disallowing deductions allocable to foreign income.
One objection to disallowing deductions incurred in the United States but allocable to foreign income is that foreign countries don’t allow deductions for these expenses. So, it can be argued that the failure of the United States to disallow these deductions is offset by the failure of foreign governments to allow them. In effect, two wrongs make a right.
It is the view of many that double taxation absolutely must be avoided. (In other words, expenses must be deductible somewhere.) According to that view, because foreign governments do not allow a deduction for expenses allocable to foreign income, it is incumbent that the U.S. government allow one. To the contrary, Shay, J. Clifton Fleming Jr., and Robert J. Peroni argue that “the United States has no obligation to grant subsidies to mitigate other counties’ tax system errors.”
In these pages in 2012, your author described a deduction disallowance that takes into account the differential between the U.S. and foreign tax rates by calibrating disallowed U.S. deductions so the expenses are deducted at a combined rate equal to the U.S. rate. Such a proposal would suffer from the same flaw as the provision of an FTC without a limitation: Foreign countries could divert tax revenue from the United States by simply raising tax rates on U.S. investors — without fear of placing additional burdens on the U.S. companies themselves.
Another objection to a deduction disallowance is that foreign governments don’t disallow deductions in their territorial systems. All other things equal, that makes U.S. multinationals less competitive than their foreign counterparts.
Yet another objection is that the calculation is too complicated. But under the law, multinational corporations subject to an FTC limitation — or anywhere close to that limit — already must determine expenses allocable to foreign-source income.
Concern about complexity invariably leads to consideration of reducing a 100 percent dividends received deduction by a percentage, usually 5 percent. Multinationals in Japan, Germany, France, and Italy have a 95 percent deduction on dividends received from foreign subsidiaries. Such a haircut would to some degree reduce the foreign domestic differential caused by the misallocation of expenses. It wouldn’t, however, reduce the dispersion of effective tax rates across taxpayers caused by the misallocation of expenses.
Conclusion
In his paper, Shay makes the case that Treasury has the authority to reduce deductions for expense allocable to the exempt portion of foreign income. It is expected that the Biden administration will make three major changes to the GILTI rules: (1) eliminate deductions for NDTIR; (2) reduce deductions under section 250 from 50 percent to 25 percent of the GILTI inclusion; and (3) compute GILTI FTCs on a country-by-country basis.
In a prior article, we suggested several other revenue-losing changes that would clean up many messy aspects of the GILTI rules. Overall, the proposals would reduce but not eliminate the tax exemption of foreign profits. In addition to those changes, the Biden administration should consider disallowing expenses allocable to the exempt portion of foreign income as part of its legislative proposal to overhaul the GILTI rules. That would promote economic efficiency directly and indirectly to the extent that such base broadening helps keep the corporate rate low.
References
Patrick Driessen, “Getting Foreign Deferral’s Epitaph Right,” Tax Notes Federal, June 15, 2020, p. 1883.
Driessen, “Expense Allocation Is Dead; Long Live Expense Location Neutrality,” Tax Notes, Mar. 25, 2019, p. 1485.
Driessen, “GILTI’s Effective Minimum Tax Rate Is Zero or Lower,” Tax Notes Federal, Aug. 5, 2019, p. 889.
Driessen, “In Defense of Cross-Border Expense Apportionment,” Tax Notes, July 30, 2018, p. 665.
Michael J. Graetz and Paul W. Oosterhuis, “Structuring an Exemption System for Foreign Income of U.S. Corporations,” 54 Nat’l Tax J. 771 (2001).
Harry Grubert and John Mutti, “Taxing International Business Income: Dividend Exemption Versus the Current System,” American Enterprise Institute (2001).
House Ways and Means Committee, “Technical Explanation of the Ways and Means Discussion Draft Provisions to Establish a Participation Exemption System for the Taxation of Foreign Income” (Oct. 26, 2011).
JCT, “Options to Improve Tax Compliance and Reform Tax Expenditures,” JCX-19-05R (Apr. 12, 2005).
JCT, “Technical Explanation of the Senate Committee on Finance Chairman’s Staff Discussion Draft of Provisions to Reform International Business Taxation,” JCX-15-13 (Nov. 19, 2013).
Thornton Matheson, Victoria Perry, and Chandara Veung, “Territorial vs. Worldwide Corporate Taxation: Implications for Developing Countries,” IMF Working Paper No. 13/205 (Oct. 2013).
National Foreign Trade Council, “Territorial Tax Study Report” (2002).
President’s Advisory Panel on Federal Tax Reform, “Simple, Fair, and Pro-Growth: Proposals to Fix America’s Tax System” (Nov. 2005).
Stephen E. Shay, J. Clifton Fleming Jr., and Robert J. Peroni, “Territoriality in Search of Principles and Revenue: Camp and Enzi,” Tax Notes, Oct. 14, 2013, p. 173.
Shay, “Applying Section 265 to Address an Opaque Foreign Income Subsidy” (Mar. 31, 2021) (draft).
Martin A. Sullivan, “The Effects of Interest Allocation Rules in a Territorial System,” Tax Notes, Sept. 3, 2012, p. 1098.
Sullivan, “What Will Treasury Do About the Sins of GILTI?” Tax Notes Federal, Apr. 5, 2021, p. 7.