Interest allocation: the dog days of summer
What a difference a summer makes! Earlier this year, many had high hopes that the United States would finally correct the most significant tax mistake facing U.S. multinationals, namely the current method for allocating and apportioning interest expense among U.S. and foreign assets.
From its inception, section 864(e) of the Internal Revenue Code was intended to be a revenue-raising provision that was not based on sound policy. (1) As such, it has created substantial harm. (2) Congress has known for years that section 864(e) is flawed, but has been unsuccessful in building enough support to amend the provision. (3) Last year, Congress passed H.R. 2488 — which would have substantially modified section 864(e)’s interest expense allocation rules (4) — but the legislation was vetoed by President Clinton. (5) With the advent of a new Administration earlier this year, the tax community was optimistic that legislation would be passed again and, this time, actually signed. (6)
A consensus exists within the U.S. Department of Treasury, Congress, and the tax community that section 864(e) is flawed. Notwithstanding this broad-based agreement, however, pragmatic politics of budget economics continues to stymie reform. The first blow came with Treasury’s decision to seek tax relief only for individuals to ensure that some tax bill actually passed this year. (7) Administration officials hinted that corporate tax relief would come in the fall. (8) Individual tax reform, set forth in Public Law No. 107-16, encountered greater than expected opposition but was finally signed into law by President Bush as the Senate passed to Democratic control. (9)
With the slow-down in the U.S. economy, the tide has turned. (10) Now, a growing opposition in Congress has coalesced. (11) The Congressional Budget Office projected that H.R. 2488’s amendment to section 864(e) would cost more than $25 billion. (12) Although Congress is considering a massive economic stimulus bill to jump start the economy, international tax reform is not among the items listed for enactment. (13) Thus, even though many argue that section 864(e) should be reformed, Congress may still not be able to muster the political will to act.
Given that a legislative overhaul of section 864(e) appears unlikely in the near term, Treasury should reexamine its existing temporary regulations to correct the most serious shortfalls. To the government’s credit, the Internal Revenue Service issued Notice 2001-59 requesting comments on whether the U.S. interest expense allocation and apportionment rules should be modified. (14) This article argues that Treasury has the regulatory authority to correct some important flaws contained in the current application of section 864(e). This article also argues that sound tax policy would be advanced if Treasury exercised that authority.
I. The Interest Expense Allocation Rules Should Further the Policy Goals of the Foreign Tax Credit Limitation Regime
Under the foreign tax credit limitation rules, foreign income is separately categorized under section 904 and then expenses are allocated and apportioned between domestic and the various separate limitation categories of foreign income to determine the U.S. taxpayer’s net foreign income in each category. With several important exceptions, section 864(e) generally seeks to make this allocation by allocating a U.S. taxpayer’s consolidated U.S. interest expense ratably among the U.S. and foreign assets held by the U.S. consolidated group. (15) Again, this allocation of interest expense is important because the United States allows foreign tax credits to be claimed if and only if there is sufficient net foreign income in the separate category to which the credits relate. Thus, the U.S. interest allocation rules are a significant component to determine the amount of net foreign source income in each respective basket. To the extent that U.S. expenses are allocated against foreign-source income, a taxpayer will lose the ability to claim foreign tax credits to offset its residual U.S. tax liability. When a taxpayer cannot use these credits to offset its U.S. tax on foreign earnings, international double taxation is created.
Under the original income tax laws of 1909 and 1913, (16) the United States provided no foreign tax credit relief, but, because the income tax rates were admittedly small, the lack of relief was not significant. With the advent of World War I, however, tax rates increased sharply in the United States and other countries. With the increasing tax rates, international double taxation became a significant expense to U.S. multinationals. As a result, in 1918 Congress adopted a regime that would allow U.S. taxpayers to claim foreign tax credits with respect to foreign income taxes. (17) The objective in allowing such credits is to prevent worldwide double taxation on the same earnings; this would be the result if both the host country and the United States attempted to assert taxing jurisdiction over the same income. (18) It is not clear why Congress chose to limit foreign tax credit relief to situations where the foreign tax is an income tax.
Between 1918 and 1921, there were no limitations on the use of foreign tax credits. As a result, taxpayers could utilize the credits to fully reduce their residual U.S. tax liability on both domestic-source and foreign-source income. Thus, the ability to apply excess foreign tax credits against the tax liability of net domestic-source income created an erosion of the U.S. tax base. Allowance of foreign tax credits is consistent with capital-export neutrality since that approach would support the allowance of a refund even where foreign tax credits exceed the U.S. tax on foreign income. (19) To protect the U.S. tax jurisdiction of U.S. territorial income, however, in 1921 Congress limited the use of foreign tax credits such that taxpayers could utilize these credits only to the extent that they otherwise had a U.S. tax liability on net foreign-source income. (20) Thus, Congress has had a longstanding intent with respect to the U.S. foreign tax credit regime to prevent international double taxation except to the extent necessary to protect against erosion of the U.S. taxing jurisdiction of domestic-source income.
The U.S.’s willingness to subordinate the goals of capital-export neutrality in order to protect its taxing jurisdiction was further exemplified in 1976. Prior to that date, taxpayers that incurred start-up foreign losses in one year and foreign income in a later year were not required to net these foreign losses against foreign income arising in later years. And yet, the foreign losses in early years could be claimed as deductions and reduce the U.S. tax liability on domestic-source income. Without recapturing this loss, the allowance of a tax credit against the future income created the ability to deduct foreign losses against U.S. domestic-source income and never pay U.S. tax on the future income. (21) In 1976, Congress enacted legislation that requires foreign-source income to be reclassified as domestic-source income (and thus excluded from the computation of the taxpayer’s overall foreign tax credit limitation) to the extent that foreign-source losses had been deducted against domestic-source income in earlier years. (32) Accordingly, the United States has made a conscious choice to deviate from capital-export neutrality in order to protect its right to tax domestic-source income.
In 1986, Congress expressed a further desire to raise revenue by limiting the ability of U.S. taxpayers to use foreign tax credits to offset U.S. residual taxation on foreign income. In this regard, Congress decided to further limit cross-crediting of foreign taxes against low-taxed foreign income. (23) Thus, Congress’s purpose with respect to the U.S. foreign tax credit regime, as redefined in 1986, is to further deviate from capital-export neutrality to the extent necessary to prevent an inappropriate loss of residual U.S. taxation on low-taxed foreign earnings.
The existence of the foreign tax credit and limitation regimes of sections 904(a), (d), and (f) can be summarized as follows: The foreign tax credit regime is intended to prevent worldwide double taxation except to the extent necessary to protect the U.S. taxing jurisdiction on domestic-source income and to the extent necessary to protect against cross-crediting of taxes against low-taxed foreign-source income. (24) If the foreign tax credit regime allows international double taxation for a reason other than these objectives, then Congress’s expressed objectives are frustrated.
It is important to recognize the fundamental choices that Congress has made with respect to the foreign tax credit regime because those decisions should be the guideposts for determining whether the interest expense allocation rules are achieving appropriate results. Several approaches have been articulated that might preserve these congressional choices. This author has advocated that a modified water’s edge fungibility approach is probably the correct general rule from a policy perspective. Others believe that a “worldwide fungibility approach” is the better view. (25) Regardless of which view one holds, a consensus exists that the current rules work unfairly and that special factual situations exist where interest expense should be allocated on a separate affiliated group basis.
In this regard, Congress provided several important exceptions to the allocation of U.S. consolidated interest expense on a consolidated basis. Congress provided an exception for banks under section 864(e) to treat these entities as a separate affiliated group for purposes of the interest expense allocation rules and provided Treasury authority to expand this exception to include bank holding companies and nonbank financial subsidiaries. (26) Treasury has exercised that authority to encompass bank holding companies and nonbank financial subsidiaries owned by bank holding companies. (27)
Congress also directed Treasury to provide “appropriate adjustments” to the interest allocation rules with respect to insurance companies, (28) and Treasury has issued rules to treat insurance companies as a separate affiliated group. (29) Broad authority was provided to create further exceptions to the principle that all interest within a U.S. consolidated group is fungible. (30) Treasury has not issued further separate affiliated group exceptions even though other situations should receive relief. (31) In this regard, a key question is whether a broader exception should be provided in the regulations to allow financial services entities (32) to avoid their aggregation with nonfinancial businesses for purposes of allocating and apportioning U.S. interest expense. From a policy perspective, the critical inquiry is: Would the treatment of financial service entities as a separate affiliated group adequately protect the U.S. taxing jurisdiction or is the current approach of combining all businesses (other than banks and bank holding companies) into a single group for purposes of allocating and apportioning U.S. interest expense a necessary protection for the U.S. taxing jurisdiction?
Due to the liquid nature of financial assets, financial service entities tend to have higher acceptable debt levels than other less liquid businesses. (33) In this regard, financial service entities are similar to banks. The higher leverage contained in a financial services business would exist whether or not a capital contribution were made to a foreign subsidiary. (34) To the extent a U.S. consolidated group maintains an autonomous and independent financial services business in the United States, the result is that U.S. interest expense is allocated to non-financial businesses. This can in turn significantly overstate the amount of interest allocated to foreign income beyond any reasonable amount needed to protect the U.S. tax base. This result occurs because Temp. Reg. [sections] 1.861-9T requires the averaging of the interest expense of a U.S. consolidated group among all U.S. and foreign assets without regard to whether a business is a highly leveraged financial business or a less leveraged nonfinancial business. As a result, a U.S. company’s ownership of a financial services entity creates significant negative consequences to the U.S. parent.
DaimlerChrysler’s example provides a good summary of the problem with allocating overall U.S. interest expense when a financial services entity is owned in a U.S. affiliated group:
DaimlerChrysler has a large affiliated finance company in the U.S. whose
primary business purpose is to provide financing to Chrysler dealers and
customers who buy Chrysler products in the U.S. However, under the U.S. tax
laws, DaimlerChrysler must apportion its U.S. affiliated group’s interest
expense between its U.S. income and its worldwide income. Had the former
Chrysler Corporation become the parent company of the merged group,
substantially over 50% of the value of the assets of the combined companies
would have been located outside of the United States. This would have meant
that more than 50% of the U.S. affiliated group’s interest would have been
apportioned to foreign source income. This would have decreased the amount
of foreign source income that was eligible for offset by the foreign tax
credit. In effect, U.S. tax would have to be paid on the amount of foreign
source income equal to the expenses allocated to that income, and that
would hove been quite a large number.
Consider, for example, a situation where the German company is a subsidiary of the U.S. company:
Assume DaimlerChrysler Corporation sold one vehicle in the United States
and made $1,000 of net taxable income on the sale. DaimlerChrysler’s
finance subsidiary financed the sale of the vehicle and that company
incurred $100 of interest expense. In that year, the former Daimler Benz AG
also earned $100, paid $50 in tax to the German tax authorities, and
remitted a $50 dividend to the DaimlerChrysler parent company in the United
Assume also that 50 percent of DaimlerChrysler Corporation’s assets were
foreign. 50 percent of the interest expense or $50 is allocated to
foreign-source income. Of the corporation’s total income subject to U.S.
tax of $1,100, only $100 is foreign-source income ($50 dividend plus $50
gross-up for German taxes). Under the U.S. method of calculating foreign
tax credits, the $100 in foreign-source income is reduced by the $50 U.S.
interest expense apportioned to that income. This results in net
foreign-source income of $50. The U.S. tax on that amount is $17.50, which
is the maximum amount of credit that may be claimed on the $100 of German
income. Therefore, on the $100 earnings in Germany, 67.5 percent would be
paid in taxes (50 percent in Germany; 17.5 in the United States). That is,
a portion of the German income will have been taxed twice. (35)
The interest allocation rules should take into account the economic reality that the use of debt in financial entities is significantly different from its use in nonfinancial service entities. Failing to recognize this fact creates significant distortions because the interest expense of financial service entities tends to be allocated away from its domestic financial services income to the U.S. parent’s foreign income, creating international double taxation. This proration of U.S. consolidated interest expense among disparate financial and non-financial businesses exaggerates the amount of interest expense that should be allocated to appropriately protect the U.S. taxing jurisdiction over domestic-source and low-taxed foreign-source income. (36)
With respect to financial services entities, H.R. 2488 could serve as a blueprint for regulatory relief in this area. In this regard, the bill allows financial services entities to be treated as a separate affiliated group for purposes of apportioning interest expense. This separate affiliated group approach recognizes that interest is fungible but that combining financial and nonfinancial businesses into the same apportionment grouping creates incorrect results since financial and nonfinancial businesses have dramatic differences in the amount of their leverage. (37) H.R. 2488 recognizes this distinction and thus avoids international double taxation while at the same time protecting the U.S. taxing jurisdiction in three ways. First, the debt of a financial service entity can be treated as part of a separate affiliated group for purposes of allocating interest expense only if the U.S. parent does not guarantee this debt and it is not held by a related person. Second, an amount of debt of the financial services entity equal to the amount of any excess dividend distributions from a financial service entity will not be treated as separately allocable under proposed section 864(f). Thus, attempting to manipulate the leverage of a financial services entity in order to distort the interest allocation rules will not be allowed. Finally, the proposed subsection provides a broad grant of regulatory authority to Treasury to promulgate regulations to prevent abuse.
Congress invited Treasury to make exceptions to section 864(e) by providing the department with a broad regulatory authority to modify the rules. (38) Expanding the definition of “certain financial corporations” to include “financial service entities” is within that authority.
This expanded exception would be consistent with the overall statutory framework of the foreign tax credit limitation rules. The concept used by section 904 to distinguish financial and non-financial businesses is the broader concept of “financial services entities,” (39) not the narrower category of banks and bank holding companies set forth in Temp. Reg. [sections] 1.861-11T(d)(4). Given that the interest allocation rules of section 864(e) serve to implement the foreign tax credit limitation rules of section 904, the interest allocation regulations should adopt the same concepts already employed within the broader limitation rules.
As early as 1992, Treasury was asked to provide that financial service entities be treated as a separate affiliated group under its regulatory authority. (40) Treasury has testified that it recognized the distortions that the fungibility concept can create in the interest expense of highly leveraged financial companies. (41) Despite this public recognition of the distortions, the broad regulatory authority, and numerous calls for providing exceptions to the interest allocation rules, (42) Treasury’s current regulations consistently provide narrow exceptions and penalize financial service entities without a stated rationale for doing so. The narrow scope of the integrated financial transaction and its outright nonapplicability to financial service entities are in stark contrast to Treasury’s willingness to issue broader exceptions with respect to other analogous provisions of the Code. (43) Financial service entities are treated more harshly than banks under the separate affiliated group rules of Temp. Reg. [sections] 1.861-11T, and are unable to qualify for relief under the integrated financial transaction exception of Temp. Reg. [sections] 1.861-10T(c)(2). (44)
Early on, many practitioners were confident that Treasury would eventually support reform of the interest allocation rules. (45) In Notice 2001-59, the government suggests that it may be willing to re-examine the scope of these rules. Treasury should modify its current temporary regulations and exercise its authority to allow financial service entities to be treated as a separate affiliated group for purposes of the U.S. interest expense allocation rules.
II. Why Treasury Should Act
Treasury should act because its current regulatory interpretation of section 864(e) exaggerates the amount of international double taxation that U.S. corporations suffer; this mistake is having a profound negative impact on global businesses. Although the United States imposes one of the highest effective corporate tax rates in the world, (46) many U.S. corporations cannot fully utilize their foreign tax credits. The U.S. interest allocation rules play a significant role in this international double taxation. (47) Several economic studies have concluded that the U.S. interest expense allocation rules have distorted the investment decisions of U.S. corporations. (48)
By overallocating interest expense to foreign income and overtaxing a U.S. parent’s foreign income, the U.S. international tax rules disadvantage foreign investments owned via a U.S. holding company. Once the market understood that foreign-owned multinationals do not suffer a double taxation problem while U.S.-owned multinational corporations tend to do so, Wall Street reacted in predictable fashion. (49) PricewaterhouseCoopers prepared a study on major mergers and acquisitions in 1998 and 1999 where a U.S. headquartered company was either an acquirer or a target. The disturbing findings showed that a majority of these transactions resulted in a loss in U.S.-headquartered companies. (50) With respect to large-scale mergers or acquisitions of financial service businesses, more than 76 percent of the acquisitions resulted in a net loss of a U.S.-headquartered company. The data from all corners suggest that the U.S. interest expense allocation rules are having a dramatic effect on the continued viability of U.S.-headquartered multinationals with the most pronounced effect on companies that have large scale financial service affiliates. Treasury should therefore act to provide some regulatory relief for companies that have a financial service entity within their affiliated group structure.
The rules have increasingly encouraged U.S.-based multinationals to convert themselves into foreign-owned corporations, thereby placing foreign investments outside the U.S. corporation’s direct or indirect ownership. The objective, in part, is to avoid the U.S. extraterritorial tax rules and the need to rely on the U.S. foreign tax credit rules to prevent international double taxation. In the now well-known outbound transfer of Helen of Troy’s stock in 1994, shares of Helen of Troy (U.S.) were exchanged for shares of Helen of Troy (Bermuda) and Helen of Troy (U.S.) became of wholly-owned subsidiary of Helen of Troy (Bermuda). (51) The purpose of this transaction was to rearrange the ownership of these companies so that additional international investments would be made outside the reach of the U.S. extraterritorial tax regime by Helen of Troy (Bermuda). The Treasury Department responded to this expatriation transaction by issuing Notice 94-46 announcing that such “inversion transactions” would be attacked. (52) Two years later, Treasury issued regulations that required the transfer of stock in a U.S. corporation to a foreign corporation to be taxable unless the pre-merger foreign corporation was more valuable than the U.S. corporation and certain other requirements were met. (53) The stated purpose for these rules was that Treasury was concerned that outbound reorganizations may provide an opportunity for corporations to avoid the U.S. extraterritorial taxation rules.
Although the current section 367 regulations are restrictive, they have not stopped outbound inversion transactions. Several private rulings have been issued since their promulgation that have allowed “acceptable” outbound “inversion transactions” to occur. (54) Further, the desire to pay only one U.S. tax instead of bearing ongoing double taxation has led the market to consider taxable expatriation transactions. Under these more sophisticated transactions, the corporation and the shareholders can divide up the cost of an outbound expatriation and minimize the up-front cost of the transaction. (55) Treasury announced in 1998 that it was aware that taxpayers were again entering into transactions designed to inappropriately avoid the inversion regulations and that it was carefully monitoring such transactions. (56) The department believes that this current trend is a sufficient reason to require a regulatory response.
Treasury is right that it should craft a regulatory response, but its response should be aimed at reforming Temp. Reg. [sections] 1.861-11T(d)(4). The fundamental problem creating this market reaction is that investing in foreign markets through a U.S. parent corporation is disadvantageous merely because the parent corporation is a U.S. corporation. There is something terribly wrong when U.S. corporations would rather have their non-U.S. assets leave the U.S. extraterritorial tax regime entirely instead of relying on the foreign tax credit regime to avoid international double taxation. Thus, instead of focusing on further refining the section 367 regulations, Treasury should seek to address the fundamental source of the problem, namely the foreign tax credit problems that Treasury’s current interpretation of section 864(e) is inflicting.
The decision by DaimlerChrysler to incorporate in Germany and not the United States should serve as a wake-up call that something is terribly wrong. The following testimony by John Loffredo, Vice President and Chief Tax Counsel for DaimlerChrysler Corporation, indicates the seriousness of the problem:
The merger of Chrysler Corporation and Daimler Benz A.G. was a marriage of
two global manufacturing companies, one with its core operations in North
America and the other headquartered in Europe, with operations around the
world. However, the U.S. tax system puts global companies at a decisive
disadvantage. This issue became a major concern and when the time came to
choose whether the new company should be a U.S. company or a foreign
company, Management chose a company organized under the laws of Germany….
[U]nder the U.S.’s worldwide tax system a U.S. parent company receiving
dividends from its foreign affiliates must include the dividends and
corresponding foreign taxes paid in its U.S. taxable income. Then it must
determine the U.S. tax on those dividends. The U.S. company may be able to
offset the U.S. tax on that income if it can meet certain limitations and
utilize the foreign tax credits generated by these foreign subsidiaries. If
the foreign tax rate is the same or higher than the U.S. tax rate, the
foreign tax credits should, in theory, offset the U.S. tax on those
dividends. If this occurred, the result would be the same in the U.S. as it
is under the German Territorial System. That is, no further U.S. corporate
tax would be imposed and the earnings will have been taxed by only one
country. However, under restrictions put in the U.S. tax laws over the past
several decades, this theoretical result is typically NOT achieved and, in
many cases, the U.S. taxpayer can NEVER fully utilize all of the foreign
taxes paid by its subsidiaries to offset the U.S. tax on foreign earnings.
The result is taxation of at least a portion of the earnings twice, by two
Under these circumstances, the German Territorial Tax System provides a
greater degree of certainty for the new DaimlerChrysler company that
corporate income earned outside of the country of incorporation for the
parent will only be taxed once (although as of January 1, 1999 dividends
remitted to Germany will be subject to the new tax equivalent of 3.5% of
the gross dividend before U.S. tax).
Why does a U.S. company have a problem utilizing all its foreign tax
credits so that foreign source income is only taxed once? The main reason
for this problem is that a U.S. company has to apportion many of its
domestic business expenses (especially interest expense) against its
foreign source income, thus reducing the amount of foreign income that may
be taken into account in meeting the limitation. This would create unused
foreign tax credits. (57)
In testimony before the U.S. Senate Finance Committee, Robert H. Perlman, Vice President, Tax, Licensing & Customs, for Intel Corporation noted that Intel is believed to be one of the five largest U.S. taxpayers. If Intel were founded today, Mr. Perlman testified he would strongly advise that the parent company be incorporated outside the United States because the U.S. tax code competitively disadvantages multinationals when the parent company is a U.S.-based multinational. (58) In today’s global economy, it is a failure of the U.S. tax system that multinational companies widely believe that the United States no longer follows norms of international taxation. (59)
Treasury’s current interpretation of section 864(e) is indefensible since it creates international double taxation without an adequate justification for doing so. This double taxation causes large-scale mergers to be structured in ways that negatively affect U.S. tax policy. Treasury has already modified its regulations under section 367 to address this trend and has issued statements that it may need to issue additional regulatory changes. Treasury should modify Temp. Reg. [sections] 1.8610-11T(d)(4) to permit “financial service entities” to be treated as a separate affiliated group for purposes of the U.S. interest allocation rules. Treasury must act now to reduce the amount of international double taxation created by its regulations that is resulting in a loss of U.S.-headquartered companies. The tragic irony is that section 864(e)’s “overprotection” of U.S. domestic-source income is, in fact, depleting the very income that those rules are designed to protect.
(1) See Joseph L. Andrus, “Planning Under U.S. Interest Expense Allocation Rules,” 70 Taxes 1008, 1010 (Dec. 1992) (stating that the current interest allocation rules were not the result of a principled approach to international taxation but rather represented a compromise position that was designed to raise revenue); T. Timothy Tuerff & Keith F. Sellers, “Taking Advantage of Exceptions to Asset-Based Apportionment,” 1 J. Int’l Tax’n 261, 262 n.4 (1991); “International Taxes: Treasury Urged to Back Interest Expense Allocation by Earnings and Profits Bases,” Daily Tax Report at G-5 (Oct. 7, 1991).
(2) 145 Cong. Rec. 105, H6203-06 (daily ed. July 22, 1999) (statement of Rep. Portman) (“[l]et me mention a couple of other great provisions in the Archer bill, such as reforming unfair tax rules like the interest allocation rules that are driving U.S. companies and jobs out of this country”). See also text accompanying notes 46 through 59.
(3) 138 Cong. Rec. H3817-03 (daily ed. May 27, 1992) (statement by Rep. Rostenkowski introducing H.R. 5270, “The Foreign Income Tax Rationalization and Simplification Act”):
Madam Speaker, the first part of this legislation corrects several problems
in the current tax law that could result in overtaxation of income earned
by U.S. companies conducting business abroad. The most significant
provision in this section of the Bill would correct anomalies in the
apportionment of interest expense of U.S. multinational companies between
domestic and foreign source income. This is a critical component in the
calculation of the foreign tax credit for a significant number of U.S.
multinational corporations. Madam Speaker, several members of the business
community have told me that this issue relating to the proper apportionment
of interest expense may be the number one tax problem for U.S.
multinational corporations attempting to conduct business effectively
abroad. The correction of these anomalies and the rationalization of these
rules would promote the significant policy objective that U.S.-based
multinational corporations should be taxed fairly on income generated from
overseas operations, and should not be subject to double taxation on such
H.R. 5270 was never enacted. Congress has engaged in several unsuccessful legislative attempts to amend section 864(e). See, e.g., H.R. 3838, 99th Cong. (1986); H.R. 3545, 100th Cong. (1987); H.R. 3299, 101st Cong. (1989); H.R. 5270, 102d Cong. (1992); H.R. 2488, 106th Cong. (2000).
(4) H.R. 2488, 145 Cong. Rec. 114, S10286-90 (daily ed. Aug. 5, 1999); H.R. 2488, 145 Cong. Rec. 114, H7251-52 (daily ed. Aug. 5, 1999).
(5) “After Veto, White House Dismisses GOP Extenders Bill,” Tax Notes Today (Sept. 23, 1999).
(6) See Martin A. Sullivan, “Interest Allocation Reform: Time to Talk or Time to Act?,” Tax Notes Today (Aug. 30, 1999); Bret Wells, “Interest Allocation: Desperately in Need of Sound Policy,” 53 Tax Law. 859 (2000).
(7) “Business Vows to Seek Its Share of Tax Relief; GOP Loyalists’ Hopes May Clash With Bush’s Plan,” Wash. Post at A04 (Feb. 7, 2001).
(8) “News: White House Economist Says Business Tax Reform Next for Administration,” 2001 TNT 124-4 (June 27, 2001).
(9) “News: Senate Vote Moves Tax Relief Bill to Bush,” 2001 TNT 124-53 (June 27, 2001).
(10) Martin A. Sullivan, Economic Analysis–Fate of Tax Policy Tied to Uncertain Economy, 2001 TNT 118-2 (June 19, 2001).
(11) “CBO Numbers Predict On-Budget Deficits,” Tax Notes Today (Aug. 27, 2001); “Rep. Rangel Blasts Bush Administration For Irresponsible Tax Cut and Budget Policy,” Tax Notes Today (Aug. 27, 2001); “News: Daschle Predicts a Democratic Senate Could Approve Business Tax Breaks,” 2001 TNT 104-1 (May 30, 2001) (“the budget doesn’t allow for any more tax cuts unless they are paid for”); “Dwindling Surplus Means Policymakers To Hunt For Tax Cut Offset,” Tax Notes Today (Aug. 22, 2001).
(12) “JCT Estimates Revenue Effects of W&M Tax Bill Report,” Tax Notes Today (July 21, 1999).
(13) “White House, Hill Discussions Continue In Preparation for Expected Stimulus Bill,” BNA Daily Tax Report, No. 187 at G-6 (Sept. 27, 2001).
(14) Notice 2001-59, 2001 TNT 183-6 (Sept. 19, 2001).
(15) Prior to 1986, interest expense was allocated on a separate company basis. See Treas. Reg. [subsections] 1.861-8(a)(2) through (e)(2), 42 Fed. Reg. 1195 (1977). Taxpayers could therefore create a corporate structure that shielded foreign-source income from interest expense by maintaining debt in domestic members that held only domestic assets. This structure was sometimes referred to as a “top hat,” meaning that the debt was maintained at the parent company level and the stock of foreign subsidiaries was held by a special purpose domestic corporation that had little or no debt. See Steven P. Hannes and James A. Riedy, “Time to Move to a Worldwide Group Approach for Apportioning Interest,” 2001 TNT 98-110 (May 18, 2001). As a result, Congress recognized that prior law allowed affiliated taxpayers to use interest expense to reduce their consolidated tax on U.S.-source income although the interest expense funded nontaxable foreign activities. See Staff of the Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986, 99th Cong., 2d Sess. 945 (1986). Not only was no U.S. tax paid on the foreign investment, Congress recognized that the mere fact of making a foreign investment generated a negative U.S. tax rate on U.S.-source income. Thus, the motivation for Congress to enact section 864(e) was the same motivation that caused Congress to enact and expand the U.S. foreign tax credit limitation rules.
(16) Revenue Act of 1909, ch. 6, 36 STAT. 11; Revenue Act of 1913, ch. 16, 38 STAT. 114.
(17) Revenue Act of 1918, ch. 18, 8 222(a), 42 STAT. 1057.
(18) Staff of the Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986, 99th Cong., 2d Sess. 852 (1986).
(19) Staff of the Joint Committee on Taxation, Description and Analysis of Present-Law Rules Relating to International Taxation, 106th Cong., 1st Sess. 74 (1999).
(20) Revenue Act of 1921, ch. 136, 8222(a)(5), 42 STAT. 227; I.R.C. [sections] 904(a).
(21) H.R. Rep. No. 94-658, 94th Cong., 1st Sess. 228 (1976) (“[I]n a case where an overall foreign loss exceeds foreign income in a given year, the excess of the losses can still reduce U.S. tax on domestic source income. In this case, if the taxpayer later receives income from abroad on which he obtained a foreign tax credit, the taxpayer receives the tax benefit of having reduced his U.S. income for the loss year while not paying a U.S. tax for the later profitable year. To reduce the advantage to these taxpayers, your committee has included a provision which requires that in cases where a loss from foreign operations reduces U.S. tax on U.S. source income, the tax benefit derived from the deduction of these should, in effect, be recaptured by the United States when the company subsequently derives income from abroad.”).
(22) I.R.C. [sections] 904(f).
(19) I.R.C. [sections] 904(d).
(24) I.R.C. [subsections] 904(a) & (d).
(25) See Bret Wells, “Interest Allocation: Desperately in Need of Sound Policy,” 53 Tax Law. 859 (2000) (this paper argues that protecting the right to domestic-source income and low-taxed foreign-source income is the ultimate goal of the U.S. foreign tax credit limitation regime; accordingly, the optimum allocation regime would be a regime that allocates U.S. interest expense among U.S. and foreign assets but for this purposes does not define a “foreign asset” to include undistributed foreign earnings; a separate affiliated group for financial businesses, however, is also necessary). In contrast, a worldwide fungibility approach has long been advocated as the correct policy approach. This approach was originally endorsed by the Senate in 1986. S. Rep. No. 99-313, 99th Cong., 2d Sess. 351 (1986). Respected commentators have advocated this position for years. See Joseph L. Andrus, “Planning Under U.S. Interest Expense Allocation Rules,” 70 Taxes 1008, 1010 (Dec. 1992); T. Timothy Tuerff & Keith F. Sellers, “Taking Advantage of Exceptions to Asset-Based Apportionment,” 1 J. Int’l Tax’n 261 (1991); Martin A. Sullivan, “Interest Allocation Reform: Time to Talk or Time to Act?,” Tax Notes Today (Aug. 30, 1999); Steven P. Hannes and James A. Riedy, “Time to Move to a Worldwide Group Approach for Apportioning Interest,” 2001 TNT 98-110 (May 18, 2001).
(26) I.R.C. [subsections] 864(e)(5)(B), (C), & (D).
(27) Temp. Reg. [sections] 1.9861-11T(d)(4).
(28) I.R.C. [sections] 864(e)(7)(E).
(29) Temp. Reg. [sections] 1.861-11T(d)(3).
(30) I.R.C. [sections] 864(e)(7)(F).
(31) Temp. Reg. [subsections] 1.861-11T(d)(3) & (4).
(32) For a definition of financial service entities, see Treas. Reg. [sections] 1.904-4(e)(3).
(33) See “Securities Industries Association’s Testimony at Ways and Means Hearing on Foreign Income Taxes,” Tax Notes Today (July 22, 1992) (reprinting testimony of Saul Rosen, Managing Director and Tax Director of Salomon Brothers, Inc.).
(34) The fundamental concern is that U.S. interest expense, as a deductible expense in the United States, can be incurred to make a foreign investment and is deductible against U.S. domestic-source income and low-taxed foreign source income. A standalone financial business that conducts relative value trading or securitization transactions does not create this same concern.
(35) See “Daimler Chrysler Testimony at W&M Hearing On U.S. Tax Rules’ Impact On International Competitiveness, Tax Notes Today (July 1, 1999) (reprinting testimony of John L. Loffredo, Vice President and Chief Tax Officer of DaimlerChrysler Corp.).
(36) Corporations have used a variety of self-help techniques short of expatriation to mitigate this foreign tax credit impact. For example, it is possible to substitute preferred stock for debt as a means of financing. In this scenario, the corporation receives a tax deduction implicitly through the lower preferred stock dividend rate as a result of the dividends-received deduction. This approach requires careful monitoring of the relative costs of the foreign tax credit effect of interest expense, the lost interest expense deduction to the corporation, and the preferred stock dividend rate. For example, in 1990 Coke Industries redeemed $300 million of Dutch auction preferred stock when Coke’s foreign tax credit situation changed. See Corporate Financing Week at 5 (Dec. 10, 1990); see also Rev. Rul. 90-27, 1990-1 C.B. 50; Steven Frost & Steven Conlon, “Adjustable Rate Preferred Stock Still Provides Tax Benefits,” 73 J. Tax’n 244 (Oct. 1990) (discussing the meaning of “Dutch Auction” preferred stock). The interest expense of deconsolidated corporations is not subject to allocation among the U.S. consolidated group. Temp. Reg. 8 1.861-9T(a). Thus, Ford deconsolidated Associates Corp. when it acquired it from Paramont Corporation to avoid having its $3.35 billion of acquisition debt included in Ford’s foreign tax credit interest allocation computations. See Matthew Winkler, “Ford Revamps Firm to Realize Big Tax Savings,” Wall St. J., [sections] 1, at 3 (Oct. 12, 1989). These self-help remedies created added cost and highlight the fact that Temp. Reg. [sections] 1.861-9T is creating mischief without a strong policy objective for doing so. See also Myron S. Scholes & Mark A. Wolfson, TAXES AND BUSINESS STRATEGIES: A PLANNING APPROACH 300 (1992).
(37) This distortion has long been recognized by the Treasury Department. See Statement of Leslie B. Samuels, Assistant Secretary (Tax Policy) Department of the Treasury Before the Subcommittee on Select Revenue Measures of the House Committee on Ways and Means (June 22, 1993) (stating that the Administration did not oppose H.R. 5270 and that this provision “recognizes the disadvantage suffered by diversified multinationals under the present interest allocation rules by virtue of the dramatic differences in leverage associated with financial and nonfinancial businesses”), reprinted at 93 TNT 133-44; see also U.S. Treasury Dep.’t, International Tax Reform: An Interim Report, reprinted in Tax Notes Today (Jan. 22, 1993).
(38) See I.R.C. [subsections] 864(e)(7)(B), (E), & (F); Staff of the Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986, 99th Cong., 2d Sess. 945 (1986). In this regard, Congress provided a statutory scheme within section 864(e)as well as Treasury authority to not apply this regime “to the extent that the Secretary determines that the application of this subsection for such purposes would be inappropriate.” See I.R.C. [sections] 864(e)(5)(D)(7). This grant of authority is incredibly broad; it literally gives Treasury discretion to apply or not to apply section 864(e). When given such authority, Treasury has broad discretion to make legislative regulations. See Chrysler Corp. v. Brown, 441 U.S. 281, 302 (1979). As a result, Treasury has the authority to promulgate any reasonable interpretation of section 864(e) that it believes is appropriate, and a court will defer to that regulation unless it is arbitrary, capricious, or contrary to the underlying statute. McKnight v. Commissioner, 7 F.3d 447, 451 (5th Cir. 1993) (citing Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837,843-44 (1984)). Further, even without an expressed delegation of rulemaking authority, Treasury has broad authority to issue interpretative regulations, and significant authority indicates that interpretative regulations may also be given Chevron deference if those regulations are issued in compliance with a notice-and-comment period. See Bankers Life and Cas. Co. v. United States, 142 F.3d 973 (7th Cir. 1998), cert. den., 477 U.S. 903 (1998).
(39) I.R.C. [sections] 904(d)(2)(C); Treas. Reg. 8 1.904-4(e)(3).
(40) “Ernst & Young Summarizes Discussions on Interest Allocations,” Tax Notes Today (Dec. 3, 1992) (reprinting letter to the Treasury from Harvey B. Mogenson).
(41) Statement of Leslie B. Samuels, Assistant Secretary (Tax Policy) Department of the Treasury Before the Subcommittee on Select Revenue Measures of the House Committee on Ways and Means (June 22, 1993) (stating that the Administration did not oppose H.R. 5270 and that this provision “recognizes the disadvantage suffered by diversified multinationals under the present interest allocation rules by virtue of the dramatic differences in leverage associated with financial and nonfinancial businesses”), reprinted at 93 TNT 133-44; see also U.S. Treasury Dep.’t, International Tax Reform: An Interim Report, reprinted in Tax Notes Today (Jan. 22, 1993).
(42) See “Gordon Offers Interest Allocation Proposal for Securities Dealers Conducting `Matched Book Repo Business,'” Tax Notes Today (Jun. 25, 1990) (reprinting letter to the Treasury from Richard A. Gordon arguing for treatment of `matched book repos’ as integrated financial transactions); see also “Integrated Financial Transaction Should Be Defined More Broadly,” Tax Notes Today (Feb. 19, 1992) (reprinting letter to the Treasury from Harvey B. Mogenson alleging that Treasury’s definition of an integrated financial transaction is so narrow as to cause it to have no practical application); “Beneficial Says Interest Expense Allocation Rules Prevent Financial Services Corporations From Being Competitive,” Tax Notes Today (Feb. 11, 1990) (reprinting letter to the Treasury from Finn M.W. Casperson of Beneficial Corp.); “Chevron Says Section 864 Regulations Draw Interest Allocation Rules So Narrowly That They Miss Intended Arbitrage Transactions,” 890 Tax Notes Int’l (TA) 17-34 (Apr. 26, 1988) (reprinting letter to Treasury from J.J. Ross, General Tax Counsel for Amoco Corp.).
(43) Compare Temp. Reg. [sections] 1.861-10T(c) with Treas. Reg. 88 1.988-5 & 1.1221-2.
(44) Temp. Reg. [subsections] 1.861-10T(c)(2)(vi) & 1.861-11T(d)(4).
(45) See Martin A. Sullivan, “Interest Allocation Reform: Time to Talk or Time to Act?,” Tax Notes Today (Aug. 30, 1999).
(46) “Tax Policy for Competitiveness, Growth, and Retirement Security,” Tax Notes Today (Mar. 15, 1999). Treasury may now be signalling, however, that it is willing to reconsider the scope of the integrated financial transaction exception. See Notice 2001-59, 2001 TNT 183-6 (Sept. 19, 2001).
(47) Robert J. Staffaroni, “Size Matters: Section 367(a) and Acquisitions of U.S. Corporations by Foreign Corporations,” 52 Tax Law. 523, 523-4 (1999).
(48) See Kenneth A. Froot & James R. Hines, Jr., “Interest Allocation Rules, Financing Patterns, and the Operations of U.S. Multinationals,” NBER Working Paper No. 4924 (Nov. 1994); Rosanne Altshuler & Jack Mintz, “U.S. Interest Allocation Rules: Effects and Policy,” NBER Working Paper No. 4712 (April 1994).
(49) Willard B. Taylor, “Corporate Expatriation–Why Not?,” 73 Taxes 146, 157 (Mar. 2000) (stating that “anyone engaged in [cross-border merger or takeover] negotiations will conclude that there is a strong bias against the survival of the U.S. corporation…. This in my judgment is a source of concern.”); David A. Waimon, Steven M. Surdell, & J. Russell Carr, “Almost a Merger: Achieving Cross-Border Shareholder Unity Without a Shareholder Exchange,” 78 Taxes 163 (2000); Dolan, U.S. TAXATION OF INTERNATIONAL MERGERS, ACQUISITIONS, AND JOINT VENTURES [paragraph] 7 (2001).
(50) PricewaterhouseCoopers, Summary of Large Cross-Border Mergers and Acquisitions, 1998-1999, prepared for the International Tax Policy Forum (April 22, 2000).
(51) The nuances of how this form of expatriating transaction was accomplished under the old section 367 regulations has been adequately addressed by other commentators. See generally David R. Tillinghast, “Recent Developments in International Mergers, Acquisitions, and Restructurings,” 72 Taxes 1061 (1994); Benjamin G. Wells, “Section 367(a) Revisited,” 71 Tax Notes 1511 (June 1996).
(52) 1994-1 C.B. 356.
(53) Treas. Reg. [sections] 1.367(a)-3(c)(1).
(54) P.L.R. 972004 (Jan. 16, 1997); P.L.R. 989014 (Sept. 4, 1998); P.L.R. 9903048 (Oct. 21, 1998).
(55) The current evolution in expatriation planning is beyond the scope of this article. For an excellent synopsis of recent expatriation transactions, see Willard B. Taylor, “Corporate Expatriation–Why Not?,” 73 Taxes 146, 157 (Mar. 2000). One can add to the list of recent expatriation transactions set forth in this article the decision of Cooper Industries, Inc. to expatriate. See Prospectus/Proxy Statement dated July 27, 2001.
(56) T.D. 8770, 63 FED. REG. 33550 (June 19, 1998).
(57) “DaimlerChrysler Testimony at W&M Hearing On U.S. Tax Rules’ Impact On International Competitiveness,” Tax Notes Today (July 1, 1999).
(58) “Unofficial Transcript of U.S. Senate Committee Hearing on International Tax Laws,” Worldwide Tax Daily (March 17, 1999).
(59) See “GM’s Remarks at W&M Hearing on International Competitiveness,” Tax Notes Today (July 1, 1999) (reprinting testimony of William H. Laitinen, Assistant General Tax Counsel for General Motors Corporation); see also “NFTC Testimony at W&M Oversight Hearing on International Tax Laws,” Tax Notes Today (June 24, 1999) (Testimony of Joe O. Luby, Jr., Assistant General Tax Counsel of Exxon Corporation, appearing as Chairman of the Tax Committee of the National Foreign Trade Council).
BRET WELLS is currently Senior Director of Taxes for Enron Corporation in Houston, Texas. He was formerly Assistant Vice President, Taxes, with Cargill, Inc. Mr. Wells is a member of the TEI International Tax Committee’s Customs and Indirect Taxes Subcommittee. He holds a bachelor’s degree from Southwestern University and a law degree from the University of Texas School of Law. The views expressed in this article are solely the individual views of the author.
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