US tax reform - going for CIN instead of CEN?

US tax policy preference has been always for Capital Export Neutrality (*) (e.g. the CFC rules and the foreign tax credit system). Is that changing? Is it now time for the US to adopt a more Capital Import Neutrality approach and what are the effects that such a change may have in the tax systems of other countries?

Why do I ask this questions? Basically, because the Advisory Panel on Federal Tax Reform recommendations released on 1 November, 2005 which may impact significantly on the U.S. international tax rules, as we (some like me think they do) know them.

You may recall, that President George W. Bush created the President’s Advisory Panel on Federal Tax Reform in January 2005. The President instructed the Panel to recommend options that would make the tax code simpler, fairer, and more conducive to economic growth. Since then, the Panel has analysed the current federal income tax system and considered a number of proposals to reform it. After 12 public meetings in five states and Washington D.C., the Panel reached consensus to recommend two tax reform plans. The Panel’s recommended plans, labelled the Simplified Income Tax Plan and the Growth and Investment Tax Plan (which I plan to tackle later because it is very inovative and I need some time to mature the ideas).

The two plans differ in the taxation of businesses and capital income. The President directed the Panel to submit at least one option using the current US income tax system as a starting point for reform. The Panel developed the Simplified Income Tax Plan to meet this objective. The Simplified Income Tax Plan would simplify the process of filing taxes and consolidate and streamline a number of major features of our current code – exemptions, deductions, and credits – that are subject to different definitions, limits, and eligibility rules. This changes also impact US international tax rules.

With regards to the international issues, three options were (form the outset) under discussion for US international outbound tax reform. The first option involves the modernization of the current regime, which could include not only a modernization of Subpart F rules but also a liberalization of foreign tax credit rules and the closing of planning opportunities (e.g. check-the-box rules). The second option would involve repealing deferral, simplifying the foreign tax credit rules and making allocation rules easier to deal with. The third option would be based on a territorial taxation system, by limiting the tax system to US source income, but retaining current tax on passive type income and eliminating the foreign tax credits (except for passive type income). This last option appears to be the chosen one by the President’s Advisory Panel.

Accordingly, the Simplified Income Tax Plan would update the US international tax regime by adopting a system that is common to many industrial countries (e.g. France and the Netherlands), a “territorial” tax system that exempts some (or all) of business earnings generated by foreign operations from home country taxation. The Simplified Income Tax Plan would adopt a straightforward territorial method for taxing active foreign income. Active business income earned abroad in foreign affiliates (branches and controlled foreign subsidiaries) would be taxed on a territorial basis.

The Simplified Income Tax Plan also would modify the definition of business subject to U.S. tax to ensure businesses that enjoy the benefit of doing business in the U.S. pay their fair share (residency rule). Under current law, residency is based on the place a business entity is organized (incorporation principle). To prevent this tax-motivated ploy, the Simplified Income Tax Plan would provide a comprehensive rule that treats a business as a resident of the U.S. (and subject to U.S. tax) if the United States is the business’s place of legal residency or if the United States is the business’s place of “primary management and control.” The new two-pronged residency test would ensure that businesses whose day-to-day operations are managed in the United States cannot avoid taxes simply by receiving mail and holding a few board meetings each year at an island resort.

Check out the complete report!
Chapter One - Four
Chapter Five - Six
Chapter Seven - Nine
Appendix
(For international issues see e.g. pages 281-287 and 314 -317)

(*) The credit method in its pure form, or full credit, is based on the principle of Capital Export Neutrality (CEN). This principle aims to achieve equal tax treatment for foreign and domestic income. The exemption method in its pure form, or full exemption, implements the principle of Capital Import Neutrality (CIN). This principle aims to achieve equal fiscal treatment of income received by domestic and foreign investors.