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Bloomberg/BNA - Rep. Brady Sees a Chance to Agree On Shift to Territorial Tax on Foreign Income

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By Aaron E. Lorenzo

Settling the debate over shifting from a worldwide to a territorial tax system could be closer than it appears, according to Rep. Kevin Brady (R-Texas), and observers suggest could bode well for broader corporate tax reform. Brady and other congressional Republicans want more of a territorial tax system for U.S.-based multinational companies, which would tax their profits where they are earned instead of taxing their worldwide earnings.

In contrast, the White House and some congressional Democrats want to maintain the current variation on worldwide taxation, in which multinationals owe U.S. taxes on domestic and foreign income, with some exceptions.

A U.S. firm can indefinitely defer U.S. tax on foreign income if conducting overseas operations through a foreign-chartered subsidiary corporation, so long as the foreign subsidiary's income is reinvested abroad. U.S. taxes apply when the income is remitted domestically, though there is also a foreign tax credit for foreign taxes paid on a dollar-for-dollar basis against U.S. taxes in order to avoid double-taxing income.

Hybrid Solution Needed

Advocates on both sides of the issue generally speak of hybrid solutions. House Ways and Means Committee Chairman Dave Camp (R-Mich.) and Senate Finance Committee Chairman Max Baucus (D-Mont.) have both indicated varying degrees of support for a move to some type of territorial tax system, which proponents generally consider simpler.

That is why Brady sees room for compromise, he told BNA.

"I think it could be closer than the rhetoric suggests," he said. "No one has suggested that we go to a pure territorial system, but rather as our competitors do [with] a hybrid, a small portion of their worldwide profits are taxed in order to prevent gaming of any tax system. That may be an area where we have some common ground."

Brady, a senior Ways and Means member, added that shifting to a territorial hybrid is essential to successfully overhauling the tax code more broadly. The committee continues to work toward tax reform, with a goal of rolling out legislation this year.

"The signal from Ways and Means is that fundamental tax reform is real," Brady said, dismissing rumors that the effort lacks backing from House GOP leadership. "The committee is taking serious steps toward that."

Paving the Way for Broader Reform

An agreement on the debate over worldwide and territorial taxation would help pave that path, said Phil West, a partner at Steptoe & Johnson LLP.

A former international tax counsel at the Treasury Department too, West called it a linchpin to unlocking a bigger breakthrough. John Harrington, a partner at Dentons LLP and also a former Treasury international tax counsel, generally agreed, calling the worldwide-or-territorial question a microcosm of wider overhaul efforts.

"If you can solve this, it will significantly increase the likelihood of broader corporate reform," West said.

But Harrington added that some of the deeper debate would have to be settled first, such as how low to reduce the U.S. corporate tax rate from the current 35 percent, because that would influence any final decisions on international taxation. Foreign-earned profits repatriated from abroad are also taxed at 35 percent under current rules.

"The closer U.S. rates are to other countries' rates, the less of an outlier the U.S. is, and the less incentive there is to shift any kind of income to a lower tax jurisdiction," Harrington said.

But even though he and West agreed with Brady that the two sides are not on opposite poles of the spectrum, they said some clear differences remain.

For example, West said more work is needed on the interplay between changing the corporate tax rate and the tax treatment of foreign income, since varying companies have opposing interests on those two elements.

Harrington said he could envision the contours of an agreement on an exemption system for foreign income that is taxed moderately in other jurisdictions, but he said addressing low-taxed income would continue to prove difficult, particularly if the income comes from intangibles.

Camp in 2011 released a proposal for moving to a territorial system that would exempt 95 percent of foreign-source dividends earned offshore from taxes, but the remainder of those profits would be taxed at a 5.25 percent tax rate as one option (208 DTR GG-1, 10/27/11).

Another option would treat low-taxed cross-border foreign income as Subpart F income, and a third option would address erosion from companies shifting income from intangibles by setting up a new category of Subpart F income from intangibles.

Compromise Will Not Please All

Harrington suggested a solution that would restrict the participation exemption only to incomes above a certain rate, triggering immediate taxes on anything below that rate. This solution also would make it harder to earn income from intangibles.

"At the end of the day, it will probably be some sort of a mixture, and some of it will have to be revenue-driven," he said.

Senate Finance Committee members are also serious about advancing the tax reform process, albeit a bit more behind the scenes, Brady said. But he complained that President Obama and his White House deputies have yet to take the lead on the initiative, which Brady said would be necessary to rewrite tax rules.

At an April 11 Ways and Means hearing with Treasury Secretary Jacob J. Lew on the administration's fiscal year 2014 budget proposal (71 DTR G-5, 4/12/13), Brady pressed for a commitment to negotiate tax reform. Lew's answers proved less direct than Brady preferred, prompting Brady to criticize Lew's vagueness and eliciting chuckles from those in attendance.

"Our point overall to the White House is come to the table, come to the table and stay at the table on tax reform before we can work these out," Brady said. "We know you have differences on revenue-neutral versus revenue raisers, you have differences on territorial versus worldwide. Fine, but come to the table now so we can work it out."

Ways and Means recently closed the public comment period for submitting input to the 11 designated members' working groups on the myriad issues inherent to rewriting tax laws (52 DTR G-8, 3/18/13). Hundreds of comments were filed before the April 15 deadline.

Brady said his experience leading an energy-focused working group reinforced his support for a territorially weighted hybrid tax system. He and the group's co-chair, Rep. Mike Thompson (D-Calif.), have held a series of meetings with stakeholders in Washington and Texas, and plan to conduct another in California.

Brady said he heard concerns that maintaining the worldwide system while removing provisions such as the dual capacity benefit enjoyed by U.S.-based oil and gas companies with foreign operations would make them globally uncompetitive. Current rules give them a foreign tax credit, but even if they could still compete, Brady said, the projects themselves would not be economically viable.

"We heard from stakeholders that the worst case scenario would be to keep in place what we've got," he said, "and then take away the provisions that today tend to offset some of our dual taxation."

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