Foreign Reporting Requirements -- Enforcement is Up -- Acceptance is Down
Foreign Reporting Requirements Go Beyond FBARs
Foreign Partnerships, Foreign Trusts, and Controlled Foreign Corporations all have their FBAR-equivalent forms with corresponding penalties. Forms such as Form 5471, Form 5472, Form 3250, and Form 8891 also have complex filing requirements and significant penalties for non-compliance.
Since 2009, when the IRS initiated the Offshore Voluntary Disclosure Program (“OVDP”), almost 100,000 taxpayers have taken advantage of the various amnesty programs the IRS has rolled out. Reporting compliance with foreign accounts and offshore assets is on a marked increase. To date, estimates are that the IRS has collected about $10bn dollars through offshore foreign asset amnesty prorgams.
Certainly, as political debates this campaign season repeatedly note, issues like offshore tax evasion, corporate inversion, and expatriation of U.S. dollars into overseas assets are major economic and socioeconomic issues within the Country. The expectation would be that the IRS will continually step up its efforts to address violations of reporting laws – their first line of defense – and will increase enforcement activities over time. But, with a dwindling IRS budget and with the high cost of enforcement and the disproportionally high reward for large companies who devote resources to minimizing their tax burdens, the playing field is unlikely to change based solely on the threat of enforcement activity.
With the passage of the Foreign Account Tax Compliance Act (“FATCA”) in 2010, the IRS and other law enforcement agencies gained the ability to go after foreign financial institutions as well as non-reporting taxpayers, vastly expanding the reach of their investigative abilities relative to foreign and offshore assets. Cross-checking self-reporting against independent information is the hallmark of many successful IRS programs, including the W2 and 1099 efforts, where mismatches between reporting by employers and employees is easily detected, aiding in audit selection. The dual-reporting regime vastly simplifies the process of detecting tax non-compliance and vastly lowers the cost of enforcing compliance. That system, however, depends on self-regulation by companies, payroll providers, etc. FATCA and related policies, wherein third parties are deputized to do the IRS’s job of reporting, are effective when they are in the public eye, but fade in effectiveness as soon as enforcement efforts are shifted elsewhere. This is the problem with all self-regulation systems.
The IRS, like many government agencies, continuously deputizes taxpayers (individual and corporate) and makes them devote time and effort to “self-regulation” and to “enforcement” of government initiatives. The “compliance era” in which productive business activities take a back seat to complying with onerous regulatory requirements has fundamentally changed how businesses conduct themselves and how competition between market participants occurs.
Undoubtedly, the United States has the most developed regulatory regime of any industrialized nation, and the exodus of large corporations and their profits from the U.S. mainland is a direct result of overregulation and high taxes. At the same time, multinational companies subject to U.S. tax, who already pay effective tax rates far below the applicable corporate rates they are subject to, have shifted large percentages of their corporate income overseas, and left it there, untaxed.
Pfizer is a case in point. The U.S. based company regularly pays effective tax rates in the range of 7.5% as opposed to the top rate of 35% that U.S. companies are subject to. Under the U.S. tax code, a U.S. Parent like Pfizer with an Irish overseas subsidiary in Ringaskiddy - Pfizer Ireland Pharmaceuticals (“Pfizer Ireland”), holds a substantial portion of its corporate profits overseas, some of which derives from patent licensing to the parent. Until Pfizer Ireland remits the profits to its parent, Pfizer, the profits are not taxed at U.S. rates of 35%, but are instead subject to lower Irish tax rates of 12.5%. With profits in the billions, that is a tremendous difference. Lipitor and Lyrica profits, for instance, are taxed at Irish rates, and that $5bn profit is not subject to current U.S. taxation, because the profits are reported by Pfizer Ireland. Income-shifting to low tax jurisdictions is a key tax minimization strategy.
Now, Pfizer, unhappy with the U.S. tax regime, has taken its tax avoidance activities a step futher and merged with Allergan, an Irish pharmaceutical company, in order to end its status as a U.S. Corporation, and to avoid the tax it would pay on repatriating the overseas income held in its various subsidiaries. Pfizer’s president, Ian Read, has gone on the record to say, “[t]he problem is our tax code is hugely disadvantageous to American high-tech multinational companies. I personally have been to Washington for the last two years,” he said, adding, “I have tried to get this as an urgent issue that we need to fix, and I have been totally unsuccessful.”
Hillary Clinton has proposed an “Exit Tax” that would apply to situations like these. This begs the question, is the answer to overregulation more regulation? Critics suggest that were Clinton’s “Exit Tax” actually proposed in Congress, the effect would be that a majority of Fortune 500 companies currently based in the United States would immediately abandon their U.S. residency, fleeing the U.S. mainland before the measure became law. The speeding up of the Pfizer-Allergan deal based on threatened Congressional action is a case study on the likely corporate response to sea changes in tax policy like a ban on inversions. The critics are probably overstating the case. Some companies would leave and it would be a blow to the U.S. economy, but some would also stay for structural reasons that make it impossible for them to transport operations overseas.
As much as U.S. companies abuse the corporate tax system, they argue that they cannot compete internationally due to the fact that their foreign competitors retain a much higher profit margin on profits earned due to more favorable foreign tax regimes. Since corporate officers of public companies have a fiduciary duty to maximize profits for their shareholders, they cannot ignore a strategy that would increase profit margins. On the campaign trail, candidates asy things like, companies should “shoulder their patriotic duty to pay a fair share of tax.” However, this ignores the legal reality that a director or officer would be breaching their fiduiciary duty to shareholders if they placed “patriotic duty” above “profits.” A director or officer making the pitch for paying higher U.S. taxes would need a colorable basis to suggest that doing so would increase corporate profits and earnings per share, rather than diminishing them. Since the tax burden is the biggest cost for most profitable public companies, it is no wonder that they work diligently to reduce their tax burden, and rightfully so. Doing otherwise would be negligent.
The U.S. tax regime of worldwide taxation, which attempts to tax all profits at 35%, even if there is a credit for foreign taxes paid elsewhere, is hard to defend. It is argued that this system puts U.S. based companies at a structural competitive disadvantage to international peers who do not face this “second tax” on corporate earnings. Many Republicans favor the concept of a “Tax Holiday” advocated by Chuck Schumer (D-N.Y.) and Rob Portman (R-Ohio), who have proposed a bi-partisan plan known as the Schumer-Portman framework to solve the problem. This policy actually rewards U.S. based companies for their tax avoidance strategies, relative to their peers who are not engaging in income-shifting or inversion. The policy is to temporarily stop inversion by providing a one-time repatriation tax of 8% to 10% on corporate earnings that are repatriated during a particular window of time. While amnesty programs like these often work to some extent in the short term, they are unfair to those who are compliant with the letter and spirit of existing law. And in the case of willful tax avoidance by companies—who are voting with their feet against corporate taxation policies that they perceive as unfair—this kind of legislative response would amount to disparate treatment (indeed favorable treatment for wrongdoers) and would signal a departure from and abandonment of the U.S. worldwide taxation regime, without actually departing from it or abandoning it altogether. And that is the one thing policymakers have not been willing to do—overhaul the tax code to lower corporate tax rates.
Were the policy implemented, it is questionable whether law abiding corporate peers, particularly those in competition with the tax avoiders, would accept that their competition is paying an 8% to 10% rate on earnings they wrongfully transported overseas, while the law abiding corporations are paying 35%. Will they sit idly by? It is doubtful. The policy of a "Tax Holiday" is a potential Pandoras box that unleashes many perverse incentives and opens the door to many counter-offensives as it peppers an uneven playing field with landmines.
Philosophically, neither proposal makes much sense. Democrats seek to deter corporations through the stick and Republicans seek to incentivize them through the carrot. The Republican carrot is a “one-time” incentive that savvy companies will astutely observe may be a “teaser-style” bait and switch tactic. One lousy carrot and you are stuck with a worldwide tax regime forever. No thanks.
As Mr. Read observed in his comments, these proposed responses do nothing about the underlying problem. Trump has suggested in interviews a “Tax Holiday” wherein U.S. companies come home without paying any repatriation tax, but his official online tax plan is the same as Mr. Schumer’s, except that it unapolagetically explains that the price of the “Holiday” is a cancellation of the U.S. company’s passport to shift-income overseas. https://www.donaldjtrump.com/positions/tax-reform
“A one-time deemed repatriation of corporate cash held overseas at a significantly discounted 10% tax rate, followed by an end to the deferral of taxes on corporate income earned abroad.”
Mr. Trump’s proposal does not seem much better than Mrs. Clinton’s or Mr. Schumer’s, and it is transparent about the bait and switch. None of these proposals get to the heart of the issue.
The U.S. Tax Code itself has a fundamental flaw which is not addressed or corrected with any of these fixes. There is nothing about the U.S. business climate today that confers a benefit that would justify paying the highest taxes in the world. Perhaps at one time there was such a justification, but that is no longer the case. That is the elephant in the room. When Wall Street interests effectively destroyed the U.S. economy, and when lawmakers stood by without correcting the structural problems caused by the subprime mortgage crisis, the U.S. economy was severely injured, and the U.S. economy no longer confers sufficient benefits to corporate stakeholders to justify their paying 1 out of 4 additional dollars earned, or 25% more tax dollars than European peers.
I would suspect that none of these proposals are likely to pass through the halls of Congress unscathed or to emerge without so many holes poked in the implementing language as to render the provisions teethless. And none of the proposals is likely to be observed, followed, or accepted by multinational corporations who are looking for an even playing field, and who are unlikely to take advantage of a temporary solution without knowing what the long-term policy of the United States will be, which is subject to much uncertainty in the current environment.
“Tax reform, if it’s done right, will get at the root problem, rather than simply dealing with symptoms,” said Orrin Hatch of Utah, the top Republican on the Finance Committee, in 2014. More recently, Chairman Hatch and Representative Kevin Brady of Texas have proposed an overhaul of the international portions of the U.S. Tax Code. In January, Brady said, "You can wring your hands as a government, you can try very weak Treasury rules. The one consistent element has been an uncompetitive tax code that’s driving this, so why don’t we go to the root cause?” Paul Ryan of Wisconsin has also made corporate inversions a major priority.
Sen. Orrin Hatch (R-Utah) said in December that lawmakers would have to lower corporate tax rates to be more competitive with other countries, adding he’d like to see the U.S. lower the rate from 35 percent to around 20 percent. In the long-run, moving to a more competitive U.S. tax regime seems inevitable. What is harder to understand is the resistance of policymakers to do so.
A competing policy, spearheaded by Senate Minority Whip, Dick Durbin of Illinois and Sen. Jack Reed (D-R.I.) and Reps. Sander Levin (D-Mich.) and Lloyd Doggett (D-Texas) is to treat a combined foreign company as a domestic corporation if the historic shareholders of the U.S. corporation held more than 50 percent of the foreign company, or if the affiliated group is managed and controlled in the U.S. The group has recenlty proposed legislation to “stop inversions” through the menas described above.
Perhaps, neither Republicans nor Democrats want to appear like they are giving tax breaks to big corporations, while everyday people continue to struggle. The alternative, defending the U.S. 35% tax on worldwide income, requires a justification that our politicians have been unable to articulate.
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