In February, 2007, Senators Levin, Coleman and Obama introduced the Stop Tax Haven Abuse Act for the ostensible purpose of curtailing alleged abuses of the tax system by both individuals and corporations. On March 3, 2009, the bill was re-introduced by Senator Levin. (Here is a link to the current version of the act.)

Then, on May 4, 2009, President Obama announced his intentions regarding the reform of alleged "loopholes" with respect to foreign source income earned by U.S. citizens and companies. The announcement was made by the White House in a release entitled, Leveling the Playing Field: Curbing Tax Havens and Removing Tax Incentives for Shifting Jobs Overseas.

Eliminating Tax Deferral on Foreign Business Profits

During his campaign, Obama repeatedly stated that he would, if elected, eliminate tax incentives for "shipping jobs overseas". Until now, he hasn't defined what he meant by that claim. It now seems that he regards the practice of deferring taxes on foreign source income earned in foreign countries by U.S. corporations as a cause of lost jobs in the U.S. His rational appears to be that if the profits from the foreign operations of U.S. companies are re-invested offshore, that represents a loss of investment within the U.S. and hence a loss of jobs in the U.S. It seems clear that Obama is also driven by pressure from union members who are not in favor of free trade. However, the Heritage Foundation refers to this is simply economic protectionism, which has the same result as imposing tariffs and import quotas, which the Heritage Foundation claims is "... building a wall behind which a few can hide from normal market forces, (which) subsidizes the wages and jobs at the protected industries at the expense of everyone else. 

Obama appears to be indifferent to the fact that U.S. companies are subject to higher tax rates than competing companies in the rest of the world (except for Japan) and that all other major countries do not impose income taxes on corporate income earned outside their borders. The U.S. tax system attempts to impose a tax on the world-wide income of its citizens and companies. But this results in a double income tax on the income of U.S. corporations that are doing business in other countries.

Free market economists advocate a reduction in the U.S. corporate tax rate for all U.S. corporations. But the politicians (who are desperately seeking more revenue for various social programs) realize that a reduced corporate tax rate on all corporations that would be deep enough to compensate for the loss of deferral on foreign subsidiaries would result in a huge loss of revenue from domestic corporations. In plainer language, it would cost a lot more to reduce the top tax rate for every corporation in order to compensate for eliminating the tax deferral on foreign source income.

Other tax reform advocates point out that most other countries in the world use a territorial tax system and only tax earnings within their borders. They argue that the U.S. should eliminate its complex efforts to impose a U.S. income tax on the world wide income of its corporations and citizens. However, the politicians see that as a much larger potential loss of tax revenue than simply keeping the deferral system as is.

Renewed Restrictions on the Foreign Tax Credit

The ostensible solution to the double tax problem is the foreign tax credit, which permits U.S. companies (and individuals in some cases) to offset their U.S. taxes on foreign source income by the foreign taxes paid. But the foreign tax credit is one of the most complicated provisions in the entire tax law because the Congress is constantly tinkering with it to either raise more revenue or to curtail alleged loopholes or to provide tax relief to political contributors. But now Obama claims that the foreign tax credit includes loopholes that artificially inflate or accelerate the tax credits. He wants to prevent companies from claiming a tax credit for taxes paid to foreign countries until the related income is subject to U.S. income taxes. While this sounds reasonable, the problem has to do with the measurement of foreign source income versus U.S. source income and whether the foreign tax credit must be computed on a country by country basis. This alleged loophole arose as a result of simplification of the foreign tax credit rules a few years ago. Obama's proposal will result in further complications in the tax system and will increase taxes on U.S. companies doing business overseas.

Limiting Deductions for Overseas Investments

Another "reform' proposal is to prohibit U.S. companies from claiming deductions on their "U.S. taxes for all of the expenses that support their overseas investment" in foreign subsidiaries. The tax law already includes substantial restrictions on claiming deductions for investments or for deducting expenses relating to non-taxable income. In addition, when a foreign subsidiary earns income that can be deferred under the current U.S. tax rules, the foreign company does not get a deduction for anything.  In spite of  having spent about 15 years trying to understand the nuances of international tax law, I fail to see any rational for this alleged loophole.

Prohibiting Transparent, Pass-Through Taxation

A proposed change with far greater impact on U.S. companies with foreign subsidiaries (and U.S. investors in foreign businesses) would be to prohibit U.S. owners of foreign corporations from making an election to treat the income of the foreign company as if the company were a partnership or a branch operation. Obama disingenuously refers to this as "disappearing foreign subsidiaries." In plain language, this election results in current taxation of the earnings of the foreign company and zero tax deferral. Let me emphasize this.


But Obama wants to prohibit companies from making that election. Why? The only reason I can think of is that this change would prohibit U.S. companies and investors from deducting losses generated by their foreign companies. They would have to pay income tax on current profits but would not be able to deduct any losses. And if the foreign operation is not successful, the U.S. owner would have to treat their loss as a capital loss rather than as a business loss. (The tax law imposes severe restrictions on deducting capital losses.)

Other Proposals

Additional provisions of Obama's proposed reform of the international tax rules are somewhat technical or simply result in heavier penalties for anyone who fails to comply with the U.S. laws and regulations regarding information reporting of any foreign investments. One provision calls for an increase of 800 new IRS field agents in the international division of the IRS. Frankly, that's most likely to result in a lot more time being spent arguing about the tax laws with people who have only had a crash course in the subject. I've spent the past 15 years trying to learn the nuances of the international sections of our tax laws and continue to find new discoveries every month. But of course, all of those 800 new IRS agents are undoubtedly a lot smarter than I am and will learn a lot faster.


President Obama has promised to simplify the tax code but these proposed changes would only add to the complexity. The simpler solution would be to (1) eliminate U.S. taxation on income earned outside the U.S. and (2) to reduce the corporate tax rate to a level that is more competitive with the corporate tax rate in other countries. However, neither of these choices are politically feasible at the present time.

Without a substantial reduction in the corporate tax rates for U.S. companies, our multi-national corporations will be put into a serious financial squeeze if the current deferral on taxing foreign source business profits is eliminated -- as Obama advocates. Our large corporations would then have to sell off many or most of their foreign operations which would result in a loss of U.S. jobs and less profits for U.S. investors -- including pension plans and mutual funds.

But before they cut back, our large multi-national corporations will invest a LOT of money to persuade the members of the U.S. Congress that this plan is defective and should not be passed. In addition, we can expect the national industry organizations like the Chamber of Commerce and the National Ass'n of Manufacturers to bring as much weight as they can on the politicians.

Even the members of the Democratic party will listen when their biggest campaign contributors have a heart-to-heart discussion with them. These proposals will be viewed by many of our very largest corporations as a matter of corporate survival and they won't consent to such changes without a massive campaign to educate the public and their representatives as to the most likely impact of this kind of punitive taxation. Every national association of diverse industries will also join in the fight, along with most (or all) of the Republicans and independents.

Right now, it seems extremely unlikely that the Congress will try to deal with this issue while they are also grappling with the proposed national health care problem, an economy in between a serious recession and a depression, plus Obama's controversial proposal for a "Cap and Trade" system to raise the cost of energy as a way to make alternative energy sources more price competitive.

The Expatriation Option

Charles Adams, author of "For Good and Evil: The Impact of Taxes on the Course of Civilization" stated that ...


However, for a U.S. individual or company, simply leaving the U.S. is not an effective solution -- as it is for residents of most other countries. We are not only taxed on our world-wide income while living in (or based in) the U.S. -- we are subject to the long arm of the IRS no matter where we reside in the world or for how long. In order to legally escape from the demands of the U.S. tax system, individuals must relinquish their citizenship (or green card) and companies must re-incorporate in another country. They must also move their headquarters and key personnel to another country. Or else they must find replacements in the country to which they have relocated.

With our current tax system, expatriation is much more difficult for a large company than for an individual or a small business with portable operations -- like an Internet based business or consulting work. But there are legal ways for a corporation to move its headquarters and primary operations to another country, along with most of the senior officers and their families. If that happens, Obama and the Democrats will most likely try to pass laws to make that more difficult, but such laws often have an outcome that is the very opposite of what was intended. Right now, foreign investors are more interested in buying U.S. companies than in investing in real estate or the stock market. Some U.S. companies with operations in many countries might be more receptive to selling the company to a foreign buyer if Obama's proposals make it difficult to compete from a U.S. home base.

Under the current tax law, a U.S. individual can expatriate from the U.S. with minimal effort and hardly any additional taxes if their net worth is less than $2 million and if they meet a few other tests. Therefore, a married couple could divide a personal estate of less than $4 million into two estates of less than $2 million and still be able to avoid the expatriation tax. But this assumes they already have a second citizenship in another country. Until they acquire a citizenship in another country and then relinquish their U.S. citizenship (or green card), they will still be subject to U.S. income taxes on their worldwide income. But moving overseas is often the first step in that process.

Prognostication

As of early May, 2009 it seems most likely that this bill won't be subject to extensive hearings before late summer at the earliest. It also seems likely that there will be intensive lobbying to (1) delay passage and (2) to modify the details. At least one international tax advisor has stated in an email discussion group that he feels this proposed bill by Obama is mainly so that he can claim to his very liberal supporters that he made a serious effort to keep this campaign promise.

I intend to update this web page with new information as it becomes available. In addition, I will include news on the development of any legislation in the free Yahoo Group that I sponsor on the subject of international financial planning.  Because of my volunteer work for the American Institute of CPAs, I have access to breaking news and I also have access to some of the top CPAs and tax lawyers in the country who deal with international tax issues. Hopefully, they will be able and willing to help me stay on top of this major legislative development in the international part of the U.S. tax law.

Here are links to some online information that may be of interest to you.

Leveling the Playing Field: Curbing Tax Havens and Removing Tax Incentives for Shifting Jobs Overseas
Obama's International Tax Plan Would Weaken Global Competitiveness
They Can't be Serious, Can They?
Americans Who Want to Expatriate
Proposed Stop Tax Haven Abuse Act

Vernon K. Jacobs
Certified Public Accountant
www.vernonjacobs.com

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Vernon K. Jacobs, All rights reserved.