Moore Thoughts on Profit-Shifting

As I wrote before, it’s hard to say a ton about the Moore v. United States Supreme Court case – it probably won't be very consequential, but if it is it could blow up the entire U.S. tax system. What else is there to say?

One of the reasons it could be so cataclysmic is because an expansive ruling would put Subpart F, one of the key pillars of the U.S. international tax code, in jeopardy. The Moores, who invested in an Indian farm equipment manufacturer, are hoping to invalidate the 2017 Tax Cuts and Jobs Act's repatriation tax after they got a bill for $15,000. (The repatriation tax was levied on deferred offshore income that had never been brought home.) They claim that because they never realized the income themselves, it was never really income, and therefore wasn't authorized by the 16th Amendment.

But there are a lot of taxes in the code that target income that is not realized, at least under this standard. One of the most prominent is Subpart F, which immediately taxes certain kinds of passive income earned by foreign subsidiaries of U.S. corporations. (Subsidiaries are recognized as separate legal entities from their parent organizations, so the income must be imputed to the domestic entity.) It's been a part of the law since 1962, and it's one of the most basic ways that the tax code prevents erosion of the U.S. tax base. Without that safeguard, there could be no way to stop domestic income from flowing offshore.

The Moores argued that this fear was unfounded, however.

Andrew Grossman, an attorney for the Moores, said he didn’t feel that Subpart F's constitutionality was in question over this issue, while arguing the case before the Supreme Court.

Grossman said that Subpart F taxes "categories of income are properly viewed as being, and Congress determined are properly viewed as being, earned by the shareholders due to the nature of the categories of income that are addressed under the statute."

Clarifying later – because clarification was needed, at least from the justices' comments – Grossman said that Subpart F addresses a "fundamental income-shifting concept." It also taxes income on an immediate basis, Grossman noted, while the TCJA tax included income from past years. (He leaned heavily on the timing issue without claiming it's a key determinant, since it's pretty clear that the 16th Amendment doesn't have a statute of limitations.)

In other words, Subpart F income meets the realization standard because it is realized, if properly understood. It’s only because of avoidance that it's recognized offshore, and it’s permissible for Congress to compensate for that that within the parameters of the 16th Amendment.

It's an interesting point, that makes some sense. There does seem to be an intuitive difference between Subpart F income, and income that has to be measured in a more novel way, like the TCJA transition tax or the tax on global intangible low-taxed income.

But there are some problems with this concept. For starters, Subpart F doesn't include any sort of intention or substance test – it just applies to all relevant passive income (such as royalties, rent and interest) immediately. The rationale, at least according to experts, is that this income is easily moved and thus often used in avoidance strategies, but that’s a bit different than being presumptively domestic income in all cases. It's not necessarily true that all passive income is income that has been shifted, although I could see the argument that in practical terms there's little difference.

In fact, Subpart F applies to income earned through foreign-to-foreign transactions (or at least it did before check-the-box), which makes this framework even more convoluted. Where is the avoidance of U.S. tax happening?

The deferred offshore income subject to the TCJA transition tax included a lot of this kind of income, for that matter. If Congress can determine that royalties or interest earned through a subsidiary is actually realized domestic income, why couldn't it decide that money hoarded offshore is also be realized domestic income?

It raises a lot of questions. But forget about the legality for a second – is this a useful framework for understanding international tax concepts generally?

The report on controlled foreign corporation rules (the term for regimes like Subpart F) released in 2015 by the Organization for Economic Cooperation and Development’s Base Erosion and Profit Shifting project provides some context. (Ironically, the U.S. pushed for CFCs as the primary answer for BEPS concerns during those negotiations, but lost the argument then. A few years later, however, the BEPS follow-up project that produced the Two-Pillar Solution largely focused on Pillar Two, arguably a souped-up CFC regime.)

The report states that existing CFC rules "generally include income that has been separated from the underlying value creation to obtain a reduction in tax," by examining a variety of factors – whether the income "is of a type that is more likely to be geographically mobile," whether it "was earned from or with the assistance of related parties," the source of the income and "the level of activity in the CFC."

On the last point, Subpart F distinguishes between active and passive royalties–whether the entity is involved in their exploitation, or if it simply collects that income through a contract. Additional modifications, like the "look-through rule," apply that same principle more broadly, including other subsidiaries in the same jurisdiction. But that’s a more recent development.

The much-reviled U.S. base erosion and anti-abuse tax also uses categorical analysis as part of its formula – "base erosion payments" under that rule are certain related-party transactions for interest, rents and royalties, as well as services, depreciation and amortization. Deductions for those items are negated when calculating BEAT income, while items like cost of goods sold are still included.

There’s a certain simplicity to this kind of rule, but it also raises concerns. "Character"-based tests open opportunities for manipulation, even for concerns as time-tested as royalties. The OECD report notes that income from intellectual property "is particularly easy to manipulate because it can be exploited and distributed in many different forms;" the income could be "embedded in income from sales and therefore treated as active sales income."

The trend in international taxation, including the Pillar Two minimum tax as well as the GILTI tax, is towards formulaic determinations of physical factors like tangible assets and workforce. Those seem easier to define than concepts like royalties or interest, although certainly they can still raise questions. It’s also somewhat less precise – passive income is at least identified as passive, while the absence of a significant workforce can be due to a lot of factors.

If the Supreme Court agrees with the Moore’s logic, it could force the U.S. to lean much more heavily on the categorical approach of Subpart F. That’s a very theoretical, far-off concern at the moment. But it’s one to maybe mull for a bit as the international tax system continues to mutate and evolve at a rapid pace.

DISCLAIMER: These views are the author's own, and do not reflect those of his current employer or any of its clients. Alex Parker is not an attorney or accountant, and none of this should be construed as tax advice.

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LITTLE CAESARS: NEWS BITES FROM THE PAST WEEK

• The Internal Revenue Service released a report Tuesday claiming that a more nuanced, comprehensive estimate of potential revenue gains from the agency’s recent boost in funding–taking into account "efficiency gains, [information technology] and analytical advancements, service improvements, and compliance through deterrence" – shows a much higher figure. As in, more than double – from $390 billion over 10 years, according to past estimates, to $851 billion. This includes a crackdown on unreported capital gains through cryptocurrencies, enabled by faster processing of returns after a new modernization program. Many of these will likely be assets held abroad, and it could dovetail with efforts at the OECD and elsewhere to create more transparency with cryptos.
• The European Commission announced Tuesday a goal to reduce greenhouse gas emissions 90% by 2040, an ambitious timeframe. In its communication announcement, the EC also said it would create a "dedicated task force" to, among other things, "develop a global approach to carbon pricing" and "intensify its carbon market diplomacy around the world." While the EC promises to work with other multilateral actors, this could potentially create tension with the OECD and other global bodies hoping to become the primary platform for what is sure to be the biggest international tax issue of the future. Unlike the OECD, the European Union does have some powers of enforcement – but those can produce politically damaging backlashes. The EU already enacted a "Carbon Border Adjustment Mechanism" which took effect last year.
• The OECD released this week an update to the Forum on Harmful Tax Practices’ work evaluating tax regimes, with four new determinations. The FHTP looks at whether tax benefits follow OECD guidelines, including in many cases that they have requirements for economic substance – meant to discourage the infamous patent boxes of the past. This time, they blessed four jurisdictions' regimes, including Hong Kong's "profits tax concessions for family offices."

PUBLIC DOMAIN SUPERHERO OF THE WEEK

Every week, a new character from the Golden Age of Superheroes who's fallen out of use.

Lightning Girl, first appearing in Lightning Comics #3 in 1942. A Navy brat who becomes entangled in an espionage plot involving brainwashing and supervillains, she becomes the partner of Lash Lightning. (Who I'll get to profiling eventually.) Lash, who's imbued with electricity-related superpowers, shoots her with "thousands of volts" so she can save the day, becoming Lightning Girl. She goes on to fight evil alongside Lash with superpowers including flight, superspeed, and "lightning heat."

Contact the author at amparkerdc@gmail.com.