Prediction: Fear of China Will Result in New Tax Legislation
There was extensive media coverage of the Congressional posturing following China’s National Offshore Oil Corporation’s (CNOOC) bid to take over Unocal, a California-based oil and gas company. But the major media has not covered the more interesting topic of how Congress will respond to China’s increasingly ambitious investment plans. There are several options, including war, economic sanctions, public shaming, and/or new tax legislation. Since war, economic sanctions, and shaming are currently disfavored, messy, time consuming and often of limited value, I predict that we will see some new tax legislation.
The current situation is very similar to the fears that arose in the 1970’s when the number of foreign investors, primarily Japanese investors, in U.S. real estate increased. At that time the petroleum crisis shifted the U.S. balance of payments and reduced the value of the U.S. dollar relative to other currencies and threw the U.S. economy into a recession. Today’s economic climate is similar. Arguably we are facing an energy crisis and a weak (and possibly declining) dollar. The naysayers would even argue that we are facing an impending economic recession.
The 1970’s fear resulted in Congress passing the Foreign Investment in Real Property Tax Act (FIRPTA), which is codified in Section 897. FIRPTA effectively narrowed the chance for foreign taxpayers to realize untaxed income from U.S. real estate investments. Today’s fears are similar. Instead of U.S. real estate, the fear involves U.S. corporations. Ultimately today’s fear involves the ability of foreign corporations to purchase U.S. corporations with the aim of stripping the U.S. corporation’s earnings from the U.S. economy without paying U.S. taxes. Acquiring U.S. corporations with debt (or later loaning funds to acquired U.S. corporations) is one way that foreign corporations do this. Section 163(j) is the Code provision that deals with this issue.
The current version of Section 163(j) limits the incentive to use debt to finance foreign investment in U.S. companies by limiting the deductibility of interest payments on such debt. Without Section 163(j) foreign corporations might be more inclined to purchase U.S. companies with the aim of making high interest loans to the U.S. corporation in order to draw out corporate earnings tax-free via interest payments. This process would be similar to how slumlords strip profits out of rental property by taking the rental income and not applying any of the proceeds to maintain or improve the property. In extreme cases, such properties end up abandoned, valueless, and community eyesores. So the idea behind Section 163(j) is to discourage slumlord type of investors from purchasing U.S. companies.
The problem is that even with Section 163(j) on the books multinational corporate organizations have been able to achieve the same result by interposing a legal entity in a country that has a tax treaty with the U.S. that exempts interest payments from U.S. withholding tax requirements. Multinational corporate organizations also use other techniques, such as foreign partnerships and transfer pricing rules, to achieve the same result.
But that is not the end of the story. Old GW has been thinking about this issue for a while now. Initially the Bush administration proposed to allow the Treasury Department to promulgate Treasury Regulations to address this issue. Then the administration proposed that the current Section 163(j) be modified to reduce, and in some cases eliminate, the amount of interest that is deductible. Neither proposal has taken hold. Since then Congress has addressed only one related issue, which involves a provision included in the Safe, Accountable, Flexible, and Efficient Transportation Equity Act of 2005 (which is currently stalled in a Congressional Committee). That provision is aimed at preventing multinational organizations from using foreign partnerships and the transfer pricing rules to strip U.S. corporate earnings from the U.S. It does not address the problems with Section 163(j) or the broader issues surrounding earnings stripping. That is where we are today.
What is that? Do you hear a political opportunity knocking? It would be surprising if the Bush administration and Congress did not use the fear surrounding China's recent investment plans to garner support for Section 163(j) reform. Okay, so it would not be that surprising given that Congress has missed a lot of opportunities in the past. In actuality Congress will probably still be tied up debating judicial appointments. So I change my prediction to: "Fear of China Will Result in New Tax Legislation When Congress is Not Focusing on Something Else."
The current situation is very similar to the fears that arose in the 1970’s when the number of foreign investors, primarily Japanese investors, in U.S. real estate increased. At that time the petroleum crisis shifted the U.S. balance of payments and reduced the value of the U.S. dollar relative to other currencies and threw the U.S. economy into a recession. Today’s economic climate is similar. Arguably we are facing an energy crisis and a weak (and possibly declining) dollar. The naysayers would even argue that we are facing an impending economic recession.
The 1970’s fear resulted in Congress passing the Foreign Investment in Real Property Tax Act (FIRPTA), which is codified in Section 897. FIRPTA effectively narrowed the chance for foreign taxpayers to realize untaxed income from U.S. real estate investments. Today’s fears are similar. Instead of U.S. real estate, the fear involves U.S. corporations. Ultimately today’s fear involves the ability of foreign corporations to purchase U.S. corporations with the aim of stripping the U.S. corporation’s earnings from the U.S. economy without paying U.S. taxes. Acquiring U.S. corporations with debt (or later loaning funds to acquired U.S. corporations) is one way that foreign corporations do this. Section 163(j) is the Code provision that deals with this issue.
The current version of Section 163(j) limits the incentive to use debt to finance foreign investment in U.S. companies by limiting the deductibility of interest payments on such debt. Without Section 163(j) foreign corporations might be more inclined to purchase U.S. companies with the aim of making high interest loans to the U.S. corporation in order to draw out corporate earnings tax-free via interest payments. This process would be similar to how slumlords strip profits out of rental property by taking the rental income and not applying any of the proceeds to maintain or improve the property. In extreme cases, such properties end up abandoned, valueless, and community eyesores. So the idea behind Section 163(j) is to discourage slumlord type of investors from purchasing U.S. companies.
The problem is that even with Section 163(j) on the books multinational corporate organizations have been able to achieve the same result by interposing a legal entity in a country that has a tax treaty with the U.S. that exempts interest payments from U.S. withholding tax requirements. Multinational corporate organizations also use other techniques, such as foreign partnerships and transfer pricing rules, to achieve the same result.
But that is not the end of the story. Old GW has been thinking about this issue for a while now. Initially the Bush administration proposed to allow the Treasury Department to promulgate Treasury Regulations to address this issue. Then the administration proposed that the current Section 163(j) be modified to reduce, and in some cases eliminate, the amount of interest that is deductible. Neither proposal has taken hold. Since then Congress has addressed only one related issue, which involves a provision included in the Safe, Accountable, Flexible, and Efficient Transportation Equity Act of 2005 (which is currently stalled in a Congressional Committee). That provision is aimed at preventing multinational organizations from using foreign partnerships and the transfer pricing rules to strip U.S. corporate earnings from the U.S. It does not address the problems with Section 163(j) or the broader issues surrounding earnings stripping. That is where we are today.
What is that? Do you hear a political opportunity knocking? It would be surprising if the Bush administration and Congress did not use the fear surrounding China's recent investment plans to garner support for Section 163(j) reform. Okay, so it would not be that surprising given that Congress has missed a lot of opportunities in the past. In actuality Congress will probably still be tied up debating judicial appointments. So I change my prediction to: "Fear of China Will Result in New Tax Legislation When Congress is Not Focusing on Something Else."
 
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