1993 Budget Act could reduce foreign investment.
John Hart, head of the international tax practice group at Latham & Watkins, New York, believes several key provisions in the act could prove detrimental to the U.S. economy.
"Just looking at it from an overall economic perspective, we have increased the cost of doing business in the U.S. for foreign multi-nationals, which is bad for the consumer," Hart said.
He cites three provisions of the act pertaining to multi-national companies, beginning with the earnings stripping rule.
Under this rule, if a company borrows money from a related foreign lender and the interest is not subject to U.S. tax, then in certain circumstances, interest deductions can be denied. The rule is intended to prevent people from setting up a U.S. subsidiary capitalized with a great deal of debt and using the interest payments on the debt to shelter income. In addition, it discourages companies from taking advantage of rules under some U.S. tax treaties that allow interest payments to be received from the U.S. free of U.S. tax.
The change made last year extends this rule to cases where the lender is unrelated but a guarantee from a related foreign party supports the loan. For example, if a U.S. subsidiary of a German company borrowed money from CitiBank--and was making interest payments to CitiBank--it could lose interest deductions if the German parent guaranteed the loan, because the guarantor is related.
"It's treating the guarantor as if the guarantor were the lender even though it isn't," Hart said. "That change had a big effect because many U.S. subsidiaries of foreign multi-nationals often rely on a parent company guarantee to lower finance costs. Their ability to do that has been limited, in some cases severely, by this new rule."
Another aspect of the earnings stripping provision was changed last year, involving debt incurred before July 1989. Such debt was previously not covered by these rules. But now the grandfather provision has been repealed, so all debt is subject to the same rules.
The second important change for multi-nationals involves the portfolio interest rule. It used to be that U.S. borrowers could pay interest to foreign lenders free of U.S. withholding if certain requirements were met under the portfolio interest rule, which is considered a good alternative for countries with no U.S. treaties (eg., the Middle East). The rule used to be available for participating debt so companies could give the lender a share of profits in addition to the principle in interest, free of U.S. withholding. Those rules have been changed so that the participating element of any debt is no longer eligible.
The final key provision for multi-nationals authorizes regulations to be issued to attack conduit financing arrangements where a U.S. subsidiary would pay interest to an entity and the entity would pay interest to the ultimate lender. By putting an entity in the middle that has a treaty with the United States, companies could claim an exemption from withholding on the payment. The new act authorizes new regulations expected this summer that will attack those conduit financing arrangements by disregarding the intermediary and treating the interest as if it were paid directly from the U.S. to the originating entity.
Hart expects these provisions to cause problems for U.S. subsidiaries of foreign multi-nationals and to increase perceptions of an unfair tax structure.
"The act is bad for business," said Hart. "One response is for the U.S. subsidiaries to enter into borrowing arrangements without the parent company guarantee, so they are increasing their finance cost."
As a result, companies have had to change the way they borrow funds and have seen their borrowing costs increase. Countries most affected by the changes are those with whom the United States has an income tax treaty that calls for a zero U.S. tax rate on interest paid from the states to that country. Hart said the clearest effect is not on the main U.S. trading partners of Canada and Japan, but on the United Kingdom, Netherlands, Germany, and France.
"I think the treasury was pushing these particular provisions," Hart said. He noted that the Budget Reconciliation Act was a broad piece of legislation, with many of its more important provisions lying outside of the foreign arena.
"These [multi-national] provisions in particular were intended to close loopholes and strengthen the ability of U.S. tax authorities to ensure that foreign investors here pay their fair share of U.S. taxes," Hart said. "The provisions are going to affect different taxpayers differently, but the overall purpose of the provisions is to prevent foreign investors in the U.S. from reducing their tax liabilities in ways that are not available to U.S.-based companies."
The biggest problem Hart sees with the legislation is that the focus is on U.S.-based firms versus foreign investors, instead of looking at how international investment activity is generally handled around the world.
"If you make that latter comparison, these are very controversial provisions, because they subject foreign investors to tax under circumstances that wouldn't have that result in other countries.
These are much more aggressive attacks on foreign investors in the U.S. than other countries are applying with respect to U.S. investors who are seeking to invest in their countries.
"It really has strained perceptions of international tax fairness and it may slow down some forms of investment in the U.S. which would be detrimental to us economically," Hart said.
Kevin C. Naff is editor/communications associate, NACM.
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|Title Annotation:||Omnibus Budget Reconciliation Act of 1993|
|Author:||Naff, Kevin C.|
|Date:||Sep 1, 1994|
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