Build Back Better’s International Tax Provisions Could Hurt U.S. Competitiveness

As Democratic Senators negotiate a version of the Build Back Better Act that can win the support of 50 Senators spanning the left side of the ideological spectrum, policymakers in both parties should be raising alarm bells about a particular quirk of the international tax proposals that could hit U.S. companies hard relative to their peers in other economically competitive nations.

First, a quick summary of the international tax provisions in the latest version of Democrats’ Build Back Better Act, which passed the House shortly before Thanksgiving 2021:

• It raises the tax rate on U.S. companies’ foreign profits (Global Intangible Low-Tax Income, or GILTI), from a range of 10.5 percent to 13.125 percent (under current law) to a range of 15 percent to 15.789 percent;^[1]
• It raises the tax rate on U.S. companies’ income derived from exports, from 13.125 percent under current law to 15.8 percent;
• The bill requires companies to calculate their GILTI liability, the income they can carve out from GILTI liability (i.e., the net deemed tangible income return), and their foreign tax credits (FTCs) on a country-by-country basis, rather than blending these figures at the global level;
• It reduces the substance-based carve-out a company can take in each country from a 10 percent return on the value of tangible assets to five percent;
• It prevents or stops U.S. businesses from carrying back excess FTCs for GILTI and non-GILTI income to a prior tax year, but also allows companies to carry forward excess FTCs for GILTI income to a future tax year for the first time; GILTI FTC carryforwards are limited to five years until 2031, after which they may be carried forward for 10 years;
• The bill allows U.S. companies with domestic losses to access the full benefits of GILTI tax deductions for the first time (for more, see here); and finally
• It reduces the “haircut” most companies must take on the FTCs they can use to offset GILTI tax liability, from 20 percent of FTCs to five percent.

The quirk mentioned above concerns the interactions between these new proposals and the existing rules governing how U.S. companies must categorize different types of foreign-source income -- especially when companies have net income in some countries and net losses in other countries. The bolded bullets above are all relevant to this quirk, and are discussed below.

How FTC Rules Currently Work

Under current law, U.S. companies are taxed on their global income, regardless of where that income is earned. However, the tax code generally allows for U.S. companies to take a dollar-for-dollar credit (the foreign tax credit) for taxes they pay to other countries on foreign-source income, so that this foreign-source income is not taxed twice (i.e., taxation by one country and then taxation by the U.S. government). While FTCs can fully offset foreign-source income in many cases, they typically cannot then reduce U.S. taxes on U.S.-source income.

FTCs are further limited by efforts companies must make to categorize different types of foreign income, expenses, taxes, and deductions or credits. Under current law, there are four such foreign income “baskets” for companies: 1) GILTI income, 2) foreign branch income, 3) passive category income, and 4) general category income. GILTI income is generally all non-passive, non-U.S. source income after accounting for a 10-percent return for tangible assets.^[2] Branch income is generally business profits from “business units” operating in one or more foreign countries. Passive income is mostly dividends and interest income (see more here on so-called subpart F income). And general category income typically includes anything not already included in the three categories above, a catch-all category of sorts.

Companies must apportion items of income, expense, tax, and deduction among those different foreign baskets. Any FTCs in each category then offsets the U.S. taxes owed on that foreign-source income, dollar for dollar, with the exception of GILTI income. For GILTI income, only 80 percent of FTCs count towards offsetting U.S. taxes owed on GILTI income. This is the aforementioned “FTC haircut,”^[3] and in some cases it raises a company’s effective GILTI rate from the statutory 10.5 percent to 13.125 percent.^[4]

When a company has more FTCs than the law allows them to use to offset income in a given year, they may generally carry back those excess FTCs to one prior tax year or carry forward those excess FTCs up to 10 years. The exception, again, is GILTI income. FTCs for GILTI income cannot be carried forward or back, yet another limitation on GILTI FTCs on top of the 20-percent FTC haircut.^[5]

How Current FTC Rules Interact With a Company’s Foreign Losses

These FTC rules get even more complex when U.S. multinational companies have net income in some countries and net losses in others. This could easily be the case for many major U.S. companies, especially ones like Coca-Cola, Procter and Gamble, or Colgate that operate in dozens and dozens of countries around the world.^[6]

Currently, companies effectively blend their gains and losses in various countries within each FTC basket (GILTI, branch, passive, and general) first. Losses in one basket offset gains in another, which creates what is called a separate limitation loss (SLL) account. Then, if all SLLs exceed all separate limitation income (SLIs), the company has an overall foreign loss that may offset U.S. income subject to U.S. taxes.

Importantly, the concept of foreign losses offsetting U.S. income subject to U.S. taxes is different from foreign tax credits offsetting U.S. taxes on U.S. income, the latter of which is generally prohibited. But the general purpose of these SLL rules, according to the IRS, is:

“...to regulate the use of FTCs among and within separate categories and generally ensure that FTCs are not utilized disproportionately.”

There are additional, more complicated rules regarding recapture of those losses when the same foreign category produces income in a future year. Those rules are important to U.S. multinational companies, but beyond the scope of this analysis.

How Build Back Better Could Affect U.S. Companies With Foreign Losses in Some Countries and Foreign Income In Others

As noted above, Build Back Better proposes requiring companies to calculate their GILTI tax liability, their carve-out from GILTI liability, and all their foreign tax credits (GILTI and non-GILTI) on a country-by-country basis, starting in 2023.

However, Democratic lawmakers are proposing to ‘layer’ this country-by-country approach on top of the existing rules regarding FTC categories of income and offsetting of foreign category income with foreign category losses. As John Harrington, of the law firm Dentons, explained in an April 2021 analysis for a similar proposal, this is important because the two methods mentioned above (country-by-country and category-by-category) are not meant to co-exist:

“Rather, [policymakers] suggest layering a per-country limitation into the existing FTC rules. This distinction is significant because, historically, the FTC basket approach (such as we use now) and per-country limitation were seen as alternative—perhaps even rival—means of limiting cross-crediting.”

Harrington further explains how this layering will increase complexity for U.S. companies in an already very complex tax code:

“To add a per-country limitation to our existing separate category approach, however, will introduce a mix-and-match element to our FTC rules that will result in complexity beyond what would occur in either a per-country or separate category approach by itself.”

Accounting firm KPMG has raised similar concerns about added tax complexity from this layering of country-by-country on the SLL rules.

But complexity is not the only concern at play here. Because multinational companies will still need to ‘blend’ different categories of income across countries under the SLL rules, companies with net non-GILTI (i.e., passive or general) foreign losses in some countries and net GILTI income in other countries may lose access to GILTI FTCs that would otherwise ensure they are not being taxed twice on the same income. A non-GILTI loss in one country would offset GILTI income in another country (or multiple other countries), reducing GILTI income in that country (or those countries) and thereby reducing the amount of FTCs a company can apply to their GILTI liability. It’s effectively ‘heads I win, tails you lose’ from the U.S. Treasury, with U.S. companies and their workers losing out as a result.

There’s already a double taxation factor in GILTI, given the five-percent FTC haircut (down from 20 percent under current law, a rare improvement in tax policy from Build Back Better). But the interaction of SLL rules and Build Back Better could make matters worse, and subject some U.S. companies to effective tax rates on their foreign income higher than the 15 percent GILTI rate.

Lawmakers appeared to attempt to address this scenario in Build Back Better by including a provision requiring non-GILTI SLLs (i.e., passive and general category SLLs) to first offset non-GILTI SLIs, before then offsetting GILTI SLIs. The apparent intent here is to preserve the benefit of GILTI FTCs in a situation like the one mentioned above, when a company has net non-GILTI foreign losses in some countries and net GILTI income in others. It is unclear, however, that this will completely resolve double taxation concerns given non-GILTI SLLs can still ultimately offset GILTI income.

How Build Back Better and SLL Rules Could Negatively Affect U.S. Tax Competitiveness

Multinational companies headquartered in other, highly economically developed countries (like much of the European Union) will likely not face the same challenges as U.S. multinational companies under the new OECD rules. This is because many countries will allow their multinational companies to simply exempt foreign-source income that’s already been taxed at a 15-percent minimum rate by another country from additional taxes by the headquarter nation. As the OECD noted in its October statement on the global tax deal: “[d]ouble taxation of profit allocated to market jurisdictions will be relieved using either the exemption or credit method” (emphasis added).

The Build Back Better Act continues with a credit method rather than an exemption method, consistent with existing tax law. But through both the existing cross-crediting and SLL rules and the old/new FTC haircut, the bill is inherently limiting the amount of foreign taxes paid that can be used to offset U.S. taxes on foreign-source income. This inevitably leads to double taxation, a practice that makes the U.S. less tax-competitive than its peers in the global effort to attract investment, high-wage jobs, and, yes, corporate profits that contribute to nations’ tax coffers.

Senators should address this situation as they evaluate and amend the House’s version of Build Back Better. American competitiveness could be at stake, and at minimum lawmakers should be seeking to minimize the burden of double taxation on U.S. companies and workers.