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September 5, 2012
The Effects of Interest Allocation Rules in a Territorial System

Full Text Published by Tax Analysts®



By Martin A. Sullivan -- martysullivan@comcast.net

Most Republicans have proposed that the United States adopt a territorial system of international taxation. However, even if Mitt Romney wins the November election, unprecedented long-term budget pressures will make it difficult for Congress to enact any territorial system that is as generous as business is hoping it will be. The need to offset the revenue costs of exempting foreign profits will bring a lot of attention to rules that limit the foreign share of multinational profits.

President Obama has called for revenue-neutral corporate tax reform and for tax increases on foreign investment by U.S. multinationals. So it is unsurprising that he has not endorsed territoriality. That does not, however, preclude him from agreeing to adopt a territorial system if he gets a second term. The Bowles-Simpson commission included territoriality as part of its deficit reduction plan. And it was a Labour government in the United Kingdom that first proposed and enacted a territorial system. Once again, however, there would likely need to be many rules addressing base erosion to keep revenue losses from international tax reform close to zero.

Lurking in the background as a catalyst for all sides to move on international tax reform is the estimated $1.7 trillion of foreign earnings trapped offshore (Dane Mott, Amy Schmidt, Kapil Dhingra, and Amyn Bharwani, J.P. Morgan, North America Equity Research, "Global Tax Rate Makers: Undistributed Foreign Earnings Top $1.7 Trillion; At Least 60% of Multinational Cash Is Abroad," May 16, 2011). If repatriated, those funds would be subject to a 35 percent tax rate, less credits for foreign tax.

One way to keep revenue losses from a territorial system in check would be to restrict the deductibility of interest expenses. Under current law, multinationals have a lot of leeway on how they deduct those expenses. In general, when a parent company borrows -- either from an external lender or from a related party -- it deducts that interest against home country profits. And if a foreign affiliate borrows, it deducts the interest against its profits.

This assignment of interest based on contractual formalities may seem natural enough to laymen, but it clashes with the notion widely accepted by economists that money is fungible. For a multinational, that means the proceeds from loans and the benefits of borrowing do not accrue to a single location but to the entire firm. Therefore, the costs of borrowing should be spread over the entire firm.

The most common allocation method is allocation in proportion to assets. If interest is allocated in proportion to assets, and the matching principle is applied, only interest allocated to the United States would be deductible against U.S. profits. So if a U.S. multinational has 50 percent of its assets in the United States, 50 percent of its worldwide interest paid to external lenders would be deductible against gross U.S. profits. Under a system of interest allocation, U.S. tax would be unaffected by which affiliate actually pays interest expense to external lenders. Nor would intercompany loans affect U.S. tax.

U.S. multinationals abhor that approach to territoriality. They point out that other countries that have adopted territorial systems do not have interest allocation rules (although they do usually use limits on interest in the form of thin capitalization and earnings stripping rules). They argue that full domestic deductibility of interest is necessary to maintain competitiveness between U.S. and foreign multinationals. Countering this view, many commentators have pointed out that if multinationals can deduct interest wherever they want and affiliates of a multinational can freely borrow and lend to each other, negative tax rates will result.

For example, if a U.S. multinational finances a foreign investment that yields $100, with domestic debt generating interest expense of $50, and if the U.S. and foreign statutory tax rates are 35 and 15 percent, respectively, additional foreign tax due as a result of that investment is $15 while U.S. tax is reduced by $17.50. The net tax change is -$2.50. The net rate of tax on $100 of investment income is -2.5 percent.

U.S. multinationals argue that the negative rate is justified because that tax treatment is comparable to how foreign multinationals are taxed by their home governments.

Critics point out that the negative rate gives multinationals a large tax incentive to favor foreign over domestic investment. It also provides the U.S. multinationals with an advantage over purely foreign firms that would pay an effective rate of 7.5 percent on a similarly financed investment.

If the United States adopts a territorial system, should it also allocate interest? The simple example used above is useful and interesting, but it is only the tip of the iceberg. There are a wide variety of circumstances that must be assessed. The effect of interest allocation rules varies with a firm's degree of leverage, the differential between domestic and foreign tax rates, the firm's behavioral response to changes in rules, and how foreign governments react to changes in U.S. rules. The purpose of this article is to flesh out how the tax treatment of interest in a territorial system affects incentives to invest.

Interest allocation is not a panacea to resolving the problems that are inherent in a world where each jurisdiction taxes multinationals at different rates and debt and equity are treated as polar opposites. For example, even under interest allocation rules, tax rates on marginal investment can be negative. However, interest allocation is an improvement over current law treatment of interest. It reduces the tax advantages that multinationals have that are unavailable to non-multinational firms, whether domestic or foreign. It reduces the tax advantages of multinational investment abroad relative to domestic investment. And it improves neutrality by reducing the dispersion of tax rates resulting from differences in leverage and tax rates. In particular, it greatly reduces the opportunities to pair low-rate income with high-rate deductions that generate negative tax rates.

Marginal Effective Rates

Table 1 shows the calculations of marginal effective tax rates for a simple example. To help prevent the reader from being overwhelmed too quickly, we begin with a base case in which marginal investment has the same degree of leverage as existing investment.

Readers who want less detail and to get straight to the policy discussion can skip the following section that explains how the calculations were made. Readers who want more detail can consult the appendix for algebraic formulas to calculate tax rates under these and alternative assumptions about tax rates and degrees of leverage.

In the following examples, the U.S. statutory rate is 35 percent, and the foreign statutory rate is 15 percent. Marginal investment generates $100 of annual income. That investment is financed by debt generating $50 of interest expense.

Throughout this article, the degree of leverage is defined as a0, the ratio interest expense of debt-financing investment to gross (before interest) profit from that investment. For the calculations in Table 1, a0 is equal to 0.5 and is not altered by new investment. (Later a0 will be allowed to change.)

Also, for simplicity's sake this article always assumes gross income is proportional to assets. (Among other things, the assumption rules out the profit shifting through aggressive transfer pricing practices.) Using this assumption, there is no difference between allocation by assets or by gross income. (For a discussion of the differences between allocation of interest by gross income and allocation of interest by assets, see "An Automatic Brake on Profit Shifting in a Territorial System," Tax Notes, July 30, 2012, p. 476, Doc 2012-15651 , or 2012 TNT 146-2 .)

For multinational corporations, the amount of worldwide profit before the new investment is $200, evenly divided between the U.S. and foreign investment country. Because a0 equals 0.5, worldwide interest is $100. If there is new domestic investment yielding an additional $100 of gross profit, the multinational will have $200 of domestic and $100 of foreign gross income. And so if interest is allocated by formula, two-thirds of worldwide interest is allocated to domestic and one-third is allocated to foreign. Similarly, if there is new foreign investment yielding an additional $100 of gross profit, the multinational will have $100 of domestic and $200 of foreign gross income. And so if interest is allocated by formula, one-third of worldwide interest is allocated to domestic and two-thirds is allocated to foreign.

All these calculations assume that multinationals book and deduct as much interest as possible in the jurisdiction with the highest tax rate. Therefore, without interest allocation rules, a multinational will deduct all interest in the United States. Under an allocation rule, it is assumed that a multinational will deduct all interest expense allocated to the United States in the United States and that it will deduct the residual overseas. (See the sidebar for more dicussion of this assumption.)

Example 1: Domestic investment yielding $100 of gross profit by a purely domestic corporation. Gross profit ($100) minus interest expense ($50) equals net taxable income ($50). With a rate of 35 percent, tax liability is $17.50. The tax change of $17.50 divided by the change in gross profit ($100) yields a marginal effective tax rate of 17.5 percent.

Example 2a: Domestic investment yielding $100 of profit by a U.S.-headquartered multinational -- current law. The $50 of additional interest expenses booked in the United States is deducted from $100 of additional gross income. Marginal tax -- the numerator of the marginal effective tax rate -- is 35 percent of $50 of marginal taxable income. Marginal gross profit -- the denominator of the marginal effective tax rate -- is $100. The marginal effective tax rate is 17.5 percent.

Example 2b: Domestic investment yielding $100 of profit by a U.S.-headquartered multinational -- multilateral allocation. In this example, it is assumed that both the United States and foreign countries adopt allocation rules. Worldwide interest grows from $100 to $150. The domestic allocation fraction grows from one-half to two-thirds, so $50 more of interest expense is now deductible in the United States. (The foreign allocation fraction shrinks from one-half to one-third, so deductible foreign interest expense remains at $50.) Marginal tax -- the numerator of the marginal effective tax rate -- is 35 percent of the marginal change in taxable income. Marginal gross profit -- the denominator of the marginal effective tax rate -- is $100. The marginal effective tax rate is 17.5 percent.

Example 2c: Domestic investment yielding $100 of profit by a U.S.-headquartered multinational -- unilateral allocation. In this example, it is assumed that only the United States adopts interest allocation rules. The results are the same as above. Additional expense allocable to the United States equals total new expense. Foreign taxes remain unchanged: U.S. investment with only U.S. borrowing has no effect on deductible foreign expense. Foreign multinationals shift expenses not deductible in the United States out of the United States.


_____________________________________________________________________

SIDEBAR: Potential Benefits of Unilateral
Adoption of Interest Allocation Rules

    To minimize taxes on new foreign investment, a U.S. multinational will book and deduct as much interest as possible in the United States under current law (assuming the U.S. statutory rate is higher than foreign statutory rates). As noted in the text, that can easily result in negative marginal effective tax rates. If the United States adopts interest allocation rules under a territorial system, these deductions would be limited and, in the absence of any change in behavior by the multinational, there would be no foreign deductions on that interest formerly deducted in the United States.

    But this static behavior is unlikely. The multinational will adjust its practices to policy changes. Because the foreign country would still allow deductions for interest booked on foreign affiliates' accounts, the multinational could book the portion of expense not deductible in the United States in the foreign country. That is what is assumed in the calculations in this article. The change in law and the reassignment of interest expense result in an increase in the marginal tax rate, because some interest would then be deductible at the low foreign rate instead of the U.S. rate. That results in the same amount of interest being deducted in the foreign jurisdiction as if the foreign jurisdiction required interest allocation.

    There is, however, another intriguing possibility. Under unilateral adoption of interest allocation rules by the United States, it is possible for a U.S. multinational to deduct some interest deductions twice, potentially reducing its marginal effective tax rate below the generous treatment under current law, all at the expense of the foreign government.

    Here is how. In response to the unilateral adoption of interest allocation rules, the U.S. multinational could deduct the portion of worldwide interest expense allocable to the United States in the United States without booking any interest there. It can then book all interest overseas and deduct all interest at the foreign rate.

    This double dipping could be prevented by the United States requiring allocable interest to be booked in the United States in order to receive a deduction (in effect, changing the interest allocation rule into a limit on interest deductions). But all this would do is raise the effective tax rate on U.S. multinationals for the benefit of foreign governments. Alternatively, in the absence of action by the United States, the foreign government could restore revenues lost by the reassignment of interest expense into its jurisdiction by limiting those expenses. It could do that through earnings stripping rules (which would be ineffectual in many cases) or by joining the United States in adopting interest allocation rules.

_____________________________________________________________________

Example 3a: Domestic investment yielding $100 of profit by a foreign-headquartered multinational -- current law. The $50 of additional interest expense is booked in the United States by the U.S. subsidiary of the foreign parent and is deducted from $100 of additional gross income. We shall assume here that earnings stripping rules of section 163(j) do not apply. Marginal tax again is $50. The marginal effective tax rate is 17.5 percent.

Example 3b: Domestic investment yielding $100 of profit by a foreign-headquartered multinational -- multilateral allocation. Worldwide interest grows from $100 to $150. As with the U.S. multinational, the U.S. allocation fraction grows from one-half to two-thirds, so $50 more of interest expense is now deductible in the United States. Marginal tax is 35 percent of the marginal change in taxable income. The marginal effective tax rate is 17.5 percent.

Example 3c: Domestic investment yielding $100 of profit by a foreign-headquartered multinational -- unilateral allocation. Same as Example 2c.

Example 4a: Foreign investment yielding $100 of profit by a U.S.-headquartered multinational -- current law. $100 of additional gross income is taxed in the foreign-source country at a 15 percent rate to increase foreign tax by $15. The $50 of additional interest expense booked in the United States is deducted in the United States and reduces tax by $17.50. The net worldwide tax change is -$2.50. The marginal effective tax rate is -2.5 percent.

Example 4b: Foreign investment yielding $100 of profit by a U.S.-headquartered multinational -- multilateral allocation. Worldwide interest grows from $100 to $150. The domestic allocation fraction shrinks from one-half to one-third. These two effects offset each other, and deductible U.S. interest expense is unchanged. There is no U.S. tax change. The foreign allocation fraction increases from one-half to two-thirds, so deductible foreign interest expense increases by $50. Additional foreign taxable income ($50) is the additional gross income ($100) minus additional deductible foreign interest expense ($50). Marginal tax is 15 percent of $50. The marginal effective tax rate is 7.5 percent.

              Table 1. Effective Tax Rates on Marginal Investment,
                    Assuming Degree of Leverage Is Unchanged
 _____________________________________________________________________________

                         Domestic Investment            Foreign Investment
                    ____________________________     _________________________

                    (1)         (2)      (3)         (4)     (5)      (6)
 Treatment of       Purely      U.S.     Foreign     U.S.    Foreign  Purely
 Interest Expense   Domestic    MNC      MNC         MNC     MNC      Foreign
 _____________________________________________________________________________

 No allocation       17.5%      17.5%     17.5%      -2.5%   -2.5%     7.5%

 Multilateral
 allocation          17.5%      17.5%     17.5%       7.5%    7.5%     7.5%

 U.S.
 unilateral
 allocation          17.5%      17.5%*    17.5%*      7.5%*   7.5%*    7.5%
 _____________________________________________________________________________

      Notes: MNC is an abbreviation for multinational corporation. Rates with
 asterisks could be lower if double dipping is allowed. On this point, see the
 box on p. 1100.

Example 4c: Foreign investment yielding $100 of profit by a U.S.-headquartered multinational -- unilateral allocation. As above, U.S. tax remains unchanged. Foreign tax depends on where the U.S. multinational books its interest expense. If all additional debt was booked in the United States, the foreign government would grant no additional interest deductions, so $100 of gross profit is taxed at 15 percent. The marginal effective tax rate would be 15 percent.

With allocation rules limiting U.S. deductions, the multinational can get deductions for interest by booking in the foreign jurisdiction the interest that is nondeductible in the United States. The U.S. multinational can achieve this reassignment of booked interest by having its subsidiary borrow directly from a third-party lender or by an intracompany loan from the U.S. parent to the foreign subsidiary. (In a world in which the United States adopts allocation rules unilaterally, cross-border related-party loans help promote, rather than frustrate, good tax policy.) In that case, the result is identical to the result under Example 4b. The marginal effective tax rate is 7.5 percent.

Example 5a: Foreign investment yielding $100 of profit by a foreign-headquartered multinational -- current law. $100 of additional gross income is taxed in the foreign-source country at a 15 percent rate to increase foreign tax by $15. The $50 of additional interest expense is booked in the United States in order to minimize taxes. (If some or all of it was booked in the foreign country, the effective tax rate would increase and, ironically, the foreign multinational would be disadvantaged relative to the U.S. multinational because it had a lower statutory rate.) The marginal effective tax rate is -2.5 percent, the same as in Example 4a above.

Example 5b: Foreign investment yielding $100 of profit by a foreign-headquartered multinational -- multilateral allocation. Worldwide interest grows from $100 to $150. The home country allocation fraction shrinks from one-half to one-third. These two effects offset each other, and deductible home country interest expense is unchanged. There is no home country tax change. The foreign-source country allocation fraction increases from one-half to two-thirds, so deductible source country interest expense increases by $50. Additional foreign-source country taxable income is $50. The marginal effective tax rate is 7.5 percent.

Example 5c: Foreign investment yielding $100 of profit by a foreign-headquartered multinational -- unilateral allocation. The multinational wants to deduct as much as possible in the United States. The amount of allowable U.S. interest remains unchanged, as in Example 5b. All $50 of new interest is deductible abroad. The marginal effective rate is 7.5 percent.

Example 6: Foreign investment yielding $100 of gross profit by a purely foreign corporation. Gross profit ($100) minus interest expense ($50) equals net taxable income ($50). With a rate of 15 percent, tax liability is $7.50 and the marginal effective tax rate is 7.5 percent.

What is Table 1 telling us? By comparing column 4 with column 2, we can see that allocation rules in a territorial system would reduce multinationals' incentive to invest abroad. By comparing column 4 with column 6, we see that the tax advantage that a U.S. multinational has over purely foreign firms is eliminated. And by comparing column 4 with column 5, we see that a U.S. multinational's marginal tax rate is equal to that of a similarly situated foreign competitor in a territorial system, whether allocation rules are applied or not.

              Table 2. Effective Tax Rates on Marginal Investment,
                           Allowing Leverage to Vary
 _____________________________________________________________________________

                         Domestic Investment           Foreign Investment
                     __________________________    ___________________________

 Allo-               (1)        (2)     (3)        (4)    (5)       (6)
 cation   Marginal   Purely     U.S.    Foreign    U.S.   Foreign   Purely
 Rule?    Leverage   Domestic   MNC     MNC        MNC    MNC       Foreign
 _____________________________________________________________________________

   No     All debt       0%       0%       0%      -20%    -20%        0%
   No     No change   17.5%    17.5%    17.5%     -2.5%   -2.5%      7.5%
   No     All equity    35%      35%      35%       15%     15%       15%
   Yes    All debt       0%     3.3%     3.3%     -3.3%   -3.3%        0%
   Yes    No change   17.5%    17.5%    17.5%      7.5%    7.5%      7.5%
   Yes    All equity    35%    31.7%    31.7%     18.3%   18.3%       15%

Without allocation rules (first row), U.S. and foreign multinationals deduct as much interest as possible in the United States. With multilateral adoption of allocation rules, U.S. and foreign multinationals allocate expense deductions between U.S. and foreign locations similarly because it is required by law. With unilateral adoption of interest allocation rules (row 3), U.S. and foreign multinationals move interest deductions out of the United States because it allows them to deduct expenses that are otherwise not deductible. So assuming multinationals want to minimize taxes and they can readily move interest expenses across borders, U.S. multinational competitiveness is not hurt by the adoption of allocation rules, even when foreign countries do not adopt similar rules.

Relaxing Assumptions About Leverage

If the leverage ratio on new investment differs from the worldwide leverage ratio before that investment takes place, the computation of deductible interest under interest allocation rules becomes much more complex. The formulas appear at the end of the article. Table 2 uses the same example as in Table 1 to illustrate the effects.

Table 2 shows that when marginal leverage differs from average leverage, effective tax rates can still vary considerably under interest allocation rules. As previously noted, interest allocation is not a magic bullet that provides neutrality in all cases. Compared with no allocation rules, however, the dispersion in effective tax rates because of variations in leverage is significantly less under an allocation rule. For example, column 4 shows that with no allocation rules, marginal tax rates vary from -20 percent to 15 percent -- a range of 35 percent. With allocation rules, marginal tax rates vary from -3.3 percent to 18.3 percent -- a range of 21.6 percent.

If foreign investment is financed with all debt and there are no allocation rules, multinationals can get large tax subsidies by booking interest in the United States. Rates can go as low as -20 percent. In plain English, that means the U.S. government in effect is paying the multinational's foreign tax bill, and on top of that it is giving the multinational an additional $20 for every $100 of foreign income generated. Adopting allocation rules for interest expenses mitigates the negative rate problem, but it does not eliminate it. In Table 2, adopting allocation rules on debt-financed foreign investment increases the marginal effective tax rate from -20 percent to -3.3 percent.

Conclusion

If the United States adopts a territorial system, revenue losses and the economic distortions resulting from the ability of multinationals to easily shift interest deductions to high-tax jurisdictions will be major problems. Adopting interest allocation rules is a sensible way of addressing both of them.


Appendix

            Formulas for Effective Tax Rates on Marginal Investment
                        (examples explained in italics)
 ______________________________________________________________________________

 Example: Before new investment, foreign and domestic investment each yields
 $100, and foreign and domestic interest expense each is $50. New (i.e.,
 marginal) investment yields additional $100 of gross income and has interest
 charges of $80. So marginal leverage (am) is 0.8. Average worldwide leverage
 before (a0) is 0.5. Average worldwide leverage after (a1) is 0.6.
 ______________________________________________________________________________

                                                                No Change in
                                                                Leverage
                                                                (a0 = a1 = am)
                              In General                        (Used in
 Type of Business             (Used in Table 2)                 Table 1)
 ______________________________________________________________________________

                             I. Domestic Investment
 ______________________________________________________________________________

                             A. No Allocation Rules
 ______________________________________________________________________________

 (1) Purely domestic          tus - am *tus                     tus *(1 - a0)

                              $100 gross taxed in U.S.;
                              $80 at margin deducted in U.S.

 (2) U.S. multinational       tus - am *tus                     tus *(1 - a0)

                              $100 gross taxed in U.S.;
                              $80 at margin deducted in U.S.

 (3) Foreign multinational    tus - am *tus                     tus *(1 - a0)

                              $100 gross taxed in U.S.;
                              $80 at margin deducted in U.S.
 ______________________________________________________________________________

                            B. With Allocation Rules
 ______________________________________________________________________________

 (1) Purely domestic          tus - am *tus                     tus *(1 - a0)

                              $100 gross taxed in U.S.;
                              $80 at margin deducted in U.S.

 (2) U.S. multinational       tus - tus*[GPus,1*a1 -            tus *(1 - a0)
                              GPus,0*ao ]/[delta]GP - GPf*
                              tf*(a1 - ao)/[delta]GP

                              $100 gross taxed in U.S.;
                              tax effect $35. In U.S. can
                              deduct two-thirds of $180
                              ($120), a change of $70;
                              tax effect is minus $24.5.
                              In F a company can deduct the
                              remainder of marginal interest
                              or $10; tax effect is minus
                              $1.5.

 (3) Foreign multinational    tus - tus*[GPus,1*a1 -            tus *(1 - a0)
                              GPus,0*ao ]/[delta]GP - GPf*
                              tf*(a1 - ao)/[delta]GP

                              Same as above.

 ______________________________________________________________________________

                             II. Foreign Investment
 ______________________________________________________________________________

                             A. No Allocation Rules
 ______________________________________________________________________________

 (1) Purely foreign           tf * (1 - am)                     tf * (1 - a0)

                              $100 gross taxed in F;
                              $80 at margin deducted in F.

 (2) U.S. multinational       tf - am *tus                      tf - a0 *tus

                              $100 gross taxed in F;
                              $80 at margin deducted in U.S.

 (3) Foreign multinational    tf - am*tus                       tf - a0*tus

                              $100 gross taxed in F;
                              $80 at margin deducted in U.S.
 ______________________________________________________________________________

                            B. With Allocation Rules
 ______________________________________________________________________________

 (1) Purely domestic          tf * (1 - am)                     tf * (1 - a0)

                              $100 gross taxed in F;
                              $80 at margin deducted in F.

 (2) U.S. multinational       tf - tf*[GPf,1*a1 -               tf * (1 - a0)
                              GPf,0*ao ]/[delta]GP - GPus*
                              tus*(a1 - ao)/[delta]GP

                              $100 gross taxed in F;
                              tax effect is $15. In U.S.,
                              a company can deduct one-third
                              of $180 ($60), a change of $10;
                              tax effect is minus $3.5. In F
                              a company can deduct the
                              remainder of marginal interest
                              or $70; tax effect is minus
                              $9.5.

 (3) Foreign multinational    tf - tf*[GPf,1*a1 -               tf* (1 - a0)
                              GPf,0*ao ]/[delta]GP - GPus*
                              tus*(a1 - ao)/[delta]GP

                              Same as above.
 ______________________________________________________________________________

 Notes: GP is gross profit (i.e., profit before interest expense), which can be
 either in the United States (U.S.) or a foreign country (F) and either before
 (period 0) or after (period 1) marginal investment takes place. The statutory
 U.S. tax rate is tus equal to 35 percent in the example. The foreign statutory
 rate is tf equal to 15 percent in the example. With no allocation rules,
 business will book profits in high-tax country. With allocation rules,
 business will deduct maximum allowable in high-tax country and remainder in
 low-tax country.

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