The TCJA Five Years Later: International Tax Issues

In the third of a three-episode series, former senior Treasury official Chip Harter discusses his experience creating the international tax guidance for the Tax Cuts and Jobs Act and the evolution of those provisions.

This transcript has been edited for length and clarity.

David D. Stewart: Welcome to the podcast. I’m David Stewart, editor in chief of Tax Notes Today International. This week: TCJA at 5, international edition.

December 22 marks the fifth anniversary of the signing of the Tax Cuts and Jobs Act into law. With half a decade of global intangible low-taxed income, foreign-derived intangible income, and the state and local tax cap behind us, we’re marking the occasion with three episodes taking a closer look at how the TCJA has affected taxes on the state, federal, and international levels.

This week’s episode, the third and last in our series, takes a closer look at the TCJA’s relationship with international taxes. Here to talk more about this is Tax Notes senior legal reporter Andrew Velarde.

Andrew, welcome back to the podcast.

Andrew Velarde: Thanks, Dave. It’s nice to be back.

David D. Stewart: We’ve already heard about the effect on state and federal taxes. Could you give us a brief overview of what effect the TCJA had on international taxes?

Andrew Velarde: Well, it essentially transformed the U.S. international tax regime. Through enactment of the transition tax and a move to a quasi-territorial system, the changes sought to bring back trillions of dollars in earnings companies had stashed, or some would argue were trapped, overseas.

There’s now a 100 percent dividends received deduction for certain foreign-source dividends for U.S. shareholders, and part of the changes also saw an enactment of rules such as GILTI, as you said. It’s kind of a type of minimum tax on offshore earnings. Then there’s the base erosion and antiabuse tax provision, designed to prevent earning stripping.

Of course, none of this has been done in a vacuum. The OECD has been looking to implement its own international reforms, which could alter the global landscape further.

David D. Stewart: Now, you recently talked to someone about this. Could you tell us about your guest?

Andrew Velarde: I had the pleasure of speaking with Chip Harter. He’s now at PwC, but from the fall of 2017, in the month leading up to TCJA passage, until the end of 2020, after the release of many of the TCJA regs, he was the former Treasury deputy assistant secretary for international tax affairs.

In that role, he oversaw a lot of the policy decisions Treasury made in implementing the guidance, following up on the act’s passage, as well as playing a vital role in U.S. negotiations at the OECD.

David D. Stewart: All right, let’s go to that interview.

Andrew Velarde: Hi, Chip. Welcome to the podcast.

Chip Harter: Thank you, Andrew.

Andrew Velarde: To kick things off here, I’d like to ask what was the atmosphere in the discussions between Treasury and lawmakers leading up to the TCJA passage?

Chip Harter: Well, it might surprise you, but Treasury had relatively little input into the design of the TCJA. The Republicans on the Hill had spent several years studying and preparing proposals for the moment when they would control the Hill and the White House, and had been considering some pretty radical proposals like former Rep. Paul Ryan’s, R-Wis., border-adjusted cash flow tax to replace the corporate income tax.

But when the Trump administration came in, they had not prepared as full an agenda in the tax area. Basically what you had were the big six negotiations with Gary Cohn and Secretary Steven Mnuchin negotiating on behalf of the administration with the congressional leaders.

But that was pretty high-level when it was concentrating on things like getting the 20 percent corporate tax rate, and it produced the so-called framework, which was basically a PowerPoint deck with one page on international tax issues that just said we would be going to a territorial system with some unspecified backup regime to prevent abuse.

In truth, the administration’s input to the process was pretty sparse, and in, let’s say, November and December as the legislation was in the process of being written, we at the Office of Tax Policy on a weekly basis would send over our technical comments and observations as we saw more text coming out. But frankly even there, the bandwidth of the Hill staffs to digest and respond was pretty narrow.

As we know, the whole process of trying to enact tax legislation based on reconciliation — instructions can be pretty chaotic. It’s time pressured, and they too had to satisfy almost every senator — this time in the Republican Party — so that the staffs had their hands full juggling all of those considerations. It’s actually pretty amazing that they succeeded enacting legislation with ultimately a 21 percent corporate tax rate. It’s not particularly surprising under the circumstances that the statute itself had some real issues when it emerged.

Andrew Velarde: Now that we’re five years out and with hindsight being 20/20, are there any international provisions in particular that you think should have been tweaked or removed?

Chip Harter: Well, again, we at Treasury obviously had to deal with the statute that Congress passed and do our best to tape off the rough edges or to implement or deal with problematic issues under it, and so that did keep us very busy.

Just starting with the BEAT, the treaty interaction issues arose during the legislative process. Mnuchin got a letter from five finance ministers where they were objecting that the BEAT was inconsistent with our existing treaty obligations.

That one, we at Treasury decided that we would simply write regulations implementing the domestic legislation and not address the treaty interaction issues. As the Treasury has been negotiating new treaties and protocols to existing treaties, it’s been very careful to specify in the treaties that the BEAT applies not withstanding anything else to the contrary in the treaties. But the issue about the priority between the BEAT legislation and preexisting treaties has not yet been resolved.

Also, with respect to the BEAT, it’s an unfortunate architecture from a policy standpoint that it combines in a single sort of minimum tax structure limitations on base erosion and limitations on credits such as the foreign tax credit. You therefore have this amazing cliff effect where a taxpayer can lose the benefit of its foreign tax credits if it trips the 3 percent or 2 percent base erosion percentage threshold, and that’s a very harsh structure.

We were able to address that to some degree by providing taxpayers with an election to forgo the benefit of deductions for income tax purposes with respect to related-party deductible payments to foreign affiliates to avoid falling off the cliff. But again, it’s just an unfortunate architecture.

Similarly, with respect to the BEAT, its application to foreign banks doing business in the United States could have been extremely harsh. For banks, interest expenses are equivalent to cost of goods sold, and taxpayers dealing in property have a cost of goods sold exception from the BEAT, but banks don’t.

Potentially the result is confiscatory taxation as a result of the bank capital adequacy requirements that required them to maintain a substantial portion of the capitalization of their U.S. operations in the form of related-party subordinated debt, usually in the form of total loss-absorbing capacity fundings. We and the secretary were getting expressions of grave concern from the parts of the federal government that regulate banks that this could drive foreign banks out of the U.S. banking market to the detriment of our capital markets.

They were telling us it was very urgent that we somehow fixed this, and ultimately we observed that the Obama administration, as one of their final acts, had granted relief with respect to TLAC debt for exactly these reasons. Basically under normal debt-equity definitions or debt-equity principles under U.S. tax law, TLAC would frequently not be debt at all and therefore have no interest deduction for payments on it.

But the Obama administration, appropriately in our view, granted relief for TLAC debt, made the interest on it deductible even where it would not otherwise be deductible. We concluded that Congress was aware of this when they passed the BEAT and that therefore it would be inappropriate to make what is really a lesser additional adjustment, which says it’s not only interest, but it’s also not subject to the BEAT.

There were some things we just were not able to fix, and it remains a quite harsh regime in part because it doesn’t depend on whether the related party or the related payee is subject to tax on its income inclusion, and so we were not able to provide exceptions where the income is picked up under subpart F or GILTI.

Again, there’s a lot left with respect to the BEAT that’s suboptimal, and I personally hope that it will be replaced eventually as part of a broader pillar 2 implementation by the United States, but again that’s probably not going to happen in the next couple years.

Andrew Velarde: I’d like to come back to your points about the BEAT a little bit later. But before we go any further on that, I did want to ask with the reg writing outside of the BEAT, were there any other particularly tough decisions that you had to make with regard to any other provisions in there?

Chip Harter: Oh, yes. I mean, the GILTI is right up there. I do think there was a genuine misunderstanding on the Hill during the legislative process as to how the GILTI was intended to operate. What was it? A true minimum tax where there would be no U.S. tax liability at the margin on tested income if it was subject to a foreign tax rate of at least 13 and an eighth percent? Or was the GILTI just one more foreign tax credit limitation basket subject to the full expense allocation such that a U.S. corporation could have a marginal U.S. tax liability from owning and operating controlled foreign corporations no matter how high the foreign tax on those CFCs was?

The statute reads as if the GILTI inclusion just goes in yet another separate foreign tax credit limitation basket. The legislative history was ambiguous. Again, I think this was an issue that was fuzzed over a little bit on the Hill as they were trying to line up all the votes in favor of the bill.

I do think most of the Republican senators voting for the bill thought that the GILTI was a true minimum tax and any CFC that pays at least 13.125 percent essentially gets full territorial treatment for its income and no marginal tax to the U.S. shareholder.

They were not bashful about calling up the secretary and telling him that that was their understanding of congressional intent. But ultimately, just staring at the statutory language, we felt that we were compelled to basically treat the GILTI as a separate limitation FTC basket, yet subject to the normal rules for FTC baskets, but we did have authority to vary the regulations dealing with expense apportionment as it applies to the GILTI basket as appropriate to reflect the special nature and characteristics of GILTI.

Thus we wrote the regulations about, for instance, research and development expense not being eligible to the GILTI basket and treating half of the stock of CFCs that produce GILTI income as a tax-exempt asset given that effectively the GILTI is taxed only at half the rate of regular inclusion.

Again, that was one where we had to maneuver to get to where we achieved a decent policy outcome in light of the statutory language. Another really tough issue that we can talk more about was the gap period for the effective date of GILTI for fiscal-year CFCs, as well as the failure to amend the section 951(a) to (b) provisions of subpart F to account for the fact that dividends paid out of CFCs received the section 245A deduction.

These were gaps in the legislation that created simply enormous loopholes. Basically the potential to get unlimited amounts of earnings and profits out from CFCs without any U.S. tax and potentially tens or hundreds of millions of dollars of earnings and profits, technical corrections were clearly the right way to address this, and technical corrections were proposed, but it was simply not politically possible to have those go forward.

So I thought it was important to draft some regulations that at least would target the most structured transactions that would likely have been aimed at achieving precisely the tax consequence.

We did draft the regulations that aimed at fairly narrowly defined extraordinary dispositions of stock and extraordinary reductions of stock holdings that taxpayers entered into not in the ordinary course of business, only on a very big scale on the premise that that type of transaction was probably highly tax motivated and did not change the economic situation of the taxpayer much because it was all executed within common ownership and essentially take away the section 245A deduction for earnings that were recognized in those transactions.

Again, we viewed these as fairly targeted anti-use regulations aimed at the defined structured transactions and in no way attempting to change the effective date of GILTI or change the operation of section 951(a) to (b). We did work very carefully with general counsel to go through a number of approaches for writing a targeted anti-use rule to address those specific structured transactions, and that’s the genesis of the section 245A-5 regs and, as you know, those are in the process of being litigated, and we’ll see where we end up.

Andrew Velarde: We have Liberty Global, a partial summary judgment motion over the section 245 dividends received deduction limitation temporary regs for Treasury ignoring notice and comment requirements.

You have FedEx challenging a foreign tax credit disallowance provision and the transition tax regs for ignoring the statute.

You have Kyocera — they’re making a challenge on the guidance provision that excluded a section 78 dividend from the DRD for violating the statute that they’re a fiscal-year taxpayer situation there, another kind of mismatch of timing.

I understand you don’t want to, can’t speak to these challenges directly, but speaking more generally, did Treasury imagine these types of challenges to the administrative process or to the authority under this statute? Did you imagine this when you were drafting your guidance?

Chip Harter: No, we were very mindful of the limits on our authority to write regulations during the whole process. I’ll observe that as Republicans, the drafters of TCJA were not particularly generous in their grants of regulatory authority to Treasury.

I’m actually particularly jealous of my successors, who, in the more recent legislation, have very broad grants of authority to do what’s necessary to effectuate the intent of Congress and the intent of the provisions where we did not have nearly as broad grants. I must say when I took the job, I never anticipated that I’d be spending as much of my time or it would be as an important part of the job as walking down the hall of the chief council to discuss whether our proposals were within our authority.

We obviously did exercise our authority where we thought it was important for us to do so and where we thought we had authority, and unfortunately in quite a few instances where the intent of Congress was pretty clear, I think it would’ve been great if we could have effectuated that intent. We concluded we didn’t have authority with respect to fixing the repeal of section 958(b)(4) or creating a subpart F exception from GILTI, or being able to entertain statements from senators saying that they didn’t think any expense should be allocated to the GILTI. There were probably as many times that we concluded that we didn’t have authority with respect to things we would’ve liked to have fixed as when we concluded that we did.

Andrew Velarde: Now, Chip, you not only oversaw the drafting of the TCJA regs, but you also served as lead negotiator during the OECD global tax discussions. To that point, when the United States passed the TCJA, how did the rest of the world view U.S. reform? Do you think the TCJA legislation influenced the direction of the international tax negotiations at the OECD?

Chip Harter: Yes. No, it was an amazing perspective to have. I joined the Treasury at the beginning of September, and the legislative momentum was picking up in October and November and through December. I must say a lot of our foreign counterparties were watching with some mix of fascination and horror as the United States was considering what they viewed as very radical proposals. We forget that the TCJA bill as it passed the House would’ve essentially taxed all imports into the United States on a destination basis.

One of the early things I had to do in my job was to keep my foreign counterparts at the OECD briefed on what was happening in the United States in terms of this legislation, and it really was a somewhat mind-blowing exercise for a lot of our European counterparts in particular.

Now at the time, most of the rest of the world had concluded that they simply were not satisfied by how far the BEPS 1.0 process had gone at the OECD. We had been seeing quite a flurry of unilateral measures being adopted around the world, and so when I actually showed up for my first OECD meeting in October in Rome, my European counterparts very politely explained to me that they were all going to adopt digital services taxes and that what the OECD should be doing is negotiating a standard DST that all countries should follow if they adopt DSTs.

Beyond that, there was not much agreement as to what else should be done, but that was the proposed immediate agenda for the OECD. I was given very clear instructions from the White House that the one thing I could not allow to happen at the OECD was to negotiate a DST that focused on an industry where U.S. multinationals would be bearing the very large majority of the tax liability.

What we did was to pivot to say that we were not willing to discuss changing the international tax rules as applied to only one industry, which the United States dominates, but we in the United States have gone through this pretty comprehensive international tax reform exercise that applies across industries generally, and we would be happy to participate in broad OECD negotiations about fundamental reform of international tax standards, provided that it applied neutrally across the board to all types of business.

It was basically that 2018 was a year of a transition where we were pivoting away from focusing on DSTs towards a more comprehensive set of proposals that in very large part were drawing on principles of the TCJA.

The pillar 2 proposals were clearly very much based on the GILTI regime, though it emerged that most countries wanted to progress the GILTI regime further by going to per-country measurement of tax rates, and the TCJA also inspired some elements of pillar 1.

But I think the main thing was that the United States had just gone through a quite comprehensive rethink of classical rules of taxing jurisdiction and shook things up quite a bit in terms of convincing the rest of the world that these rules might be in play and created an openness to reconsider some of these rules on a coordinated basis for the first time in many decades.

Andrew Velarde: The Biden administration proposed several sweeping changes to several of the key TCJA international provisions, which didn’t come to pass. We have moved GILTI to country-by-country determination, removed the exemption for the qualified business asset investment, and raised the rate. You have previously said that some of these proposals would be — I think your words were “a daunting prospect” for U.S. multinationals — you said that previously on a panel, but had also proposed doing away with the BEAT, designed to discourage earning stripping but some would argue not acting as it should, and replace it with the OECD’s pillar 2 global anti-base erosion rules.

As I said, these proposals didn’t come to pass, despite GILTI not being aligned with pillar 2’s min tax and BEAT receiving criticism as being ineffective. Do you think GILTI, BEAT — and I don’t want you to conflate these too much, obviously two very different provisions — but have they reached their intended targets and accomplished their goals? Can they exist side by side long-term with the OECD international rules that they do not fully align with, or will something have to be done?

Chip Harter: Well, backtracking a bit. While I was at the OECD, my negotiating instructions were pretty clear. With respect to the pillar 2 proposals, we could fully support the rest of the world adopting a minimum tax regime, but I was not able to promise that the United States would change its GILTI regime. We liked the fact that it would level the playing field for U.S. multinationals if multinationals based elsewhere were subject to a comprehensive minimum tax regime, but the administration was very proud of just what it had accomplished in the TCJA and was not prepared to say that we’d go back to the Hill to reexamine that and modify it.

While I was there, we were talking about sort of GILTI compatibility, and I think we got reasonably close to reaching agreement that under the proposed pillar 2 at the time, that the GILTI would be treated as a qualified income inclusion rule, even if it were applied on a global blending basis.

Again, things were a little different back then when the proposed pillar 2 rate was likely to be like 12.5 percent and GILTI was 13.125 percent, etc. But we got reasonably close. Now, for reasons I understand and have some sympathy for, the Biden administration thought that the BEAT could be materially improved, and then they also wanted to dramatically increase the rate on it, which is what I was commenting on being a daunting prospect, and the new administration viewed the OECD negotiations as a way to help get that done.

We know that they were not successful in using reconciliation procedures to get their Build Back Better proposals with respect to the GILTI enacted into law. We are now in a very awkward position where they’ve negotiated one set of rules at the OECD, but at least for the next couple years, we’re unlikely to be able to conform the U.S. rules to that OECD model, and that raises not insuperable difficulties, but it certainly will make life much more complicated for U.S.-based multinationals in terms of compliance.

It also raises some serious issues about what needs to be done to avoid double taxation. That having been said, I think that the BEAT and GILTI remain quite flawed regimes yet notwithstanding in our efforts at Treasury in the last administration to take some of the rough edges off through regulations.

I believe that on balance, the best outcome for U.S. multinationals would be if the United States simply adopted pillar 2 in substitution for the current GILTI and BEAT regimes, to where basically we would have a level playing field for U.S. multinationals and foreign multinationals applying the same regime. I do recognize that there are a number of design issues and flaws in the current pillar 2 rules, but I do think there is some hope that some of those could be addressed over time.

It’s not like we don’t have flaws under the GILTI and BEAT. I also recognize there’s always a risk that when the United States adopts any sort of minimum tax regime, that in the future, the rate of that minimum tax could be raised for U.S. multinationals by the United States. But I don’t think that’s [a] materially bigger risk if the United States adopts pillar 2 instead of the GILTI.

But life is uncertain, and obviously these views are my personal views and not necessarily those of any current or prior employer, but just having practiced international tax for 40 years or so and having lived through a lot of the evolution of the current rules and participated in the current OECD negotiations and the TCJA drafting exercise, I do think it would be a beneficial landing place for U.S. multinationals if we could simply adopt pillar 2 in the United States and do away with our current GILTI and BEAT rules.

Andrew Velarde: Chip, I want to thank you very much for taking the time to talk with us today.

Chip Harter: Well, my pleasure. These are interesting times and great topics.