The Obama administration has proposed to defer deductions for certain expenses incurred by U.S. multinationals with deferred foreign income. This blog posting first discusses two other U.S. tax matching principles and then discusses the proposed Obama matching principle.
Exempt Income / Expense – Matching Principle
Expenses are often incurred in the process of generating taxable income. These expenses are generally deductible for tax purposes, so that only the net profit is subject to income tax.
Certain types of income are exempt from income taxes. Examples include municipal bond interest income and certain foreign earned income. As would be expected, expenses related to the exempt income are generally not deductible for tax purposes.
The disallowance of expenses related to tax exempt income can be thought of as a matching principle: if the income is not taxable, the related expense should not be tax deductible.
Timing of Income / Expense – Matching Principle
Certain types of expenditures create assets or other long term benefits. U.S. tax law generally requires that the cost of creating or purchasing assets, and expenditures that create long term benefits, be deducted for tax purposes over the useful life of the asset, or over the term of the benefit.
This deferral of deductions is based on an accounting matching principle which attempts to match the timing of expense deductions with the timing of income recognition.
Deferral of Foreign Income / Expense – Obama Proposed Matching Principle
U.S. based businesses with foreign subsidiaries are often able to defer U.S. taxation of foreign profits, sometimes for extended or even indefinite periods.
Expenses related to the foreign operations, however, are often incurred and deducted by the U.S. parent company on a current basis. Thus, there is a mismatch with the timing of income recognition and the timing of deductions – income is deferred but expenses are not deferred.
The Obama administration has proposed to create a matching principle: foreign related expenses cannot be deducted until the foreign related income is subject to U.S. tax. There are large dollar amounts at stake.
Example of Interest Expense
Interest expense is an example of the mismatch of income and expenses. Say a U.S. parent company typically earns $100 of profit before income taxes on its U.S. operations. Say also that the U.S. parent is considering expanding its operations by borrowing and investing $1,000. The expanded operations can be located either in the U.S. or overseas. Say also that labor and material costs are identical in the U.S. and in the proposed foreign country. As long as the tax rate in the foreign country is lower than the tax rate in the U.S., the U.S. parent can reduce its current worldwide tax cost by expanding its operations outside the U.S. rather than inside the U.S.
This can be demonstrated as follows: Assume the U.S. parent borrows $1,000 at 10% interest per annum in the U.S. The U.S. parent invests the $1,000 as equity into a foreign subsidiary in a lower tax country with an active foreign business. Assume also that the foreign subsidiary earns $150 per year and reinvests its earnings in the foreign business.
Under today’s tax rules, the U.S. parent can generally deduct the $100 of interest expense in the U.S. on a current basis. This interest expense wipes out the U.S. parent’s U.S. taxable income ($100 pre-interest profit minus $100 interest expense). The foreign income of $150, however, is not currently taxed in the U.S.
Incentive to Invest Overseas
The current deduction for the U.S. interest expense combined with the deferral of the foreign income creates an incentive for the U.S. parent to invest in new businesses overseas rather than to invest in the U.S. The proposed matching principle would eliminate this incentive by deferring the $100 of interest expense until the $150 of foreign earnings were subject to U.S. tax.