Will Congress Act to Save Tax Break on Foreign Subs?

A rule that has nearly halved the effective tax rates on some controlled foreign corporations must be renewed by the end of the year, or else.

General Electric’s (GE) effective tax rate for the year ended December 31, 2007, was only 15.5 percent. The statutory rate, of course, is 35 percent. Virtually all of the discrepancy (between the statutory rate and GE’s effective rate) is explained by an item referred to as “tax on global activities,” in the conglomerate’s annual report. As a result, a substantial part of GE’s worldwide pre-tax income is taxed at rates that are substantially lower than the U.S. tax rate of 35 percent.

Moreover, because these lower-taxed earnings are designated as “indefinitely invested” outside of the United States, GE is not required to “provide” deferred taxes with respect to these earnings. That means that from a financial accounting perspective, the earnings from these activities are not burdened by taxes imposed at rates even approaching 35 percent.

The effect of this phenomenon on GE’s net income is both substantial and, arguably, tenuous. This is so because GE’s Form 10-K goes on to explain that while the tax benefit is in place for 2007, there is no guarantee that Congress will extend the provision for 2009.

The company’s 10-K is up front about the matter. It states that, “GE effective tax rate is reduced because active business income earned and indefinitely reinvested outside of the United States is taxed at less than the U.S. rate. A significant portion of this reduction depends upon a provision of the U.S. tax law that defers the imposition of U.S. tax on certain active financial services income until that income is repatriated … If this provision is not extended, the current U.S. tax imposed on active financial services income earned outside the U.S. will increase….” Here’s how the tax provision is structured, and why GE reaps the benefits.

Subpart F income

U.S. shareholders of a controlled foreign corporation (CFC) are taxed on their pro-rata share of certain income earned by the CFC. Such income is subject to U.S. tax regardless of whether the income is actually distributed by the CFC to U.S. shareholders. For this purpose, a CFC is any foreign corporation in which more than 50 percent of the voting power — or value of the stock — is owned by U.S. shareholder on any day during the taxable year1. According to the tax rules, GE’s foreign subsidiaries are CFCs, and GE is a U.S. shareholder thereof.

The income of a CFC that is attributed to its U.S. shareholders consists of two components: (1) “Subpart F” income, and (2) the increase in the CFC’s earnings invested in U.S. property. Subpart F income, in turn, consists primarily of “foreign base company income. Further, an important component of foreign base company income is denominated “foreign personal holding company income” (FPHCI).

FPHCI consists of dividends, interest, royalties, and similar categories of passive income.2 Therefore, any FPHCI earned by a CFC is generally included in the income of its U.S. shareholders, regardless of whether such income is actually remitted by the former to the latter.

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