My parental leave has officially started and I have limited time for blogging (or sleeping).  Friend and WashU law faculty member Adam Rosenzweig has written up another guest post on how firms can avoid (or minimize) corporate taxes.  See below.

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Imagine you are a hedge fund in the business of investing in high-yield bonds (otherwise known as junk debt).  Investors in the hedge fund come from all over the world, including US individuals, foreign individuals, corporations and pension plans.  An opportunity arises to make a loan to a US company as part of a leveraged buyout of the company.  You are extremely interested in making the loan.  Should you do it?

Of course, the answer ultimately is a business decision.  But what if I told you that the LBO loan would always have a thirty-five percent lower return than junk bonds purchased on the market?  How could this be the case?  Taxes.

For the most part, hedge funds are organized offshore so as not to be subject to US tax.  This is primarily for the benefit of their foreign investors who typically are not subject to US tax themselves and thus do not want to invest in entities that would be subject to US tax.  The problem is that foreign entities investing in US assets can be subject to US tax if they look too much like US business.

More specifically, under US international tax rules non-US persons (such as offshore hedge funds) are not subject to tax on their income unless that income is either, (1) fixed, determinable, annual or periodic income (“FDAP”) paid from sources within the United States, or (2) effectively connected with the conduct of a US trade or business (“ECI”).  The first refers to payments such as interest and dividends.  Such payments made by a US corporation to a non-US person are subject to a thirty-percent gross withholding tax (unless a treaty applies to reduce the rate).  Hedge funds can relatively easily avoid this provision, either by buying assets that do not pay FDAP type income or by entering into derivatives against the assets paying FDAP income instead of owning them directly (subject, as always, to certain anti-abuse rules).

The second refers to non-US persons engaged in a trade or business in the United States (or if a treaty applies have a permanent establishment in the United States).  This rule treats all income effectively connected with such a business as if it were earned by a US business.  The idea is to put US and non-US companies competing in the United States on equal footing.  This ECI is subject to a net income tax (meaning income less deductions) under the same rates as US people.

The problem arises because investing one’s own money is not treated as a trade or business for these purposes but banking is.  The tax law has a hard time figuring out which is which, however.  An entity need not take deposits and make individual loans to be in the banking business.  Rather, any entity that advances money and seeks out borrowers for the money (or “originates” the loan) can potentially be in the banking business for US tax purposes.  So if the hedge fund seeks out the US company, negotiates the terms of the loan, and advances the money, it sure looks like it is in the US trade or business of banking.  If so, all interest on the loan would be subject to US tax.

The solution is for the hedge fund not to originate the loan but instead to passively buy and sell an existing loan (for bank loans this is accomplished by buying “participations” in the loan).  But if the hedge fund truly was passive and waited to see what loans came on the market it would not be able to control the terms of the deal in the first place, meaning the payout may not be as good as the fund expected when it found the business opportunity.

The “season-and-sell” solves this problem.  Under the season-and-sell, a hedge fund identifies a lending opportunity in the United States.  It then forwards the opportunity to a friendly US bank with the proposed terms.  The US bank negotiates and makes the loan.  Then, the US bank waits for a period of time (how long is an issue of contention, discussed below) and then sells a participation in the loan to the hedge fund.  Assuming each step is respected, it now looks like the US bank originated the loan and that the hedge fund merely purchased a passive investment in debt.

Voila – the hedge fund gets the investment it wants, at the terms it wants, but is not engaged in a US trade or business.  Yes, the US bank will charge a fee for this service, but that is much less than the US tax would have been (and also avoids all the messy US tax return filings).

The season-and-sell has proven both popular and controversial.  Some people find it offensive that by using a US bank as a “front” and merely waiting to buy into the deal a hedge fund can completely avoid US tax.  Such people contend that the entire transaction should be collapsed into a single hypothetical transaction since the intervening steps are hard-wired and in substance the hedge fund made the original loan.  Under this hypothetical, the hedge fund would be treated as directly lending to the US borrower and thus would be engaged in a US trade or business for tax purposes.

Proponents of the season-and-sell anticipated this argument, however.  By waiting a certain amount of time before selling the participation to the hedge fund, they contend that the US bank takes on real risk.  If the price of debt drops in that period of time the bank loses real money.  Although it is unlikely that the price of debt would drop that quickly, those around in 2008 can easily remember seeing the value of mortgage loans crashing in a matter of days.  So how could an investment where the US bank takes on real risk of loss be a sham and disregarded for tax purposes?  And if the tax law did pretend like it never occurred, what would happen if the bank really did lose money?  How would the tax law account for that?

Based on these arguments, the market seems comfortable that season-and-sell works for tax purposes so long as the period of time is long enough.  How long would you guess is long enough?  One year?  One month?  As Lee Sheppard, a leading tax journalist, noted “[w]e’re not talking fine wine here. We’re not even talking Beaujolais Nouveau.”  Although there is no clear answer, the practice seems to be that three days is enough.  Yup, three days.  By paying a US bank a fee and waiting three days, the theory goes, the hedge fund can make any US loan it wants without paying US tax.

I am ambivalent about whether season-and-sell works under current law.  More interesting to me, however, season-and-sell demonstrates pretty starkly the limits of the existing US international tax laws to modern finance.  The US corporate tax system was designed to tax real multinational companies selling real stuff like General Motors or Standard Oil.  It is debatable how effectively it does so in the modern world, but season-and-sell seems to make clear that rules meant for companies that sell real stuff are toothless in the face of financial businesses.  After all, to a hedge fund a dollar is a dollar.  They don’t care whether an investment is called a loan, or a participation, a bond, a total-return swap, or anything else, so long as the cash flows are the same under their models.  So they can buy and sell any of these, or turn one into the other, solely for tax savings.  By contrast, I am assuming it would matter to General Motors whether they sold a Chevy Corvette or Ford Mustang, notwithstanding that both are cars.

As a result, it is nearly impossible to apply a substance-over-form analysis to a business model (such as a hedge fund) that is completely indifferent to form.  In other words, when is a participation in “substance” a loan and in “substance” a passive investment when to the hedge fund they are completely identical?  That, ultimately, is the true weakness of the US international tax rules.  Season-and-sell is just one (relatively clever) example.

Below is a guest post by Washington University Law Professor Adam Rosenzsweig on international tax law.

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The Problem of Intuition in International Tax Law

The news is filled with stories of abuse of the international tax system, from General Electric to Apple to Google toPfizer, typically with outrage and scorn.  There seems to be consensus that these are examples of how the system clearly is broken and in need of desperate repair.  What follows is typically calls for obvious solutions to these obvious problems, whether it be replacing transfer pricing with formulary apportionment or adopting minimum foreign tax rates or shifting to a territorial tax system.  Yet, when pushed, few can clearly articulate exactly why these examples are so troubling in the first place.

For example, if Apple pays too little US tax, it would be simple to impose a US excise or excess profits tax on Apple’s cross-border activity.  If Google uses artificial shell companies to hide income in Ireland without any real economic activity, it would be easy to disregard such sham entities.  If GE siphons all of its US profits to other countries it would be easy to impose US tax on its foreign source income.  Yet for the most part nobody has proposed these solutions, presumably because they violate some underlying deeply held norm of the international tax system.  So what are these norms, and why are they not being discussed?

This cycle is not new, however.  In the early 1960s Congress adopted the Subpart F rules as a way to shut down the scourge of tax havens by requiring current inclusion of certain highly mobile income.  This was supposed to kill the use of tax havens by US companies.  By the mid-1970s, however, the system was perceived as broken again, this time because of gaping exceptions permitting deferral for investments in “less developed” countries.  By the end of the decade the less developed country rules were repealed.  And then again a new concern arose about the abuse of the foreign tax credit by cross- crediting income from one country with tax credits from another, leading to the credit being “basketed” on a per-country basis.  And this itself was also repealed once it came to light that taxpayers could simply shift losses around countries rather than pool income and credits, leading to income-type baskets rather than per-country baskets.  Even then the problem continued, leading to calls to prevent companies from “inverting” by moving their headquarters offshore to avoid paying US tax.  This led to the enactment of the so-called anti-inversion legislation, or what could be thought of as the “once a US company, always a US company” rule, in turn leading to our current debate over “Double Irish” sandwiches and the like.

Each of these rule changes was supposed to end the apparent and outrageous abuse of the international tax regime.  Yet we find ourselves once again in the thick of this debate, with new obvious abuses and new obvious solutions.  But if none of the old obvious solutions fixed the problem, what makes us so sure the new ones will?

This is what I refer to as the problem of intuition in the international tax laws.  There is near-uniform scorn and outrage over international tax abuse but very little discussion over precisely what is so troubling about them in the first place.  Is it any surprise, then, that the obvious solutions rarely solve the problem?  How can we measure if we are any closer to an ideal system if we don’t identify the ideal in the first place?

This is not a problem of second-best, as that would require a clear first-best and some constrained variable preventing achievement of that first best.  This is recourse to deep-seated intuitions about a field that should be purely instrumental in its goals.  This, I would contend, is the real problem underlying international tax law.

Not everyone would agree on the underlying normative goals of the international tax regime, or even where to start.  But there is an obvious place to start as an initial matter, and that is where the focus traditionally has been, i.e., on the efficiency of the international tax regime.  From that perspective, the international tax laws have two consequences: (1) they raise revenue, and (2) they distort cross-border activity.  The second has received significant attention, in the form of the debate over “capital export neutrality” and “capital import neutrality” among others.  But the first has received less attention.  At first this would seem strange – isn’t the outrage over Apple and Google and GE all about revenue?  Yes and no.  Most of the outrage over these companies seems to that they are not paying the US enough revenue.  But, by definition, international tax is only relevant when more than one country is involved.  So what about the other country?  What would it do with the revenue?  Is one dollar in revenue for the United States more important than ten cents in revenue for Haiti?  Perhaps that intense need for ten cents is contributing to tax competition in the first place?

The answer, at least from an efficiency standpoint, depends on what the relative countries do with the revenue.  After all, raising tax revenue would never be worth the efficiency losses if the money was simply thrown in the ocean.  Assume the revenue is used to provide for industrial public goods, those public goods that increase returns to private capital within a jurisdiction.  Now the question is whether, at some point, the twentieth or fiftieth or one thousandth port in the United States is always more efficient than the first one in Haiti.  If returns to industrial public goods are constantly increasing in scale, then the answer is yes; if returns diminish in scale, then the answer is no.

This too is not a completely new idea.  Keen and Wildasin modeled a similar concept in 2000, among others.  But the legal literature, and the popular debate, hasn’t seemed to have caught up.  Raising US taxes on companies with activities in Haiti may be good for the US but it may be bad for Haiti.  Raising US taxes may increase distortions to cross-border activity, but it may better allocate returns to revenue.  It is this tradeoff that has been underappreciated in the current debate for the most part.

For example, if opponents of Google really wanted to raise the taxes it pays to the United States doing so would be easy: simply deny Google all of its foreign tax credits (or impose an excise tax on their use).  But nobody proposes this, presumably because it would “double tax” Google on its cross-border activity, a cure considered worse than the disease.  Rather, opponents of Google want Google to pay more tax to the United States and less to other countries.  But this then directly confronts the revenue question.  If building a port in Haiti is better for worldwide growth than paying for social security in the United States, which country should have a greater claim to the tax revenue?  Does the fact that Google is incorporated in the United States answer this question at all?  If not, then why adopt increasingly complex anti-inversion rules to prevent companies like Google from moving its place of incorporation to Haiti?

Perhaps this post raises more questions than it answers.  But at a minimum I would like to start a conversation challenging the intuitions, apparently deeply held, upon which most of the legal debate seems to rest.  Agree or disagree with this normative starting point, as I have done in prior work, but the debate should be engaged explicitly on that level rather than simply labeling some companies good and others bad, some countries cooperative and others tax havens, changing the rules to combat phantom menaces only to discover they were never there in the first place.

Today’s FT is filled with stories on pressure to crack down on tax havens and calls for reform of OECD corporate taxation.  Why now?

The timing of policy choices, from government expropriations of foreign investment, the signing of trade agreements, to the iniation of intermational conflict are some of the toughest questions in international relations.

I’m curious why is there so much pressure to enact corporate tax reform.  A few quick thoughts

• NGOs and journalists have broken a number of high profile stories on corporate tax reform.  This is plausible, but I know of of at least one other major investigation from the early 1990s by Time Magazine. 
• Companies have gone too far in their ability to dodge taxes.  This is plausible, and there is some evidence that effective tax rates have declined over time.
• Fiscal pressures are forcing governments to make major tax and spending reforms, often calling for some sacrifice by numerous groups in society.  Governments simply can’t ignore corporate tax reform if they are going to make major changes to their tax systems.

These are just some quick thoughts while my newborn naps.  Thoughts?