Following up on his campaign promises, President Obama's first two budgets have included a package of tax hikes on multinationals intended to close loopholes and level the playing field between foreign and domestic investment. Among those proposals, the one that is getting the most attention is the newest addition to the list: the imposition of full U.S. tax on some profits from intellectual property (a.k.a., "intangibles") like patents and trademarks located in tax havens. There is strikingly little detail in the official Treasury release (and this is one of the many complaints by multinationals). But from what we can piece together, the proposal can be described like this: any return on investment in intangible capital in excess of 30 percent, earned in a foreign jurisdiction with a tax rate of less than 10 percent, will be immediately included in the U.S. parent corporation's taxable profits and therefore subject to 35 percent U.S. tax (with offsetting credits for any foreign tax paid). Under current law, the tax on this income can be indefinitely deferred and is only triggered if the parent company repatriates foreign profit as a dividend from the foreign subsidiary.

Multinationals and their political allies have long complained about U.S. tax rules that limit deferral. (In the trade, these rules are known as "Subpart F" rules. Now you can impress people at parties.) For example, here is what senior Bush administration Treasury official Kenneth Dam said in 2002:

After many amendments and elaborations, Subpart F today, generally speaking, taxes the U.S. parent on passive income earned by its controlled foreign subsidiaries. Moreover, in some cases Subpart F income includes income from active business pursuits abroad. For example, even the marketing activities of foreign subsidiaries aiding exports from a U.S. parent may produce Subpart F income. The same is true for various forms of service transactions by foreign subsidiaries. . . .

I believe that legislative changes could be enacted to limit Subpart F to truly passive income – such as portfolio dividends, interest and the like. At the very least we should take a hard look at the so-called active/passive dichotomy in Subpart F rules. We should not preserve tax rules that do not reflect the present realities of international corporate business, in which globalization requires centralization of functions, and in which services are not just a major wealth-creating activity, but one in which U.S. businesses have a comparative advantage. In short, I believe that we can sweep away the cobwebs of outmoded rules, and make U.S. businesses and workers more competitive.

Dam is correct that in many cases the rules go too far in the sense that in some cases the balancing act the rules are supposed to perform may have tilted too far in one direction. The balance we are talking about is the desire to (A) promote competitiveness and (B) prevent the erosion of the U.S. tax base. Because the rules are outdated in some circumstances we may be getting too much of (B). One particularly prominent problem is the rule that eliminates deferral when subsidiaries of U.S. corporations do business with related parties in other countries. (These are called the "base company" rules.) Back in the 1960s when these rules we originally formulated, multinationals generally set up one subsidiary for each foreign country in which they did business. Transfer pricing abuse was associated with base companies that did a lot of related-party cross border transactions. Fifty years later, it is common practice to set up regional headquarters, so transactions with related parties in other countries are entirely justified from the commercial perspective. In this case, the Subpart F rules can penalize sound business practice not motivated by tax avoidance.

But in the second paragraph cited above, Dam goes too far. Subpart F rules are not just needed for passive income (otherwise, U.S. companies would just stuff all their investments in tax haven shell corporations.) Subpart F rules sometimes must also include active income in situations where the tax authorities have excellent reason to believe there is inappropriate tax avoidance. What do we mean by "inappropriate tax avoidance"? Answer: Shifting profit from the United States to low-tax countries. (Please see my prior post about why excessive profit shifting is not consistent with competitiveness and is detrimental to the economy.) Here's the main point of this post: subpart F rules are a backstop to the transfer pricing rules. That backstop can be extremely beneficial because holes in U.S. transfer pricing rules are bad economics and they cost the U.S. Treasury tens of billions of dollars each year.

Hardly a week passes when proponents of multinational tax relief do not remind members of Congress and the public that we need to emulate the purportedly advantageous tax rules of other major industrial countries. Well, this concept of preventing tax avoidance with these types of rules is well-established throughout the world. Japan, France, the United Kingdom, Italy, Germany all have these types of backstops to their transfer pricing rules hard-wired into their foreign tax rules.

Moreover, these countries make a point of focusing their Subpart F rules on low-tax jurisdictions. They do this by setting up black lists (for low-tax countries), white lists (for high-tax countries), and -- like the Obama proposal -- case-by-case calculations of effective rate rates.

Other countries' rules on taxing foreign active income vary widely, but in addition to looking at low-tax situations, they generally deny deferral to active income when conditions are ripe for transfer pricing abuse. Indicators of transfer pricing abuse include: lots of related party transactions, lack of commercial activity, and the absence of local management in the low-tax jurisdiction.

The Administration's proposal follows squarely in this tradition of restricting deferral where transfer pricing abuse is likely. The proposal targets the excess profits of intangibles. That makes a lot of sense. It is widely agreed that the greatest potential and actual transfer pricing abuse occurs with intangibles. Current rules, which purport to uphold the arm's length standard, rely heavily on finding comparable transactions between unrelated parties to determine transfer prices between related parties. That works well for commodities such as wheat or iron ore, and you might be able to pull it off for television sets and motorcycles, but trademarks and patents are inherently unique.

The Obama administration's proposal is not out of left field. It addresses an important economic and revenue problem. And it is entirely consistent with the well-established concept of using Subpart F rules to support weaknesses in transfer pricing rules. As is true with similar rules in other countries, when the details of the Obama proposal are worked out, the rules will be complicated and messy. But the degree of uncertainty and complexity is comparable to that spawned from current transfer pricing rules.

I plan to comment on the pros and cons of the details of the Obama proposal in a upcoming post. But before we get critical of the smaller issues, let's not lose sight of the big picture.