Florida Tax Review

The Taxation of Treasury Inflation Protected Securities

Robin Morgan — Mon, 04 Dec 2023 00:00:00 -0500

Inflation is back, causing problems for taxpayers looking for safe, inflation-protected investments. This Article engages in an in-depth analysis of an understudied part of the Internal Revenue Code and associated Treasury Regulations section 1.1275-7, the inflation-indexed debt rules, asking whether Treasury Inflation Protected Securities (TIPS) can act as a suitable hedge against inflation for taxable investors. TIPS are often considered tax-disadvantaged instruments, and this Article questions the extent to which that is true. I examine TIPS relative to inflation, nominal Treasuries and I Bonds, and in doing so make three important contributions to tax scholarship. First, I present original empirical analysis on financial data from the 2003-22 period, finding that TIPS are taxed at least as favorably as nominal Treasuries on a buy-and-hold basis. Under certain assumptions, like interest withholding, the section 1.1275-7 regime imposes less onerous tax consequences on TIPS than on nominals. Second, my results confirm that the performance of TIPS relative to nominal Treasuries depends on how unanticipated inflation deviates from expected inflation. Analysis of the 2003-21 period shows that nominals outperformed TIPS on both a pre-and a post-tax basis, while analysis of the 2003-22 period shows that 10-year TIPS issued between 2012 and 2022 generally outperformed nominals precisely because of the rise in unanticipated inflation in 2021 caused by the response to COVID-19. Third, I find that since 2011 all riskless bonds have generally had negative real yields on an after-tax basis. These findings have important implications for current tax policy since they show that taxpayers cannot access positive real riskless returns on an after-tax basis. With the world in a period of rising interest rates and high inflation, this suggests that it may be time to reconsider the canonical emphasis on nominal rather than real taxation.

Taxation at a Distance

Jeff Gordon — Mon, 04 Dec 2023 00:00:00 -0500

Wealthy Americans escape the income and estate taxes by holding assets at a legal remove. This general tax avoidance strategy—holding wealth “at a distance”—takes several forms, but the most powerful of all is the use of life insurance. Tax law has come to afford special treatment to life insurance due to some combination of reasoned policy, industry lobbying, and illogical application of existing tax rules and judicial anti-abuse doctrines. Courts have only recently begun to push back against taxpayers’ use of life insurance as a tax-free brokerage account, but the judicial crackdown is fatally flawed. This is because it rests on what I call “control doctrines,” or arguments that taxpayers should only become liable for paying taxes on their life insurance investments when they exercise direct, personal control over those investments. But I argue that taxpayers can benefit from such arrangements without exercising any control, and that economic benefit is a more appropriate basis for tax liability. I show that applying an economic benefit principle would produce simple, administrable rules superior to the control-based status quo in both the income tax and estate tax settings. My argument demonstrates that tax law must reject extreme legal formalism—such as the legal “distance” created through life insurance and trusts—in order to meet the challenge of high-wealth exceptionalism.

The Executive Compensation Threat to Retirement

Peter Wiedenbeck, Norman Stein — Mon, 04 Dec 2023 00:00:00 -0500

In recent years a new phenomenon has appeared on the retirement savings landscape: the expansion into middle management ranks of a traditional tool of executive compensation, the so-called “top hat” pension plan. Top hat plans are unfunded deferred compensation programs for a “select group of management or highly compensated employees.” Properly structured, top hat plans amass retirement resources that are taxed to employee-participants only when distributed. From the participant’s viewpoint, that delayed inclusion appears comparable to the tax deferral accorded qualified retirement plan savings, yet top hat plans are exempt from all of the Code’s qualification conditions. They are likewise excused from virtually all of ERISA’s pension plan participant protections, including vesting, funding and fiduciary responsibilities.

This regulatory immunity licenses three interconnected pathologies that undermine core retirement policy objectives. The inapplicability of ERISA’s worker protections, combined with preemption of state law, relegates top hat plan participants to a uniquely precarious position: their retirement savings are more exposed to depredation and vulnerable to loss than if ERISA had never been enacted. The inapplicability of the Code’s qualified plan nondiscrimination requirements allows employers to offer additional retirement savings to highly-paid managerial, technical and professional employees without having to pay comparable benefits to rank-and-file workers. And the dramatic disparity, post-2017, between income tax rates applicable to corporations and high-income
individuals incentivizes that favoritism with a substantial tax subsidy that is unmeasured and generally overlooked.

This article explores the unresolved ambiguity that has enabled top hat plan metastasis into upper-middle compensation ranges. It documents the sources of the pathologies associated with the expansion of top hat pensions and traces their consequences. And it surveys the leading responses to these developments, some of which offer only partial solutions, while others could be accomplished only by legislation.

Revisiting the Interaction of the Interest Expense Deduction and the Foreign Tax Credit

Bret Wells — Mon, 04 Dec 2023 00:00:00 -0500

This Article demonstrates that the most appropriate proxy for allocating and apportioning U.S. interest expense is one that first identifies the incremental U.S. deduction benefit attributable to the inclusion of foreign income. Now that the positive section 163(j) limitation enhancement attributable to the inclusion of foreign income into the section 163(j) computation can be readily determined, the allocation and apportionment regime should allocate that amount of U.S. interest expense (and only that amount) because that methodology actually matches the amount of the allocation and apportionment of U.S. interest expense to the actual interest deduction benefit derived from the inclusion of foreign income. The Article sets forth the manner in which this reform proposal would harmonize the section 163(j) disallowance regime with the allocation and apportioinment regime of section 861 and also discusses the advantages that the Article’s reform proposal has over competing paradigms.

The Dubious Constitutional Origins of Treaty Overrides

Reuven Avi-Yonah — Mon, 04 Dec 2023 00:00:00 -0500

In 1888, the Supreme Court decided a case called Whitney v. Robertson, which is generally considered to be the source of the proposition that, under the Constitution, later-in-time statutes can override earlier treaties (the Rule). The Rule is highly controversial because it violates articles 26 and 27 of the Vienna Convention on the Law of Treaties (VCLT), which the United States has accepted as binding on it as customary international law (CIL). Despite that, the United States has since Whitney routinely engaged in treaty overrides, and the Court has repeatedly endorsed the Rule even while narrowing its application to cases where Congress has clearly expressed its intent to override.

Despite the common consensus, the statement of the Rule in Whitney was dicta since the Court held that the later statute did not conflict with the earlier treaty. So, when did the Court state the Rule as a holding that can be relied upon when Congress enacts legislation that purports to override treaties? The answer is that the Rule is based not on the Constitution (since the Supremacy Clause says nothing about the relationship between treaties and statutes) but on two old cases from 1870 and 1884, both of which related to disfavored groups: Cherokee Tobacco (Indians) and Head Money (Jews). This Article argues that the Rule is not needed as a constitutional matter. Outside the tax area, the courts will interpret later statutes as overriding earlier treaties only if Congress makes its desire to do so explicit, but when it does, then the courts will defer to it regardless of the VCLT because CIL in the United States is limited to situations where Congress has not spoken, and because courts respect the explicitly expressed will of Congress and follow the later-in-time principle as a matter of statutory interpretation. There is no need to rely on the Constitution for this outcome, nor for avoiding treaty overrides where Congress has not been clear because that result follows from an application of the lex specialis canon (i.e., that a more specific law (the treaty) overcomes the more general one (the generally applicable statute) even when the statute is later in time). In the tax area, Congress codified the Rule in 1988 as section 7852(d) of the Code, and in that context made it clear that later-in-time tax statutes can override earlier tax treaties even when there is no clear statement of congressional intent. This exception has implications involving hundreds of billions in tax revenue.

Given this outcome and the dubious historical origins and doubtful Constitutional basis for the Rule, the Court should overrule Cherokee Tobacco and Head Money and leave the issue of overrides to Congress.

The Common Sense of a Wealth Tax

Jeremy Bearer-Friend, Vanessa Williamson — Mon, 04 Dec 2023 00:00:00 -0500

Thomas Paine’s writing helped spur the American colonies to independence and ensure that the new nation would be a republic, not a monarchy. In light of the renewed interest in wealth taxes, this article provides a close examination of Thomas Paine’s wealth tax proposal in the second volume of The Rights of Man. Unlike Paine’s proposal to tax inheritances, his 1792 proposal to tax wealth on an annual basis is often overlooked. The article identifies Paine’s various design specifications, provides original estimates of the impact of Paine’s wealth tax proposal within his own time period and as applied to billionaires today, and discusses ambiguities in the proposal. The article then places Paine in conversation with the contemporary wealth tax policy debate and demonstrates how Paine informs both the design and evaluation of tax policy. Lastly, the article clarifies the relationship between democratic ideals and taxation, portraying tax policy as a normative expression of republican ideals.

Reimagining a U.S. Corporate Tax Increase as a Supplemental Subtraction VAT

Daniel S. Goldberg — Mon, 04 Dec 2023 00:00:00 -0500

The U.S. federal government raises tax revenue almost exclusively through income taxes, both corporate and individual, whereas its trading partners and competitors rely for their national revenue on both income taxes and “destination based” value added taxes (VATs), which are not imposed on exports but are imposed on imports. As a result, U.S. corporations, which are subject to U.S. corporate income tax, may be at a serious trade disadvantage to competitor non-U.S. corporations with respect to both U.S. domestic sales and foreign sales, if the U.S. corporate income tax exceeds the foreign country’s income tax imposed on those competitors.

The Biden administration has proposed raising the tax rate on U.S. corporate income from its current 21 percent to 25 percent and perhaps even more likely to 28 percent. The proposed rate increase faces substantial Republican opposition. The opposition to the proposed rate increase argues that such an increase will chase business offshore and put the U.S. at a competitive disadvantage in attracting business and selling products both in the U.S. and abroad that compete with foreign products. The problem, simply put, is that foreign countries rely on VATs and can afford to maintain lower corporate income tax rates than otherwise, but the U.S. does not have a supplemental source of revenue like a VAT.

The issue of a competitive U.S. corporate income tax is not simply a current Biden/Republican tax rate disagreement about raising the U.S. corporate income tax. Rather, it is an issue about U.S. corporations having to compete with foreign corporations from countries that impose a lower income tax (and no VAT on exports) on those corporations than the U.S. imposes on its domestic corporations, and, further, that the U.S. cannot reciprocate by charging a lower income tax on its exports than on its domestic sales because of international treaty constraints. Thus, the issue reaches well beyond a proposed Biden administration corporate income tax increase, but rather to the structure of the U.S. business tax system of not having a VAT in some form as an integral part.

This Article considers revenue raising alternatives to supplement the current business income taxes and recommends that a subtraction VAT should be added to the corporate income tax as, at the very least, a step in keeping the corporate income tax competitive with the U.S.’s trading partner countries, perhaps as the long-term solution but perhaps as a first step to the adoption of a credit VAT to supplement the corporate income tax. In doing the foregoing, the Article compares the two types of business-level consumption taxes, the credit method VAT and the subtraction method VAT, relating them back to the most basic consumption tax, the retail sales tax. The Article argues that the subtraction method VAT, although not adopted by any other country, should be the choice because it can be added to the corporate income tax as a supplemental tax and can most easily coexist and be coordinated with that tax. It thereby allows for the easiest transition and is likely to be most acceptable to the public, which is well used to the corporate income tax and, as many observers believe, would be unwilling to adopt a credit method VAT, seeing it as a refined retail sales tax, which is a consumption tax imposed on individuals.

The Article then describes the proposed “Supplemental Subtraction VAT” that would supplement the tax on a corporation’s income and how it can be engrafted onto the existing corporate income tax to minimize the disruption to the current corporate income tax collection system. It then argues that the new supplemental subtraction VAT imposed on corporations, which would be destination-based, should be accepted as a VAT by the WTO and the U.S.’s trading partners for international tax and trade treaty purposes.

Safe Harbor Regimen in Transfer Pricing—An African Perspective

Alexander Ezenagu — Mon, 04 Dec 2023 00:00:00 -0500

The transfer pricing methods established by the transfer pricing rules and practices of many countries (generally modelled after the OECD Transfer Pricing Guidelines) are not only complex to implement, but also fraught with challenges such as the lack of availability of comparables for benchmarking purposes, low accessibility of databases and the failed capacity of tax authorities to implement them. For tax authorities in African countries, these challenges are further amplified, for example, by lack of resources, especially human and capital, and a shortage of experience in applying transfer pricing rules. As a result of these challenges, achieving arm’s length prices for transactions between related entities has posed a significant burden and cost to both taxpayers and tax authorities. The OECD and the G20 initiated the Base Erosion and Profit Shifting (BEPS) project to ameliorate some of the challenges listed above and to address the erosion of tax bases and shifting of profit to low-tax jurisdictions—challenges ultimately tied to the limitations of the arm’s-length standard and application of transfer pricing methodologies.

However, tax authorities in some jurisdictions already apply safe harbors and other simplified measures to mitigate the challenges of applying transfer pricing rules and practices. These measures reduce the need for taxpayers to prepare detailed transfer pricing documentation in justifying the arm’s-length price fixed for goods and services transferred among related entities. They also remove the need for tax authorities to audit the books of taxpayers where they act within approved margins. In some cases, they exempt taxpayers from applying transfer pricing rules to related-party transactions. Historically, the OECD discouraged the use of safe harbors by tax jurisdictions, claiming that they conflict with the arm’s length standard. In recent times, the OECD has changed its views on the use of safe harbors. The Statement on a Two-Pillar Solution to Address the Tax Challenges Arising from the Digitalization of the Economy recommends the use of safe harbors, including those in the GloBE rules, in determining marketing and distribution profits.

Given the positive recommendation by the OECD on the use of safe harbors in recent times, this Article analyzes the adoption and application of safe harbor regimes by certain countries and discusses how they should be designed. It recommends the cautious adoption and application of safe harbor regimes by tax authorities in African countries to achieve increased revenue collection, tax efficiency, certainty, simplicity and convenience, and to circumvent the complicated comparability analysis.