Reform U.S. International Tax System
The president proposes to tighten enforcement of tax laws to limit offshore tax evasion and change the way U.S. businesses are taxed on foreign income. In combination, the proposals would raise $122 billion over the 2010-2020 period.
During his campaign, the president promised to make it more difficult for individuals to use foreign tax havens to evade U.S. taxes. The budget would make good on this promise with a collection of measures designed to combat tax evasion by Americans and foreigners who use offshore accounts to shelter income from U.S. taxation. Those provisions, which would raise $5.4 billion from 2010 to 2020, would require more information reporting, increase tax withholding, and strengthen penalties to support U.S. taxation of income earned or held in offshore accounts or entities.
The president also proposes to change the way the international income of American corporations is taxed. Currently, the U.S. taxes both the domestic and foreign earnings of U.S. corporations. The time at which firms pay U.S. taxes on their foreign profits depends on how the parent company organizes its foreign operations. If operations are organized as subsidiaries (that is, they are separately incorporated in the foreign country), then the profits are generally not taxed until they are paid to the U.S. parent. If operations are organized as branches (that is, they are not separately incorporated in the foreign country), then the profits are taxed when they are earned.
Not all classes of foreign source income earned by foreign subsidiaries enjoy deferral. Under current tax law, certain “passive” income such as income earned from investments in foreign assets, foreign base company sales and services income, and income from the insurance of U.S. risk is taxed upon accrual. In addition, the parent company pays U.S. tax immediately on dividends, interest, or royalties paid by one subsidiary to another. That last rule does not apply, however, to payments within a corporation—for example, from a local branch to the home office.
To prevent income earned abroad from being taxed twice, the U.S. allows firms to claim tax credits for income taxes paid to foreign governments. Firms can use these tax credits to offset U.S. tax liability on foreign-source income. A limitation on the credit for foreign taxes prevents U.S. firms from using these credits to reduce U.S. tax liabilities on income earned at home. The limit is the amount of tax that would be due if the foreign income were earned in the United States.
To understand how the credit works, consider a U.S. company that earns $100 in a subsidiary located in a country with a tax rate of 25 percent so the subsidiary pays $25 tax to the host country. If the subsidiary immediately remits the $100 of earnings to the parent company, the parent company owes $35 of U.S. tax on the $100 (since the U.S. corporate tax rate is 35 percent). However, the company may claim a $25 credit for the tax paid to the foreign country, leaving a net U.S. tax of only $10 (the $35 tax minus the $25 credit).
If the foreign tax rate were 45 percent, and as before the profits are sent home to the parent, the firm would owe $45 in foreign tax, $10 more than the $35 U.S. tax liability. A firm in this situation is said to have "excess credits” of $10 (the $45 foreign tax minus the $35 U.S. tax) because its foreign tax payment exceeds the U.S. credit it may claim in the current year. In some situations, the foreign tax credit system allows firms to use excess credits from one source of foreign income to offset U.S. tax payments on income from another source in a procedure called "cross-crediting."
To understand how cross-crediting works, consider a company with both of the subsidiaries described above. Cross-crediting allows the parent corporation to offset the $10 net U.S. tax liability on the first subsidiary (in the low-tax country) against the $10 of excess credits of the second subsidiary (in the high-tax country). In this case, simultaneously repatriating income from subsidiaries in both high- and low-tax countries results in no net U.S. tax liability on the $200 of foreign-source income.
Differences in taxation between the United States and other countries give multinational companies an incentive to alter their transfer prices —that is, the prices they charge for goods transferred to their affiliates—from what a nonaffiliated customer would be charged. For example, by underpricing sales to their affiliates in low-tax countries and overpricing purchases from them, companies can shift reported profits to those countries, thus reducing their tax. To deal with this practice, for tax reporting purposes most governments require firms to use an "arm’s length" standard, setting transfer prices equal to the prices that would prevail if the transaction were between independent entities. Yet ample room remains for firms to manipulate transfer prices, because arm’s-length prices are often difficult to establish for many intermediate goods and services, including intangibles, such as patents, that are unique to the firm.
There are other ways for firms to shift income from high- to low-tax countries. For example, by borrowing money in high-tax countries to finance their overall operations, they can claim larger interest deductions in those countries and so report more profits in low-tax countries. Research using Treasury tax files suggests that two of the most important vehicles for income shifting are placing debt in high-tax locations and transferring very valuable intangible assets to low-tax subsidiaries without adequate compensation in the form of royalties. Treasury economist Harry Grubert reports that location of intangible income and the allocation of debt among high- and low-tax countries seem to account for all of the observed differences in profitability across high- and low-statutory tax countries.
The president proposes a package of revenue raising reforms of the international tax system that would affect both the deferral and foreign tax credit features of current law as well as income shifting. The bulk of the revenue raised from these provisions would come from changes related to the deduction of interest expenses against deferred foreign income, the calculation of the foreign tax credit, and the treatment of returns associated with the transfer of intangibles abroad to affiliated foreign companies. All three provisions would take effect in 2011.
Changes related to the deduction of interest expenses against deferred foreign income. Under current law, companies with overseas operations may immediately deduct expenses supporting foreign investment while deferring payment of taxes on profits from those investments until they repatriate the profits. Under the president’s proposal, companies could not claim deductions on their U.S. tax returns for interest expenses that are properly allocable to foreign source income until they pay U.S. taxes on their foreign earnings. The provision would effectively limit the benefit of deferral by raising the cost of delaying U.S. tax payments on foreign profits. The rules governing the provision are complicated and have uneven effects across different industries and companies. Multinational companies that are heavily leveraged would suffer most from the provision.
Changes related to foreign tax credits. The president proposes to limit cross-crediting by requiring firms to consider the foreign tax they pay on all of their foreign earnings and profits in determining their foreign tax credits. Under current law, the foreign tax credit is based on earnings and profits on which U.S. tax has been paid. Companies would receive no foreign tax credits for foreign taxes paid on deferred income until they repatriate that income. The provision would limit firms’ ability to blend their repatriations to minimize or avoid U.S. taxes on foreign source income. This proposal would also increase the cost of deferral.
The budget also includes a provision aimed at curbing methods companies use to inappropriately separate creditable foreign taxes from the associated foreign income. Under current law, companies can use a tax planning technique separate foreign tax credits from the underlying income. This allows them to claim credits for foreign taxes paid on income that has not been recognized for U.S. tax purposes. The president proposes to allow a credit for foreign tax only when and to the extent the associated foreign income is subject to U.S. tax in the hands of the taxpayer claiming the credit.
Changes related to income shifting. The president proposes two measures to prevent the inappropriate shifting of income outside the United States through the transfer of intangible property. One proposal would scrutinize the income arising from transfers of intangible property. If a U.S. company transfers an intangible asset such as a patent to a related foreign company in a country with a low effective tax rate and circumstances indicate that there is excessive income shifting into the low-tax country, then under the proposal the return that is deemed to be “excessive” would be taxed currently and not allowed deferral. The inclusion of this proposal in the President’s budget suggests that the Administration does not believe that the current transfer pricing regulations are working adequately for intangible property transfers. A second proposal would clarify the definition of intangible property in an effort to reduce controversy that has arisen in IRS examination. In addition, the proposal would clarify that when valuing intangible property, the IRS may take into consideration the prices or profits that the controlled taxpayer could have realized by choosing a realistic alternative to the controlled transaction taken. This seems to be a movement away from the “arm’s length” standard for transfer pricing. Finally the second provision would allow the Commissioner value multiple intangible properties on an aggregate basis if doing so would achieve a more reliable result.
In his State of the Union address, President Obama announced that “to encourage these [clean energy businesses] and other businesses to stay within our borders, it is time to finally slash the tax breaks for our companies that ship our jobs overseas, and give those tax breaks to companies that create jobs right here in the United States of America.” The proposals have the effect of limiting the benefits of deferral and limiting income shifting, but would not create more jobs in the United States. The number of jobs in the United States has little to do with tax provisions that affect selected investments or industries. Instead, employment is influenced by fiscal and monetary policies—as well as periodic shocks to the system such as financial market meltdowns—that determine whether American and foreign consumers and investors are willing to purchase enough American-made goods, services, and assets to keep U.S. workers fully employed. Taxes can indirectly affect employment to the extent they affect overall wage levels, but the effect is likely quite small because labor supply is not very sensitive to wages. Specific tax incentives do affect where Americans work and what they produce. They also affect overall living standards by influencing how efficiently we use our scarce workers and capital and how much we invest for the future. Specific tax incentives have little impact on total employment.
Additional Resources
Tax Policy Briefing Book: International Taxation: How does the current system of international taxation work?
Will Paring Deferral Create Jobs? TaxVox, May 5, 2009
Intangible Income, Intercompany Transactions, Income Shifting, and the Choice of Location, Harry Grubert, National Tax Journal Vol. 56 No. 1 Part 2, pp. 221-242, March 2003
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