The voices of Tax Policy Center's researchers and staff
The Tax Cut and Jobs Act (TCJA) that the Senate is debating this week would fundamentally change the way US-based multinational corporations are taxed on their overseas income. But contrary to the claims of President Trump and congressional supporters, the new approach may still encourage US companies to shift production overseas.
Under the current worldwide corporate income tax model used by the United States, all profits earned by foreign subsidiaries of US firms are supposed to be taxed in the US at a 35 percent rate. But the tax is imposed only when the earnings are repatriated, such as when the foreign subsidiary pays its US parent a dividend. Companies can defer the US tax indefinitely by postponing dividends, and they often do. More than $2.6 trillion in such profits are booked abroad by foreign subsidiaries of US firms.
By contrast, both the House version of the TCJA and the bill being debated in the Senate would shift to a territorial system. These bills generally would not tax profits of US firms earned in foreign countries, except for returns on securities and other passive activities, such as investments. Instead, the proposals would allow income to be taxed only in the country where it is earned. Within the OECD, the statutory corporate income tax rates range from more than 30 percent in France and Australia to 12.5 percent in Ireland and 9 percent in Hungary. Tax havens like Bermuda have no corporate income tax at all.
Supporters of the TCJA argue that a territorial approach would allow US companies to compete abroad without the burden of additional US taxes. But to prevent US multinationals from shifting production and profits to low-tax or zero-tax jurisdictions, both the House and Senate bills establish a guardrail: a 10 percent minimum US tax that applies to profits that exceed the firm’s “routine” returns on tangible property held abroad. The minimum tax is intended to target, indirectly, profits from intangible property held abroad (such as patents, trademarks, brand names, and software), which can be highly mobile. Unfortunately, the bills’ approach could still encourage production and profits to be shifted abroad, for three principal reasons.
First, the formula bases a firm's "routine" return as a percentage of its tangible assets located overseas, including plant, equipment, and other physical assets. Because “routine” returns are not subject to US tax, this definition of "routine" returns could give US firms a perverse incentive to shift more tangible assets to lower-taxed overseas locations. This would increase a US firm's tax exempt "routine" returns and thereby decrease its excess returns -- the key amount subject to the US minimum tax.
Second, the proposed minimum tax rate, after exempting those “routine” returns, is too low, which makes the guardrails largely ineffective. Under the Senate bill, a US firm that invests $100 million in tangible property abroad and makes a foreign profit of $20 million, would pay only about $1 million in tax (only 5 percent of $20 million) rather than the $2 million it would owe under a 10 percent minimum tax without the exemption.
How can the tax bill be cut in half? By deducting a “routine” return on tangible property which, in this example, would be a 10 percent return on the $100 million, or $10 million. The 10 percent tax on the remaining excess return, $10 million, equals $1 million. Thus, by subtracting those “routine” returns, the firm would lower its effective tax rate to 5 percent for its foreign profits, compared to the 20 percent rate on domestic profits. To put it another way, the firm would pay $1 million in tax on $20 million in foreign profits but $4 million on the same amount of earnings from a factory in the US.
Finally, both bills take an aggregate approach to determine whether the foreign tax on foreign profits of a US multinational exceed the specified minimum rate, which could let corporations game the system. Thus, a US firm could use the 30 percent tax its pays on income earned in France to offset the 0 percent rate it pays on income attributed to Bermuda. A US firm might even shift more income from the US to Bermuda, and blend the tax rates from both France and Bermuda, while still staying above the 10 percent minimum tax rate.
If Congress adopts a territorial system for corporate taxes, it needs effective guardrails to discourage the shifting of jobs and production abroad. In my opinion, those minimum-tax guardrails should ensure that: (1) the minimum tax is assessed on a country by country basis—so companies can’t use relatively high tax rates in countries like France and Australia to shelter paper profits in Bermuda: (2) if the US corporate tax rate is 20 percent, the minimum tax rate is around three-quarters of that low corporate tax rate, or around 15 percent; and (3) the minimum tax applies to all earnings of the foreign subsidiary--regardless of a firm’s tangible assets in the country. As it stands now, the proposed legislative shift to a territorial system could still encourage jobs, factories, and profits to move out of instead of into the US.
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