More On Tax Planningfrom The Advisor's Professional Library
- Annuities: Estate Tax The value of certain types of annuities may be included in an estate’s value. Understanding the intricacies of these inclusions is a critically important aspect of estate planning.
- Taxation of Real Estate Real estate may be used to shelter income and may offer certain tax benefits. However, the type of real estate investment may result in different tax treatment. Learn how to use these investments to help your clients.
Everyone along the political spectrum says that corporate tax reform is a priority. But no one in Washington seems ready to make the tough choices necessary to develop a system that forces multinational corporations to pay their fair share without hurting U.S. competitiveness in the world markets. Overtax multinational corporations and they’ll move their operations overseas; under-tax and you’ll reduce revenue that is sorely needed by the U.S. government.
What follows is a summary of the U.S. taxation of multinational corporations, a discussion of the primary mode of taxation that’s employed by other countries, and a discussion of testimony recently heard by the U.S. House Committee on Ways and Means as it struggles to find a workable solution to the problem of corporate taxation in an increasingly globalized marketplace.
Taxation of U.S. Multinational Corporations
The United States taxes both individuals and corporations on their worldwide income. So a U.S. corporation that sells soap in Bangladesh, for instance, will be taxed in the U.S. on its Bangladesh income. That’s simple enough to understand, but this simplistic example doesn’t take into consideration the more complex situations that exist in the real world of international business.
Companies often don’t operate in a foreign jurisdiction themselves. Instead, they form a subsidiary in the foreign jurisdiction and use that wholly owned – but separate – company to conduct their business there.
What’s the tax situation if the U.S. corporation forms a new corporation in Bangladesh that will sell soap in that country? The Bangladeshi subsidiary of the U.S. corporation is not a U.S. resident. It is a resident of Bangladesh, and the U.S. can’t directly reach it for tax purposes.
These subsidiaries are basically off-limits to the IRS; the IRS only has authority over the U.S. parent company. That gives the U.S. leverage to tax the profits of the subsidiary indirectly. The U.S. can tax the parent company on the subsidiary’s profits, bypassing the foreign subsidiary.
The U.S. does tax a U.S. parent of a foreign company on some of the foreign subsidiary’s income, but Congress decided not to tax all such income. Instead, the U.S. tax system selects particular types of foreign subsidiary income to tax—even when that income is not repatriated, that is, sent back, to the U.S.. This subsidiary income that is subject to being taxed to the U.S. parent company is referred to as “Subpart F income.”
In general, income earned on a passive investment by a foreign subsidiary of a U.S. corporation is Subpart F income, but income earned from active operations in a foreign jurisdiction generally isn’t Subpart F income and isn’t taxed to the U.S. parent company. That income is, however, taxed to the parent company if the funds are repatriated back into the U.S.
Because income earned from active operations of a foreign subsidiary generally aren’t taxed to the parent company unless the funds are brought back into the U.S., multinational companies based in the U.S. have a strong incentive not to repatriate their foreign profits. In other words, they elect to defer their tax on those profits as long as possible. This is
referred to as the “trapped earnings problem.”
Deferral is a big problem with the U.S. international corporate tax system. It disincentivizes multinational companies from bringing overseas profits into the U.S. since this will trigger U.S. taxation of those profits. This is the “trapped earnings problem.” U.S. companies have as much as $1 trillion of foreign sourced income trapped overseas.
The U.S. has taken steps to deal with the trapped earnings problem before, giving multinationals a temporary reprieve from the dividend tax in 2004. Under that program, U.S. companies brought over $300 billion in profits into the U.S. from overseas—convincing evidence that U.S. companies are hoarding their cash in foreign jurisdictions.
Foreign Taxation of Multinational Corporations
Many jurisdictions other than the United States use a territorial system of taxation. Under a territorial system, only domestic profits are taxed. Foreign-sourced income—income earned from a foreign source—is generally not taxed.
Many critics of the U.S. tax system support movement of the U.S. from a worldwide to a territorial tax system. They believe that the U.S. system harms U.S.-based multinationals by making them less competitive in the world marketplace. They also claim that moving to a territorial system would eliminate the effect of deferral and free companies to move capital back to the U.S. without fear of being taxed on those funds.
Testimony to the U.S. House Committee on Ways and Means
As part of the ongoing debate and investigation of the corporate tax system, the House Committee on Ways and Means is hearing testimony from experts on the U.S. tax system and alternatives. One such witness, Professor Reuven S. Avi-Yonah–who testified on May 24th of this year—disagreed wholeheartedly with the premise that a territorial system is a panacea for what ails the U.S. tax system.
Avi-Yonah believes that adopting a territorial system of taxation “is not relevant to the competitiveness of U.S.-based multinationals.” He says that international competitiveness of U.S. multinationals is related not to their U.S. tax burden, but to their overall effective tax rate. According to the Professor, there is no good evidence that the overall effective tax rate of U.S. multinationals is any higher than that of multinationals based in other countries. In fact, he indicated that there is evidence that the overall effective tax rate of U.S. multinationals on their foreign source income is lower than that of multinationals based in other jurisdictions.
Further, although a territorial system would address the “trapped earnings” problem, the Professor believes that the problem is better addressed in other, less disruptive ways. For instance, the deferral of tax on foreign source income could be repealed—in other words, U.S.-based multinationals would be taxed on their worldwide income, including that of foreign subsidiaries. This would certainly eliminate the disincentive to repatriate profits into the U.S. On its own, that solution would exacerbate the tax burden of U.S.-based multinationals, decreasing their competitiveness in the world economy. But a balancing reduction in those companies’ effective tax rates could be used to balance the increase. For instance, a reduction in the U.S. corporate tax rate could be used to balance these companies’ total effective tax rate.
Critics of the U.S. system often point to the fact that corporations avoid U.S. tax on foreign subsidiaries’ income by shifting income between foreign jurisdictions by using a low-tax
jurisdiction as an intermediary. That theoretically allows the corporation to keep the income out of the U.S. and avoid U.S. taxation. Such income shifting would be irrelevant if the U.S. instituted a territorial system. But Professor Avi-Yonah argues that switching to a territorial system of taxation would only exacerbate the problem of “income shifting” by making it easier to avoid U.S. taxation of shifting their operations so that profits are not deemed earned in the U.S. and thus subject to U.S. taxation.
Instead of switching to a territorial system, Avi-Yonah recommends that the U.S. focus on plugging holes that allow multinationals to move profits offshore and give other countries a competitive advantage over the U.S. “in attracting investment capital from this country.”
He also made the point that other countries should not be viewed as a viable model for the advantages of the territorial system. The U.S. is in a unique position in the world economy. What proponents of a U.S. territorial tax system fail to note is that tax law in jurisdictions with a territorial system often includes stricter provisions for taxing income that’s being diverted offshore or to a jurisdiction where the company is not doing business.
It is also important to note that other taxes affect the viability of a particular jurisdiction as a corporate home. Executives and other employees of a multinational company are subject to a host of personal taxes, including income taxes and Value Added Taxes (VATs). That’s another reason why other countries could afford to adopt a territorial system. Any corporate tax revenue lost could be made up by taxing employees more heavily.
For additional coverage of this issue and similar ones, we invite you to sign up with AdvisorOne’s partner, AdvisorFX, for a free trial.
See also The Law Professor's blog at AdvisorFYI.