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