A Win-Win: Compromise on Foreign Profits

In last year’s State of the Union, President Obama argued in favor of reforming how the U.S. taxes the foreign profits of U.S. corporations: “From now on, every multinational company should have to pay a basic minimum tax.” While an international minimum tax is a sound idea, it should be part of a broader effort to fix our dysfunctional system for taxing foreign profits.

Currently, foreign profits of U.S. corporations are subject to a Hobson’s choice. Such profits are subject to a 35 percent tax rate if repatriated to the U.S. parent company. But if a corporation keeps that money permanently outside of the U.S., it typically owes no U.S. tax on those profits.

This bifurcated tax treatment leads to two related economic problems. First, corporations can reduce their tax burden by artificially shifting their profits from the U.S. to a tax haven, such as Bermuda or the Cayman Islands. Because highly mobile intellectual property (such as patents, brand names, and the like) has become an increasingly important driver of corporate profits, corporations have been able to shift more and more of their profits to tax havens. In 2008, U.S. corporations reported profits in Bermuda over 1000% of that island’s GDP.

Second, U.S. corporations have a huge disincentive to bring any profits earned in a foreign country back to the U.S. If a corporation did repatriate those profits, it would owe the difference between the 35 percent U.S. corporate tax rate and the local corporate tax rate. As a result, trillions of dollars in cash is currently being held by overseas affiliates of U.S. corporations—cash that cannot be invested in the U.S. by the parent company.

An international minimum tax, as President Obama has proposed, is a smart way to reduce profit-shifting—the first problem. Such a minimum tax should allow a credit for foreign taxes paid (as allowed under the current system); if the minimum tax were 17 percent and the local tax rate were 5 percent, the U.S. would impose an immediate tax equal to the difference between the two rates (12 percent in this case).

However, the international minimum tax would not address the second problem of today’s system: the incentive for U.S. corporations to keep their cash in the hands of their foreign affiliates. The U.S. could fix this second problem if it taxed foreign profits at 35 percent regardless of whether they were repatriated. But such a “worldwide system” of taxation would put U.S. corporations at a significant disadvantage to their foreign competitors. For instance, McDonald’s would face a 35 percent tax rate on the profits they earn in their restaurants in the United Kingdom, while a U.K.-based competitor (say, Harry Ramsden’s) would pay the U.K. rate of 24 percent.

Most jurisdictions take the opposite approach, taxing only those profits earned within their borders (with limited modifications to try to prevent egregious forms of profit-shifting). This system, known as the “territorial system” of taxation, is also the proposed solution of the GOP. If Congress enacted a territorial system, it would essentially remove the tax-related barriers blocking corporations from using foreign profits to invest in the United States. However, it would also strongly encourage the transfer of corporate profits to tax havens—especially income attributable to intellectual property or mobile investments.

Fortunately, there is a sensible compromise in the offing: policymakers could combine President Obama’s proposed international minimum tax with the GOP’s proposed territorial system. Here’s how this combination could work:

First, there would be an international minimum tax rate equal to, say, 17 percent. If a corporation paid less than 17 percent to a foreign government, it would immediately owe the difference to the U.S.—reducing the incentive to artificially shift profits to tax havens.

Second, if a corporation paid more than 17 percent in taxes to a foreign country, it would be allowed to repatriate that income freely to the United States and owe no (or minimal) taxes. This would substantially reduce the incentive to keep cash in the hands of overseas affiliates.

By imposing an international minimum tax, this combination would ensure that all corporate profits were taxed at some reasonable rate by some government. And by allowing corporations to easily repatriate profits earned in most foreign countries, this combination would strengthen the competitive position of multinational corporations based in the United States. President Obama proposed the first half of this combination in last year’s State of the Union; I hope he finishes the job in this year’s speech.