How to Tax U.S. Companies’ Foreign Profits

On Wednesday the Obama administration proposed a long-awaited cut in the top rate of U.S. corporate tax from 35 per cent to 28 per cent. But the White House also disclosed something more contentious. The administration is suggesting U.S. companies’ foreign earnings should be subject to a “minimum tax”.

The current system for taxing earnings of foreign subsidiaries controlled by U.S. companies is controversial and counterproductive. Such foreign earnings are theoretically taxed at a 35 per cent rate if brought back to the U.S., but not taxed at all by the U.S. as long as these earnings are kept abroad.

Faced with this choice, U.S. companies are unsurprisingly holding abroad more than $1.5tn in foreign profits. The current tax system thus discourages U.S. companies from using their foreign profits to build facilities in the U.S. or buy American companies. It also generates almost no tax revenues for the U.S. Treasury.

To replace the current system, business lobbyists have suggested the U.S. follow the lead of other industrialized countries by adopting a “territorial” system for taxing foreign profits of domestic corporations. In such a territorial system, the foreign profits of U.S. companies would be taxed only in the country where they were earned, and not by the U.S.

However, none of our major trading partners actually has a pure territorial system for taxing foreign corporate profits. Almost all countries impose domestic taxes on “mobile” corporate income such as investment interest. And many still collect taxes on corporate income earned in tax havens. These tax havens violate the fundamental premise supporting a territorial system – that foreign profits are already effectively taxed where they are earned, so should not be taxed again in the home country.

Mr. Obama’s idea could fix this problem by ensuring that all foreign profits of U.S. companies are taxed once at a minimum rate – either by the U.S. or another country. To be workable, this proposal should have three main components.

First, Congress should enact a permanent tax exemption for U.S. corporate profits earned in countries with effective corporate tax rates above a specified minimum. The minimum rate should be no higher than 20 per cent because that is the effective corporate tax rate in most of our major trading partners, according to a 2011 study by the National Bureau of Economic Research.

Second, Congress should levy a minimum tax on U.S. corporate profits in any tax haven to prevent a “race to the bottom” in which countries bid for corporate facilities by offering to minimize corporate taxes. In other words, the U.S. would no longer allow its corporations to defer indefinitely U.S. taxes on any profits allocated to these tax havens.

This general rule should be subject to a major caveat for low-tax jurisdictions where corporations conduct actual operations. A U.S. company should receive a credit against the minimum tax for the taxes it actually paid in such a jurisdiction. For example, if the profits of an Irish subsidiary of a U.S. corporation were taxed at 12.5 per cent in Ireland and the U.S. minimum tax was 20 per cent, these profits would be subject to a U.S. tax of only 7.5 per cent.

Third, Congress should allow all corporate profits earned overseas before 2012 to be repatriated to the U.S. at a low rate, such as 8 per cent, for the next two or three years. This low rate would facilitate the transition to a better permanent system, and would not be part of a one-off tax holiday for repatriated corporate profits. Another tax holiday would merely reinforce the current counterproductive system for deferring U.S. taxes on foreign profits.

Such a transitional rule is needed because corporations reasonably relied on the current system in the past – which allowed U.S. corporations to defer U.S. taxes forever on all their foreign profits as long as they were kept abroad. It would be unfair to impose a minimum tax now on a corporate strategy that was perfectly legitimate for many years.

This three-part proposal would be superior to the current system, which discourages U.S. companies from deploying their foreign profits in the U.S. and raises almost no tax revenues for the U.S. This proposal would raise revenues from U.S. corporate activities in jurisdictions with no or low taxes, while encouraging U.S. corporations to use their foreign profits to build facilities and create jobs in the U.S.

The critical political question that Mr. Obama needs to answer is: what should be the minimum tax rate? Although 20 per cent is the effective corporate tax rate in our major trading partners, business lobbyists might push for a lower rate – such as a 12.5 per cent rate, like in Ireland.

Critics might say even 20 per cent is too low, relative to the newly proposed 28 per cent rate on domestic corporate profits. However, with the effective U.S. tax rate on foreign profits of U.S. corporations currently at zero, there should be clear incentives for even Congress to reach a reasonable compromise.