As Congress starts the next round of debt ceiling negotiations, the United States Chamber of Commerce and other business groups are advocating tax relief for foreign profits of corporations based in the United States. Those profits are now subject to a 35 percent corporate tax rate, but the tax can be totally avoided as long as the United States corporations hold the profits in their accounts at foreign banks.
The current system needs reform: it generates minimal tax revenue while deterring American corporations from using their foreign profits to build facilities in the United States.
Business interests are calling for a so-called tax holiday, in which American corporations would be allowed to transfer their foreign profits to their American bank accounts at a tax rate under 6 percent for one year. Such a holiday would raise revenues and create jobs in the United States, according to the WinAmerica Campaign, a coalition of companies including Apple, Google and Pfizer.
But the last time such a holiday was tried, in 2004, it raised less than $19 billion and did not substantially increase jobs. Most of the repatriated profits went to corporate shareholders, through dividends or stock repurchases.
Instead of a one-off holiday, some corporations — Caterpillar and Kimberly Clark, for example — have called for a permanent fix: a territorial system for taxing foreign corporate profits, as most industrialized countries use. In a pure territorial system, the profits of multinational companies based in the United States would be taxed only by the country in which the profit is earned.
But none of our major trading partners takes a pure territorial approach, for two good reasons. First, almost all countries impose domestic taxes on “mobile” corporate income — for example, investment interest or royalties that can easily be shifted from one country to another. Second, many countries still collect taxes on foreign profits of domestic corporations if those profits are earned in tax havens that collect little or no taxes, like Bermuda and the Cayman Islands. These havens violate the premise of the territorial system, which is that corporate profits are taxed somewhere in the world at a reasonable rate. (The major European powers have been pressing Ireland to raise its 12.5 percent corporate tax rate to a minimum level acceptable to the European Union.)
Congress should use the budget crisis as an opportunity to permanently adopt a modified territorial system for taxing foreign corporate profits. Here is how the system would work.
First, Congress should exempt United States corporate profits earned in countries with effective corporate tax rates, on average, of 20 percent or higher. These countries include England, France and Japan. (This exemption would be subject to two exceptions: passive income like investment interest, and profits artificially transferred through complex transactions to countries exempt from United States tax.)
Second, Congress should levy a 20 percent tax on United States corporate profits in any country with an effective corporate tax rate below, on average, 20 percent. Corporations would no longer be allowed to indefinitely defer American taxes on profits in these jurisdictions.
But the 20 per cent levy should be reduced to reflect any taxes paid by United States multinationals in low-tax jurisdictions.
If a foreign subsidiary of an American corporation pays some tax in a low-tax jurisdiction, it should receive a tax credit for that amount against the 20 percent tax. For example, if corporate profits in Ireland were taxed at 12.5 percent, they would be subject to an American tax of only 7.5 percent (20 percent minus 12.5 percent).
Third, Congress should allow American corporations to transfer foreign profits earned overseas before 2012 back to the United States at a low rate — say, 10 percent — for the next two or three years. This rate would be part of a transition to a better permanent approach — not a one-off repatriation holiday.
Such a transition is needed because, in the past, corporations reasonably relied on the current system, which allowed them to defer American taxes forever on their foreign profits as long as they were kept abroad. It would be unfair to suddenly impose a 20 percent tax on a strategy that until now has been perfectly legitimate.
This three-part proposal, while not perfect, is far superior to a one-off tax holiday or indefinite deferral under the current system. This proposal would raise revenues from corporate activities in jurisdictions with no or low taxes, while encouraging American corporations to repatriate their foreign profits at reasonable rates.
The money can be used to reward shareholders, build factories or create jobs in the United States. Our economy needs all of these.