Corporate Tax Reform Part 2: A Middle-Ground Proposal for Taxing Foreign Earnings

Robert C. Pozen

As discussed in Part 1 of this paper, the current U.S. tax rules strongly discourage U.S. corporations from repatriating almost $2 trillion in foreign profits. Such profits cannot be used to build U.S. facilities, pay dividends to U.S. shareholders or acquire U.S. firms—unless the U.S. corporation pays a 35% U.S. tax on such profits (minus applicable foreign tax credits). Congress should be able to change the current tax system for foreign corporate profits since it benefits almost no Americans (other than tax lawyers). The U.S. Treasury receives little tax revenues from these foreign profits and corporate executives are prevented from making sensible decisions about how to deploy those foreign profits.

To change the current tax system, however, both political parties will have to seek a middle ground on tax rates. Liberal Democrats should not insist on taxing foreign corporate profits at 35% regardless of whether they are brought back to the U.S. The immediate application of a 35% rate to foreign profits of U.S. corporations would put them at a tremendous competitive disadvantage to foreign firms. In most countries, foreign competitors to U.S. multinationals are paying effective corporate tax rates between 10% and 25%.

On the other hand, Republicans should not insist on moving to a pure territorial system for taxing foreign profits of U.S. corporations. Under such a system, foreign profits would be subject to tax only in the foreign jurisdictions where they were legally “earned”. In practice, such a system is open to considerable manipulation through clever lawyering. In a pure territorial system, most foreign profits of U.S. multinational would be “relocated” to foreign jurisdictions with minimal corporate tax rates.

What is a reasonable middle ground? In my view, Congress should enact a global competitiveness tax, totaling roughly 17% on all foreign profits of U.S. corporations. This tax should be due and payable every year—with no more deferral of corporate taxes. But the U.S. should give credits in this new system for any foreign taxes paid by U.S. corporations on their foreign profits to foreign countries.

For example, suppose Corporation X pays a 20% tax rate on its 2014 profits in the UK. Since 20% is higher than 17%. X would have no U.S. corporate taxes to pay on its 2014 profits. Moreover, X may then use these profits for an legitimate business activity in the U.S. without paying additional corporate U.S. taxes. On the other hand, suppose Corporate Y pays only 2% on its 2014 corporate profits earned in the Cayman Islands. In 2104, Y would have to pay the U.S. an additional corporate tax of 15% (17% -2%) on such foreign profits. Then Y could use these foreign profits for any legitimate business in the U.S. without paying additional U.S. corporate taxes.

Why do I choose 17% as the global competitiveness rate? Because this is the effective marginal rate paid, on average, by corporations in advanced industrial societies, according to a neutral organization called the OECD. In other words, the 17% rate would generally allow U.S. corporations to avoid a tax albatross when competing abroad—they would be paying a similar marginal tax rate as paid by their foreign competitors in most (but not all) OECD nations.

Such a global competitiveness tax would create the right incentives for U.S. multinationals. First, it would encourage U.S. corporations to deploy their foreign profits in the U.S.—because they always would pay a total tax of 17% on foreign profits and no additional tax if these profits are brought back to the U.S. Second, it would discourage U.S. corporations from cleverly transferring their foreign profits to tax havens—because such profits, even if earned in a tax haven, would still be subject to a total global competitiveness tax of 17%.

At the same time, the global competitiveness tax has several advantages relative to other recent proposals to reform the U.S. tax system for foreign corporate profits.

In December, 2013, Senator Baucus, Democratic Chairman of the Senate Finance Committee, proposed that foreign corporate profits be taxed alternatively at 60% or 80% of the then U.S. statutory rate on domestic corporate profits. Senator Baucus also expressed support for lowering this U.S. statutory rate from 35% to below 30%.

However, as discussed in Part I of this paper, it is quite unclear whether Congress could substantially lower the U.S. statutory rate on corporate profits on a revenue neutral basis—and, if so, to what rate. It is therefore imprudent to peg the tax rate on foreign profits to an unpredictable rate on domestic profits. (Note that if the U.S. statutory rate dropped to 30%, then 60% of 30% would imply a 18% tax rate on foreign corporate profits—very close to the 17% proposed for the global competitiveness tax).

Republican David Camp, Chairman of the House Ways and Means Committee, has released three alternative proposals on foreign tax reform—Options A, B and C. Options A and C share the same serious design flaw; they apply a much higher U.S. tax rate to foreign income related to intangible property than to other types of foreign income. Unfortunately, it is very difficult to segment what corporate income is attributable to intangible property since it is defined by the Internal Revenue Code to encompass customer lists and government licenses as well as patents, copyrights and trademarks. The ensuring interpretive battles would be a lawyer’s dream, but a disaster for company and tax officials.

Although Option B does not specially treat foreign income related to intangibles, it provides a 95% exemption from U.S. taxes for all foreign income based on an “active” business outside of the U.S. (as do Options A and C of the Camp proposals). Such a broad exemption would strongly encourage U.S. corporations to locate most of their manufacturing facilities and other operations in foreign countries, such as Switzerland or Singapore, with reasonable business infrastructures and very low tax rates. Such a broad exemption would predictably create a “race to the bottom,” whereby foreign countries would bid to attract manufacturing and other operations of U.S. corporations by offering them corporate tax rates as low as 5% plus other incentives to locate there.

The global competitiveness tax avoids these design problems of other tax reform proposals. It directly establishes a 17% rate for foreign corporate profits, instead of depending on the then current U.S. tax rate on domestic corporate income. It treats all foreign income the same, instead of requiring its segmentation into components. And it does NOT provide an almost complete U.S. exemption for active business income of U.S. corporations in foreign jurisdictions. Instead, if a U.S. corporation paid only 5% in corporate taxes on its manufacturing income in Singapore, it would have to pay the U.S. an additional 12% (17%-5%) under the global competitiveness tax.

Once Congress agreed on a tax rate for foreign corporate income going forward, it would then have to choose a rate for a one-time, transitional tax on pre-2014 foreign profits held abroad by U.S. corporations. Both parties appear to recognize that the transitional rate should be much lower than the 35% statutory rate, since this one-time tax is perceived as retroactive. Over the last few decades, corporate executives have reasonably relied on existing U.S. laws, which expressly permitted U.S. corporations to indefinitely defer any U.S. taxes on foreign profits kept overseas.

Democratic Senator Baucus proposed a transitional rate of 20% on pre-2014 foreign corporate profits—payable over eight years. Republican Camp proposed that U.S. corporations pay a transitional tax of close to 6% on pre-2104 foreign corporate profits so they could be brought back to the U.S. A reasonable middle ground would be something like a 12% rate payable over 10 years on pre-2014 foreign profits held abroad in cash or short term investments. The headline rate would look relatively high, although the net present value over 10 years would be much lower.

In conclusion, Congress should move quickly to address the problem of foreign corporate profits “locked out” of the U.S. because of its tax laws. This is a huge problem that expands every day as U.S. corporations do more and more business overseas. However, to solve this problem, both political parties would have to move away from their ideological positions toward a more pragmatic middle ground that improves the current situation for U.S. companies and the U.S. Treasury.

A 17% competitiveness tax on foreign corporate income would allow U.S. multinationals to compete effectively in most—but not all—advanced industrial nations. And the U.S. Treasury would receive much more revenue from such a tax over the next ten years than it would by waiting—perhaps forever—for U.S. corporations to repatriate these foreign profits at a 35% rate. Indeed, if Congress enacted a 17% competitive tax on future foreign profits and a transitional tax on pre-2014 foreign profits—and these taxes were scored in comparison to the current reality—they could generate enough incremental tax revenue to finance a significant reduction in the 35% statutory rate for all corporate income.