Author: Ryan Kenny, Associate Member, University of Cincinnati Law Review
For some time in American politics, one important issue has been domestic corporations that keep profits earned overseas in subsidiaries and other investments, rather than repatriating those profits to the United States. The Internal Revenue Code §901(a) provides that any income corporations earned outside the United States shall be credited.[1] Foreign income is not taxed until it is repatriated to the United States, meaning that it is removed from the foreign country where it was earned and brought back to the United States, and can be credited for taxes paid in the country from which the profits were earned.[2] Because the United States has one of the highest tax burdens in the world, and because our tax credit allows corporations to defer taxes until the income is repatriated, the current system incentivizes corporations to keep profits in countries with lower taxes. In 2015, United States companies had about two trillion dollars in profits in overseas markets.[3] The United States can incentivize corporations to repatriate foreign income into the United States and make the United States more competitive for business investment by reducing the corporate tax burden and introducing more elements of a territorial tax system
I. The United States Must Lower its Corporate Marginal Effective Tax Rate in Order to Incentive Corporations to Repatriate Profits
Currently, the United States has the highest statutory tax rate among other industrialized nations at thirty-five percent.[4] However, corporations rarely pay the actual statutory rate. Through tax credits, deduction, deferrals, and withholdings, corporations are able to reduce their tax burdens. The amount paid after these taxable-income reductions is called the effective tax rate: the percentage of actual tax dollars paid compared to total corporate taxable income.[5] The United States’ effective corporate tax rate was about 27.1% in 2008.[6] Because most economists agree that effective tax rates follow the trend of the statutory rate in the long term,[7] and because the statutory rate in the United States has remained relatively the same,[8] one can assume that the effective tax rate has remained relatively the same since 2008. However, the effective tax rate may not provide the entire picture on total corporate tax burden.
A. The Marginal Effective Tax Rate, Including both Federal and State Tax Burdens, Provides the True Picture of Corporate Tax Burden in the United States.
“The marginal effective tax rate measures the tax impact on capital investment as a portion of the cost of capital.”[9] The marginal effective tax rate (METR) measures not only federal income tax obligations, but also non-income-based federal taxes on capital as well as state and local taxes.[10] This includes property taxes, transaction taxes, and other taxes corporations incur in the course of operations.[11] In short, the METR considers all of the tax costs in running a corporation, this impacts the corporation’s ability to invest in new capital. Once these other taxes are considered, corporations’ tax burdens sharply increase. In 2013, the METR in the United States was 39.1%.[12] In comparison, the average Organization for Economic Cooperation and Development (OECD) METR was 25.5% in 2013.[13]
Moreover, not all industries are treated the same by the METR. The communications sector had an METR of 39.3% in 2013, while the public utilities sector was only 29.8%, nearly a ten percent difference.[14] Certain industries are unable to invest their profits in capital to expand their businesses as easily as others, as the METR between different industries can vary.[15] Due to these high corporate METR rates, the incentive is to reinvest money in a more tax-efficient manner, this may limit capital investments that create jobs.
While the federal government cannot force the states to change their tax systems, the federal government must recognize that these high taxes on profits and capital expenditures encourage corporations to keep foreign-earned profits overseas, rather than repatriate those profits back into the United States. Not only will they have to pay an effective income tax rate of about 27.1%, but corporations also have federal payroll, state, and local taxes, that increases the total amount of taxes paid. In an opinion article in Forbes, Joe Harpaz provides an example of just how costly METR effects can be. He provides a hypothetical scenario:
“Two tech companies are identical on paper . . . and both could be acquired for $1 billion. But one is in the U.S. and one [sic] is in Ireland. When considering tax leakage – the cost of taxes for repatriating the money to the U.S. to buy the U.S. firm – the added cost could be as high as $350 million to repatriate, depending on the specifics of your foreign tax credit position.”[16]
This demonstrates the why corporations would rather reinvest profits in capital overseas, rather than the United States. In 2013, S&P 500 companies had made 1,554 foreign acquisitions, with a total value of $119 billion dollars.[17] If this incentive is to be reversed, the corporate tax rate needs to be lowered to a competitive level with the rest of the OECD.
B. The Tax Repatriation Holiday of 2004 Does Not Illustrate the Benefits of Long-Term Tax Reform for Foreign-Profit Repatriation.
In 2004, as part of the American Jobs Creation Act, the federal government created an incentive system for corporations to repatriate their foreign profits.[18] This incentive became known as a tax holiday, where the government temporarily removes or decreases certain taxes to influence economic behavior.[19] This included an eighty-five percent deduction on cash dividends on foreign corporations[20] on the first five hundred million dollars on dividends repatriated.[21] The purpose of the bill was to bring in a large amount of the overseas corporate profits to fund infrastructure projects and generate jobs in the United States.[22] However, the results of the repatriation have been widely criticized as an absolute failure. The fifteen companies that benefited the most from the holiday cut more than twenty-thousand net jobs, the United States Treasury estimated that its cost would be over three billion dollars over ten years, and most of the repatriated funds were not invested in capital growth, but rather in buying back corporate stocks and increasing executive pay.[23]
As a result, some organizations argued that this tax holiday proves that lowering the corporate tax rate will not result in the economic growth.[24] Broad conclusions on lower corporate taxes should not be drawn from a single tax holiday. A tax holiday does not provide the incentive for a corporation to reinvest profits into capital expenditures or restructure its current tax system because of the holiday’s limited time of application. A tax holiday is more like a “free-for-all” incentive, where profits would are invested based on short-term financial incentives rather than a long term growth strategy. Moreover, the promise of a second repatriation tax holiday incentivizes corporations to keep investing profits overseas in anticipation of Congress enacting another tax holiday.[25] However, lowering the corporate tax rate for a long-term period would incentivize corporations to invest in long-term capital expenditures, because the tax cost of such expenditures would be more in line with what corporations pay in other countries. This may result in the type of economic growth and revenue boost that were the originally sought by the tax holiday.
A lower corporate METR that is comparable to other OECD nations’ METRs would reduce the incentive for tax-avoidance that many corporations have used. Lowering the tax obligations in the United States, would eliminate the benefits of a corporation keeping its profits in Germany or Canada. Lowering the corporate METR would only be one step in creating a tax system that rewards repatriation instead of offshoring. A more comprehensive change to how the United States taxes foreign profits will also be necessary to make the United States a competitive place for business along with the rest of the OECD.
II. Including Elements of a Territorial Tax System Will Help Ensure that Foreign Income is Not Subject to Double-Taxation.
The majority of the OECD has adopted some form of a territorial tax system. This means that “active business income earned abroad by foreign subsidiaries is wholly or partially exempt from home country tax with no credit for foreign taxes.”[26] Unlike a worldwide tax system, which is what the United States uses, there is no tax on repatriation of profits earned in another country. This is because income is only taxed where it is generated. As an analogy, if the United States adopted such a tax system and applied it to the several Fifty States, a company in Kentucky would not pay Kentucky income tax on profits it earned in Illinois. The concept remains the same in an international context. A territorial tax system removes the need for a foreign income tax credit, because rather than crediting foreign income on domestic taxes, the corporation is only taxed on profits earned in the domestic market.
A worldwide system also creates the current issue facing corporate taxes in the United States: corporations keeping profits overseas rather than repatriating them, referred to as the “‘lockout’ effect.”[27] As of 2012, twenty-eight of the thirty-four OECD member states had some form of a territorial tax system.[28] Some countries place limitations on their territorial tax system.[29] The only OECD members who still use a predominately world-wide tax system are the United States, Chile, Ireland, Israel, Republic of Korea, and Mexico.[30]
A. Territorial Tax Countries Are More Appealing to Businesses and Reduces the Incentive to Keep Foreign-Earned Profits Overseas.
Many countries have imposed a territorial tax system to appeal to businesses looking to expand internationally. For example, in 1891, New Zealand became one of the first nations to adopt a territorial tax system.[31] In 1988, New Zealand abandoned this system and implemented elements of a worldwide taxation system by taxing the income of domestic corporations’ dividends in foreign subsidiaries, along with a credit that exempted the income from taxation until it was repatriated in New Zealand.[32] Twenty years later, New Zealand reinstated its territorial tax system for domestic corporations’ subsidiaries in any foreign country. During the twenty-one-year worldwide tax program, New Zealand’s foreign direct investment[33] (FDI) as a share of its GDP only grew by seven percent, much slower than Australia (150%) and the OECD average growth (190%), both under territorial tax systems.[34]
Overall, the share of FDI has shifted from worldwide tax countries to territorial tax countries. In 1980, only 22.4% of FDI in the OECD was directed towards territorial tax countries.[35] By 2011, that number was 69.9%.[36] However, it can be inferred that a country’s appeal for investing and doing business is not only perceived by foreign corporations. Rather, the country’s competitiveness may also help draw corporate investments from domestic corporations’ subsidiaries back into the country. Canada, shortly after lowering its METR, saw an increase in its corporate profits as a share of GDP, the Tax Foundation suggests this may be due to less of an incentive to keep offshore profits.[37] Canada uses a territorial tax system, which would contribute to the increase in repatriation of foreign-earned income by Canadian companies. The current foreign income tax credit provides the greatest incentive to keep foreign profits overseas, due to its generous tax rate of zero percent. Thus, more elements of territorial taxation may incentive corporations to repatriate foreign-earned profits back into the United States.
Conclusion
The current system of taxation in the United States is the driving factor behind corporations keeping foreign profits overseas rather than repatriating the profits. In 2015, the World Economic Forum ranked the United States the third most competitive country for attracting businesses due to the high level of innovation and the large market size, but noted that the most problematic factor for businesses was high tax rates.[38]
Lowering federal levels of taxation to reduce the United States’ corporate METR is critical. This will allow corporations to direct more money in actual job-creating investments, such as capital expenditures on buildings, machinery, and inventory. Bringing the United States’ METR to the levels of OECD is one step in incentivizing corporations to repatriate their profits. However, so long as the United States has a worldwide taxation system using a foreign tax credit, making corporations’ taxes on foreign profits zero percent so long as they do not repatriate profits, there will still not be an incentive to reinvest those profits here in the United States. Rather, lower corporate METR rates along with a territorial tax system which only taxes income if it is generated in the United States will remove the most important barriers to profit repatriation for corporations.
[1] 26 U.S.C. §901(a).
[2] Thomas L. Hungerford, The Simple Fix to the Problem of How to Tax Multinational Corporations—Ending the Deferral, Economic Policy Institute (Mar. 31, 2014), https://www.epi.org/publication/how-to-tax-multinational-corporations/#_ref4.
[3] Richard Rubin, U.S. Companies Are Stashing $2.1 Trillion Overseas to Avoid Taxes, Bloomberg (Mar. 4, 2014 at 5:00 a.m.), http://www.bloomberg.com/news/articles/2015-03-04/u-s-companies-are-stashing-2-1-trillion-overseas-to-avoid-taxes.
[4] Corporate Income Tax Rate, Organization for Economic Co-Operation and Development (last visited Sept. 29, 2016), http://stats.oecd.org//Index.aspx?QueryId=58204.
[5] Michael Kitces, Understanding Marginal Tax Rate Vs. Effective Tax Rate and When to Use Each, Kitces (Jan. 30, 2013 at 1:03 p.m.), https://www.kitces.com/blog/understanding-marginal-tax-rate-vs-effective-tax-rate-and-when-to-use-each/.
[6] Jane G. Gravelle, International Corporate Tax Rate Comparisons and Policy Implications, Congressional Research Service (Jan. 6, 2014), *8, http://www.fas.org/sgp/crs/misc/R41743.pdf.
[7] Jack Mintz and Duanjie Chen, The U.S. Corporate Effective Tax Rate: Myth and the Fact, Tax Foundation (Feb. 6, 2014), *2, http://taxfoundation.org/article/us-corporate-effective-tax-rate-myth-and-fact.
[8] Historical Corporate Top Tax Rate and Bracket: 1909-2014, Tax Policy Center (Dec. 2, 2015), http://www.taxpolicycenter.org/sites/default/files/legacy/taxfacts/content/pdf/corporate_historical_bracket.pdf (citing 1909-2001: World Tax Database, Office of Tax Policy Research (downloaded on Oct. 17, 2002), http://www.wtdb.org/index.html)).
[9] Jack Mintz and Duanjie Chen, supra Note 5 at 3.
[10] Id. at 5.
[11] Id.
[12] Id. at 7.
[13] Id.
[14] Id. at 10.
[15] Id.
[16] Joe Harpaz, Does U.S. Corporate Tax Rate Incentivize Foreign Acquisitions?, Forbes (Oct. 31, 2013 at 11:35 a.m.), http://www.forbes.com/sites/joeharpaz/2013/10/31/does-u-s-corporate-tax-rate-incentivize-foreign-acquisitions/#5da426ad69e8.
[17] Id.
[18] American Jobs Creation Act of 2004 §422, Pub. L. No. 108-357 (Oct. 22, 2004) (LEXIS).
[19] Business Dictionary (accessed on Oct. 4, 2016 at 11:19 p.m.), http://www.businessdictionary.com/definition/tax-holiday.html.
[20] 26 U.S.C. §956(a) (as amended by §422 of the American Jobs Creation Act of 2004).
[21] 26 U.S.C. §(b)(1)(A).
[22] Chuck Marr and Chye-Ching Huang, Repatriation Tax Holiday Would Lose Revenue and is a Proven Policy Failure, Center on Budget and Policy Priorities (June 20, 2014), http://www.cbpp.org/research/repatriation-tax-holiday-would-lose-revenue-and-is-a-proven-policy-failure.
[23] Kristina Peterson, Report: Repatriation Tax Holiday a ‘Failed’ Policy, Wall Street Journal (Oct. 10, 2011 at 9:41 p.m.) (citing a report from the Senate Permanent Subcommittee on Investigations).
[24] Fact Sheet: Corporate Tax Rate, Americans for Tax Fairness (accessed on Sept. 27, 2016), http://www.americansfortaxfairness.org/tax-fairness-briefing-booklet/fact-sheet-corporate-tax-rates/.
[25] Chuck Marr and Chye-Ching Huang, supra Note 20, “Second Repatriation Holiday Would Be Even Costlier Mistake.”
[26] Evolution of the Territorial Tax Systems in the OECD, PricewaterhouseCoopers (Apr. 2, 2013) at *1, http://www.techceocouncil.org/clientuploads/reports/Report%20on%20Territorial%20Tax%20Systems_20130402b.pdf.
[27] Id.
[28] Id. at 3.
[29] Id. Australia, Canada, the Czech Republic, and Portugal limit their territorial tax systems to countries with whom they have treaties. Greece and Poland limit their territorial tax systems to subsidiaries in the European Union. Id.
[30] Id.
[31] Id. at 9.
[32] Id.
[33] Barry Kolodkin, What is Foreign Direct Investment?, About News (accessed on Sept. 30, 2016), http://usforeignpolicy.about.com/od/introtoforeignpolicy/a/what-is-FDI.htm (Foreign Direct Investment shows long-term investment in a market other than the investing company’s domestic market).
[34] Id. The data used was the first and last five years of the twenty-one-year period in which New Zealand had its worldwide taxation system.
[35] Id. at 15.
[36] Id.
[37] Jack Mintz and Duanjie Chen, supra Note 8 at 13.
[38] Elena Holodny, The 33 Most Competitive Countries in the World, Business Insider (Oct. 1 2015 at 9:15 a.m.), http://www.businessinsider.com/world-economic-forum-most-competitive-countries-2015-9/#33-spain-1.
