The current system for taxing foreign source income of U.S. corporations makes no sense. In theory, income earned by controlled foreign subsidiaries of American companies is taxed at the U.S. corporate rate of 35 percent; in practice, the Treasury receives no taxes on that income as long as it is held overseas. U.S. corporations now have overseas cash holdings of almost $2 trillion, which they are encouraged to deploy by acquiring companies and building facilities outside the U.S.
As an alternative, business lobbyists have advocated a so-called territorial system under which foreign source income would be taxed only in the country where it is earned. These lobbyists correctly argue that almost all advanced industrial countries now follow this system, though many don’t allow tax havens to take advantage of it.
This alternative is based on the premise that foreign source income is being taxed once somewhere, at a reasonable rate by a credible tax-enforcing government such as Germany. But this premise doesn’t apply to tax havens, like the Cayman Islands, where the tax rate is minimal, or a reasonable official rate isn’t enforced.
To reform the current system, Congress should exempt from U.S. taxes corporate income earned in foreign countries with an effective corporate tax rate of 20 percent or higher. Such earnings could be repatriated to the U.S., subject to payment of a 5 percent administrative charge. Such a fee, applied in France and other countries, would be a simple way to account for prior deductions from U.S. taxes by American corporations to generate foreign source income — for example, on salaries of U.S. executives who helped start European operations.
At the same time, Congress should end the current deferral system for foreign source income earned by U.S. corporations in countries with effective tax rates under 20 percent. Instead, that income would be taxed every year in the U.S. at a rate equal to the difference between 20 percent and the actual rate paid by the corporation in the tax haven. For example, if an American company generated $100 million of income in Bermuda, which collected $2 million in taxes on that income, the corporation would pay $18 million in U.S. taxes. And if the company repatriated that income to the U.S., it would pay the 5 percent administrative charge.
There are a few likely objections to this proposal. First, some might take issue with the 20 percent rate because it is much lower than the current 35 percent corporate rate. But few companies in the U.S. ever pay such a high rate. A recent academic study on effective corporate rates — what companies paid on average in major countries — found the average was 22.5 percent in the U.S., and 19.8 percent to 21.5 percent in large European countries. In addition, U.S. corporations never are subject to the 35 percent rate on foreign source income that is kept overseas.
Moreover, there is little merit to the argument that the difference between the 35 percent rate on domestic income and the proposed 20 percent rate on foreign income would reward U.S. companies for building facilities abroad. This incentive is much stronger under current law, which effectively subjects companies to a 0 percent tax rate on foreign source income.
Second, there is some truth to the claim that a territorial tax would encourage American companies to move income to countries such as the U.K., where they wouldn’t be subject to U.S. corporate tax. Yet even that situation would be much better than the current system, which encourages U.S. corporations to move income to countries that collect minimal corporate taxes. A company that transfers income to the U.K. will probably be taxed there at an effective rate of 20 percent or higher.
In addition, to limit the ability of U.S. multinationals to shift easily movable income from country to country, Congress should strengthen existing rules for mobile income such as investment interest or royalty fees.
Third, it would be feasible to identify countries with average effective corporate rate of 20 percent or higher — not the rate paid by the individual company. In most cases, the conclusion will be clear. Nevertheless, there will be countries with borderline tax systems that will have to be evaluated by the Treasury, which should establish a transparent determination process for country appeals.
Fourth, a scaled approach would to be devised for U.S. companies that already have located substantial facilities in countries like Ireland because of their low tax rates. Under the new system, U.S. corporate income earned in Ireland would be taxed at its local 12.5 percent rate, and would be subject to U.S. taxes at a 7.5 percent rate. This proposed approach would encourage U.S. companies to choose the location of their European operations on the basis of non-tax factors such as workforce productivity and transport links. This result would be strongly supported by our major trading partners in Europe, which have objected to Ireland’s low tax rate.
As the proposed approach is put in place, the U.S. would have to devise a transitional regime to minimize disruption. When American companies built facilities in Ireland and similar countries, they reasonably relied on the current system that allows indefinite deferral of taxation on foreign source income. Therefore, Congress should enact a transitional rule that would allow prior foreign profit of U.S. corporations to be repatriated for the next few years at a favorable rate such as 10 percent.
Fifth, the proposed system is a much better solution than granting another tax holiday to U.S. multinationals, which in 2005 were allowed to repatriate foreign profit at a tax rate below 6 percent. Such measures only encourage U.S. companies to keep their foreign profits abroad until the next tax holiday.
But we shouldn’t wait for a promised comprehensive reform of the corporate tax code to take action on foreign income. Both the Obama administration and the business community want to lower the corporate tax rate to approximately 25 percent from 35 percent on a revenue neutral-basis. However, it is unclear whether a tax-neutral package can be enacted because such a measure would require several important industries to lose their special tax benefits.
The current tax system for foreign-source income is so poorly designed that reform wouldn’t be a zero-sum game. By adopting the modified territorial approach I propose, Congress could simplify the rules and give companies more flexibility on their business decisions, and still increase the total revenue collected by the U.S. government.