25/10/17

Want To Cut The Cost Of Tax Reform? Don't Reward Companies That Shifted Profits Offshore

(Forbes) -- There’s a major disconnect between the rhetoric and anger expressed by politicians, the media, and taxpayers about companies that shift profits offshore and the gift to these same companies that Congress expects to include as a part of the tax reform it is fashioning with the help of President Donald Trump's Administration.

Last month, Lee Sheppard explained on Forbes how companies holding offshore earnings (believed to be approaching $3 trillion) would get a tax reduction under a deemed repatriation of these offshore earnings. She described briefly the format that has been proposed in various iterations by both political parties, noting that “a much lower rate than the prevailing rate or the new rate” would apply to some offshore earnings while “a higher rate” would apply to offshore earnings held as cash.

The table below gives a sense of what this tax reduction might mean. It assumes a company having $200 billion of offshore earnings that have not been subjected to tax by any country and where the U.S. parent has no available foreign tax credits. It also assumes that half of that $200 billion is held in cash.  If the U.S. parent received that $200 billion as a dividend today (instead of leaving it within its foreign subsidiaries), the tax payable would be $70 billion based on the present 35% U.S. tax rate.  But just $12 billion in tax would be payable under the deemed repatriation using the tax rates proposed in the June 2016 Republican Blueprint ---8.75% on earnings held in cash or cash equivalents and 3.5% on the remainder.

Tax on Offshore Earnings 

Source: Forbes 

However, since it’s difficult to pay a real dividend out of offshore earnings that have been reinvested in hard assets like inventory and plant and equipment, let’s just focus on the $100 billion of cash or cash equivalents. We should make our comparison a fair one. Here, the table shows that the tax reduction from the 8.75% rate instead of the normal 35% rate would be about $26 billion. That’s not merely a significant tax savings; it’s a real gift.

A virtually always unstated, but critically important point is that much of these trillions of foreign earnings held in cash result directly from the artificial profit-shifting schemes that have been so much in the news over the past several years.

When instituted, these schemes, often using tax havens, are based on intercompany contractual arrangements and involve few if any meaningful changes to a company’s business model or operations. Such companies invest little or no money and add few employees in the locations where they purport to earn significant profits. Without these schemes, much of these trillions would have been currently taxable at 35% in the U.S. Many politicians, including for example, Senator John McCain, have been very vocal about the use of these artificial schemes to accumulate cash overseas.  (For example, in his opening statement at the 2013 hearings on Apple Inc.'s offshore tax avoidance he said: “It is completely outrageous that Apple has not only dodged full payment of U.S. taxes, but it has managed to evade paying taxes around the world through its convoluted and pernicious strategies.”)

The point here, of course, is that what Sheppard described will blatantly reward those companies that have been most aggressive in shifting profits and in retaining those profits as cash balances within their foreign subsidiaries.

It is very reasonable that upon a change to a new taxation system (whether it be a territorial system or some other approach) that Congress could choose to apply some low favorable tax rate to earnings legitimately earned through actual value-adding foreign operations. However, such a favorable rate should not be applied to overseas earnings that result not from real value-adding foreign operations, but rather principally from artificial schemes that have shifted profits into tax havens. These artificially transferred earnings should have been taxed at 35% when originally earned. It is inconceivable that we should now reward these companies with any rate below 35% on such earnings.

To summarize, these companies, through artificial means, paid no U.S. tax when the profits were earned; now the tax reform proposals would apply a favorable low rate such as the above-mentioned 8.75% and simply reward these companies’ aggressive behavior.

Congress is now looking for the additional revenues necessary to fund tax reform. House Ways and Means Committee Chair Kevin Brady, R-Texas, is reported to have said on August 23rd that “we’re scrubbing the business side of the tax code”. Clearly, the need for additional revenues and the political and public anger over aggressive profit shifting makes this the time to re-examine the taxation of offshore earnings.

The amounts are not small. With overseas profits reportedly approaching $3 trillion, appropriately taxing shifted profits would surely raise many hundreds of billions in additional revenue---much more than the paltry $200 billion of additional revenue mentioned in Sheppard’s article.

How can this be implemented? What is needed is an administratively workable mechanism that separates the legitimate overseas earnings from those that result from artificial profit-shifting schemes. The legitimate earnings would receive whatever favorable low tax rate that Congress decides upon. The artificially shifted earnings would be taxable at 35%.

There are two such administratively workable mechanisms that Congress could evaluate. One is the approach used in the Republican Blueprint, which separates earnings based on whether or not they are held as cash or cash equivalents. If held in cash, then the 35% would apply (with a reduction for foreign taxes paid).

The other approach is to provide an objective bright-line definition for a “tax-structured vehicle”, all earnings of which would be subject to the 35% rate. The objective definition would likely include all foreign subsidiaries established in certain countries often used as tax havens. The presumption of this objective definition would be rebuttable, based on evidence that could be presented to the Secretary of the Treasury.  (You can read more detail on this proposal here and here.)

Tax reform and finding the revenue to implement it are now on everyone’s mind. Now is the time for Congress to seriously focus on whether they want to discourage artificial profit shifting and secure a major revenue source.