We'll each be talking for 5 minutes near the start on assigned topics, before getting to general discussion. My assigned topic is deferral. Since I talk fast, I am hoping to use my 5 minutes to say something rather like this:
If there’s one U.S. international tax rule that everyone hates, with good reason, it’s deferral. Proponents of a strong worldwide tax want to replace it with full accrual. Proponents of a more territorial system want to replace it with exemption of foreign source income.
The reason they can’t agree to get rid of it is that each side hates the other side’s proposed system even more. So deferral is the boundary line of an enforced political ceasefire in place between armed camps, like the trench lines between the German and Allied forces in World War I.
Deferral originally arose for purely formalistic reasons, via realization doctrine. If you own GE stock and GE has profits, you don’t personally have taxable income until you get dividends or sell the stock. But applying this concept to a company and its wholly-owned foreign subsidiaries is just silly.
So in 1962, when the Kennedy Administration proposed repealing deferral, U.S. companies did NOT primarily respond by making formalistic arguments, such as saying the income hasn’t been realized yet. Instead, they talked policy, saying that the U.S. tax burden on their foreign operations would be too high if we adopted a worldwide system with full accrual.
OK, what’s wrong with deferral? It’s not that it prevents U.S. companies from getting their hands on cash that they want to invest at home. I wouldn’t gratuitously insult these companies’ tax directors by falsely suggesting that they are too lame or dense to figure out how to get around the rules. But once a lot of money is nominally abroad – often, due to profit-shifting games – the tax planning games start getting costly, as Rosanne showed in a recent paper.
In practice, companies may pay less attention to the tax rule as such than to the associated accounting rule, under which all deferred U.S. taxes are a current expense unless you declare that the earnings have been permanently reinvested, in which case the deferred tax expense goes to zero.
You don’t have to know anything about accounting to see what a stupid rule this is – it’s just too discontinuous. Once companies get the PRE designation, that alone deters taxable repatriations, both to avoid an earnings hit and so the accountants won’t start questioning other claimed PRE.
While simply bad considered in itself, deferral also has important effects at two completely distinct margins. First, in practice it effectively lowers the U.S. tax burden on U.S. companies’ foreign earnings. This could be good or bad, depending on how the actual effective rate that U.S. companies face compares to the optimal effective rate, all things considered. That is an issue on which serious people disagree.
Second, deferral makes the allowance of foreign tax credits domestically tolerable, rather than intolerable. Under a worldwide / foreign tax credit system without deferral, each dollar of foreign tax liability costs domestic companies precisely zero, until the foreign tax credit limit is reached. But with deferral, U.S. companies generally are foreign tax cost-conscious – which is good, from a U.S. standpoint.
Suppose we adopted a worldwide minimum tax for U.S. companies with full foreign tax credits – unlike the recent Administration proposal, which limited them to 85%. Even if the rest of the current system remained in place, that would be like partly repealing deferral. A company that was currently paying zero worldwide would say: Hey, we might as well pay 19% to other countries and still pay zero to the U.S. Why keep on bothering with all the extra overseas tax planning if it makes no bottom line difference anyway?
At that point, you’d have to ask exactly what the U.S. had accomplished by enacting the minimum tax. Why should we be glad that other countries are getting more tax revenues from companies with U.S. shareholders?
In sum, it’s a great idea to get rid of deferral – everyone agrees. But if we do it, we have to think about 3 things. First, what should be the tax rate on foreign source income? Definitely not zero, at least not for all foreign source income. All of the major so-called territorial countries, such as Germany, the U.K. and Japan, agree. They all have anti-tax haven rules of some kind, which can cause certain foreign source income of resident companies to face a domestic tax.
Second, without deferral and without full territoriality, it’s a big mistake to offer full foreign tax credits, which would eliminate the companies’ zero foreign tax cost-consciousness in certain ranges. Now, there are ways of taxing foreign source income at a low though positive rate, and not granting full foreign tax credits, that might avoid formally violating any treaties with rules against “double taxation.”
Third, the word is deferral because taxes are just being deferred. U.S. tax liabilities have been at least hypothetically accruing, and they are even effectively accruing interest as they naturally grow over time. The most prominent Republican and Democratic international tax reform proposals that would repeal deferral both include a one-time transition tax on prior foreign earnings. These wouldn’t be unfair retroactive taxes – they’d be fair, anti-windfall taxes.
Now, we can debate how high or low the transition tax should be. But not imposing it would be a giveaway. It also would be inefficient. Companies that anticipated the giveaway would be even more anxious than under present law to avoid any taxable repatriations until the change in law occurred. So it would be desirable if both parties committed today to enacting a transition tax when and if deferral is finally repealed.