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.
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