Yesterday, we had our Week 4 session at the Colloquium, featuring Eric Toder’s Lessons the United States Can Learn From Other Countries’Territorial Systems for Taxing Income of Multinational Corporations (co-authored by Rosanne Altshuler and Stephen Shay). The following is an expanded version of a much shorter outline that I prepared to guide my portion of the discussion.
1. International tax policy at a crossroads
(a) International tax policy is arguably at a crossroads. It has been there for a while, and may stay there for a while. But changes on the ground have important implications for current regime’s workability. This comes from 2 related but distinct types of changes: rising actual global capital mobility, and advances in tax planning technology that create greater mobility for reported income, even if just from paper-shuffling. The latter reflects not just ongoing innovation by tax planners, but also rule changes – e.g., U.S. adoption of check-the-box rules and these rules’ disregard of transparent single-owner entities (leading to the effective quasi-repeal of our CFC rules). All this has fueled the newspaper headlines we see about Apple, Google, GE, corporate inversions, etc. It also has influenced the U.K. & Japan to change their international tax systems in ways that have been described as replacing “worldwide” systems with “territorial” ones.
(b) Many argue that the U.S. should do this too. But there has also been pushback, as per calls in the U.S. for tougher rules and the OECD BEPS initiative. Overall, our options could be classified as “retreat” versus “advance” versus “do something different entirely” (such as replacing the corporate income tax, and/or the entire U.S. tax system, with something very different – there are several alternatives that would eliminate the current dilemmas of international tax policy, which rest on the problems associated with entity-level income taxation).
(c) The paper’s main takeaways are twofold. First, the “worldwide vs. territorial” framework is not a useful way of describing our choices. Second, a simplistic narrative holding that the U.S. must become territorial because otherwise we will be “out-of-step” is wrong on two grounds: in some respects we aren’t actually that out-of-step, and neither Japan’s nor the U.K.’s reasons for adopting changes apply to us.
2. What’s wrong with the “worldwide versus territorial” framework?
(a) As I discuss at length in my 2014 book, Fixing U.S. International Taxation, this is not a well-posed choice, because it conflates 2 distinct margins. The first is what tax rate a given country applies to resident companies’ foreign source income (FSI). The second is what marginal reimbursement rate (MRR) the country offers with respect to resident companies’ foreign income tax liabilities.
(b) Statutory tax rate on FSI: It’s often assumed that this must either be the same as the domestic rate (under “worldwide”) or else zero (under “territorial”). Refreshingly widening the options, however, the Obama Administration recently proposed a 19% tax rate on resident companies’ FSI.
(c) MRR: In a worldwide system without foreign tax credit limits and without deferral (which I discuss below) the MRR is 100%, thus completely eliminating resident companies’ foreign tax cost-consciousness. A territorial or exemption system provides implicit deductibility of foreign taxes, in that the MRR equals the marginal tax rate or MTR, inducing resident companies to seek to maximize after-foreign-tax foreign income.
(d) In Fixing, I argue that, assuming our distortionary system for taxing business income will generally remain in place, an intermediate tax rate on FSI (i.e., between zero and the full domestic rate) is likely to be optimal if we have some market power over corporate residence. The MRR should equal the MTR – the deductibility result – if (i) there is no reciprocity (e.g., we aren’t agreeing with other countries to credit each other’s taxes – and we aren’t if they are generally territorial AND (ii) there are no other issues to consider here. As I discuss below, it’s plausible that there are other issues, supporting better-than-deductible (albeit worse-than-creditable) treatment for foreign taxes in the tax that the MRR should actually exceed the MTR, at least in certain settings. But even so, the MRR shouldn’t be 100%. When I wrote Fixing, I was concerned that this might require violating bilateral tax treaties (which address “double taxation”), albeit not actually to the disadvantage of other countries, relative to treaty-compliant things that we could do. But since then, both the Baucus staff tax reform plan and the recent Obama Administration budget proposal have shown how one might be able to combine an intermediate rate for FSI with an intermediate MRR, without formally violating the anti-“double tax” requirement of our tax treaties.
(e) Toder et al Case Study, point 1: So-called “territorial” countries do indeed tax certain FSI of their corporate residents, in particular if it is passive income or associated with tax havens. (These are effectively the same thing, as passive income tends to show up in tax havens.) Such countries may also have tougher rules for the U.S. for defining domestic source income. In practice, this can have very similar effects to taxing FSI that shows up in tax havens, especially if the tougher source rules apply distinctively to resident companies.
(f) Toder et al Case Study, point 2: Widespread anti-tax haven rules, yielding a positive tax rate on certain FSI of resident companies, effectively extend better-than-deductible treatment to foreign tax liability. After all, a company that reduces its foreign tax liabilities by shifting income to tax havens ends up paying more domestic tax, effectively causing the extra foreign taxes that one pays by reason of not going to tax havens (and thus not incurring domestic tax liability) to be better-than-deductible at the margin.
(a) As is well known, deferral for FSI that is earned through one’s CFCs does not lower the present value of the deferred taxes under new view assumptions, which are twofold: (i) there is permanently fixed repatriation tax rate that will be paid at some point, (ii) convergence of all the after-tax rates of return one might earn, even with different source-based tax rates. But the first of these assumptions clearly does not hold in practice, and the second may not either.
(b) Under new view assumptions plus a couple of extra ones (including the inapplicability of foreign tax credit limits), deferral does not reduce the 100% MRR that a “worldwide” system offers via foreign tax credits. However, once we recognize that the new view assumptions do not generally hold in practice, deferral may and does lower effective MRRs, pushing towards (and possibly even all the way to) a deductibility result.
(c) For this reason, repealing or reducing deferral in favor of a more accrual-style worldwide system requires rethinking foreign tax credits. The Obama Administration apparently recognized this. Their 19 percent “minimum tax” proposal would have led U.S. companies to face zero after-tax cost from increasing their foreign tax liabilities, say, from 0 percent to 19 percent of FSI, if not for the fact that the proposal offers what are only, in effect, 85 percent foreign tax credits (i.e., a dollar of foreign tax liability effectively reduces one’s U.S. tax liability, within the range of potential application, by only 85 cents).
(c) Toder et al Case Study, point 1: Why did the U.K. & Japan even bother to go territorial? After all, their deferral rules were so weak – since the domestic parent could borrow from CFCs without its being treated as a taxable repatriation – that it is unclear why the companies even cared. I think an important part of the answer is that making the systems (more) territorial served as protection against possible tightening of the existing rules.
(d) Toder et al Case Study, point 2: As noted in the paper, the burden of avoiding the repatriation tax is much higher for U.S. firms than it was for U.K. and Japanese firms, recently estimated as akin to a 7% tax rate albeit taking the form of deadweight loss rather than U.S. revenue-raising. This helps to explain U.S. inversions and support for territoriality? Is this a helpful “friction” in any way? The “yes” argument would hold that it deters U.S. companies from engaging in even more profit-shifting to the detriment of the U.S. domestic tax base.
(e) The fact that U.S. companies have deferred tax on more than $2 trillion of foreign earnings provides strong grounds in favor of enacting a “transition tax” if the repatriation tax is eliminated, whether by a shift towards territoriality or an accrual-based worldwide system. There is some bipartisan support for this. For example, both the Camp plan and the Obama Administration’s budget proposals provide transition taxes, although the latter has a higher rate than the former.
4. The paper’s response to claims that the U.S. is “out-of-step” unless it adopts a territorial system
(a) Despite our system’s distinctive (and often ill-chosen) features, we are not out-of-step if “territorial” countries are actually similar. Apparently, one thing that German CFOs and company tax directors have in common with their American counterparts is that each group is convinced that its home country international tax system is the more rigorous of the two, thus placing their companies at a competitive disadvantage relative to the other country’s companies.
(b) Japan and the U.K. don’t offer us much in the way of relevant lessons. Japan’s system appears to operate very differently than ours – for example, the companies are far less willing to engage in aggressive tax planning. It’s very plausible that this has less to do with cultural differences (other than peer pressure that can support either equilibrium) than with Japanese firms’ having more reason to want to please government counter-parties, and also facing worse prospects if they try litigation. Also, the Japanese government seems to have thought that formally eliminating the already trivial repatriation tax would help counter economic stagnation and recession. This was not convincing as a matter of economic theory – especially given how easy it was to repatriate funds tax-free. As for the U.K., its being a small island nation and one that was severely constrained by the European Court of Justice put it under pressures that the U.S. does not currently face to the same degree.
(c) Admittedly, one can’t do a case study of the future. The paper agrees that competitive pressures on the ability of the U.S. to depart from international norms (insofar as it is even doing so) seem likely to increase over time.
(a) Ought we to broaden the menu of choices? Australia’s full-imputation approach to shareholder-level taxation, the Toder-Viard plan to replace the corporate income tax with a shareholder-level mark-to-market tax, the Auerbach plan to replace the corporate income tax with a destination-based VAT-style approach, and progressive consumption tax models such as the X-tax, would eliminate certain of the dilemmas that one inevitably faces when engaged in entity-level corporate income taxation.
(b) Assuming that we retain entity-level corporate income taxation , I would say that the approach I advocated in Fixing – involving an intermediate tax rate on FSI, an intermediate MRR, and the repeal of deferral – is looking pretty good, and has been gaining support, as reflected by the embrace of all three of these concepts in recent proposals by the Senate Finance Committee majority staff (under Senator Baucus) and the Obama Administration.