Corporate America Desperately Craves Tax Reform. Here’s Why CEOs Are Worried It Won’t Be Everything They Want.

Wed Sep 27 2017
Mark Cooper (3143 articles)
Corporate America Desperately Craves Tax Reform. Here’s Why CEOs Are Worried It Won’t Be Everything They Want.

Corporate America has been pushing tax reform for years. Now it may be on the verge of happening—and business leaders aren’t happy about the details. Or lack of details.

Although Republicans in Congress have curbed their ambitions for corporate tax reform, party leaders are still pledging to substantially lower rates. And probably no economic proposal in years has garnered a more enthusiastic endorsement from CEOs and investors than the prospect of bringing down the federal rate—which is nominally 35%, though many companies effectively pay a much lower rate—to the Republicans’ new target range of 20%.

That’s the number unveiled on September 27 in the long-awaited framework for reform authored by the White House and its allies in Congress. Though the plan does contain some specifics, it’s extremely short on the details that will determine what companies will actually pay. And no subject is more critical to corporate America than the tax treatment of foreign earnings, an area where CEOs argue that they’re unfairly penalized versus foreign rivals. In their view, our highly excessive levies on overseas profits is the heaviest drag on the competitiveness of U.S. industry.

Put simply, America’s multinationals fret that the final rules on foreign earnings won’t deliver nearly what they need. In fact, the just-released plan is a worrisome melange. It first champions a 100% exemption from U.S. taxes for all foreign earnings “for dividends from foreign subsidiaries.” But before CEOs cheer, they should read on. That statement doesn’t mean our multinationals would pay no tax on their foreign profit–far from it. They’d face a minimum levy on their total non-U.S. earnings, a measure designed to shield the U.S. tax base, and prevent a collapse in revenues to the Treasury. If that levy that is stiff enough, it could undermine the benefits of overhauling the code on foreign profits for many companies. CEOs also fear that Congress may enact rules that rather than delivering what they want––zero US tax on overseas profits––hit key industries, notably tech, with targeted penalties that handicap them in the race against European players in the same turf.

What’s most likely to be enacted? Besides the new plan, too detail-light as yet to fully judge, two major proposals have emerged in the past three years—the first was put forth by former House Ways and Means Committee chairman Dave Camp (R-Mich.), and the second was part of President Obama’s fiscal year 2016 budget. In fact, some Democrats have embraced elements of Camp’s blueprint, and some Republicans are looking to the Obama minimum tax plan as a starting point for their proposals.

Broadly speaking, CEOs—especially those running big tech companies—detest both plans.

Their beef: Either framework would leave U.S. multinationals at a substantial disadvantage to foreign competitors benefiting from more favorable tax treatment. In their view, legislation incorporating either one would seriously undermine what they regard as an historic opportunity for boosting profits and spurring growth.

“Companies want a system that’s a lot more lenient, like the one in place for most European countries,” says Kyle Pomerleau, an economist at the conservative-leaning Tax Foundation. “If they don’t get it, they fear that Europeans and others will keep, or even increase, the edge from competition on sales of mobile phones, pharmaceuticals, and other foreign-made products outside the U.S.”

It’s remarkable that companies are so concerned, given that the U.S. is on the brink of shifting its architecture to the one that they’ve long craved, and that most of the developed world has long practiced. Today, the U.S. employs a “domestic” tax system. Under current law, all earnings that U.S.-based multinationals book abroad are subject to the U.S. corporate tax. By contrast, 29 of the 35 OEC nations deploy a “territorial” regime that exempts all, or almost all, of their companies’ overseas profits from levies at home. Companies headquartered in those nations pay tax just once—in the foreign country where they’re actually making products.

Currently, U.S. companies pay local taxes on the goods they produce in Ireland or Germany, then also cover the difference between those local levies and the U.S. corporate tax, pushing the total up to the U.S. rate of 35% (or 38.9% when state taxes are included). But, for example, a Swiss manufacturer pays only the Irish rate of 12.5% on electronics or drugs it produces there—or 22.5 percentage points less than its American rival. Since the U.S. corporate rate is the highest in the OECD, U.S. companies are paying far more taxes to make the same goods, in the same nations, as their foreign competitors.

In reality, the “effective” rate on worldwide profits for U.S. multinationals is around 28%, according to the U.S. Treasury Office of Tax Analysis, well below the statutory federal level of 35%. Big companies have many strategies for lowering their effective tax rates. But one major reason why America’s global giants pay less than the official maximum rate is precisely because such a big share of their profits remain abroad—subject in a given year only to the levies in lower-tax, foreign jurisdictions.

Besides sandbagging U.S. producers abroad, the domestic system imposes a variety of costs on our economy.

For instance, many companies have “inverted” by moving their headquarters from the U.S. to foreign nations, exclusively to escape paying towering U.S. rates on goods they manufacture in low-tax nations. The government is now missing out on tax revenue from those corporations, even though many of them maintain large operations in the U.S. and benefit from American markets and infrastructure.

Then there’s the gargantuan and growing pile of cash that’s sitting offshore. A loophole allows multinationals to defer paying taxes on overseas profits until they’re returned, or “repatriated,” those profits to the U.S. parent. As a result, $ 2.6 trillion in earnings sits parked in foreign subsidiaries, where the cash can be used to build new plants, acquire local suppliers, or otherwise enrich the host country. In recent years, as much as 40% of S&P 500’s annual earnings has remained stashed abroad.

The phenomenon is known as the “lockout effect,” and it frequently prevents U.S. capital from flowing to the most profitable places. For example, earnings from Japan or Hungary that might best be deployed building plants in America remain overseas simply to avoid the big tax hit if they’re repatriated.

Given those severe drawbacks, both Republicans and Democrats now advocate moving to a territorial system. That regime would end deferrals, the unlimited holidays for leaving earnings abroad. Hence, U.S. companies would be required to pay all corporate tax, on profits booked anywhere in the world, in the current year.

The framework from the White House and Congressional Republicans would immediately impose U.S. tax on all earnings parked abroad. But it makes a distinction between profits sitting in cash or securities, and those invested in “illiquid” assets such as factories and research labs. The former would face full taxation, meaning companies would pay the difference between the levies already imposed in the host country and the U.S. rate. Illiquid assets would be taxed at a lower rate. For both categories, companies could spread those tax payments “over several years.”

The proposal would impose a “deemed” or mandatory, repatriation of all tax-deferred profits held in foreign subsidiaries. That could produce a one-time windfall of well over $ 100 billion in tax revenue, funds that leaders of both parties have advocated deploying to rebuild America’s crumbling infrastructure.

In theory, shifting to a territorial system would erase the tax penalty on U.S. manufacturers, and greatly improve efficiency by freeing managers to make decisions based on real economics rather than taxes.

The territorial system, however, has pitfalls of its own. It furnishes an incentive to artificially shift profits to low-cost nations. Those practices can sharply erode the home nation’s tax base, and hammer its budgets.

Two techniques are especially threatening. The first: lending abuse. A multinational’s subsidiary in a low-tax nation such as Ireland or Hungary can make big loans to the U.S. parent, raising interest income where rates are low, and lifting interest expense, and hence taxes payable stateside, where rates are three-times higher. It’s all a game designed to steer taxable income away from the US. Second, companies with globe-spanning operations could lodge highly-mobile assets such as IP in low-tax jurisdictions, so that the royalties are taxed only in say, Ireland, and escape the 35% U.S. rate.

Indeed, it’s the the balance between protecting the tax base and eliminating the handicap on U.S. manufacturers that’s the big challenge. The issue centers on the treatment of “active” vs, “passive” income. Most European nations impose their domestic tax on passive foreign income from interest, rents or royalties—in other words, profits that don’t flow from making things. On the other hand, they generally exempt 100%, or nearly all, of active income from plants producing auto parts, semiconductors, drugs, or computers from all home-country taxation.

In effect, American multinationals want the same benefits. But neither of the two recent major proposals, or apparently what Congress is now considering, provide that prize. “U.S. companies don’t worry about paying U.S. taxes on passive income in places where they aren’t making things,” says Pomerleau. “What they want is a total or near total exemption on active income, for real plants that employ real people and produce products. And they’re seeing the type of proposal they would prefer, one resembling, for example, the regime in the U.K. or France.”

Under the influential Camp plan from 2014, the corporate rate would drop to 25%, not far from the current Republican goal. Companies would receive an exemption on 95% of profits repatriated from abroad––with a major exception. Multinationals would pay a 25% rate on all income from all goods using intellectual property that are produced abroad and sold in the US. That’s mobile phones, computers, and cancer drugs that are actually produced overseas in physical plants, not patents parked abroad in an island tax shelter under a nameplate that generate royalties.

That provision, known as “round-tripping,” is designed to protect the U.S. tax base by removing any incentive to make goods in Ireland, say, instead of the US just for tax avoidance. But it’s an anathema to tech and pharma. For example, a Swiss company making drugs in Ireland and selling them in the U.S., would pay only the Irish rate of 12.5%, whereas a U.S. rival would shoulder twice that burden.

The new White House-Republican leadership platform makes no mention of a special rate on IT produced abroad and sold in the U.S. The fear is that Congress will add this restriction to forestall a shrinking of our corporate tax base.

It seems surprising that the Obama plan, proposed as part of his 2016 budget, would be getting serious consideration in the Republican-controlled Congress. But its foundation as a “minimum tax” has broad appeal. The Obama blueprint, and the minimum tax concept, does not exempt active income earned abroad from U.S. tax. Instead, it imposes a minimum levy on all foreign income (whether active or passive). Under the Obama formula, companies would pay nothing extra on profits from nations such as Germany, where taxes are already high.

The rub is that they’d take a big additional hit on profits from low-tax nations. A drugmaker in Ireland would pay the usual 12.5% local tax. But since the effective minimum tax is around 21%, it would hand an extra 8%-plus to the U.S. Treasury. Once again, the U.S. manufacturer would face far higher total costs than a Swiss rival making the same drug in Ireland and paying Irish taxes only. Unlike the Camp plan, the minimum tax system wouldn’t just apply to tech or pharma products shipped to the US, but those sold all over the world.

“The minimum tax would actually make many pharma and tech companies pay higher taxes on foreign-made goods than they pay today,” says Pomerleau. The reason is that multinationals now have the option of leaving capital abroad, tax free, for decades, so that the present value of the taxes they’ll eventually pay when and if they repatriate those long-ago profits is small.

The new framework indeed advocates a minimum tax, but states only that it would carry a “reduced rate,” without citing a number. So it’s uncertain whether U.S. multinationals in the future will get sandbagged by a base levy that’s higher than the low local taxes their competitors enjoy.

Although business leaders laud the ideal of tax reform, the proposals now under consideration don’t nearly deliver what they’re seeking: A regime that puts U.S. companies on an equal footing with foreign rivals. They’ll lobby hard to obtain the same advantages enjoyed by their European competitors. But in this era of big and growing deficits, politicians will resist reforms that shrink America’s tax base and threaten to swell the looming shortfalls.

Indeed, the benefits of corporate tax reform, if it happens at all, could prove far weaker than the radical overhaul the Trump Administration has advertised, and businesses have long craved.

Mark Cooper

Mark Cooper

Mark Cooper is Political / Stock Market Correspondent. He has been covering Global Stock Markets for more than 6 years.