Foreign Corporate Profits and Repatriation- The Problem

Much has been written and debated about the “repatriation” of corporate profits which, depending on the source, totals somewhere between $1.3 and $2.1 TRILLION.  In a broad stroke analysis, if those profits should somehow magically be brought to the United States, it would make the Obama stimulus look like small potatoes.  Before discussing any proposal to encourage the return of those profits, you have to look at the reason why American corporations stockpile cash/profits offshore in the first place and this inevitably leads back to a perverse and complicated tax code that is neither fair, efficient, nor simple.

A lot is made of the fact that the United States has one of the highest corporate tax rates among developed countries.  This is based on the top marginal rate of 35%, but that is the top rate.  In practice, few corporations with foreign earnings actually pays the top rate of 35% since they receive a credit for taxes paid to other jurisdictions.  The United States is one of the few countries that does not use the “territorial system” of taxation which taxes a corporation’s profits only on those earned within its borders.  In reality, this system acts as a huge exemption- up to 95% of foreign earnings.  By contrast and in theory, the United States treats all corporate income as equal and one lump sum and subject to the US corporate tax.  The most radical reform would simply tax that entire sum regardless of where it was earned and regardless of what taxes were paid in the foreign country.  This type of proposal is likely to be seen from the most extreme political candidate and it is inherently unfair.

Sound tax policy with regards to corporations should be functionally neutral. That means that the tax policy and structure should not influence where a corporation operates or locates.  Obviously, the US system violates this important principle given the purported profits parked overseas.  Further, it provides no incentive for investment.  No company will invest in anything if the rate of return is less than the investment; they are in business to make a profit.  The US tax code actually creates a huge disincentive to investment, especially domestically given the high marginal rates.  The argument against this is that credits for taxes paid to foreign countries and deferral- the foreign profits are not taxed until actually repatriated- mitigate this problem, but this is obviously not true.  Otherwise, that money would be brought back to the United States and we would not be talking about $1.3-$2 trillion overseas.  Thus what often happens with deferral is that corporations use those profits to invest abroad rather than here.  The US ends up the loser in two ways: loss of any potential tax revenue and decreased domestic investment.

Some politicians have suggested a “tax holiday” whereby foreign profits would be repatriated during a certain window when they would be taxed at a considerably lower rate.  This was done in the Bush administration in 2004-2005.  Although it did swell the federal coffers by some $300 billion, it created almost no jobs and minimal domestic investment.  Many argue (probably correctly) that tax holidays only encourage further offshoring of profits as companies just wait until the next tax holiday.  These are, admittedly, short-sighted remedies.  The Bush holiday had alleged safeguards to make sure that jobs would be produced, but there were enough loopholes in the legislation so that this did not occur.  Instead, corporations paid higher dividends to stockholders when they were not using the windfall to buy back stock (and increase executive pay).  In fact, Bush’s own economic advisers deemed the program an overall failure in its goals.  Yet today organizations, led by the US Chamber of Commerce, argue that it would add over $300 billion in tax revenue and 2.9 million jobs in direct contradiction to what we know from the last tax holiday.  It may be good for Washington’s coffers and executive boardrooms, but the claims of job creation are without merit.

Instead, the root cause of the problem needs to be addressed.  Obama has proposed an international minimal tax- or a baseline standard- that has some appeal.  In such a system, a minimum tax of perhaps 18% would be established (this is below the OECD average of 22.5%).  If a US corporation paid a tax of 10% to Ireland, for example, they would be subject to an 8% tax here in the United States on foreign profits.  It has some appeal in that it is considerably lower than the current possible tax liability of 35%, would eliminate the process of deferral, and would eliminate the credit provisions which are rife with loopholes.  Although not getting the maximum added to the federal coffers, they would be getting at least something added which is better than the current system which adds nothing.  Although this appears to be a nice compromise and a slow internationally-sanctioned move to a territorial system with an international standard, it would require agreements which may prove tricky as foreign countries would move to protect their companies and their coffers.

The problem, however, is what do you do with companies that derive profits in countries with no or bare minimum corporate taxes.  Over 43% of corporate offshore profits are parked in five countries: Bermuda, Ireland, Luxembourg, the Netherlands, and Switzerland.  The Democratic Party’s solution is to create disincentives for corporations to derive and keep profits offshore.  Their solution is one of penalties which derives from their anti-corporate rhetoric.  The conservative solution is to provide incentives to bring offshore profits home- to reward domestic investment.  Unfortunately, the most extreme conservative response- the tax holiday- is only a short term “fix” and was a failure in its intended objectives the last time around.  In fact, since 2005 the practice has only increased as corporations await the next inevitable tax holiday.

Also, in many cases, again attributable to the complexity of US tax laws, many “offshore profits” are, in fact, not truly offshore.  There is no store of cash under some mattress in Ireland or Bermuda.  The offshore profits are simply profits placed on the books of offshore subsidiaries of a domestic corporation.  Take this perverse example of the US tax laws in action: a US company patents and produces software in California.  They then “sell” those patent and licensing rights to a subsidiary in Ireland.  The subsidiary then charges the California company to actually produce the software.  The California company then writes off these charges as an expense, the subsidiary takes the profit, and is taxed on the Ireland rate of only 10%.  Therefore, there must be some incentive to reduce the lure of foreign tax havens.

That lure is an overall reduced corporate tax rate.  Even the most liberal of think tanks agree that if the US corporate tax rate were seriously reduced, close to 85% of offshore profits would be repatriated.  That would be the starting point.  But what can be done about corporate behavior that is not considered “good?”  If the goal is to (1) keep profits here and tax them at a considerably lower rate, (2) create jobs, and (3) spur domestic investment while (4) increasing federal coffers, then we must learn from the past.  There must be mechanisms that discourage stock buybacks, increased stockholder dividends with the windfall, and increased executive pay.  Consider also that under existing law and all its complexity, in some years certain Fortune 500 companies paid no taxes- companies like Boeing, GE, and Verizon.  Furthermore, many companies use the cash from foreign profits as collateral to borrow from US banks.  By borrowing money to pay stockholders, they can then write off the interest on those loans as an expense.  It is estimated that American corporations are borrowing $4 for every $1 earned creating a credit market bubble.

Companies also use that borrowed money to purchase foreign companies.  For example, that is what is behind the Pfizer idea to buy the British pharmaceutical giant AstraZeneca.  They are using (1) foreign profit as collateral to (2) borrow from US banks to (3) purchase a foreign company and (4) eventually relocate their headquarters to London to (5) take advantage of Britain’s lower corporate tax rate.  The winner is American banks; the loser is the US Treasury and American workers.  That is the definition of perversion of the current tax system.

Another system is called “deemed repatriated.”  Under this system, the US would treat all corporate income and profit as repatriated regardless of whether it was or not.  Domestic profit would be taxed domestically while corporate profit derived from overseas operations would be taxed at a lower rate.  Again, this has some appeal and acts like a sort of mini-tax holiday, only on a permanent basis.  However, it does nothing to discourage offshoring profits and may only serve to increase the practice.

Given the state of the problem, it is obvious that the United States has gotten themselves into a jam through the complexity of the existing tax laws.  Some blame corporations for the state of affairs, but they are acting exactly like a company should work- maximizing profits.  The main dilemma with any corporate tax reform as it applies to offshore profits is how to encourage “good” corporate behavior.  By “good,” this writer means domestic investment and job creation.  If we believe the estimates of $2 trillion and that 85% of that would be repatriated under favorable tax conditions, then it would create a huge revenue windfall and economic stimulus.  Until needed reforms are instituted, that $2 trillion figure will continue to grow and the losers will be American workers and the US Treasury.  In part 2, there is a solution that may provide a win-win-win situation all the way around.


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