The $2 trillion in U.S. corporate cash that is held, or “trapped,” in locations overseas may be the most potent evidence for the case that the nation needs to switch to a territorial system for taxing multinational companies based here. Under the United States’ so-called worldwide tax system, U.S. MNCs face a 35% tax on cash repatriated to this country, minus credits for foreign taxes paid.
As a result, most companies have chosen to defer bringing back the cash indefinitely. If they wish, they can use it abroad for operations, mergers and acquisitions, and dividends without fear of double taxation. That’s because an overwhelming number of foreign countries employ a territorial system, under which U.S. MNCs can earn income and only be taxed on it in the country where it’s earned.
Momentum is gathering in Congress for a changeover to such a system. If the United States adopted one, U.S. MNCs would have incentives to repatriate much of that trapped cash, advocates for territoriality contend. In particular, a territorial system is seen as providing such companies with the ability to use the cash more efficiently, rather than deploying it overseas in a roundabout way simply to make use of the tax advantages.
For Dell CFO Thomas Sweet, the current worldwide system creates “restrictions and constraints about how you manage your global liquidity and how you insure that you remain compliant.” Like other large U.S.-based companies doing extensive business abroad, Dell finds itself in something of a bind, says Sweet. On one hand, the technology giant must adhere to the U.S. tax code. On the other hand, it must seek to minimize its tax costs and make the best use of its cash.
At its core, the case for switching to a territorial system is an economic one. Theoretically, if such a system were installed in this country, companies would be motivated to invest a lot more cash in their U.S. operations, thus spurring growth and creating jobs. According to a 2013 study by the Berkeley Research Group, the enactment of a territorial system would lead U.S. MNCs to repatriate about $1 trillion of their foreign earnings.
To be sure, the current system provides substantial advantages for U.S.-based global companies. Along with the ability to defer paying large amounts of U.S. tax, it provides tax credits for the foreign taxes companies pay on their offshore earnings.
Nevertheless, corporate executives have been among the biggest advocates for making the tax code territorial. One reason is the aforementioned flexibility in allocating corporate cash; another is competitiveness. Most non-U.S. companies aren’t taxed on income based abroad, meaning they have lower tax costs and hence can price their products and services lower than U.S. companies can. “What it comes down to is our ability to efficiently utilize our global footprint and to insure that our products are priced properly against the competitive benchmark of global competition,” says Sweet.
The return of the deferred cash could make U.S. products more competitive domestically, thereby increasing domestic consumption and, in turn, business growth and jobs, the reasoning for the case for territoriality goes. The Berkeley group estimates that the $1 trillion cash repatriation would spawn a one-time rise in U.S. gross domestic product by at least $208 billion (or about 1.2% of current GDP) and create at least 1.46 million new jobs in the United States.
Over the long haul, Berkeley reckons, a territorial system would increase current annual repatriations by about $114 billion, each year spurring GDP growth by at least $22 billion and the creation of at least 154,000 new U.S. jobs a year.
Armed with such forecasts, powerful Republican advocates like Senate Finance Committee chairman Orrin Hatch and House Ways and Means Committee chairman Paul Ryan are pushing for at least a “quasi-territorial” system — a system that would include safeguards against abuses that could substantially cut U.S. tax revenues.
Although the Obama administration’s tax-reform efforts have focused more on income equality for the middle class, it has shown some interest in MNC tax reform. But it may not be the kind of reform that executives and Republicans are looking for. The president’s February 2 budget proposal includes a plan to finance a $478 billion, six-year plan for fixing the nation’s roads and bridges with a “transition tax” on U.S. companies’ foreign-based income — meaning “that companies have to pay U.S. tax right now on the $2 trillion they already have overseas, rather than being able to delay paying any U.S. tax indefinitely,” according to a White House statement.
Granted, the president’s budget calls for a cut in corporate taxes from 35% to 28%, according to The New York Times. But it would also install a one-time 14% tax on all currently tax-deferred foreign income and a 19% tax on all foreign future foreign earnings, minus the taxes such companies have paid overseas. “The one-time tax would hit hardest the businesses with huge cash piles abroad like G.E. ($110 billion), Microsoft ($74 billion), Pfizer ($69 billion), and Apple ($54.4 billion),” the newspaper reported. Some observers reportedly consider the plan to be merely an opening gambit in the negotiations on overseas MNC tax reform, however.
From the Republican point of view, one of the key rallying points in the effort to make the establishment of a territorial system a major focus of tax reform is what advocates see as a fundamental unfairness to U.S. corporations. In a December 2014 report, the Republican staff of the Senate Finance Committee cited the need for parity. “Foreign companies are currently taxed by the United States only on income earned in the United States,” the staffers wrote. “As a result, foreign companies are taxed by the United States on a territorial basis.”
At the same time, “the U.S. taxes American companies on their worldwide income,” the report continued. “Taxing U.S. companies on a territorial basis would ensure that our tax system is no longer biased in favor of foreign businesses.”
Given the strong advocacy of territoriality by senior managements of MNCs and the Republican majorities in both the Senate and the House, you might think that a territorial tax system would have a better than middling chance of being enacted into law in 2015 — especially in view of the apparent willingness to negotiate on the part of the president and congressional Democrats.
But if you think so, think again. The most fundamental argument being made against territoriality is that stripping the federal government of its ability to tax foreign-based, repatriated income would severely cut government revenues. Experts call this narrowing of taxable income “base erosion,” and the Organisation for Economic Co-operation and Development has made it the centerpiece of an ambitious action plan aimed at keeping taxable income within host countries. (The United States is a member of the OECD.)
Many tax scholars have argued that if income earned in the United States is subject to a hefty corporate tax rate but offshore earnings are liable for very little or no U.S. tax, then U.S. MNCs have a motive to shift income offshore through aggressive transfer pricing, according to the Senate Finance Committee Republican staff report. In such an arrangement, a U.S.-based parent company might have a foreign-based subsidiary substantially raise the prices it charges the parent for goods or services.
If the nation moves to a territorial system, such MNCs may also shift foreign-based expenses back onshore so as to be able to deduct them at the higher U.S. tax rate. That could further erode the country’s tax base.
To guard against those maneuvers, “anti–base erosion measures would need to be enacted to protect the U.S. tax base,” the Republican finance committee staffers acknowledged. One such measure could make income earned in a low-tax foreign locale “subject to immediate U.S. tax unless significant business activity were conducted in the foreign jurisdiction.”
Hence the mixed feelings congressional Democrats are voicing about a territorial system. In a January 29 letter to Hatch, 12 prominent Democratic senators, including Ron Wyden of Wisconsin, the ranking minority member of the Senate Finance Committee, and Charles Schumer of New York, acknowledged that “there can be little debate that the current rules for taxing earned income abroad [represent] a current challenge to U.S. firms, and significant improvements can be made to put our companies on a level playing field in the global marketplace.”
But the Democrats still raise the possibility that territoriality could erode the U.S. tax base and enable U.S. companies to game the system. “The goal of any tax reform effort must be more jobs and growth here in the U.S., not more opportunities for tax planning and offshoring, either of jobs or investment,” the senators wrote.
Nevertheless, the need for a territorial system — at least one with anti-abuse provisions — seems to have attracted the broadest Washington consensus among the proposed changes in the tax law. If territoriality fails to be enacted as part of a broader tax reform measure this year, it will likely have been scuttled by other sticking points.
To put first things first, however, agreement hasn’t even been reached on whether or how corporate and individual measures should be melded in comprehensive tax reform legislation. Indeed, Republicans and Democrats “agree on the big picture that we should have low rates and somehow broaden the base and lower [government] tax expenditures to pay for that lower rate,” says John Gimigliano, head of the tax legislative group at KPMG. But that’s the easy part.
The hard part, he says, is coming to agreement on the many details on which the two parties seem far apart. A major potential stumbling block is the question of whether tax reform should focus only on issues concerning business (including the taxation of foreign-based income) or tackle corporate and individual taxation in tandem. President Obama has appeared very much in favor of the former, while prominent Republicans like Hatch have advocated the latter. (Ryan, however, has said that he would rather have business-only reform than no reform at all.)
Once the shape of the legislation has been determined, legislators will have to come together on many thorny matters only tangentially related to territoriality. Among the key differences, says Jon Traub, managing principal of Deloitte’s Washington-based national tax group, are whether tax reforms should be used to raise government revenue and whether to make the tax code more progressive.
A much bigger barrier to tax reform is the fact that 2015 is the run-up to an election year. With the Iowa presidential caucuses barely a year away, members of Congress won’t have much time to focus on weighty matters like revamping the federal tax code. “Honestly, by the time they come back from the July-August recess, they’re going to be in presidential campaign mode,” says Gimigliano. “The ability to do much becomes limited because of the politicized environment.”
The odds that broad tax reform will be enacted this year are less than 50-50, says Traub. “But it is by no means impossible for Congress to do it, even in an election year,” he adds. Maybe the battle for a territorial system will energize that effort.
David Katz is a deputy editor of CFO.
One CFO’s loophole is another’s essential tax credit.
If federal corporate income taxes were cut from their current top marginal rate of 35% to, say, 25%, U.S. multinationals would be more motivated to invest their foreign earnings here, the reasoning goes. But there’s a catch: “We’re just not going to see Congress cut the corporate rate and watch revenue decline as a result,” says Jon Traub, managing principal of Deloitte’s national tax group in Washington.
Indeed, there’s general agreement in Congress that corporate taxes can be cut only in a revenue-neutral way. “And the way to do that is to pull out — pick your euphemism — ‘loopholes,’ ‘base broadeners,’ ‘preference items’” from the tax code, says John Gimigliano, head of the tax legislative group at KPMG.
The problem then becomes: Which deductions or tax credits should be reduced? And by no means is there any consensus on that. “If you’re a relatively plain-vanilla company with not that many special deductions, you’ll do well with a rate reduction,” says Traub. “If you’re a company that depends on deductions, you may do better with the loopholes.”
Dell might be an example of the former kind of firm. Dell CFO Tom Sweet says he would take the elimination of various loopholes in exchange for a 25% top marginal rate. To be sure, the company takes advantage of the federal R&D tax credit, “which I think helps promote appropriate research and development,” says Sweet. “And whether you would consider that a loophole would be subject to interpretation by whomever you talk to.”
In sharp contrast to Dell is Nextility, a five-year-old energy technology firm. “Reducing the corporate tax [would have] a negative impact on us” because the value the company derives from the 30% federal tax credit for solar-energy projects would drop proportionately, says Joyce Ferris, the firm’s CFO.
To construct its solar-energy rooftop systems, the firm attracts investors who finance the projects and are the taxpayers on the gains of the investment. “We have to find investors that can use the tax credit as part of the return on their investment in order for the numbers to work,” she says. But if tax reform is enacted and the investors’ tax rate decreases, the 30% credit would be calculated on the basis of a lower tax bill. Thus the return on investment that Nextility could offer investors would be slashed relative to electric utilities and other energy producers that don’t have the benefit of the solar tax credit.
That means that Nextility would have to charge its customers more for installing the systems in order to keep the ROI for investors competitive, Ferris notes. “A 30% tax credit for our business is obviously really meaningful,” she says. “The interesting thing is that everybody’s got a different definition of a loophole, depending on whom it impacts.” — D.M.K.