Would a Territorial Tax System Squeeze IRS Coffers?

More companies would shift income abroad under proposed tax reform, although the amounts would likely be relatively modest, new research suggests.
David McCannOctober 27, 2016
Would a Territorial Tax System Squeeze IRS Coffers?

If U.S.-based multinational companies didn’t have to pay any U.S. tax on profits earned in other countries — as some current proposals advocate — how much income would such firms shift outside the United States?

Not nearly as much as you might think, according to new research.

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Offshore Banking and Tax Havens ConceptWith more than $2 trillion in foreign profits currently being held abroad by U.S. multinationals, reform of international taxation has achieved a new priority in the national political agenda. Prominent in the discussion are ideas to change the way the federal government taxes foreign earnings of these companies.

Proposals have been advanced to move from the current system, which subjects U.S. companies’ foreign profits to a steep federal levy when they are brought home (and thereby motivates multinationals to keep those earnings abroad), to a territorial system, common in the rest of the world, that taxes only income earned at home.

Such proposals raise a portentous question: To what extent would exempting foreign-earned income from the federal 35% statutory corporate tax under a territorial tax system prove a drain on much-needed tax revenues? It has been speculated that the loss to the treasury over 10 years could be as much as $500 billion, as companies shift income to lower-tax countries abroad, knowing that they will owe no federal tax on it.

Now, a paper in the current issue of The Accounting Review, an American Accounting Association journal, suggests that a territorial system may well lead to income-shifting abroad by hundreds of firms that presently are financially constrained from doing so.

However, at a time when federal budgets are in the trillions of dollars, the lost tax revenue is likely to be comparatively modest.

Scott Dyreng of Duke University and Kevin Markle of the University of Iowa analyzed the effect of financial constraints (that is, lack of readily available cash to meet domestic expenses) on income shifting by 2,058 U.S.-based multinationals from 1998 through 2011.

The professors estimated that, had a territorial system been in effect over that time instead of the so-called worldwide system, the financially constrained firms in the sample would have shifted about $80 billion more of their income out of the country. That would have increased the amount the whole sample shifted by about 8%.

Assuming that such firms paid the statutory corporate rate of 35% on that non-shifted income (which is more than the effective rate many companies actually pay), the loss to the federal treasury would have totaled $28 billion over the 14 years.

The findings reflect the fact that companies with ready access to funds to meet their expenses at home have reaped benefits from shifting income to low-tax countries, while financially constrained firms have not been able to enjoy such benefits.

Why? Because firms in the former group, not needing to tap foreign profits to meet company expenses, are free to leave that money where it is and defer the federal taxes they would have to pay if they brought the income home. The U.S. tax code permits companies to defer taxes on foreign earnings as long as that money remains abroad.

This tactic, employed by Apple, Google, Microsoft, Yahoo and others, has evoked outrage from legislators who have vowed to change the system.

In effect, Dyreng and Markle reasoned, such firms have already been operating in a territorial system, paying taxes on their domestic income but not on the profits of their foreign subsidiaries. Under a territorial system, financially constrained firms would gain the same benefit.

To gauge the effect of implementing such a system, the professors compared the difference in income-shifting of the two groups of companies over 14 years.

They employed three measures used in scholarly literature as indicative of financial constraint: a junk rating below BBB from Standard Poor’s on company bonds; a measure based on a firm’s size and age, where lower numbers are associated with less access to cash; and whether the company pays dividends. About half the sample turned out to be financially constrained by the first and third measures, and about one-third by the second measure.

Firms with junk ratings (which recent research suggests to be the most reliable measure of financial constraints, Dyreng and Markle noted) were found to shift 19.5% less of their income abroad than relatively unconstrained companies.

The authors cautioned that their estimate “ignores unanticipated behavioral responses by firms and actions taken by governments that would certainly arise with a change in the tax system.”

For example, legislators have proposed that initiation of a territorial system be accompanied by a reduction in the U.S. statutory corporate tax rate, which at 35% considerably exceeds the world average of 22.5%. Such a change could, of course, mitigate increases in outbound shifting of corporate income that the new research suggests a territorial system would occasion.

The new study, “The Effect of Financial Constraints on Income-Shifting by U.S. Multinationals,” is in the November issue of The Accounting Review, published every other month by the American Accounting Association.

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