A New International Tax System? Finding The Middle Ground
The Editor interviewsTimothy R. Larson,Leader of the International Tax Practice and Tax Partner-in-Charge in the New York City office of Marcum LLP.
Editor: Tell us about your professional background.
Larson: I’ve been at Marcum LLP for just over a year now. Prior to joining Marcum LLP, I spent almost 18 years at a Big Four public accounting firm, where I was a partner for five years, and then more recently at a regional firm based in New Jersey, also as a partner. During my Big Four tenure, I did step out and spend a couple of years in-house as a Director of Tax Planning for a Fortune 500 company. Throughout my career, my sweet spot of focus has been on the U.S. aspects of international taxation, especially cross-border tax planning for business entities.
Editor: Please tell us about the international taxation system the United States uses.
Larson: The U.S. currently utilizes a worldwide tax system, which means the income a U.S. company earns anywhere in the world is going to be taxed in the United States, either currently or at some future date. For a company with offshore operations, this could result in double taxation – i.e., absent a correcting mechanism, the company is taxed first in the foreign jurisdiction where the income was generated, and then it is taxed again in the United States. The foreign tax credit mechanism is intended to eliminate or mitigate this potential double taxation.
For example, assume a U.S. company is subject to a 20 percent tax rate on its foreign subsidiary earnings in Country X. In a simple scenario, the U.S. company would be subject to a 35 percent tax rate (the highest in the developed world right now) on the Country X foreign subsidiary earnings when a dividend is repatriated to the U.S. from Country X. The company would claim a foreign tax credit of the 20 percent against the 35 percent U.S. tax paid on the foreign dividend, resulting in a residual U.S. tax of 15 percent on the foreign dividend. Said differently, while the foreign dividend did not result in double taxation after taking into account the foreign tax credit, the U.S. company is subject to a residual 15 percent U.S. tax on income that was earned in Country X. This is worldwide taxation. Income earned in Country X is not only being taxed in Country X, but to the extent the tax rate in the foreign country is lower than the U.S. tax rate (which is predominantly the case), the foreign income is also ultimately taxed in the U.S. on the tax rate differential.
The question is one of timing: when is the foreign income taxed in the United States? In most cases, the residual U.S. tax is paid when the foreign company chooses to repatriate dividends to its U.S. shareholder company. Herein lies the sticking point. Many U.S. multinationals choose not to repatriate dividends from their foreign subsidiaries, and thus the U.S. does not have an opportunity to tax the foreign earnings. This concept is commonly referred to as deferral planning. The foreign earnings are essentially parked offshore because U.S. companies do not want to pay the residual U.S. tax if and when those earnings are repatriated. Public data indicates the latest estimate of total un-repatriated foreign earnings to be upwards of $2 trillion. U.S. companies are deferring this $2 trillion from U.S. taxation by choosing to keep the cash offshore. Perhaps these companies are sitting on the sidelines waiting to see how the U.S. tax system might be changed and/or overhauled, or whether another one-time tax-favored repatriation portal like the one in 2004/2005 orbits back around as a temporary fix to encourage U.S. companies to repatriate their otherwise trapped foreign earnings.
Editor: How is territorial taxation different?
Larson: A territorial tax system is quite the opposite of a worldwide tax system. To use our previous example, in a territorial system, once a U.S. company pays its 20 percent tax in Country X on its foreign earnings, it typically does not again have to pay any U.S. tax when such Country X earnings are repatriated to the United States – essentially “one and done” taxation. Foreign earnings are not taxed again in the parent home country, only the country in which the earnings are actually generated. In principle, it is (or should be) just that simple.
Editor: What would be the advantages and disadvantages of adopting a territorial tax system in the U.S.?
Larson: On the positive side, territorial taxation would greatly simplify the current web of complexity that is woven throughout our current system of international taxation. For one thing, no onerous foreign tax credit calculations would be needed. Furthermore, territorial taxation would, in principle, encourage investment in the U.S. as a result of eliminating the U.S. tax on repatriated foreign earnings. U.S. multinationals would no longer have to pay to bring overseas income home to the United States.
On the flip side of the coin, territorial taxation encourages U.S. companies to shift activities to jurisdictions with lower corporate tax rates, taking U.S. jobs and revenue along with them and consequently eroding the U.S. tax base. This is because in most foreign countries with low(er) tax rates, investing companies must have “boots on the ground” or actual “bricks and mortar” – i.e., substance – to qualify for such lower corporate tax rates. Empty shell companies do not fit the bill.
Despite the fact that the United States remains the only G-8 country with a worldwide tax system (all others have moved to territorial tax systems), the Obama administration has provided specific reasons for not supporting a territorial tax system. The administration believes that if foreign earnings of U.S. multinational corporations are not taxed at all, these firms would have even greater incentives to locate operations abroad, merge with non-U.S. companies or use accounting mechanisms to shift profits out of the United States. Moving to a territorial system would also call into question the $2 trillion of foreign income that was previously earned but not yet repatriated to the United States.
Editor: Are there any realistic solutions?
Larson: Thus far we have discussed worldwide taxation and territorial taxation. Congress recognizes there is a problem with the current system and that change is needed, but cannot agree on the remedy. Some feel that deferral should be ended immediately, once and for all, with a tax on foreign profits – e.g., 25 percent or 30 percent, the percentage varying depending on whose proposal it is. This would continue to put U.S. corporations at a competitive disadvantage with non-U.S. corporations. Others feel a pure territorial system is optimal. The likely solution lies somewhere between these two, a middle ground of sorts sometimes referred to as a “modified worldwide” system.
Thus, if there ever is a change (this notion of territorial, modified worldwide, etc. has actually been bantered around in various forums for at least a decade), it would most likely be a modified worldwide system of taxation. That is, some element of a worldwide or foreign (minimum) tax would be imposed on the foreign subsidiary income when earned, irrespective of whether it is repatriated. However, there have been several proposals as to how to complete this Rubik’s cube. Suffice it to say, in each proposal the primary focal point underpinning such a modified worldwide system is that the resulting system consequently would not (or should not) distort or skew the decision by U.S. companies of where to invest (not to mention the increased U.S. tax revenue).
Again, there still remains the issue of repatriation of the $2 trillion of foreign income that was previously earned but not yet repatriated to the United States. Some proposals would suggest that U.S. companies would pay, for example, a 20 percent tax on the unremitted foreign earnings over the course of eight years in installments. Variations on this proposal really just modify the rate of the one-time tax imposed and the period of time over which the tax can be paid.
Editor: This would not affect what they owe the foreign jurisdiction where the earnings are made, though.
Larson: Correct, there is no impact on what tax is paid to the foreign jurisdiction in these proposals. These are merely suggested remedies to cure perceived U.S. tax inefficiencies. For example, let’s assume in a modified worldwide plan that the (immediate) U.S. tax rate on current foreign subsidiary earnings under one of these proposals would be 20 percent and the foreign subsidiary is subject to a tax rate of 15 percent in Country Y. One version of such a proposal would essentially require a U.S. company to pay immediately a U.S. tax of 5 percent on the foreign subsidiary earnings. Furthermore, a U.S. company would also have to pay, likely in installments over several years, some percentage on the existing unremitted foreign subsidiary earnings. Bottom line, the deferral feature of our existing worldwide taxation system is eliminated.
Editor: Do you think that’s a reasonable solution and preferable to territorial tax in terms of protecting the U.S. tax base?
Larson: A modified worldwide system is absolutely a reasonable start to protecting the U.S. tax base, but another significant component of addressing the “right and fair” U.S. taxation of offshore earnings and any tax overhaul needed includes reducing the corporate tax rate here in the United States. To overhaul the international tax system, the U.S. corporate tax rate must be reduced. There is widespread support for reducing the 35 percent statutory tax rate, but the obvious tension and challenge to doing so is figuring out how to pay for it (i.e., other tax revenue needs to be found to essentially finance such a reduction). Just like the international tax proposals, there has been a plethora of proposals on what the “right” U.S. corporate tax rate should be.
Editor: So would intangibles play a pivotal role in any tax system?
Larson: Yes, absolutely. In every proposal I’ve read to date, intangibles are definitely considered. Congress is very much focused on the treatment of intangible income — i.e., the revenue U.S. companies generate from technology, patents, goodwill, trademarks and other nonphysical aspects of the products they sell globally. Fundamentally, the underlying issue is how corporate income should be deemed tangible or intangible for businesses that operate globally, an especially challenging question for manufactured products that have significant intangible value from the continuously evolving and ever-advancing technology that goes into making them.
Since the last major overhaul of the tax code in 1986, many foreign countries have changed their tax laws favorably as they relate to the taxation of intangible income. Thus, U.S. multinationals have become very sophisticated (or have utilized sophisticated advisors) about moving assets tax efficiently to lower-tax jurisdictions to take advantage of such tax-favored rates. For example, consider public examples such as Apple and Google, which have received unwanted attention for their sophisticated structures. At the heart of these structures are essentially shifts of certain intangible income, coupled with deferral, away from the United States tax net (thus eroding our U.S. tax base) to more tax-rate-favorable non-U.S. jurisdictions. Thus, U.S. companies have increasingly urged Congress to acknowledge that intellectual property and intangible income is now a significant part of the economy and that U.S. corporations should be encouraged (with U.S. tax incentives) to keep that money in the United States.