The Trump administration and Republican congressional leadership recently released their unified framework for tax reform, which includes a proposed territorial system for taxing foreign profits of U.S. multinational corporations. Yet, the proposal does not define what it declares are necessary protections against “stopping corporations from shipping jobs and capital overseas.”
Under our current system, the United States taxes foreign profits of U.S. companies at 35 percent, if and when these profits are repatriated to the United States. Because of this deferred taxation, U.S. companies now hold more than $2.5 trillion in foreign profits abroad. These holdings are a drag on potential U.S. economic growth, because U.S. companies may not use their deferred foreign profits to build facilities or make acquisitions within our borders.
However, as the Republican proposal recognizes, a territorial system would encourage U.S. companies to ship jobs and capital to foreign countries. Under a territorial system, U.S. companies would likely double down on their current efforts to relocate their intellectual property, such as patents, copyrights and trademarks, to subsidiaries in places with no corporate taxes like Bermuda.
Similarly, under a pure territorial system, certain foreign countries would try to attract American-owned facilities by offering very low tax rates. This could quickly degenerate into a “race to the bottom.” For instance, Poland and Singapore can be expected to offer U.S. companies tax rates far below 10 percent if they locate research units there.
What could Congress do to thwart these strategies to reduce investments and jobs in the United States? Other countries have modified their territorial systems by taxing profits from their own companies if earned in tax havens without a substantial nontax business purpose. But the success of these efforts depends on semantical debates about what countries should be called tax havens and what constitutes a sufficient business purpose.
When Republican David Camp was head of the House Ways and Means Committee, he proposed taxing all profits of U.S. companies related to intellectual property at a global minimum of 15 percent of profits. This was based on concerns that intellectual property can easily be moved to jurisdictions with minimal taxes. In practice, however, identifying the actual portion of a product's profits stemming from its intellectual property would be very difficult.
A simpler and more effective approach would be for Congress to adopt a modified territorial system in which U.S. companies would generally be taxed in the country where their profits were earned. However, if U.S. companies did not pay taxes at least equal to 15 percent of their actual profits in any country, they would then owe U.S. taxes equal to the difference between 15 percent and the amount of taxes actually paid to that country without deferral. Such a modified system would strongly discourage U.S. companies from shifting capital or facilities to low tax countries.
Consider a U.S. multinational with operations in the United Kingdom taxed at 20 percent and the Cayman Islands taxed at 3 percent. Since 20 percent is larger than the 15 percent guardrail, the U.S. multinational could bring back its U.K. profits to the United States, or use these profits otherwise, without paying any U.S. corporation taxes. On the other hand, since 3 percent is 12 percentage points lower than the 15 percent guardrail, then the U.S. multinational would owe 12 percent of their Cayman profits in U.S. taxes without deferral.
The Trump administration would seem receptive to such guardrails, though the Unified Framework suggests a global rather than country by country approach. But a global approach would be inconsistent with Trump’s goal of stopping U.S. multinational from moving facilities to low tax jurisdictions. Under a global approach, for example, Google could avoid paying U.S. taxes on income from new Swiss facilities, even if taxed there at 8 percent, as long as the company earned an equal amount in France taxed there at 24 percent. The company’s global average would above the 15 percent guardrail at be 16 percent.
Of course, U.S. companies would argue that the 15 percent guardrail would subject them to unfair competition from foreign companies in countries with significant manufacturing operations like Ireland with a 12 percent corporate tax rate. Yet most territorial systems levy a 5 percent tax on their own companies when they repatriate their profits. So, for example, the effective tax rate for French companies repatriating their Irish profits to France would be 17 percent.
In short, the authors of the Republican framework are correct that a territorial system requires strong guardrails to prevent U.S. companies from shifting capital and jobs out of the United States to low tax jurisdictions. A modified territorial system would limit such shifts in an easy to administer manner, although politicians could debate whether the guardrail rate should be higher or lower than 15 percent.