A Clarification on “Unrepatriated Earnings” and Uncompetitive U.S. Tax Policy
Already uncompetitive.... and soon to worsen?
A couple of days ago, I pounded out a late-evening diatribe, complaining about the oddities in how U.S. tax law handles the repatriation (or lack thereof) of profits earned outside the country by U.S.-based corporations – and how these odd policies are hobbling U.S-based corporations…. and how the effort to make this mess even worse would increase the problems even further.
There were no problems here, but when others cited it elsewhere, it was quickly noted that I had missed something (oops) and this caused a problem. Yeah, I botched the job a bit.
I’ll plead fatigue, anger, …. and the “misfortune” of dealing almost exclusively with low-tax overseas jurisdictions.
But the key point is that the core contention of that Tuesday post stands unchanged. Both quantitative and procedural aspects of the U.S. system for taxing corporate profits are putting U.S.-based corporations at a serious disadvantage. And worse, it seems that pigheaded, purely-ideologically-motivated changes being bruited in Washington (in the interest of “fairness”) will, if implemented, make the situation even worse.
So, let’s walk through this again, get the mechanics right…. and note with a little more care the points-of-contact that seem likely to be exploited by the suddenly-resurgent zombie-progressive demagogues….
More below the fold….
Let’s walk through the basics from scratch.
If you are a corporation that does business in multiple nations, there is a simple up-front way that corporate taxation is handled. You do business in country-A, you make a profit there, and you pay the corporate tax on those profits earned in country-A to the revenue authorities of the government of country-A at the rate specified by the laws of country-A.
Those profits having been taxed in country-A, you can then bring those after-tax profits back home to your “base” country – and since those profits were earned in country-A and were taxed in country-A, your home country doesn’t further tax them.
That’s the case for every major industrialized nation (and then some) – except for one.
The United States of America.
If you repatriate those after-tax profits from country-A back to the United States, unlike the case for those based in our jurisdictional competitors, you are required to pay the full U.S. corporate tax on the pre-tax (not after-country-A-tax) profits. The U.S. corporate tax rate is an uncompetitively-high 35%, so you get hit with that on top of the tax you already paid to country-A.
In compensation, U.S. tax law includes a provision for a “foreign tax credit” when this kind of double-taxation occurs. What does that do?
This was briefly an issue back during the 2004 election, and there was a Wall Street Journal editorial about this topic – which was quoted here, from which I’ll quote the original:
A company earns $100 million abroad in Lowtaxistan where the corporate tax rate is 20%. The foreign subsidiary pays that money to the U.S. parent. The parent then pays $35 million to the U.S. government and takes a credit for the 20% (or $20 million) payment to the Lowtaxistan government. So the net to the U.S. Internal Revenue Service is $15 million.
So of your $100 million profit in “Lowtaxistan,” you pay $20 million to the tax authorities there, you bring $80 million home to the U.S.; you have to pay the U.S. corporate rate of 35% on the pre-tax $100 million (not the after-tax $80 million), for a total corporate tax of $55 million (or a staggering 55%). But you also are allowed a foreign tax credit; that lets you “get back” the equivalent of the tax you paid to the authorities in “Lowtaxistan” – basically, $20 million. So of the $100 million you made as a profit in “Lowtaxistan,” “Lowtaxistan” gets $20 million (20%) in corporate tax and the IRS gets $15 million (15%). Your total effective tax rate is basically forced to end up being the overall U.S. rate of 35%.
Now, suppose you are a corporation based in “Lowtaxistan.” If you make a $100 million profit in the U.S., you pay the IRS the U.S. corporate tax rate of 35% ($35 million), you bring the money home to “Lowtaxistan” and pay no local corporate tax on the $65 million – for an effective rate of 35% as well.
Is this a “level playing field?” Only if we’re comparing things as per the above.
For a U.S. corporation making widgets in either the U.S. or “Lowtaxistan,” your total corporate tax rate comes out to 35%. However, if you are a “Lowtaxistan” corporation making widgets at home in “Lowtaxistan,” your total corporate tax rate is only 20%. In running the exact same business, the U.S. corporation is placed at a significant disadvantage – solely because of the oddball U.S. practice of double-taxing out-of-country profits.
Now, to date there has been one way for a U.S.-based corporation to avoid the extra penalty of the U.S. double-taxation scheme. Instead of bringing home your after-tax profits from “Lowtaxistan,” you simply leave them outside the country.
As that quoted Wall Street Journal piece puts it,
These are called “unrepatriated earnings” and they are increasingly commonplace.
This is the so-called “loophole” available via “unrepatriated earnings”….
But here’s how it works with the loophole: The U.S. subsidiary simply keeps the money offshore and certifies to its accountants that the money is invested overseas. It never remits the money to the parent and so never pays the $15 million extra to Uncle Sam.
I hate to call this a “loophole” (since that word has sinister connotations) – it’s basically another “adjustment” to the system to try to keep U.S. corporations from being hobbled into uncompetitiveness.
The upside is that it indeed helps U.S.-based corporations to remain competitive. One item you always see reported on corporate balance sheets is the “effective corporate tax rate” – and, obviously, the lower you can make this, the better. If you are a U.S.-based corporation paying only U.S. corporate income tax, your ECTR is 35%. If you bring overseas profits home and jump through all the hoops, your ECTR is…. 35%. However, if you leave your after-tax profits from “Lowtaxistan” outside the country (and thus only pay 20% of that money), you are lowering your ECTR nicely. As this gent noted as an example, General Electric (GE) was able, in 2003, to achieve an ECTR of 21.7%. Being less than 35% this leaves more money available for things like covering the shareholder dividend payments and…. investing in new capacity.
But on that score…. the downside is that by basically forcing U.S.-based corporations to keep their overseas profits outside the country, those profits are invested overseas – doing the good things investment does…. there rather than here.
“As of December 31, 2003, we have not made a U.S. tax provision on approximately $38 billion of unremitted earnings of our international subsidiaries. These earnings are expected, for the most part, to be reinvested overseas….”
Now, if we look at the “exploitable” (by bad people) political liabilities in this, there are a couple of note.
First, the way the U.S. corporate tax on repatriated profits is handled – as noted above – involves paying the full 35% on the overseas pre-tax profits, and then getting a tax-credit “back” to offset the foreign tax payment (to bring the total net tax to an overall 35% – preventing the double-taxation of both “Lowtaxistan” and the U.S. from ganging-up to a mind-boggling 55%). According to the IRS, in 2005 the disbursements of the foreign tax “credit” amounted to some $90 billion. Well, you can see what can happen with this arrangement – that’s pollen for the usual demagogues who want to rail against a “$90 billion giveaway to big rich corporations” and demand that it be stopped. That would take the already-goofy U.S. double-taxation to its maximum level of pain – making being a U.S.-based corporation a pure cost with no tangible benefit.
Second, the characterization of the non-taxation of overseas profits left overseas as a “loophole” (when it’s actually – like the foreign tax credit – an ex post facto attempt to patch things up a bit to keep U.S.-based corporations from becoming completely uncompetitive) just sets things up as being (to a demagogue) a special favor that was wrongly granted and that should be withdrawn. (Looking through the 2004 campaign rhetoric from Senator Kerry, it appears that he started down this road and then thought better of it.) The problem is the same here – forcing the double-shuffle that leads to a total 35% rate on your profits (even if they are now not repatriated) makes you much less competitive vs. your non-U.S.-based competition. It also makes being a U.S.-based corporation a pure cost with no benefit.
As noted on Tuesday, things are bad now – and things like the above would only serve to make them worse. With being a U.S.-based corporation amounting to just a pure cost, these changes would basically make it untenable to remain a U.S.-based corporation. If you run the business globally, you are faced with a 20% rate if you are based in “Lowtaxistan” vs. a 35% rate if you are based in the U.S. Go have a chat with your board – it makes absolutely no business sense to remain based in the U.S., and a great deal of sense to re-base yourself in “Lowtaxistan” – or someplace even better.
Given the uncompetitively-high U.S. corporate tax rate and this uniquely-awful double-taxation on repatriated profits, the way to fix this is obvious. The U.S. corporate tax rate simply needs to be reduced to make the U.S. more competitive, and this awful double-taxation nonsense needs to end. The present system (and its possible even-worse versions as per the above) serves chiefly to drive foreign investment to other jurisdictions, induce American corporations to invest outside the country (putting the jobs and other benefits outside the country as well), and even force U.S.-based corporations to re-base themselves in other jurisdictions in order to be competitive and do what’s best for the business.
Things are already bad; adjusting things to make them worse – as noted Tuesday – is indeed “A plan of breathtaking stupidity”….
Now, to close, one final note about the present system of double-taxation and foreign-tax-crediting of overseas profits. One odd aspect is that the seeming object of the game of present U.S. corporate tax law is to force your corporate tax rate to be 35% – if you pay a foreign corporate profits tax, you get a “deduction” back that is intended to bring the effective rate to 35%.
The odd thing about this is that…. as a U.S.-based corporation, if you want to repatriate overseas profits, you take a nastier effective hit in proportion to the degree of low taxation of any particular foreign jurisdiction.
Let’s explain by example. “Lowtaxistan” has a 20% rate; ergo, your de facto penalty for repatriating profits from “Lowtaxistan” is a 15% hit.
But let’s go back to the real world. You all know that I love the business climate of Estonia – by lots of direct exposure and for obvious reasons. The corporate tax rate in Estonia is…. 0%. If you don’t believe me, let’s look here:
Reinvested profit is not subjected to Corporate Income Tax (dividends paid to resident legal persons are exempt from tax). Companies are subjected to Corporate Income Tax 21/79 if the profit will be distributed.
Now, things are a bit more complicated than what follows (if you can stand it, go paddle around in this), but we can get the gist.
If I have profits in Estonia and I re-invest the profits there, the ECTR is 0%.
If I repatriate the profits to the U.S., because there was no corporate tax paid to Estonia to qualify for the “foreign tax credit” I get hit for the full 35% U.S. rate – period.
If the “loophole” of leaving those profits in Estonia (rather than repatriating them) is “closed,” I’m getting hit with a 35% “fee” just for being a U.S.-based corporation.
If the “loophole” is closed, the only way to get away from that fee for the “privilege” of being a U.S.-based corporation is simply to take the enterprise itself out of the country – to Bermuda, or the Cayman Islands, or…. Estonia.
The caveat (as per the above) is that if you start to slip into international tax treaties, things get complicated and “conditionalized” very quickly.
But the key point still stands – some of the ideas being bruited these days in Washington will make a bad situation even worse, and will be in fact be a very large prod to get American corporations to leave the country and be based in more “friendly” jurisdictions.
Talk to your board; they’ll get the gist of this quickly….