Bipartisan international tax reform should not cross red lines

The Senate Finance Committee recently released a series of bipartisan working group reports on tax reform. One of the papers, The International Tax Bipartisan Tax Working Group Report, reflected the work of a group of Senate Finance Committee members whose co-chairs are Sens. Rob Portman (R-Ohio) and Charles Schumer (D-N.Y.).

Especially with this Congress, efforts at bipartisanship should generally be applauded. Just as with international agreements, however, with respect to tax reform, it is important that critical red lines not be crossed. No deal is better than a bad deal. Furthermore, enacting international tax reform in a vacuum, i.e., without a simultaneous reduction in the overall corporate rate reduction, would open a Pandora’s box with regard to shifting jobs and income offshore.

{mosads}The Committee’s report correctly recognizes that one objective of international tax reform has to be for our tax laws not to impede the ability of U.S. multinationals to compete with foreign headquartered companies. It also properly appreciates that another goal of international tax reform is to address the lock-out effect that results in over $2 trillion of earnings of foreign subsidiaries of U.S. companies not being repatriated. Among other recommendations, the report urges tax reform that would move the country toward a hybrid territorial tax system. The report also notes the problem of inversions under the current system.

A hybrid territorial tax system was, in fact, endorsed in the Obama administration’s FY 2016 Budget Proposal, which would exempt from federal taxation most offshore corporate profits from active sources. On the other hand, the proposal also contained an immediate tax, subject to an allowance for foreign tax credits on certain foreign earnings that were not subject to a minimum foreign tax of at least 19 percent, with certain adjustments. This strategy was made in conjunction with a proposed rate reduction for C corporations from 35 percent to 28 percent for non-manufacturers and 25 percent for manufacturers. The proposal would also impose a mandatory one-time tax of 14 percent on foreign earnings of controlled foreign corporations accumulated before January 1, 2016.

Even under the current international tax system, the Internal Revenue Service has enormous difficulty policing the artificial shifting of profits from the U.S. to related foreign entities. Any international tax reform agreement should be made in a fiscally responsible manner and meaningfully address inversions. It should not provide a major incentive to shift profits or jobs overseas.

In 2004, Congress enacted the American Jobs Creation Act which included new section 965 which generally permitted U.S. multinationals to repatriate foreign earnings at a tax rate of 5.25 percent versus the normal 35 percent. It didn’t create many jobs in the U.S. and exacerbated the budget deficit. It also encouraged companies to lock-out future foreign earnings until such time as they could again successfully lobby Congress to enact a similar tax break.  This provision was a fiscally irresponsible payoff to major campaign contributors that should never be repeated in any future international tax reform agreement.

Both the minimum tax rate on future foreign earnings and any provision with respect to historical earnings should reflect a tax rate that while certainly less than the normal federal tax rate on C corporations is not inordinately lower than the rate companies face on domestic source income. Furthermore, the special treatment on existing foreign earnings should be mandatory.  If international tax reform is enacted on a piecemeal basis, as some have suggested, without including a reduction of the federal tax rate on C corporations, even the minimum tax rate contained in the Obama administration’s proposal would serve as a major impetus for U.S. companies to both move real operations offshore and artificially adjust transfer pricing to garner the significant U.S. tax advantage accorded foreign earnings. Decreasing the proposed foreign minimum tax rate further would aggravate the problem. 

Even with a hybrid territorial system, the inversion problem of U.S. incorporated companies becoming foreign will remain unless dealt with as part of any international tax reform agreement. If the inverted company continues to be managed and controlled in the U.S., the Internal Revenue Code should be revised to treat such company as a domestic corporation absent substantial business activities in the foreign country in which the entity is now organized.

Ensuring these red lines are not crossed in enacting international tax reform will undoubtedly irritate past and future campaign contributors. Those on Capitol Hill and in the Obama administration, however, should be focused on what is in the best interest of the American people.

Cohen is an associate professor of Taxation at Pace University Lubin School of Business and a retired vice president-Tax & General Tax counsel at Unilever United States, Inc. The views expressed herein do not necessarily represent those of any entity to which the author is or was associated with.