New ‘GILTI’ tax is killing private enterprise, and it must be fixed

In March, Kansas City Southern railroad garnered attention because it likely owed an additional $25 million in taxes due to the new minimum tax on Global Intangible Low-Taxed Income (GILTI). The only problem is that Kansas City Southern did not have any of the income from trademarks and patents toward which the 10.5 percent tax was directed.

More recently Tupperware, hardly a Silicon Valley darling, filed a 10-Q that reported its effective tax rate rose from 26.2 percent in the first quarter of 2017 to 38.8 percent in the first quarter of this year, saying “The change in the rate was primarily due to the estimated impact of Global Intangible Low-taxed Income (GILTI) under the newly enacted Tax Cuts and Jobs Act” (TCJA). Given additional time for tax planning, the rate fell to 28.1 percent in the second quarter.

{mosads}A central plank of the TCJA was to improve the incentives to innovate and invest, and to make U.S.-based multinationals more internationally tax-competitive. A key part of this effort was to move toward a more territorial-based corporation tax, with minimum taxes like that on GILTI to ensure compliance. Now, however, those intentions are being violated as companies without intangible-related income are being swept up in the GILTI tax, and they are being taxed at rates above the new 21 percent statutory corporate rate. What happened?

The logic of the GILTI tax was impeccable: in those circumstances where the level of reported income was inordinately high compared to the depreciable assets that would generate income, presume this stems from geographically mobile intellectual property (IP) and levy a tax on income in excess of a normal rate of return.

But there is no actual attempt to identify income from IP or intangible sources. Instead, the GILTI tax depends on the amount by which net foreign income exceeds the specified percentage of the tax basis of tangible assets. As fate would have it, many companies (think services) do not have significant tangible assets. For others, they have already depreciated the costs of those tangible assets. In either case, the tax basis is essentially zero and all foreign income ends up in the GILTI.

Now it goes from bad to worse. Unlike conventional tax treatment, credits for foreign taxes already paid on the GILTI income are not fully available to offset the GILTI tax — only 80 percent of actual taxes paid can be used. These credits are further limited by expenses allocated to earning the foreign income, and the credits cannot be carried forward. Without those credits, the income is double-taxed and the effective rates can climb. Finally, because of limits in foreign tax credit expense allocation rules, there could be some instances where companies don’t even get to credit that 80 percent of their foreign taxes paid.

The upshot of these economic realities and the expense allocation rules is effective rates above the maximum promised (13.125 percent) and even above the U.S. statutory rate of 21 percent.

It seems like a no-brainer that one would want to fix the GILTI tax and get the policy right as the U.S. begins its transition to a new territorial corporation tax. A couple of possible routes to fixing the drafting defects present themselves. The most direct would be to simply have a “high tax exception” to GILTI tax and preclude effective tax rates above a set rate.

Alternatively, one could change the foreign tax credit regime that problematically interacts with the GILTI tax; specifically, do not allocate expenses to the GILTI income. Unfortunately, both of these solutions likely would require new legislation and the odds of a statutory fix in the near term look to be slim and none.

The Treasury, however, also has the opportunity to fix, at least in part, the drafting flaws. Treasury has begun issuing the large number of regulations needed to implement TCJA, but those on tax credits, expense allocation, and the GILTI are not yet among them. One possibility is that Treasury could modify the expense allocation rules to reduce the impact of the GILTI tax. Alternatively, it could permit companies to elect to identify ordinary foreign business income as so-called “Subpart F income.”

Subpart F existed to identify foreign income on which tax could not be deferred under the previous worldwide system. While it was immediately subject to the U.S. tax, it did permit full offset for tax credits and the carry forward of unused credits.  Allowing firms to move GILTI income to the Subpart F regime would avoid the extreme effective rates that appear to be undercutting the goals of the TCJA.

There may be other administrative solutions as well. But the least attractive option is to cement by regulatory fiat the ill-drafted mistake that is the statutory GILTI tax. Fixing the GILTI tax, it should be acknowledged, will reduce the revenue collected from the TCJA. But in the context of federal fiscal challenges, the amount is small and is outweighed by the need to get incentives right in the context of a permanent business tax reform.

Congress could fix the GILTI tax. Treasury could fix the GILTI tax.  Without question, someone needs to fix the GILTI tax.

James Carter served as a deputy assistant secretary of the Treasury and deputy undersecretary of Labor under President George W. Bush. Douglas Holtz-Eakin is president of the American Action Forum and former director of the Congressional Budget Office.