07 Apr 2008  Research & Ideas

The Debate over Taxing Foreign Profits

Corporate tax policy has suddenly become a hot topic in the U.S., including the issue of whether current tax laws encourage American firms to outsource jobs to other countries. Harvard Business School professor Mihir Desai makes a case for exempting foreign profit from taxes if proper safeguards are put in place. Key concepts include:

  • The United States is increasingly an outlier in its taxation of corporate income earned on foreign soil.
  • Critics argue the ability to defer U.S. taxation until profits are repatriated provides an incentive to ship jobs overseas.
  • On the other hand, the current worldwide system is often derided as making American firms uncompetitive relative to their foreign competition.
  • An alternative may be to exempt foreign income from taxes paired with safeguards against an overly aggressive use of tax havens.

 

Congress and the next president of the United States will be under pressure to make major changes to U.S. corporate tax policy, the consequences of which could have significant impact on profit and competitiveness of American companies on the global stage.

(Editor's note: President Obama announced a plan to curb foreign tax havens and end tax breaks for "companies that ship jobs overseas" in May, 2009.)

One heated issue is the charge that the U.S. tax code provides incentives for companies to ship jobs overseas. It's nothing new. In the 2004 presidential race, then-candidate John Kerry blasted "Benedict Arnold CEOs" for using tax advantages to do exactly that.

We asked Harvard Business School professor Mihir Desai, an expert on international and corporate finance, to guide us through the complicated U.S. tax law on foreign profits, and to explain why this system is so different from those found in other countries.

Sean Silverthorne: Why has this issue on taxing foreign profit become so central?

Mihir Desai: I think there are several reasons for these developments. First, the integrated, global nature of firm operations has increased to such a degree that it's hard to think about taxing corporations without figuring out what to do with their foreign profits. As one example, more than half of GE's assets are not in the United States now, and close to half of GE's profits are abroad as well. Foreign operations are growing very quickly and can be more profitable than domestic operations. There's also a growing awareness that not all countries tax their corporations in the same way, and that American firms have to compete with firms that face very different tax regimes, many of which also feature a much lower tax rate.

Second, Americans are coming to question whether globalization broadly and the foreign activities of American firms specifically are really fostering their welfare. As such, we've seen a dramatic increase in the importance of foreign activities, and this has given rise to increased scrutiny of how we should tax these operations.

Finally, there is a growing sense that firms are increasingly savvy with respect to tax planning and that profits are easily reallocated through the movement of intangible property or otherwise. As a result, the fairness of the overall system has come into question. When a number of firms tried to "expatriate" from the United States and reincorporate in tax havens in the Caribbean several years ago to avoid the U.S. tax system, their chief executives were labeled "Benedict Arnold CEOs." As such, this topic has evolved into quite a heated area.

Q: Rhetoric aside, how do the U.S. tax rules for corporations work? And how do U.S. rules compare to how other countries tax their corporations on foreign profits?

A: While the overall picture is somewhat complex, there are several underlying principles that help explain it.

First, every country must decide whether it wants to tax its citizens, including its corporations, on their domestic or worldwide income. The United States taxes its citizens and corporations on worldwide income. As a result, when engine maker Cummins, for example, makes profits in Germany, its subsidiary pays German taxes, and the U.S. government retains the right to tax those profits as well.

Second, when the United States imposes its taxes on Cummins's German activity, the government provides some relief for the foreign taxes paid by Cummins to avoid double taxation of overseas profits. In particular, Cummins would receive credits for foreign income taxes paid, up to the U.S. statutory rate. In effect, this means that Cummins will ultimately pay a total of the U.S. statutory rate on its overseas activities in lower tax countries and pay the local rate in higher tax countries. One way to understand this is to say that the United States tries to top up the tax bill on lower tax country profits to the U.S. statutory rate and doesn't do this for profits earned in higher tax countries. This system is known as the foreign tax credit system.

Third, the United States only imposes this additional tax on foreign profits when those profits are returned to the United States, not when those profits are earned. This resembles the treatment of capital gains for individuals where capital gains taxes are only due when gains are realized rather than when they're accrued. As with individual capital gains, there is value in this ability to defer taxes, and this effectively reduces the tax burden on foreign profits. But, to receive the benefits of deferral, Cummins must reinvest the profits in active businesses as opposed to passive portfolio assets.

Finally, a number of significant corporate expenses that Cummins undertakes in the United States and that might otherwise offset its U.S. tax liability—such as interest expenses and some HQ expense—are allocated abroad so that they cannot be used to lower the firm's U.S. taxes. Because foreign governments, unsurprisingly, don't recognize these expenses, these deductions are effectively lost to Cummins. One way to analogize this is to imagine if a fraction of your mortgage interest deduction was disallowed, and that fraction reflected the number of days you spent abroad. Such a disallowance would increase your taxes and effectively puts a tax on you going abroad.

So, in effect, the United States operates a mishmash of a system that taxes worldwide income, provides partial relief for foreign taxes paid, imposes those taxes only upon repatriation, and forces firms to allocate expenses on a worldwide basis.

The major other alternative out there is to simply exempt foreign income from taxation or, said another way, simply tax corporations on their domestic income. Interestingly, the United States is increasingly an outlier in the way it tries to tax overseas income of corporations. The United Kingdom was the only really other significant country that tried so hard to impose taxes on foreign income; it is undertaking a serious reexamination of that now.

In terms of the political debate, the ability to defer U.S. taxation until profits are repatriated is often framed as providing an incentive to ship jobs overseas. On the other hand, the current worldwide system is often derided as making American firms uncompetitive relative to their foreign competition. So, there are easy ways to take political potshots at the current system from both sides.

Q: Do any of these taxes really influence how corporations work?

A: It's now quite clear that these rules significantly influence how investors diversify their portfolios; the organizational and ownership decisions firms make; firm investment[PDF] decisions; and myriad financing decisions, including capital structure and repatriation. Perhaps, the biggest single sign of how these rules matter is the little experiment that the United States ran in 2004. As part of the American Jobs Creation Act, firms were allowed a "one-time" reduced tax on any profits repatriated back to the United States. Predictions varied at the time, but I don't think anyone expected the approximately $350 billion that was repatriated to the United States to take advantage of that incentive. This really woke people up about the importance of these rules.

Q: So, what is the right way to tax global corporations on their overseas profits?

A: Fortunately, economic theory can help us think through what the right way to do this is.

Historically, the idea was that multinational firms were looking at after-tax rates of return around the world and choosing to invest their capital eitherat home or abroad up to the point that those returns were equalized. If you believe that, economic theory tells you that a tax system should effectively neutralize tax differences around the world so that firms would make the decisions based on pretax rates of return. More specifically, the United States should, under this view, operate a worldwide system without deferral and with unlimited foreign tax credits so that, effectively, Cummins would pay the U.S. statutory rate no matter where it invested and would make the decision on purely pretax rates of return. The goal of that regime is to leave the distribution of capital undistorted. Indeed, this path of thinking has been highly influential in shaping how U.S. taxation has evolved.

Recently, the underpinnings of this historic view have been questioned. In particular, the historic view assumes that what multinational firms do is choose between investing at home and abroad and effectively arbitrage any differences in returns in the process. Scholars of multinational firms, however, don't really think about these firms in that way; that characterization would seem more apt for a hedge fund than Cummins. In reality, increased foreign activity by Cummins need not be associated with reduced domestic activity; and much of what these firms do is not to ship capital around the world but to take ownership of assets and run them more productively. If productivity differences are central to what these firms do and outbound investment does not reduce firms' domestic investment, then a completely different prescription emerges. In this case, it makes sense for countries to exempt foreign income from taxation.

The intuition for this is that tax rules should leave "who owns what" undistorted. If countries impose worldwide taxation, then the highest-productivity buyers may be handicapped by their tax systems, and the gains from having the right owner of those assets are lost. Concretely, imagine that Cummins is bidding on that operation in Germany and so is Mitsubishi. If Cummins is the higher productivity owner, it should win that auction in order to maximize social welfare. But tax systems can distort that, so Cummins might not win that auction.

In order to make sure that the highest-productivity owner wins, countries should typically adopt exemption of foreign income so that overall productivity is as high as it could be. Said another way, it may well be more important to leave who owns what undistorted rather than leaving the capital flows undistorted.

So, we're in the middle of a changing understanding of what these firms do and how they should be taxed. As I mentioned, most of the world has moved to exemption systems, which is consistent with this emphasis on ownership as being central to multinational firm activity.We've also come to understand that the current system is highly distortionary and, yet, raises very little revenue. As such, the rationale for the current rules is increasingly outdated, and the current rules don't appear to function very well.

Q: You mentioned that one critical assumption underlying the historic rationale for taxing corporations on foreign profits was that firms choose to invest either at home or abroad. Do we know if the activities abroad of U.S. firms really reduce their activities at home in the way that many people have suggested?

A: This intuition that firms substitute between domestic and foreign activity is the basis of much of tax policy and also of the rising concern over the global activities of American multinational firms. While a popular belief, it doesn't seem to hold up to closer scrutiny. Indeed, if anything, the opposite appears to be the case. Recent research indicates that firms that grow abroad are also more likely to grow domestically; this relationship is robust to a variety of alternative explanations. As such, the rationale for current tax policy might have the relationship between foreign and domestic activity exactly wrong.

Q: Will there be a significant change in these rules in the coming years? And if there is a change, what direction will it take?

A: I think there will be a change soon, but it's unclear which direction we will go in.

One possibility is that we move toward a greater tax burden on foreign operations. This could take the form of a repeal of deferral or the selective repeal of deferral with respect to a "blacklist" of countries that are deemed to be tax havens. Or we could try to define what a "patriotic" firm is and base the tax system on that. Some have even called for a system similar to what U.S. states do, which is a "formulary apportionment" system whereby profits would be allocated around the world on the basis of a formula. Any of these possibilities would likely result in a greater tax burden on foreign income.

Alternatively, we could move to where much of the rest of world is, which is effectively exempting foreign income from U.S. taxation. This could be accompanied by some bells and whistles to ensure that American firms didn't react to exemption by trying to shift profits offshore more so than they do now. Depending on these bells and whistles, this could result in an increase or decrease in the tax burden on foreign profits.

It's also possible that the entire corporate tax system should be rethought, given a variety of very serious problems associated with it—including the gap between profits reported to capital markets and tax authorities and the treatment of corporate capital gains.

Change is afoot, but the direction in which we move will be a function of the election and the prevailing sense of Americans toward globalization and the foreign activities of their firms. It should be interesting.

Q: What do you think should happen?

A: I think we should consider a broader restructuring of the corporate tax, and with respect to foreign income, we should consider exemption with some safeguards against an overly aggressive use of tax havens. I fear that alternative paths will lead to much more harm than good and won't raise much revenue, either. I'm in the middle of detailing some of these ideas for a proposal and will share them as soon as I have it fully cooked!

About the author

Sean Silverthorne is the editor of HBS Working Knowledge.

For more of Mihir Desai's research on this topic, visit his Web page: www.people.hbs.edu/mdesai. For a variety of research on these topics, he also recommends the International Tax Policy Forum.