Richard Rubin and Jonathan Allen at Bloomberg report that the Obama administration's budget will include a proposal to change the tax treatment of American companies' foreign profits. Were it to pass, these proposals would increase long-term tax revenue while lowering statutory rates, and also create a one-time surge in tax revenue that would finance infrastructure investments.
The plan as described has, roughly speaking, three elements:
- A one-time 14 percent tax on stockpiles of cash being held in foreign tax havens.
- A forward-looking 19 percent tax rate on foreign profits.
- New measures to discourage tax avoidance.
To understand the significance and meaning of these measures, it's useful to start with a high-level view of how the status quo works.
Current US global corporate taxation
Under current law, in theory all American companies pay a 35 percent corporate income tax rate on all of their profits regardless of where the profits are earned. Corporations get a credit for corporate income tax they pay to foreign governments.* And money earned by foreign subsidiaries is not taxed until it is transferred back to the American parent company. The United States is unusual in attempting to tax foreign profits of US-based companies, and it's not very successful at it.
Here's how it works in practice.
Companies with global operations invest heavily in legal and accounting advice that helps locate as many profits as possible in low-tax foreign countries — places like Ireland and Bermuda. A simple example is that a company can decide all its patents are owned by its Irish subsidiary. Its subsidiaries in higher-tax jurisdictions need to license the right to use those patents from the Irish subsidiary. That makes those other subsidiaries not-so-profitable and the Irish subsidiary super-profitable. Because the Irish profits would be subject to taxation if they were transferred back to the US, the profits simply aren't transferred. This is why Apple borrows money to finance payouts to shareholders, even though the company has plenty of cash.
The final phase in the plan is that companies with lots of "foreign" cash invest heavily in lobbying for a "repatriation holiday" (Barbara Boxer and Rand Paul recently proposed one) that would let them transfer the cash at a discount rate.
According to the Bloomberg reporters, Obama's plan has three elements:
A one-time tax: Obama would levy a one-time 14 percent tax on accumulated foreign cash. This is an alternative to the repatriation idea that raises revenue rather than losing it, and in this case it would be applied whether the cash is repatriated or not. It would create a one-time surge of funds that would be used for transportation infrastructure.
A new global corporate tax: Obama would also abandon the pretense that the US is going to collect a 35 percent tax rate on foreign earnings. Instead, corporations would have to pay a much lower 19 percent tax on profits earned by foreign subsidiaries. The difference is that companies would actually need to pay the tax, rather than deferring it until the money is transferred back to the American parent company.
A crackdown on tax avoidance: This new framework would still leave US-based companies with a significant incentive to transfer profits to foreign subsidiaries. That's why the proposal will also "include rules that would make it harder for U.S. companies to shift profits overseas or to change their addresses through inversion transactions." Bloomberg does not have further details on this, but the administration has some longstanding proposals about loopholes and some newer ones about tax inversions.
What to do with the revenue
These proposals would raise a significant amount of new tax revenue. The money from the one-time change is earmarked for use in new infrastructure spending. The long-term money is mostly part of Obama's plan to lower the statutory corporate tax rate to 28 percent for most companies and 25 percent for manufacturing. But rather than go for full revenue neutrality, Obama's plan is designed to raise about $250 billion in new revenue over a ten-year horizon.
Correction: The original version of this article said foreign corporate income tax is deductible from US corporate income tax, when in fact companies take a tax credit for their foreign taxes paid.