Designing a More Competitive International Tax System

At 35 percent, the United States has one of the highest corporate tax rates in the world. For years, businesses have argued that high taxes make U.S. companies less competitive in the global marketplace. But lowering basic tax rates may be just one part of an equation that would ultimately lead to greater competitiveness, higher overall tax revenues and the holy grail of economic policy – job creation.

Critics of our current system of international corporate taxation say that it creates a disincentive for companies doing business overseas to reinvest and create jobs at home. Whereas most countries only tax earnings generated within their borders (or tax some and exclude others), the U.S. system is set up to tax all corporate earnings, including those generated offshore.

Our extra-territorial approach is moderated somewhat by foreign tax credits, which allow credit for taxes paid in other countries. Without it, U.S. companies would face double taxation. Since no one is anxious for that, domestic companies must deal with complex calculations to determine how much is taxed and by which country.

Domestic corporations can forestall paying any tax on foreign earnings through deferral, which puts off the tax on foreign earnings until they are repatriated. Many U.S. corporations do just that, leaving untaxed earnings in other countries, rather than bringing them home and reinvesting them domestically.

A number of reform scenarios are likely to be on the agenda of Congress’s Joint Select Committee on Deficit Reduction. Even though the commission’s mandate is debit reduction, few are optimistic that drastic tax reform will be one of the strategies chosen. Still, a number of options are often discussed. Individually, they do not address all of the issues of revenue and spending, but combined, they might provide a partial solution that is acceptable economically and politically.

Lower Corporate Tax Rates – Corporate rates as low as 20 percent have been suggested, but this would likely only be a first step. Foreign tax credits would still be needed to prevent double taxation. If U.S. rates remain higher than those in the country where the revenue is generated, there is still a disincentive to repatriation (although not as great as it is currently). Eliminating deferrals would force repatriation, bringing billions of taxable dollars back from foreign corporations.

Eliminating "Loopholes" – The R&D tax credit, domestic production activities deduction and others are seen by some as loopholes that allow corporations to avoid taxes that they should be paying. In fact, these are highly targeted incentives designed to encourage innovation, competitiveness and job creation. They help reduce a company’s global effective tax rates, but they do so on the way to generating economic activity and encouraging domestic innovation and competitiveness.

Territorial Tax – For simplicity, a territorial tax system can’t be beat. Profits earned within a country’s borders are taxed; profits earned outside of the country’s borders are not taxed. What’s not to like about it? Critics say that, unless U.S. multinationals are required to repatriate foreign earnings, a territorial tax encourages them to create foreign subsidiaries and move jobs outside of the United States, where tax rates are lower.

Value Added Tax – Proponents of a value added tax (VAT) say it could solve many of the government’s current deficit problems, while also allowing personal and corporate income tax rates to be dropped permanently. Basically, a value added tax is a consumption tax that functions like a sales tax, but instead of the consumer paying the tax at retail, the tax is collected at each stage of the production chain as value is added to the product. Canada, Germany, the United Kingdom and Australia are among more than 130 countries using a VAT.

Repatriation Holiday – This spring, legislation was introduced in the House that would give corporations one year to repatriate cash at substantially lower tax rates. The Freedom to Invest Act of 2011 (H.R. 1834) would provide for a 5.25 percent tax rate on repatriated earnings, instead of the 35 percent that would otherwise apply. Tax savings for U.S. companies could be in the billions, although it is not clear whether repatriated dollars would be reinvested in American jobs, as intended. The Freedom to Invest Act has been sent to committee, where its fate is unclear.

When the issue is international taxation, one thing is certain: There is no simple answer to our imposing and complex system. In the current political and economic climate, it may be more important and more difficult than ever to make substantial and permanent changes.

Contact our international tax professionals for strategies to reduce your global effective tax rate.

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